**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-Q**

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

**Forthe quarterly period ended: March 31, 2007**

**OR**

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

**Forthe transition periodfrom                  to**

**Commission file number001-32542**

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**KKR FINANCIAL CORP.**

(Exact name of registrantas specified in its governing instruments)

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

 

**(415) 315-3620**

Registrant’s telephone number, including area code

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Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding12 months and (2) has been subject to such filing requirements forthe past 90 days. Yes x   No o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act. (Check one):

| Large accelerated filer x |   | Accelerated  filer o |   | Non-accelerated  filer o |
|--------------------------------|--------|---------------------------|--------|-------------------------------|

 

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

Thenumber of shares of the registrant’s common stock outstanding as of May 1, 2007was 80,464,713.

 

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**TABLE OF 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  1A.              | Risk  Factors                                                                               |
| 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. Financial Statements(Unaudited)**

**KKRFinancial Corp. and SubsidiariesCondensed Consolidated Balance Sheets(Unaudited)(Amounts in thousands, except share information)**
| ** **                                                                                                                                                                                                           | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                                           |       |                     |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                                           |       | $                        | 3,296      |                        | $          | 5,125 |   |
| Restricted cash and  cash equivalents                                                                                                                                                                                |       | 291,117                  |       | 138,065                     |       |
| Trading securities,  $6,988,360 and $0 pledged as collateral as of March 31, 2007 and December 31,  2006, respectively                                                                                               |       | 7,033,094                |       | —                      |       |
| Securities available-for-sale,  $734,108 and $8,336,435 pledged as collateral as of March 31, 2007 and  December 31, 2006, respectively                                                                         |       | 880,340                  |       | 8,500,636                   |       |
| Loans ($4,845,144 and  $0 at fair value as of March 31, 2007 and December 31, 2006, respectively),  net of allowance for loan losses of $0 and $1,500 as of March 31, 2007 and  December 31, 2006, respectively |       | 8,042,492                |       | 8,442,021                   |       |
| Derivative assets                                                                                                                                                                                                    |       | 49,387                   |       | 63,433                      |       |
| Interest receivable                                                                                                                                                                                                  |       | 77,603                   |       | 84,048                      |       |
| Principal receivable                                                                                                                                                                                                 |       | 8,201                    |       | 4,540                       |       |
| Non-marketable equity  securities                                                                                                                                                                                    |       | 173,823                  |       | 166,323                     |       |
| Investment in  unconsolidated affiliate                                                                                                                                                                              |       | 128,813                  |       | 104,035                     |       |
| Other assets                                                                                                                                                                                                         |       | 52,598                   |       | 56,951                      |       |
| **Total  assets**                                                                                                                                                                                                    |       | $                        | 16,740,764 |                        | $          | 17,565,177 |   |
| **Liabilities**                                                                                                                                                                                                      |       |                     |       |                        |       |
| Repurchase agreements                                                                                                                                                                                                |       | $                        | 3,551,840  |                        | $          | 4,457,089 |   |
| Collateralized loan  obligation senior secured notes                                                                                                                                                                 |       | 2,252,500                |       | 2,252,500                   |       |
| Asset-backed secured  liquidity notes                                                                                                                                                                                |       | 8,822,785                |       | 8,705,601                   |       |
| Secured revolving  credit facility                                                                                                                                                                                   |       | 25,200                   |       | 34,710                      |       |
| Secured demand loan                                                                                                                                                                                                  |       | 41,658                   |       | 41,658                      |       |
| Junior subordinated  notes                                                                                                                                                                                           |       | 257,743                  |       | 257,743                     |       |
| Accounts payable, accrued  expenses and other liabilities                                                                                                                                                            |       | 46,032                   |       | 45,237                      |       |
| Accrued interest  payable                                                                                                                                                                                            |       | 42,163                   |       | 36,991                      |       |
| Related party payable                                                                                                                                                                                                |       | 10,221                   |       | 6,901                       |       |
| Income tax liability                                                                                                                                                                                                 |       | 877                      |       | 601                         |       |
| Derivative liabilities                                                                                                                                                                                               |       | 3,811                    |       | 2,715                       |       |
| **Total  liabilities**                                                                                                                                                                                               |       | 15,054,830               |       | 15,841,746                  |       |
| **Stockholders’ Equity**                                                                                                                                                                                        |       |                     |       |                        |       |
| Preferred stock, $0.01  par value, 50,000,000 shares authorized and none issued and outstanding at  March 31, 2007 and December 31, 2006                                                                        |       | —                   |       | —                      |       |
| Common stock, $0.01 par  value, 250,000,000 shares authorized and 80,464,713 shares issued and  outstanding at March 31, 2007 and December 31, 2006                                                             |       | 805                      |       | 805                         |       |
| Additional  paid-in-capital                                                                                                                                                                                          |       | 1,676,168                |       | 1,670,330                   |       |
| Accumulated other  comprehensive income                                                                                                                                                                              |       | 77,940                   |       | 70,520                      |       |
| Accumulated deficit                                                                                                                                                                                                  |       | (68,979                  | )          | (18,224                     | )          |
| **Total  stockholders’ equity**                                                                                                                                                                                 |       | 1,685,934                |       | 1,723,431                   |       |
| **Total liabilities and  stockholders’ equity**                                                                                                                                                                 |       | $                        | 16,740,764 |                        | $          | 17,565,177 |   |

 

See notes to condensed consolidated financialstatements.

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, 2007** | ** ** | **For the three  months ended  March 31, 2006** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| **Net  investment income:**                                                        |       |                                                                     |       |                                                                     |       |
| Securities  interest income                                                        |       | $                                                                        | 115,608    |                                                                     | $          | 79,964 |   |
| Loan interest  income                                                              |       | 133,742                                                                  |       | 125,106                                                                  |       |
| Dividend income                                                                    |       | 974                                                                      |       | 883                                                                      |       |
| Other interest  income                                                             |       | 2,687                                                                    |       | 1,845                                                                    |       |
| Total investment  income                                                           |       | 253,011                                                                  |       | 207,798                                                                  |       |
| Interest expense                                                                   |       | (200,066                                                                 | )          | (156,563                                                                 | )          |
| Net investment  income                                                             |       | 52,945                                                                   |       | 51,235                                                                   |       |
| **Other  income:**                                                                 |       |                                                                     |       |                                                                     |       |
| Net unrealized  gain on trading securities and loans carried at fair value         |       | 2,769                                                                    |       | —                                                                   |       |
| Net realized and  unrealized gain on derivatives and foreign exchange              |       | 7,138                                                                    |       | 10                                                                       |       |
| Net realized  gain on investments                                                  |       | 6,944                                                                    |       | 1,448                                                                    |       |
| Fee and other  income                                                              |       | 2,048                                                                    |       | 215                                                                      |       |
| Total other  income                                                                |       | 18,899                                                                   |       | 1,673                                                                    |       |
| **Non-investment  expenses:**                                                      |       |                                                                     |       |                                                                     |       |
| Related party  management compensation                                             |       | 19,299                                                                   |       | 14,440                                                                   |       |
| Professional  services                                                             |       | 541                                                                      |       | 947                                                                      |       |
| Loan servicing  expense                                                            |       | 3,263                                                                    |       | 3,996                                                                    |       |
| Insurance  expense                                                                 |       | 194                                                                      |       | 224                                                                      |       |
| Directors  expenses                                                                |       | 320                                                                      |       | 373                                                                      |       |
| General and  administrative expenses                                               |       | 6,008                                                                    |       | 2,228                                                                    |       |
| Total  non-investment expenses                                                     |       | 29,625                                                                   |       | 22,208                                                                   |       |
| Income before  equity in income of unconsolidated affiliate and income tax expense |       | 42,219                                                                   |       | 30,700                                                                   |       |
| Equity in income  of unconsolidated affiliate                                      |       | 6,981                                                                    |       | —                                                                   |       |
| Income before  income tax expense                                                  |       | 49,200                                                                   |       | 30,700                                                                   |       |
| Income tax  expense                                                                |       | 776                                                                      |       | 312                                                                      |       |
| Net income                                                                         |       | $                                                                        | 48,424     |                                                                     | $          | 30,388 |   |
| Net income per  common share:                                                      |       |                                                                     |       |                                                                     |       |
| Basic                                                                              |       | $                                                                        | 0.61       |                                                                     | $          | 0.39 |   |
| Diluted                                                                            |       | $                                                                        | 0.60       |                                                                     | $          | 0.38 |   |
| Weighted-average  number of common shares outstanding:                             |       |                                                                     |       |                                                                     |       |
| Basic                                                                              |       | 78,768                                                                   |       | 77,675                                                                   |       |
| Diluted                                                                            |       | 80,257                                                                   |       | 79,314                                                                   |       |
| Distributions declared  per common share                                           |       | $                                                                        | 0.54       |                                                                     | $          | 0.40 |   |

 

See notes to condensed consolidated financialstatements.

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** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|---------------------------------------|------------|----------------------------------|------------|-----------------------------------------------|------------|--------------------------|------------|---------------------------|------------|---------------------------------------|------------|
| **Balance  at January 1, 2007**                                                                              |       | 80,465                            |       | $                                     | 805        |                             | $          | 1,670,330                                     |       | $                        | 70,520     |                      | $          | (18,224                               | )          |   |   | $ | 1,723,431 |   |
| Cumulative  effect of adjustment from adoption of SFAS No. 159                                               |       | —                            |       | —                                |       | —                           |       | —                                        |       | (55,728                  | )          |                      |       | (55,728                               | )          |
| Net income                                                                                                   |       | —                            |       | —                                |       | —                           |       | —                                        |       | 48,424                   |       | $                         | 48,424     |                                  | 48,424     |   |
| Net change in  unrealized gain on cash flow hedges                                                           |       | —                            |       | —                                |       | —                           |       | (18,173                                       | )          | —                   |       | (18,173                   | )          | (18,173                               | )          |
| Net change in  unrealized gain on securities available-for-sale                                              |       | —                            |       | —                                |       | —                           |       | 24,681                                        |       | —                   |       | 24,681                    |       | 24,681                                |       |
| Net change in  unrealized gain on securities available-for-sale from investment in  unconsolidated affiliate |       | —                            |       | —                                |       | —                           |       | 912                                           |       | —                   |       | 912                       |       | 912                                   |       |
| Comprehensive  income                                                                                        |       |                              |       |                                  |       |                             |       |                                          |       |                     |       | $                         | 55,844     |                                  |       |   |
| Cash  distributions on common stock                                                                          |       | —                            |       | —                                |       | —                           |       | —                                        |       | (43,451                  | )          |                      |       | (43,451                               | )          |
| Amortization of  restricted common stock                                                                     |       | —                            |       | —                                |       | 5,216                            |       | —                                        |       | —                   |       |                      |       | 5,216                                 |       |
| Amortization of  common stock options                                                                        |       | —                            |       | —                                |       | 622                              |       | —                                        |       | —                   |       |                      |       | 622                                   |       |
| **Balance at March 31, 2007**                                                                           |       | 80,465                            |       | $                                     | 805        |                             | $          | 1,676,168                                     |       | $                        | 77,940     |                      | $          | (68,979                               | )          |   |   | $ | 1,685,934 |   |

 

See notes to condensed consolidated financialstatements.

4

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**KKR Financial Corp. and SubsidiariesCondensed****Consolidated Statements of Cash Flows(Unaudited)(Amounts in thousands)**
| ** **                                                                     | ** ** | **Three months ended  March 31, 2007** | ** ** | **Three months ended  March 31, 2006** | ** ** |
|--------------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| **Cash  flows from operating activities:**                                     |       |                                                       |       |                                                       |       |
| Net income                                                                     |       | $                                                          | 48,424     |                                                       | $          | 30,388 |   |
| Adjustments to  reconcile net income to cash provided by operating activities: |       |                                                       |       |                                                       |       |
| Net realized and unrealized (gain) loss on  derivatives                        |       | (7,139                                                     | )          | 643                                                        |       |
| Unrealized gain on equity short positions                                      |       | —                                                     |       | (53                                                        | )          |
| Net realized and unrealized (gain) loss on foreign exchange                    |       | 1                                                          |       | (374                                                       | )          |
| Write-off of capitalized costs                                                 |       | 2,247                                                      |       | —                                                     |       |
| Share-based compensation                                                       |       | 5,838                                                      |       | 6,783                                                      |       |
| Net unrealized gain on trading securities and loans  carried at fair value     |       | (2,769                                                     | )          | —                                                     |       |
| Net gain on sale of securities available-for-sale                              |       | (4,008                                                     | )          | (639                                                       | )          |
| Net gain on sale of loans                                                      |       | (2,936                                                     | )          | (810                                                       | )          |
| Depreciation and net amortization                                              |       | 2,136                                                      |       | 804                                                        |       |
| Deferred income tax benefit                                                    |       | —                                                     |       | (590                                                       | )          |
| Equity in income of unconsolidated affiliate                                   |       | (6,981                                                     | )          | —                                                     |       |
| Changes in  assets and liabilities:                                            |       |                                                       |       |                                                       |       |
| Interest receivable                                                            |       | 6,445                                                      |       | (4,939                                                     | )          |
| Other assets                                                                   |       | 597                                                        |       | (7,009                                                     | )          |
| Related party payable                                                          |       | 3,321                                                      |       | 1,507                                                      |       |
| Accounts payable, accrued expenses and other  liabilities                      |       | 794                                                        |       | 15,737                                                     |       |
| Accrued interest payable                                                       |       | 5,172                                                      |       | 362                                                        |       |
| Income tax liability                                                           |       | 276                                                        |       | —                                                     |       |
| Net cash provided by operating activities                                      |       | 51,418                                                     |       | 41,810                                                     |       |
| **Cash  flows from investing activities:**                                     |       |                                                       |       |                                                       |       |
| Principal  payments on trading securities                                      |       | 506,630                                                    |       | —                                                     |       |
| Purchase of  securities available-for-sale                                     |       | (52,140                                                    | )          | (833,894                                                   | )          |
| Principal  payments on securities available-for-sale                           |       | 56,351                                                     |       | 495,160                                                    |       |
| Proceeds from  sale of securities available-for-sale                           |       | 88,342                                                     |       | 13,638                                                     |       |
| Purchase of  loans                                                             |       | (308,267                                                   | )          | (638,449                                                   | )          |
| Principal  payments on loans                                                   |       | 451,001                                                    |       | 858,254                                                    |       |
| Proceeds from  sale of loans                                                   |       | 220,622                                                    |       | 104,714                                                    |       |
| Purchases of  non-marketable equity securities                                 |       | (7,500                                                     | )          | (50,930                                                    | )          |
| Payments on  non-marketable equity securities                                  |       | —                                                     |       | 2,405                                                      |       |
| Net settlement  from derivatives                                               |       | 2,687                                                      |       | —                                                     |       |
| Proceeds from  sale of derivatives                                             |       | —                                                     |       | 973                                                        |       |
| Net additions to  restricted cash and cash equivalents                         |       | (153,052                                                   | )          | (47,449                                                    | )          |
| Addition of  leasehold improvements and equipment                              |       | (62                                                        | )          | (2,701                                                     | )          |
| Investment in  unconsolidated affiliate                                        |       | (16,885                                                    | )          | —                                                     |       |
| Net cash provided by (used in) investing activities                            |       | 787,727                                                    |       | (98,279                                                    | )          |
| **Cash  flows from financing activities:**                                     |       |                                                       |       |                                                       |       |
| Proceeds from  borrowings:                                                     |       |                                                       |       |                                                       |       |
| Repurchase agreements                                                          |       | 28,973,821                                                 |       | 29,203,926                                                 |       |
| Asset-backed secured liquidity notes                                           |       | 28,362,435                                                 |       | 8,090,097                                                  |       |
| Secured revolving credit facility                                              |       | 76,610                                                     |       | 100,000                                                    |       |
| Junior subordinated notes                                                      |       | —                                                     |       | 50,000                                                     |       |
| Other  capitalized costs                                                       |       | 52                                                         |       | (2,876                                                     | )          |
| Repayments of  borrowings:                                                     |       |                                                       |       |                                                       |       |
| Repurchase agreements                                                          |       | (29,879,070                                                | )          | (30,190,865                                                | )          |
| Asset-backed secured liquidity notes                                           |       | (28,245,251                                                | )          | (7,061,554                                                 | )          |
| Secured revolving credit facility                                              |       | (86,120                                                    | )          | (96,366                                                    | )          |
| Distributions on  common stock                                                 |       | (43,451                                                    | )          | (32,150                                                    | )          |
| Net cash (used in) provided by financing activities                            |       | (840,974                                                   | )          | 60,212                                                     |       |
| **Net  (decrease) increase in cash and cash equivalents**                      |       | (1,829                                                     | )          | 3,743                                                      |       |
| **Cash  and cash equivalents at beginning of period**                          |       | 5,125                                                      |       | 16,110                                                     |       |
| **Cash  and cash equivalents at end of period**                                |       | $                                                          | 3,296      |                                                       | $          | 19,853 |   |
| ** **                                                                     |       |                                                       |       |                                                       |       |
| **Supplemental  cash flow information:**                                       |       |                                                       |       |                                                       |       |
| Cash paid for  interest                                                        |       | $                                                          | 205,076    |                                                       | $          | 156,201 |   |
| Cash paid for  taxes                                                           |       | $                                                          | 500        |                                                       | $          | 1,838 |   |
| **Non-cash  investing and financing activities:**                              |       |                                                       |       |                                                       |       |
| (Receivable) payable  for securities (sales) purchases                         |       | $                                                          | (1,494     | )                                                          | $          | 562,555 |   |

 

See notes to condensed consolidated financialstatements.

5

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**KKR Financial Corp. and Subsidiaries**

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

**Note 1. Organization**

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

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

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

**Basis of Presentation**

The accompanying condensed consolidated financialstatements have been prepared in conformity with accounting principles generallyaccepted in the United States of America (“GAAP”). The condensed consolidatedfinancial statements include the accounts of the Company, certain of itstaxable REIT subsidiaries, its qualified REIT subsidiaries, consolidatedresidential mortgage loan securitization trusts where the Company is theprimary beneficiary, and entities established to complete secured financingtransactions that are considered to be variable interest entities and for whichthe Company is the primary beneficiary. The Company owns a 49.9% limitedpartnership interest in KKR Financial Holdings I, L.P. (“KFH”) that isaccounted for using the equity method.

These condensedconsolidated financial statements are unaudited and should be read inconjunction with the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2006.

6

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**Use of Estimates**

The preparation of financial statements in conformitywith GAAP requires management to make estimates and assumptions that affect theamounts reported in the Company’s consolidated financial statements andaccompanying notes. Actual results could differ from management’s estimates.

**Consolidation**

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

KKR Financial CLO 2005-1, Ltd. (“CLO 2005-1”),KKR Financial CLO 2005-2, Ltd. (“CLO 2005-2”), KKR FinancialCLO 2006-1, Ltd. (“CLO 2006-1”), and KKR Financial CLO 2006-2,Ltd. (“CLO 2006-2”), are entities established to complete securedfinancing transactions. These entities are VIEs and are not considered to bequalifying special-purpose entities (“QSPE”) as defined by Statement ofFinancial Accounting Standards No. 140, *Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities*(“SFAS No. 140”). The Company has determined it isthe primary beneficiary of these entities and has included the accounts ofthese entities in these consolidated financial statements. Additionally, theCompany is the primary beneficiary of six residential mortgage loansecuritization trusts that are not considered to be QSPEs under SFAS No. 140and the Company has therefore included the accounts of these entities in theseconsolidated financial statements.

All inter-company balances and transactions havebeen eliminated in consolidation.

**Cash and CashEquivalents**

Cash and cash equivalents include cash on hand, cashheld in banks and highly liquid investments with original maturities of threemonths or less. Interest income earned on cash and cash equivalents is recordedin other interest income.

**Restricted Cashand Cash Equivalents**

Restricted cash and cash equivalents represent amountsthat are held by third parties under certain of the Company’s financing andderivative transactions. Interest income earned on restricted cash and cashequivalents is recorded in other interest income.

**Trading Securities**

Effective January 1, 2007, the Company classifies itsinvestments in residential mortgage-backed securities as trading securities(see “Recent Accounting Pronouncements”). These investments are carried at estimated fair value, with unrealizedgains and losses reported in income. Estimated fair values are based onestimates provided by independent pricing sources or dealers who make marketsin such securities. Upon the sale of a security, the realized net gain or lossis computed on a specific identification basis.  Unamortized premiums and discounts onsecurities that are highly rated are recognized over the contractual life,adjusted for estimated prepayments using the effective interest method. Forsecurities representing beneficial interests in securitizations that are nothighly rated (i.e., subordinate tranches of residential mortgage-backedsecurities), unamortized premiums and discounts are recognized over thecontractual life, adjusted for estimated prepayments and estimated creditlosses of the securities using the effective interest method.  Actual prepayment and credit loss experienceis reviewed quarterly and effective yields are recalculated when differencesarise between prepayments and credit losses originally anticipated compared toamounts actually received plus anticipated future prepayments.

**SecuritiesAvailable-for-Sale**

The Company classifies its investments in securitiesother than residential mortgage-backed securities as available-for-sale sincethe Company may sell them prior to maturity and does not hold them principallyfor the purpose of selling them in the near term. These investments are carriedat estimated fair value, with unrealized gains and losses reported inaccumulated other comprehensive income. Estimated fair values are based onquoted market prices, when available, or on estimates provided by independentpricing sources or dealers who make markets in such securities. Upon the saleof a security, the realized net gain or loss is computed on a specificidentification basis.

The Company monitors its available-for-sale securitiesportfolio for impairments. A loss is recognized when the Company determinesthat a decline in the estimated fair value of a security below its amortizedcost is other-than-temporary. The Company considers many factors in determiningwhether the impairment of a security is deemed to be other-than-temporary,including, but not limited to, the length of time the security has had adecline in estimated fair value below its amortized cost, the amount of theunrealized loss, the intent and ability of the Company to hold the security fora period of time sufficient for a recovery in value, recent events specific tothe issuer or industry, external credit ratings and recent changes in such ratings.

7

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Unamortized premiums and discounts on securitiesavailable-for-sale are recognized in interest income over the contractual life,adjusted for actual prepayments, of the securities using the effective interestmethod.

**Non-marketableEquity Securities**

Non-marketable equity securities consist primarily ofprivate equity investments. These investments are accounted for under the costmethod. The Company reviews these investments quarterly for possibleother-than-temporary impairment. The Company reduces the carrying value of theinvestment and recognizes a loss when the Company considers a decline inestimated fair value below the cost basis of the security to beother-than-temporary.

**Loans**

The Company purchases pools of residential mortgagewhole loans and participations in corporate leveraged loans and commercial realestate loans in the primary and secondary market. Loans are held for investmentand the Company initially records loans at their purchase prices. EffectiveJanuary 1, 2007, the Company accounts for residential mortgage loans at fairvalue with changes in fair value recorded in income (see “Recent AccountingPronouncements”). For non-residential mortgage loans, the Company accounts forthese loans based on their outstanding principal plus or minus unaccretedpurchase discounts and unamortized purchase premiums. In certain instances,where the credit fundamentals underlying a particular loan have materiallychanged in such a manner that the Company’s expected return may decrease, theCompany may elect to sell a loan held for investment due to adverse changes incredit fundamentals. Once the determination has been made by the Company thatit will no longer hold the loan for investment, the Company accounts for theloan at the lower of amortized cost or estimated fair value.

Interest income on loans represents interest at statedcoupon rates adjusted for accretion of purchase discounts and the amortizationof purchase premiums. For corporate and commercial real estate loans,unamortized premiums and discounts are recognized in interest income over thecontractual life, adjusted for actual prepayments, of the loans using theeffective interest method. For residential mortgage loans, unamortized premiumsand discounts are recognized over the contractual life, adjusted for estimatedprepayments using the effective interest method.

**Allowance andProvision for Loan Losses**

The Company maintains an allowance for loan losses ata level that the Company believes is adequate based on an evaluation of known andinherent risks related to its loan investments. When determining the adequacyof the allowance for loan losses the Company considers historical and industryloss experience, economic conditions and trends, the estimated fair values of itsloans, credit quality trends and other factors that the Company determines arerelevant. 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.

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

An impaired loan may be left on accrual status duringthe period the Company is pursuing repayment of the loan; however, the loan isplaced on non-accrual status at such time as: (i) management believes thatscheduled debt service payments may not be paid when contractually due;(ii) the loan becomes 90 days delinquent; (iii) managementdetermines the borrower is incapable of, or has ceased efforts toward, curingthe cause of the impairment; or (iv) the net realizable value of theunderlying collateral securing the loan decreases below the Company’s carryingvalue of such loan. While on non-accrual status, previously recognized accruedinterest is reversed and interest income is recognized only uponactual receipt.

As disclosed under “Recent Accounting Pronouncements”upon adoption of SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities — Including an amendment of FASBStatement No. 115* (“SFAS No. 159”) as of January 1, 2007, theCompany accounts for its investments residential mortgage loans at fair valueand therefore does not record an allowance for loan losses for theseinvestments. 

**LeaseholdImprovements and Equipment**

Leasehold improvements and equipment are carried atcost less depreciation and amortization and reviewed for impairment wheneverevents or changes in circumstances indicate that the carrying amount of theassets might not be recoverable. Equipment is depreciated using thestraight-line method over the estimated useful lives of the respective assetsof three years. Leasehold improvements are amortized on a straight-line basisover the shorter of their estimated useful lives or lease terms. Leaseholdimprovements and equipment, net of accumulated depreciation and amortization,are included in other assets.

8

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**Borrowings**

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

**Trust PreferredSecurities**

Trusts formed by the Company for the sole purpose ofissuing trust preferred securities are not consolidated by the Company inaccordance with FIN 46R as the Company has determined that it is not theprimary beneficiary of such trusts. The Company’s investment in the commonsecurities of such trusts is included in other assets on the Company’sconsolidated financial statements.

**DerivativeFinancial Instruments**

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

The Company formally documents its hedge relationshipsat inception, including identification of the hedging instruments and thehedged items, its risk management objectives, strategy for undertaking thehedge transaction and the Company’s evaluation of effectiveness of its hedgedtransactions. Periodically, as required by SFAS No. 133, *Accounting for Derivative Instruments and HedgingActivities*, as amended and interpreted (“SFAS No. 133”), theCompany also formally assesses whether the derivative it designated in eachhedging relationship is expected to be and has been highly effective inoffsetting changes in estimated fair values or cash flows of the hedged itemusing either the dollar offset or the regression analysis method. If theCompany determines that a derivative is not highly effective as a hedge, it discontinueshedge accounting.

**Foreign Currency**

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

**ManagerCompensation**

The Management Agreement provides for the payment of abase management fee to the Manager, as well as an incentive fee if the Company’sfinancial performance exceeds certain benchmarks. See Note 12 for thespecific terms of the computation and payment of the incentive fee. The basemanagement fee and the incentive fee are accrued and expensed during the periodfor which they are earned by the Manager.

**Share-BasedCompensation**

The Company accounts for share-basedcompensation issued to its directors and to its Manager using the fair valuebased 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 ratably over the vesting period. Compensation costrelated to restricted common stock and common stock options issued to theManager is initially measured at estimated fair value at the grant date, and isremeasured on subsequent dates to the extent the awards are unvested. TheCompany has elected to use the graded vesting attribution method pursuant toSFAS No. 123(R) to amortize compensation expense for the restrictedcommon shares and common stock options granted to the Manager.

**Income Taxes**

The Company has elected to be taxed as a REIT and isrequired to comply with the provisions of the Code with respect thereto.Accordingly, the Company is not subject to federal income tax to the extentthat its distributions satisfy the REIT requirements and certain asset, incomeand ownership tests and recordkeeping requirements are fulfilled. Even thoughthe Company qualifies for federal taxation as a REIT, it may be subject to someamount of federal, state, local and foreign taxes based on the Company’staxable income.

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KKR TRS Holdings, Inc. (“TRS Inc.”), KKR TRS Holdings,Ltd. (“TRS Ltd.”), CLO 2005-1, CLO 2005-2, CLO 2006-1, andCLO 2006-2 are not consolidated for federal income tax return purposes.For financial reporting purposes, current and deferred taxes are provided foron the portion of earnings recognized by the Company with respect to itsinterest in TRS Inc., a domestic taxable REIT subsidiary, because it istaxed as a regular subchapter C corporation under the provisions of the Code.

Deferred income tax assets and liabilities arecomputed based on temporary differences between the GAAP consolidated financialstatements and the federal income tax basis of assets and liabilities as ofeach consolidated balance sheet date. TRS Ltd., CLO 2005-1, CLO 2005-2,CLO 2006-1, and CLO 2006-2, the Company’s foreign taxable REITsubsidiaries, are organized as exempted companies incorporated with limitedliability under the laws of the Cayman Islands, and are generally exempt fromfederal and state income tax at the corporate entity level because theyrestrict their activities in the United States to trading in stock andsecurities for their own account. Therefore, despite their status as taxableREIT subsidiaries, they generally will not be subject to corporate income taxon their earnings, and no provisions for income taxes for the quarter endedMarch 31, 2007 were required; however, the Company will generally berequired to include their current taxable income in its calculation of REITtaxable income.

**Earnings Per Share**

In accordance with SFAS No. 128, *Earnings per Share*, the Company presentsboth basic and diluted earnings per common share (“EPS”) in its consolidatedfinancial statements and footnotes thereto. Basic earnings per common share (“BasicEPS”) excludes dilution and is computed by dividing net income or lossallocable to common stockholders by the weighted-average number of commonshares, including vested restricted common shares, outstanding for the period.Diluted earnings per share (“Diluted EPS”) reflects the potential dilution ofcommon stock options and unvested restricted common stock, if they are notanti-dilutive. See Note 3 for earnings per common share computations.

**Recent Accounting Pronouncements**

In February 2006, the FASB issued SFASNo. 155, *Accounting for Certain Hybrid FinancialInstruments* (“SFAS No. 155”). 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*,* thereby narrowing such exception; (3) a requirementthat beneficial interests in securitized financial assets be analyzed todetermine whether they are freestanding derivatives or whether they are hybridinstruments that contain embedded derivatives requiring bifurcation;(4) clarification that concentrations of credit risk in the form ofsubordination are not embedded derivatives; and (5) elimination of theprohibition on a QSPE holding passive derivative financial instruments thatpertain to beneficial interests that are or contain a derivative financialinstrument. In general, these changes will reduce the operational complexityassociated with bifurcating embedded derivatives, and increase the number ofbeneficial interests in securitization transactions, including interest-onlystrips and principal-only strips, required to be accounted for in accordancewith SFAS No. 133. The Company adopted SFAS No. 155 as of the beginning of2007 and the adoption of SFAS No. 155 did not have a material impact on theCompany’s consolidated financial statements.

In June 2006, the FASB issued InterpretationNo. 48, *Accounting for Uncertainty in IncomeTaxes—an interpretation of FASB Statement No. 109* (“FIN 48”).FIN 48 clarifies the accounting for uncertainty in income taxes recognized inan enterprise’s financial statements in accordance with FASB StatementNo. 109, *Accounting for Income Taxes*. FIN48 prescribes a recognition threshold and measurement attribute for thefinancial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. The Company adopted FIN 48 as of thebeginning of 2007 and the adoption of FIN 48 did not have a materialimpact on its consolidated financial statements.

In September 2006, the FASB issued SFASNo. 157, *Fair Value Measurements*(“SFASNo. 157”). This statement defines fair value, establishes a framework formeasuring fair value in GAAP and expands disclosures about fair valuemeasurements. SFAS No. 157 does not require any new fair valuemeasurements. The Company adopted SFAS No. 157 as of the beginning of 2007and the adoption of SFAS No. 157 did not have a material impact on themanner in which the Company measures the fair value of its financialinstruments, but did result in certain additional disclosures, which arecontained in Note 13.

In February 2007, FASB issued SFAS No. 159, *The Fair Value Option for Financial Assets and FinancialLiabilities—Including an amendment of FASB Statement No. 115*(“SFASNo. 159”). This statement permits entities to choose to measure manyfinancial instruments and certain other items at fair value (i.e., the fairvalue option). The election to use the fair value option is available when anentity first recognizes a financial asset or financial liability or uponentering into a firm commitment. Subsequent changes in fair value must be recorded in earnings.  Additionally, SFAS No. 159 allows for aone-time election for existing positions upon adoption, with the transitionadjustment recorded to beginning retained earnings.

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The Company adopted SFAS No.159 as of the beginning of 2007 and elected to apply the fair value option forits investments in residential mortgage loans and residential mortgage-backed securities.Additionally, the Company intends to consistently apply the election of thefair value option to any future residential mortgage investments. The Companyhas elected the fair value option for its residential mortgage investments forthe purpose of enhancing the transparency of its financial condition as fairvalue is consistent with how the Company manages the risks of residentialmortgage investments. The transition adjustment to beginning accumulated deficitthat was recorded as of January 1, 2007 due to the adoption of SFAS No. 159 wasa loss of $55.7 million.  The followingtable presents information about the eligible instruments for which the Companyelected the fair value option and for which transition adjustments wererecorded as of January 1, 2007 (amounts in thousands):
| ** **                                                  | ** ** | **Carrying Value at  January 1, 2007** | ** ** | **Transition Adjustment to  Accumulated Deficit  Gain/(Loss)** | ** ** | **Carrying Value at  January 1, 2007  (After Adoption of  SFAS No. 159)** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|
| Residential  mortgage loans                                 |       | $                                                          | 5,109,261  |                                                                          | $          | (35,653                                                                                                           | )          | $ | 5,073,608 |   |
| Allowance for  loan losses                                  |       | (1,500                                                     | )          | 1,500                                                                         |       | —                                                                                                            |       |
| Residential  mortgage-backed securities (1)                 |       | 7,536,196                                                  |       | (21,575                                                                       | )          | 7,536,196                                                                                                         |       |
| Cumulative effect of  the adoption of the fair value option |       |                                                       |       | $                                                                             | (55,728    | )                                                                                                                 |       |   |
|                                                             |            |                                                            |            |                                                                               |            |                                                                                                                   |            |  |  |  |

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(1)             Priorto January 1, 2007, residential mortgage-backed securities were classified asavailable-for-sale and carried at fair value. Accordingly, the election of the fair value option for mortgage-backedsecurities did not change their carrying value and resulted in areclassification from accumulated other comprehensive income to beginningaccumulated deficit.

**Note 3. Earnings per Share**

The Companycalculates basic net income per common share by dividing net income for theperiod by the weighted-average shares of its common stock outstanding forthe period. Diluted net income per common share takes into account the effectof dilutive instruments, such as common stock options and unvested restrictedcommon stock, but uses the average share price for the period in determiningthe number of incremental shares that are to be added to the weighted-averagenumber of shares of its common stock outstanding. The following table presentsa reconciliation of basic and diluted net income per common share for the threemonths ended March 31, 2007 and March 31, 2006 (amounts in thousands,except per share information):
| ** **                                                                | ** ** | **Three months ended  March 31, 2007** | ** ** | **Three months ended  March 31, 2006** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| **Basic:**                                                                |       |                                                       |       |                                                       |       |
| Net income                                                                |       | $                                                          | 48,424     |                                                       | $          | 30,388 |   |
| Weighted-average  number of common shares outstanding                     |       | 78,768                                                     |       | 77,675                                                     |       |
| Basic net income  per common share                                        |       | $                                                          | 0.61       |                                                       | $          | 0.39 |   |
| **Diluted:**                                                              |       |                                                       |       |                                                       |       |
| Net income                                                                |       | $                                                          | 48,424     |                                                       | $          | 30,388 |   |
| Weighted-average  number of common shares outstanding                     |       | 78,768                                                     |       | 77,675                                                     |       |
| Plus:  Incremental shares from assumed conversion of dilutive instruments |       | 1,489                                                      |       | 1,639                                                      |       |
| Adjusted  weighted-average number of common shares outstanding            |       | 80,257                                                     |       | 79,314                                                     |       |
| Diluted net income per  common share                                      |       | $                                                          | 0.60       |                                                       | $          | 0.38 |   |

 

**Note 4.Trading Securities**

Upon adoption of SFAS No. 159 as of January 1, 2007,the Company elected the fair value option for its investments in residentialmortgage-backed securities.  As ofDecember 31, 2006 the Company’s investments in residential mortgage-backedsecurities were classified as securities available-for-sale; however, inaccordance with SFAS No.159, the election of the fair value option for theCompany’s residential mortgage-backed securities results in these investmentsbeing classified as trading securities as of January 1, 2007. As ofMarch 31, 2007, trading securities totaled $7.0 billion.

 

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Note 8 to these condensed consolidated financialstatements describes the Company’s borrowings under which the Company haspledged trading securities for borrowings under repurchase agreements andasset-backed secured liquidity notes.  Asof March 31, 2007, $7.0****billion oftrading securities were pledged as collateral for both borrowings underrepurchase agreements and as collateral for asset backed-backed securedliquidity notes.

**Note 5.Securities Available-for-Sale**

The following table summarizes the Company’ssecurities classified as available-for-sale as of March 31, 2007, which arecarried at estimated fair value (amounts in thousands):
| **Description**                        | ** ** | **Amortized  Cost** | ** ** | **Gross Unrealized  Gains** | ** ** | **Gross Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
|----------------------------------------|------------|---------------------|------------|----------------------------------|------------|-----------------------------------|------------|--------------------------------|------------|
| Commercial  mortgage-backed securities |       | $                   | 32,000     |                             | $          | 133                               |       | $                              | —     |   | $ | 32,133 |   |
| Asset-backed securities                |       | 28,385              |       | 479                              |       | —                            |       | 28,864                         |       |
| Corporate securities                   |       | 698,357             |       | 37,136                           |       | (5,129                            | )          | 730,364                        |       |
| Common and preferred  stock            |       | 84,561              |       | 5,059                            |       | (641                              | )          | 88,979                         |       |
| Total                                  |       | $                   | 843,303    |                             | $          | 42,807                            |       | $                              | (5,770     | ) | $ | 880,340 |   |

 

The following table shows the gross unrealized lossesand fair value of the Company’s available-for-sale securities, aggregated bylength of time that the individual securities have been in a continuous unrealizedloss position, at March 31, 2007 (amounts in thousands):
| ** **                  | ** ** | **Less Than 12 months** | ** ** | **12 Months or More** | ** ** | **Total**           | ** ** |
|-----------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|---------------------|------------|
| **Description**             | ** ** | **Fair Value**                    | ** ** | **Unrealized Loss**             | ** ** | **Fair Value** | ** ** | **Unrealized Loss** | ** ** | **Fair Value** | ** ** | **Unrealized Loss** | ** ** |
| Corporate securities        |       | $                                      | 67,277     |                                 | (5,129     | )                   | $          | — |   | $ | — |   | $ | 67,277 |   | $ | (5,129 | ) |
| Common and preferred  stock |       | 45,374                                 |       | (641                                 | )          | —              |       | — |   | 45,374 |   | (641 | ) |
| Total                       |       | $                                      | 112,651    |                                 | $          | (5,770              | )          | $ | — |   | $ | — |   | $ | 112,651 |   | $ | (5,770 | ) |
|                             |            |                                        |            |                                      |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

The following table summarizes the Company’ssecurities classified as available-for-sale as of December 31, 2006, whichare carried at estimated fair value (amounts in thousands):
| **Description**                         | ** ** | **Amortized  Cost** | ** ** | **Gross Unrealized  Gains** | ** ** | **Gross Unrealized  Losses** | ** ** | **Fair Value Hedge  Adjustment** | ** ** | **Estimated  Fair Value** | ** ** |
|-----------------------------------------|------------|---------------------|------------|----------------------------------|------------|-----------------------------------|------------|--------------------------------------------|------------|--------------------------------|------------|
| Residential  mortgage-backed securities |       | $                   | 7,557,771  |                             | $          | 16,130                            |       | $                                          | (37,705    | )                              | $          | — |   | $ | 7,536,196 |   |
| Commercial  mortgage-backed securities  |       | 32,000              |       | 36                               |       | —                            |       | (13                                        | )          | 32,023                         |       |
| Asset-backed securities                 |       | 31,071              |       | 203                              |       | (37                               | )          | —                                     |       | 31,237                         |       |
| Corporate securities                    |       | 799,900             |       | 36,697                           |       | (4,385                            | )          | —                                     |       | 832,212                        |       |
| Common and preferred  stock             |       | 68,113              |       | 1,314                            |       | (459                              | )          | —                                     |       | 68,968                         |       |
| Total                                   |       | $                   | 8,488,855  |                             | $          | 54,380                            |       | $                                          | (42,586    | )                              | $          | (13 | ) | $ | 8,500,636 |   |

 

The following table shows the gross unrealized lossesand fair value of the Company’s available-for-sale securities investments,aggregated by length of time that the individual securities have been in acontinuous unrealized loss position, at December 31, 2006 (amounts inthousands):
| ** **                              | ** ** | **Less Than 12 months** | ** ** | **12 Months or More** | ** ** | **Total**           | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|---------------------|------------|
| **Description**                         | ** ** | **Fair Value**                    | ** ** | **Unrealized Loss**             | ** ** | **Fair Value** | ** ** | **Unrealized Loss** | ** ** | **Fair Value** | ** ** | **Unrealized Loss** | ** ** |
| Residential  mortgage-backed securities |       | $                                      | —     |                                 | $          | —              |       | $ | 1,853,323 |   | $ | (37,705 | ) | $ | 1,853,323 |   | $ | (37,705 | ) |
| Commercial  mortgage-backed securities  |       | —                                 |       | —                               |       | —              |       | — |   | — |   | — |   |
| Asset-backed  securities                |       | 7,462                                  |       | (37                                  | )          | —              |       | — |   | 7,462 |   | (37 | ) |
| Corporate  securities                   |       | 61,848                                 |       | (4,106                               | )          | 18,907              |       | (279 | ) | 80,755 |   | (4,385 | ) |
| Common and  preferred stock             |       | 33,063                                 |       | (459                                 | )          | —              |       | — |   | 33,063 |   | (459 | ) |
| Total                                   |       | $                                      | 102,373    |                                 | $          | (4,602              | )          | $ | 1,872,230 |   | $ | (37,984 | ) | $ | 1,974,603 |   | $ | (42,586 | ) |

 

 

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

During the three months ended March 31, 2007, theCompany’s gross realized gains from the sales of available-for-sale securitieswere $4.7 million. The Company had gross realized losses of $0.7 million fromthe sales of available-for-sale securities during the three months ended March31, 2007. During the three months ended March 31, 2006, the Company’sgross realized gains from the sales of available-for-sale securities were $0.6million. The Company had gross realized losses of $11,000 from the sales ofavailable-for-sale securities during the three months ended March 31, 2006.

Note 8 to these condensed consolidated financialstatements describes the Company’s borrowings under which the Company haspledged securities available-for-sale for borrowings under repurchaseagreements, asset-backed secured liquidity notes, and all other securedfinancing transactions. The following table summarizes the estimated fair valueof securities available-for-sale pledged as collateral under repurchaseagreements, asset-backed secured liquidity notes, and all other securedfinancing transactions as of March 31, 2007 (amounts in thousands):
| ** **                                                                     | ** ** | **Commercial  Mortgage-Backed  Securities** | ** ** | **Corporate  Securities(1)** | ** ** | **Common and  Preferred Stock** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------------|------------|------------------------------|------------|-------------------------------------------|------------|
| Pledged as  collateral for borrowings under repurchase agreements              |       | $                                           | 32,133     |                         | $          | 291,055                                   |       | $ | — |   |
| Pledged as  collateral for borrowings under secured revolving credit facility  |       | —                                      |       | 33,456                       |       | —                                    |       |
| Pledged as  collateral for borrowings under secured demand loan                |       | —                                      |       | —                       |       | 46,838                                    |       |
| Pledged as  collateral for collateralized loan obligation senior secured notes |       | —                                      |       | 330,626                      |       | —                                    |       |
| Total                                                                          |       | $                                           | 32,133     |                         | $          | 655,137                                   |       | $ | 46,838 |   |

 

The following table summarizes the estimated fairvalue of securities available-for-sale pledged as collateral under repurchaseagreements, asset-backed secured liquidity notes, and all other securedfinancing transactions as of December 31, 2006 (amounts in thousands):
| ** **                                                                     | ** ** | **Residential  Mortgage-Backed  Securities** | ** ** | **Commercial  Mortgage-Backed  Securities** | ** ** | **Corporate  Securities(1)** | ** ** | **Common and  Preferred Stock** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|------------------------------|------------|-------------------------------------------|------------|
| Pledged as  collateral for borrowings under repurchase agreements              |       | $                                            | 1,378,199  |                                        | $          | 32,023                       |       | $                                         | 310,856    |   | $ | — |   |
| Pledged as  collateral for asset-backed secured liquidity notes                |       | 6,126,699                                    |       | —                                      |       | —                       |       | —                                    |       |
| Pledged as  collateral for borrowings under secured revolving credit facility  |       | —                                       |       | —                                      |       | 33,186                       |       | —                                    |       |
| Pledged as  collateral for borrowings under secured demand loan                |       | —                                       |       | —                                      |       | —                       |       | 47,056                                    |       |
| Pledged as  collateral for collateralized loan obligation senior secured notes |       | —                                       |       | —                                      |       | 408,416                      |       | —                                    |       |
| Total                                                                          |       | $                                            | 7,504,898  |                                        | $          | 32,023                       |       | $                                         | 752,458    |   | $ | 47,056 |   |

----

(1)             Includesasset-backed securities.

13

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**Note 6.Loans**

Upon adoption of SFAS No. 159 as of January 1, 2007,the Company elected the fair value option for its investments in residentialmortgage loans.  Prior to the Company’selection of the fair value option for its investments in residential mortgageloans, the loans were carried at net unamortized cost less an allowance forloan losses. As described in Note 2, the Company recorded a transitionadjustment to adjust the carrying value of its portfolio of residentialmortgage loans to fair value and reverse its allowance for loan losses for itsresidential mortgage loan portfolio as of January 1, 2007.  The following table summarizes the Company’sloans as of March 31, 2007 and December 31, 2006 (amounts in thousands):
| ** **                                                | ** ** | **As of  March 31, 2007** | ** ** | **As of  December 31, 2006** | ** ** |
|-----------------------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Residential  mortgage loans, at fair value                |       | $                                        | 4,845,144  |                                        | $          | — |   |
| Residential  mortgage loans, at net amortized cost        |       | —                                   |       | 5,109,261                                   |       |
| Corporate loans,  at net amortized cost                   |       | 3,092,020                                |       | 3,225,567                                   |       |
| Commercial real  estate loans, at net amortized cost      |       | 105,328                                  |       | 108,693                                     |       |
| Allowance for  loan losses for residential mortgage loans |       | —                                   |       | (1,500                                      | )          |
| Total loans                                               |       | $                                        | 8,042,492  |                                        | $          | 8,442,021 |   |

 

The following table summarizes the components of thecarrying value of the Company’s loans recorded at net amortized cost as ofMarch 31, 2007 (amounts in thousands):
| ** **                    | ** ** | **Principal** | ** ** | **Unamortized  Discount** | ** ** | **Net  Amortized Cost** | ** ** |
|-------------------------------|------------|---------------|------------|---------------------------|------------|------------------------------|------------|
| Corporate loans               |       | $             | 3,098,594  |                      | $          | (6,574                       | )          | $ | 3,092,020 |   |
| Commercial real  estate loans |       | 105,412       |       | (84                       | )          | 105,328                      |       |
| Total loans                   |       | $             | 3,204,006  |                      | $          | (6,658                       | )          | $ | 3,197,348 |   |

 

The following table summarizes the components of thecarrying value of the Company’s loans as of December 31, 2006 (amounts inthousands):
| ** **                                                | ** ** | **Principal** | ** ** | **Unamortized  Premium/(Discount)** | ** ** | **Net  Amortized Cost** | ** ** |
|-----------------------------------------------------------|------------|---------------|------------|-------------------------------------|------------|------------------------------|------------|
| Residential  mortgage loans                               |       | $             | 5,092,419  |                                | $          | 16,842                       |       | $ | 5,109,261 |   |
| Corporate loans                                           |       | 3,232,414     |       | (6,847                              | )          | 3,225,567                    |       |
| Commercial real  estate loans                             |       | 108,790       |       | (97                                 | )          | 108,693                      |       |
| Allowance for  loan losses for residential mortgage loans |       | (1,500        | )          | —                              |       | (1,500                       | )          |
| Total loans, net  of allowance for loan losses            |       | $             | 8,432,123  |                                | $          | 9,898                        |       | $ | 8,442,021 |   |

 

Note 8 to these condensed consolidated financialstatements describes the Company’s borrowings under which the Company haspledged loans for borrowings under repurchase agreements, asset-backed securedliquidity notes, and all other secured financing transactions. The followingtable summarizes the carrying value of loans pledged as collateral underrepurchase agreements, asset-backed secured liquidity notes, and all other securedfinancing transactions as of March 31, 2007 (amounts in thousands):
| **(amounts in thousands)**                                           | ** ** | **Residential  Mortgage Loans** | ** ** | **Corporate Loans** | ** ** | **Commercial Real  Estate Loans** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|
| Pledged as  collateral for borrowings under repurchase agreements              |       | 2,071,329                            |       | 558,082                  |       | $                                           | 15,000     |   |
| Pledged as  collateral for asset-backed secured liquidity notes                |       | 2,729,205                            |       | —                   |       | —                                      |       |
| Pledged as  collateral for borrowings under secured revolving credit facility  |       | —                               |       | 105,200                  |       | —                                      |       |
| Pledged as  collateral for collateralized loan obligation senior secured notes |       | —                               |       | 2,428,738                |       | 90,328                                      |       |
| Total                                                                          |       | $                                    | 4,800,534  |                     | $          | 3,092,020                                   |       | $ | 105,328 |   |
|                                                                                |            |                                      |            |                          |            |                                             |            |  |  |  |

 

The following table summarizes the carrying value ofloans pledged as collateral under repurchase agreements, asset-backed securedliquidity notes, and all other secured financing transactions as ofDecember 31, 2006 (amounts in thousands):

14

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

 

The following table summarizes the delinquencystatistics of residential mortgage loans as of March 31, 2007 (dollar amountsin thousands):

| Delinquency Status | ** ** | **Number of Loans** | ** ** | **Principal Amount** | ** ** |
|-------------------------|------------|-------------------------------|------------|---------------------------|------------|
| 30 to 59 days           |       | 82                            |       | $                         | 33,321     |   |
| 60 to 89 days           |       | 22                            |       | 6,583                     |       |
| 90 days or more         |       | 22                            |       | 7,332                     |       |
| In foreclosure          |       | 23                            |       | 6,681                     |       |
| Total                   |       | 149                           |       | $                         | 53,917     |   |

 

The following table summarizes the delinquencystatistics of residential mortgage loans as of December 31, 2006 (dollaramounts in thousands):

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

 

As of March 31, 2007 the aggregate fair value ofresidential mortgage loans that are 90 days or more past due or inforeclosure approximated the unpaid principal balance of these loans. As ofMarch 31, 2007, the uncollected principal amount of the Company’s residentialmortgage loans exceeded their fair value by $20.7 million. As of March 31,2007, eight****of the residential mortgage loansowned by the Company with an outstanding balance of $1.2 million (not includedin the table above) were real estate owned (“REO”) as a result of foreclosureon delinquent loans.****As ofDecember 31, 2006, six of the residential mortgage loans owned by theCompany with an outstanding balance of $1.3 million (not included in the tableabove) were REO as a result of foreclosure on delinquent loans. As of March 31,2007 and December 31, 2006, the estimated fair value of the underlying propertyfor these loans approximated the loan balance and the loans have beenreclassified from loans to other assets on the Company’s balance sheet at thelower of cost or estimated fair value.

As of March 31, 2007, the Company had forty-fiveloans that were either 90 days or greater past due or in foreclosure and placedon non-accrual status. As of March 31, 2007, the Company had not recognizedapproximately $0.3 million in interest income for loans that were eitherin non-accrual status or classified as REO.

The following table summarizes the changes in theallowance for loan losses for the Company’s residential mortgage loan portfolioduring the three months ended March 31, 2007 (amounts in thousands):

| Balance, beginning of period                                  |   | $      | 1,500  |   |
|---------------------------------------------------------------|--------|--------|--------|--------|
| Transition to  SFAS No. 159 adjustment to accumulated deficit |   | (1,500 | )      |
| Balance, end of period                                        |   | $      | — |   |

 

**CorporateLoans**

As of March 31, 2007 and December 31, 2006, nocorporate loans were delinquent and as of March 31, 2007 and December 31,2006, the Company had not recorded an allowance for loan losses for itscorporate loan portfolio. In reviewing the Company’s portfolio of corporateloans, the Company determined that no loans were impaired as of March 31, 2007and December 31, 2006.

15

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**Note 7.Investment in Unconsolidated Affiliate**

As of March 31, 2007, the Company’s investment inan unconsolidated affiliate consisted of a 49.9% limited partnership interestin KFH. The remaining 50.1% of KFH is owned by three private investment funds(collectively, the “KKR Strategic Capital Funds”) and the general partner ofthe KKR Strategic Capital Funds. The KKR Strategic Capital Funds are managedby an affiliate of the Company’s Manager and the KFH general partner is 100%owned by the Company’s Manager. The Company’s investment in KFH is accountedfor under the equity method. Under the equity method, the Company’s initialinvestment is recorded at cost and is subsequently adjusted to recognize theCompany’s share of KFH’s earnings or losses. Distributions received reduce thecarrying amount of the investment.

KFH was formed during the third quarter of 2006 and isthe primary beneficiary of four special purpose entities formed during thethird quarter of 2006 to complete secured financing transactions to financecertain investments in corporate loans and securities. The special purposeentities are KKR Financial CLO 2007-1, Ltd. (“CLO 2007-1”), KKR FinancialCLO 2007-2, Ltd. (“CLO 2007-2”), KKR Financial CLO 2007-3, Ltd. (“CLO2007-3”), and KKR Financial CLO 2007-4, Ltd (“CLO 2007-4”). Each of theseentities was established to complete secured financing transactions. CLO2007-1, CLO 2007-2, and CLO 2007-3 have elected to be treated astaxable REIT subsidiaries for federal tax purposes. During August 2006,CLO 2007-1, CLO 2007-2 and CLO 2007-3 each entered into separate creditfacilities, with a maximum commitment amount of $750.0 million, $750.0 millionand $600.0 million, respectively. Each of these facilities bear interest at arate of 30-day London Interbank Offered Rate (“LIBOR”) plus 0.50%. As of March31, 2007, CLO 2007-4 had not entered into a credit facility agreement and hadno assets or liabilities.

As of March 31, 2007, KFH had $1.5 billion in assetsconsisting of $1,200.1 million of corporate loans, $296.4 million of corporatesecurities, $35.1 million of restricted cash, $15.9 million of interestreceivable, and $0.4 million of other receivables. As of March 31, 2007, KFHhad liabilities totaling $1.3 billion consisting of $1,263.0 million ofborrowings under repurchase agreements, $26.5 million of interest payable and$0.7 million of other payables. As of March 31, 2007, KFH had net unrealizedgains on its investments in securities classified as available-for-saletotaling $17.6 million. During the quarter ended March 31, 2007, KFH hadnet income of $14.0 million consisting of $28.3 million of interest income less$14.3 million of interest expense.

As of December 31, 2006, KFH had $1.1 billion inassets consisting of $746.3 million of corporate loans, $294.5 million ofcorporate securities, $12.5 million of restricted cash, $12.1 million ofinterest receivable, and $6.6 million of other receivables. As ofDecember 31, 2006, KFH had liabilities totaling $863.9 million consistingof $851.8 million of borrowings under repurchase agreements and $12.1 millionof interest payable. As KFH was formed in the third quarter of 2006, KFH didnot have any net income during the quarter ended March 31, 2006.

16

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**Note 8.Borrowings**

The Company leverages its portfolio of securities andloans through the use of repurchase agreements, asset-backed secured liquiditynotes, warehouse facilities, demand loans, and securitization transactionsstructured as secured financings. Each of the borrowing facilities used by theCompany bears interest at floating rates based on a spread above LIBOR orasset-backed secured liquidity note interest rates.

Certaininformation with respect to the Company’s borrowings as of March 31, 2007 issummarized 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                 |       | $                           | 2,969,968  |                                   | 5.33       | %                                                          | 22         |                                             | $          | 2,843,508 |   |
| Demand loan                           |       | 41,658                      |       | 5.88                                   |       | 1                                                          |       | 46,838                                           |       |
| Secured revolving  credit facility    |       | 25,200                      |       | 6.07                                   |       | 18                                                         |       | 138,146                                          |       |
| Asset-backed secured  liquidity notes |       | 8,822,785                   |       | 5.35                                   |       | 22                                                         |       | 9,153,825                                        |       |
| CLO 2005-1 senior  secured notes      |       | 773,000                     |       | 5.64                                   |       | 3,679                                                      |       | 985,883                                          |       |
| CLO 2005-2 senior  secured notes      |       | 752,000                     |       | 5.63                                   |       | 3,893                                                      |       | 952,267                                          |       |
| CLO 2006-1 senior  secured notes      |       | 727,500                     |       | 5.72                                   |       | 4,165                                                      |       | 930,192                                          |       |
| CLO 2006-2 repurchase  agreements     |       | 581,872                     |       | 5.92                                   |       | 23                                                         |       | 694,459                                          |       |
| Junior subordinated  notes            |       | 257,743                     |       | 7.71                                   |       | 10,721                                                     |       | —                                           |       |
| Total                                 |       | $                           | 14,951,726 |                                   |       |                                                       |       |                                             | $          | 15,745,118 |   |

 

Certaininformation with respect to the Company’s borrowings as of December 31,2006 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                 |       | $                           | 3,824,728  |                                   | 5.44       | %                                                          | 19         |                                             | $          | 3,728,241 |   |
| Demand loan                           |       | 41,658                      |       | 5.88                                   |       | 1                                                          |       | 47,056                                           |       |
| Secured revolving  credit facility    |       | 34,710                      |       | 6.07                                   |       | 18                                                         |       | 208,536                                          |       |
| Asset-backed secured  liquidity notes |       | 8,705,601                   |       | 5.38                                   |       | 14                                                         |       | 9,015,211                                        |       |
| CLO 2005-1 senior  secured notes      |       | 773,000                     |       | 5.78                                   |       | 3,769                                                      |       | 984,837                                          |       |
| CLO 2005-2 senior  secured notes      |       | 752,000                     |       | 5.65                                   |       | 3,983                                                      |       | 982,976                                          |       |
| CLO 2006-1 senior  secured notes      |       | 727,500                     |       | 5.73                                   |       | 4,255                                                      |       | 1,001,405                                        |       |
| CDO 2005-1 repurchase  agreements     |       | 1,074                       |       | 6.45                                   |       | 18                                                         |       | 1,434                                            |       |
| CLO 2006-2 repurchase  agreements     |       | 631,287                     |       | 5.95                                   |       | 1                                                          |       | 734,348                                          |       |
| Junior subordinated  notes            |       | 257,743                     |       | 7.71                                   |       | 10,811                                                     |       | —                                           |       |
| Total                                 |       | $                           | 15,749,301 |                                   |       |                                                       |       |                                             | $          | 16,704,044 |   |

----

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

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**Note 9. Derivative Financial Instruments**

The Company enters into derivative transactions inorder hedge its interest rate risk exposure to the effects of interest ratechanges. Additionally, the Company enters into derivative transactions in thecourse of its investing. The counterparties to the Company’s derivativeagreements are major financial institutions with which the Company and itsaffiliates may also have other financial relationships. In the event ofnonperformance by the counterparties, the Company is potentially exposed tolosses. The counterparties to the Company’s derivative agreements haveinvestment grade ratings and, as a result, the Company does not anticipate thatany of the counterparties will fail to fulfill their obligations.

**Cash Flow and FairValue Hedges**

The Company uses interest rate derivatives consistingof swaps and corridors to hedge a portion of the interest rate risk associatedwith its borrowings under repurchase agreements, asset-backed secured liquiditynotes and CLO senior secured notes. The Company designates these financialinstruments as cash flow hedges. The Company also uses interest rate swaps tohedge all or a portion of the interest rate risk associated with certain fixedinterest rate investments. The Company designates these financial instrumentsas fair value hedges.

**Free-StandingDerivatives**

The Company has entered into free-standing derivativesthat in conjunction with its investment and risk management activities, but forwhich the Company has not designated the derivative contract as a hedginginstrument for accounting purposes. Such derivative contracts may includecredit default swaps, foreign exchange contracts, and interest ratederivatives. Free-standing derivatives also include investment financingarrangements (total rate of return swaps) whereby the Company receives the sumof all interest, fees and any positive change in fair value amounts from areference asset with a specified notional amount and pays interest, fees andany negative change in fair value amounts from such reference asset.

Thetable below summarizes the estimated net fair value of the derivativeinstruments as of March 31, 2007 and December 31, 2006 (amounts inthousands):

|                                 | ** ** | **As of  March 31, 2007** | ** ** | **As of  December 31, 2006** | ** ** |
|---------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **Notional**                             | ** ** | **Fair Value**                         | ** ** | **Notional** | ** ** | **Fair Value** | ** ** |
| **Cash  Flow Hedges:**          |       |                                     |       |                                        |       |   |   |   |   |
| Interest rate corridors         |       | $                                        | 728,465    |                                        | $          | 10,638 |   | $ | 702,369 |   | $ | 13,591 |   |
| Interest rate swaps             |       | 4,264,167                                |       | 29,248                                      |       | 4,567,828 |   | 45,314 |   |
| **Fair  Value Hedges:**         |       |                                     |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | 32,000                                   |       | (562                                        | )          | 32,000 |   | 13 |   |
| **Free-Standing  Derivatives:** |       |                                     |       |                                        |       |   |   |   |   |
| Interest rate swaptions         |       | 31,000                                   |       | 60                                          |       | 31,000 |   | 75 |   |
| Credit default swaps - long     |       | 56,614                                   |       | (185                                        | )          | 3,000 |   | 179 |   |
| Credit default swaps - short    |       | 315,614                                  |       | (271                                        | )          | 275,000 |   | (797 | ) |
| Total rate of return swaps      |       | 343,670                                  |       | 6,218                                       |       | 222,647 |   | 2,343 |   |
| Common stock warrants           |       | —                                   |       | 430                                         |       | — |   | — |   |
| Net fair value                  |       | $                                        | 5,771,530  |                                        | $          | 45,576 |   | $ | 5,833,844 |   | $ | 60,718 |   |

 

During the quarters ended March 31, 2007 andMarch 31, 2006, the Company recognized no ineffectiveness in income fromits cash flow and fair value hedges.

**Note 10. Accumulated Other Comprehensive Income**

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

|                                                                                                     | ** ** | **As of  March 31, 2007** | ** ** | **As of  December 31, 2006** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Net unrealized  gains on available-for-sale securities                                              |       | $                                        | 36,457     |                                        | $          | 11,776 |   |
| Net unrealized  gains on available-for-sale securities from investment in unconsolidated  affiliate |       | 8,810                                    |       | 7,898                                       |       |
| Net unrealized  gains on cash flow hedges                                                           |       | 32,673                                   |       | 50,846                                      |       |
| Accumulated other  comprehensive income                                                             |       | $                                        | 77,940     |                                        | $          | 70,520 |   |

 

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

|                                                                                                                                          | ** ** | **Three months  ended March 31,  2007** | ** ** | **Three months  ended March 31,  2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| Unrealized gains  on securities available-for-sale:                                                                                      |       |                                                   |       |                                                   |       |
| Unrealized holding gains (losses) arising during  period                                                                                 |       | $                                                      | 6,914      |                                                   | $          | (4,056 | ) |
| Transition adjustment to accumulated deficit in  conjunction with fair value option election for residential mortgage-backed  securities |       | 21,575                                                 |       | —                                                 |       |
| Reclassification adjustments for (gains) losses  realized in net income                                                                  |       | (3,808                                                 | )          | 639                                                    |       |
| Unrealized gains  (losses) on securities available-for-sale                                                                              |       | 24,681                                                 |       | (3,417                                                 | )          |
| Unrealized gains  on available-for-sale securities from investment in unconsolidated affiliate                                           |       | 912                                                    |       | —                                                 |       |
| Unrealized  (losses) gains on cash flow hedges                                                                                           |       | (18,173                                                | )          | 47,067                                                 |       |
| Other comprehensive  income                                                                                                              |       | $                                                      | 7,420      |                                                   | $          | 43,650 |   |

 

**Note 11. 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 and other share-based awards may be granted to the Manager,directors, officers and any key employees of the Manager and to any otherindividual or entity performing services 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 authorizes a total of 8,089,625 shares that may be used tosatisfy awards under the 2004 Stock Incentive Plan. The Company made itsinitial grants under the 2004 Stock Incentive Plan on August 12, 2004, andAugust 19, 2004, the dates that the Company closed its initial privateplacement of common stock and the date that the over-allotment option wasexercised, respectively.

Thefollowing table summarizes restricted common stock transactions:

|                                                                         | ** ** | **Manager** | ** ** | **Directors** | ** ** | **Total** | ** ** |
|-------------------------------------------------------------------------|------------|-------------|------------|---------------|------------|-----------|------------|
| **Unvested shares as of January 1, 2007** |       | 1,647,955   |       | 52,033        |       | 1,699,988 |       |
| Issued                                                                  |       | —      |       | —        |       | —    |       |
| Vested                                                                  |       | —      |       | (5,150        | )          | (5,150    | )          |
| Forfeited                                                               |       | —      |       | —        |       | —    |       |
| **Unvested shares as of  March 31, 2007**                          |       | 1,647,955   |       | 46,883        |       | 1,694,838 |       |

 

Theshares of restricted common stock granted to the directors were valued usingthe fair market value at the time of grant, which was $21.30 per share, for theshares of restricted common stock granted in 2006. Pursuant to SFAS No. 123(R),the Company is required to value any unvested shares of restricted common stockgranted to the Manager at the current market price. The Company valued theunvested restricted common stock at $27.43 and $22.43 per share atMarch 31, 2007 and March 31, 2006, respectively.

19

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Thefollowing table summarizes common stock option transactions:

|                                            | ** ** | **Number  of Options** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|------------------------------------------------|------------|
| **Outstanding  as of January 1, 2007**     |       | 1,932,279                   |       | $                                              | 20.00      |   |
| Granted                                    |       | —                      |       | —                                         |       |
| Exercised                                  |       | —                      |       | —                                         |       |
| Forfeited                                  |       | —                      |       | —                                         |       |
| **Outstanding as of  March 31, 2007** |       | 1,932,279                   |       | $                                              | 20.00      |   |

 

57,500and nil of the common stock options outstanding were exercised atMarch 31, 2007 and March 31, 2006, respectively. 1,269,020 and 663,260common stock options were exercisable on March 31, 2007 and March 31,2006, respectively. The common stock options are valued using the Black-Scholesmodel using the following assumptions:

|                | ** ** | **As of  March 31, 2007** | ** ** | **As of  March 31, 2006** | ** ** |
|----------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| Expected life  |       | 7.3 years                                |       | 8.3 years                                |       |
| Discount rate  |       | 4.63                                     | %          | 4.96                                     | %          |
| Volatility     |       | 22.10                                    | %          | 20.00                                    | %          |
| Dividend yield |       | 9.00                                     | %          | 9.00                                     | %          |

 

Theestimated fair value of the common stock options was $3.37 and $1.60 atMarch 31, 2007 and March 31, 2006, respectively. For the quarters endedMarch 31, 2007 and March 31, 2006, the components of share-basedcompensation expense are as follows (amounts in thousands):

|                                                 | ** ** | **For the three  months ended  March 31, 2007** | ** ** | **For the three  months ended  March 31, 2006** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| Options granted  to Manager                     |       | $                                                                        | 622        |                                                                     | $          | (12 | ) |
| Restricted  shares granted to Manager           |       | 5,110                                                                    |       | 6,621                                                                    |       |
| Restricted  shares granted to certain directors |       | 106                                                                      |       | 174                                                                      |       |
| Total share-based  compensation expense         |       | $                                                                        | 5,838      |                                                                     | $          | 6,783 |   |

 

**Note 12.** **Management Agreement and Related Party Transactions**

The Manager manages the Company’s day-to-dayoperations, subject to the direction and oversight of the Company’s Board ofDirectors. The Management Agreement expires on December 31, of each year,but is automatically renewed for a one-year term on each December 31 unlessterminated 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, based upon (1) unsatisfactoryperformance by the Manager that is materially detrimental to the Company or (2)a determination that the management fee payable by the Manager is not fair,subject to the Manager’s right to prevent such a termination under this clause(2) by accepting a mutually acceptable reduction of management fees.  The Manager must be provided 180 days priornotice of any such termination and will be paid a termination fee equal to fourtimes the sum of the average annual base management fee and the average annualincentive fee for the two 12-month periods immediately preceding the date oftermination, calculated as of the end of the most recently completed fiscalquarter prior to the date of termination.

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

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

For the quarter ended March 31, 2007, the Companyincurred $7.2 million in base management fees. In addition, the Companyrecognized share-based compensation expense related to common stock optionsand restricted common stock granted to the Manager of $5.7 million for thequarter ended March 31, 2007 (see Note 11). The Company alsoreimbursed the Manager $1.7 million for expenses for the quarter endedMarch 31, 2007. For the quarter ended March 31, 2006, the Companyincurred $7.1 million in base management fees. In addition, the Companyrecognized share-based compensation expense related to common stockoptions and restricted common stock granted to the Manager of $6.6 millionfor the quarter ended March 31, 2006 (see Note 11). The Company alsoreimbursed the Manager $1.4 million for expenses for the quarter ended March31, 2006. Base management fees incurred and share-based compensationexpense relating to common stock options and restricted common stock granted tothe Manager are included in related party management compensation on the condensedconsolidated statements of operations. Expenses incurred by the Manager andreimbursed by the Company are reflected in the respective consolidated statementof operations non-investment expense category based on the nature of theexpense.

20

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Incentive fees of $6.4 million and $0.7 million wereearned by the Manager during the quarters ended March 31, 2007 and 2006,respectively.

An affiliate of the Company’s Manager has entered intoseparate management agreements with the respective investment vehicles for CLO2005-1, CLO 2005-2, and CLO 2006-1 and is entitled to receivefees for the services performed as collateral manager. As of March 31, 2007,the collateral manager has permanently waived approximately $7.7 million infees. The waivers for CLO 2005-1, CLO 2005-2, and CLO 2006-1expire in April 2007, May 2007, and May 2007, respectively. Thecollateral manager evaluates such waivers on a quarterly basis and there are noassurances that the collateral manager will waive such management feessubsequent to those dates.

**Note 13.   Fair Value Disclosures**

Effective January 1, 2007 the Company early adoptedSFAS No. 157, which requires additional disclosures about the Company’s assetsand liabilities that are measured at fair value.  The following table presents informationabout the Company’s assets (including derivatives that are presented net)measured at fair value on a recurring basis as of March 31, 2007, and indicatesthe fair value hierarchy of the valuation techniques utilized by the Company todetermine such fair value.  In general,fair values determined by Level 1 inputs utilize quoted prices (unadjusted) inactive markets for identical assets that the Company has the ability to access.Fair values determined by Level 2 inputs utilize inputs other than quotedprices included in Level 1 that are observable for the asset, either directlyor indirectly. Level 2 inputs include quoted prices for similar assets inactive markets, and inputs other than quoted prices that are observable for theasset or liability.  Level 3 inputs areunobservable inputs for the asset, and include situations where there is little,if any, market activity for the asset or liability. In certain cases, theinputs used to measure fair value may fall into different levels of the fairvalue hierarchy. In such cases, the level in the fair value hierarchy withinwhich the fair value measurement in its entirety falls has been determinedbased on the lowest level input that is significant to the fair valuemeasurement in its entirety. The Company’s assessment of the significance of aparticular input to the fair value measurement in its entirety requiresjudgment, and considers factors specific to the asset.
| **(amounts in  thousands)**    | ** ** | **Quoted Prices in  Active Markets  for Identical Assets  (Level 1)** | ** ** | **Significant Other  Observable Inputs  (Level 2)** | ** ** | **Significant   Unobservable Inputs  (Level 3)** | ** ** | **Balance as of  March 31, 2007** | ** ** |
|--------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Trading securities             |       | $                                                                                                   | —     |                                                               | $          | 7,033,094                                                       |       | $                                                     | —     |   | $ | 7,033,094 |   |
| Securities  available-for-sale |       | 88,979                                                                                              |       | 686,009                                                            |       | 105,352                                                         |       | 880,340                                               |       |
| Loans                          |       | —                                                                                              |       | 4,845,144                                                          |       | —                                                          |       | 4,845,144                                             |       |
| Derivatives, net               |       | —                                                                                              |       | 44,467                                                             |       | 1,109                                                           |       | 45,576                                                |       |
| Total                          |       | $                                                                                                   | 88,979     |                                                               | $          | 12,608,714                                                      |       | $                                                     | 106,461    |   | $ | 12,804,154 |   |

 

The following table presents additional informationabout assets, including derivatives, which are measured at fair value on arecurring basis for which the Company has utilized Level 3 inputs to determinefair value:
| ** **                                                                                                                                                                              | ** ** | **Fair Value Measurements Using  Significant Unobservable Inputs  (Level 3)** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|
| **(amounts in  thousands)**                                                                                                                                                             | ** ** | **Securities  Available-For-Sale**                                                                          | ** ** | **Derivatives,  net** | ** ** |
| Beginning  balance                                                                                                                                                                      |       | $                                                                                                           | 104,498    |   | $ | — |   |
| Total gains or  losses (realized/unrealized):                                                                                                                                           |       |                                                                                                        |       |   |   |
| Included in  earnings                                                                                                                                                                   |       | —                                                                                                      |       | 1,109 |   |
| Included in  other comprehensive income                                                                                                                                                 |       | 854                                                                                                         |       | — |   |
| Ending balance                                                                                                                                                                          |       | $                                                                                                           | 105,352    |   | $ | 1,109 |   |
|                                                                                                                                                                                    |       |                                                                                                        |       |   |   |
| The amount of total  gains or losses for the period included in earnings attributable to the  change in unrealized gains or losses relating to assets still held at the  reporting date |       | $                                                                                                           | —     |   | $ | 1,109 |   |

 

As of March 31, 2007, the Company did not have anyassets or liabilities measured at fair value on a non-recurring basis.

**Note 14.   Subsequent Events**

On May3, 2007, the Company’s shareholders approved a restructuring transaction (the“Conversion Transaction”) whereby KKR Financial Corp., currently a publiclytraded Maryland corporation, will become a subsidiary of a recently formedDelaware limited liability company that will be publicly traded.  The Delaware limited liability company, namedKKR Financial Holdings LLC, will not be taxed as a REIT, but is expected to betreated as a pass-through entity for U.S. federal income tax purposes.  The Conversion Transaction will result ineach share of currently issued and outstanding KKR Financial Corp. common stockbeing converted into an equal number of limited liability company shares in KKRFinancial Holdings LLC (“Holdings”). The Company expects that the ConversionTransaction will be consummated on May 4, 2007.

On May3, 2007, the Company’s Board of Directors declared a cash distribution for anaggregate amount of $45.1 million for the three months ended March 31, 2007 onthe Company’s common stock.  Thedistribution is payable on May 31, 2007 to common stockholders of record as of theclose of business on May 17, 2007. However, assuming that the ConversionTransaction is consummated on May 4, 2007, the Company’s sole commonstockholder after that date will be Holdings and this cash distribution willtherefore be paid to Holdings.  Accordingly,the Company expects that the board of directors of Holdings will declare a cashdistribution in the same aggregate amount payable on May 31, 2007 to thepersons who are holders of its common shares as of the close of business on May17, 2007. Based on the number of shares of Holdings that the Company expectswill be issued in the Conversion Transaction, the Company expects that Holdingswill pay a distribution of $0.56 on each of its common shares on May 31, 2007.

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

*Exceptwhere the context suggests otherwise, the terms “we,” “us” and “our” refer toKKR Financial Corp. and its subsidiaries. The following management’s discussionand analysis (“MD&A”) is intended to assist the reader in understanding ourbusiness. The MD&A is provided as a supplement to, and should be read inconjunction with, our Condensed Consolidated Financial Statements andaccompanying notes included in this Quarterly Report on Form 10-Q and ourConsolidated Financial Statements and accompanying notes included in our AnnualReport on Form 10-K for the year ended December 31, 2006.*

**ForwardLooking Statements**

Certain information containedin this Quarterly Report on Form 10-Q constitutes “forward-looking”statements within the meaning of Section 27A of the Securities Act of 1933and Section 21E of the Securities Exchange Act of 1934 that are based onour current expectations, estimates and projections. Pursuant to thosesections, we may obtain a “safe harbor” for forward-looking statements byidentifying those and by accompanying those statements with cautionarystatements, which identify factors that could cause actual results to differfrom those expressed in the forward-looking statements. Statements that are nothistorical facts, including statements about our beliefs and expectations, areforward-looking statements. The words “believe,” “anticipate,” “intend,” “aim,”“expect,” “strive,” “plan,” “estimate,” and “project,” and similar wordsidentify forward-looking statements. Such statements are not guarantees offuture performance, events or results and involve potential risks anduncertainties. Accordingly, actual results and the timing of certain events coulddiffer materially from those addressed in forward-looking statements due to anumber of factors including, but not limited to, changes in interest rates andmarket values, changes in prepayment rates, general economic conditions, andother factors not presently identified. Other factors that may impact ouractual results are discussed in our Annual Report on Form 10-K under thesection titled “Risk Factors.”  We do not undertake, and specificallydisclaim, any obligation to publicly release the result of any revisions thatmay be made to any forward-looking statements to reflect the occurrence ofanticipated or unanticipated events or circumstances after the date of suchstatements.

**Executive Overview**

Weare a specialty finance company that invests in multiple asset classes and usesleverage with the objective of generating competitive leveraged risk-adjustedreturns subject to maintaining our status as a real estate investment trust (“REIT”)under the Internal Revenue Code of 1986, as amended (the “Code”), and ourexemption from regulation under the Investment Company Act of 1940, as amended(the “Investment Company Act”). Our objective is to provide competitive returnsto our investors through a combination of distributions and capitalappreciation. As part of our multi-asset class strategy, we seek toinvest opportunistically in those asset classes that can generate competitiveleveraged risk-adjusted returns. Investing in multiple asset classes does not,however, reduce or eliminate many of the risks associated with our investmentportfolio such as geographic concentration risk, asset class concentrationrisk, market risk and credit risk. We currently make investments in thefollowing asset classes: (i) residential mortgage loans and mortgage-backedsecurities; (ii) corporate loans and debt securities;(iii) 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 dividend incomeearned on our investments and the cost of our borrowings, plus(i) realized and unrealized gains and losses on its derivatives that arenot accounted for as hedges, (ii) realized gains and losses from the salesof investments, (iii) unrealized gains and losses on trading securities andloans carried at fair value, and (iv) fee income.

Ourboard of directors and shareholders have approved a restructuring transaction(the “Conversion Transaction”) whereby KKR Financial Corp., currently apublicly traded Maryland corporation, will become a subsidiary of a recentlyformed Delaware limited liability company that will be publicly traded. TheDelaware limited liability company, named KKR Financial Holdings LLC, (“Holdings”)will not be taxed as a REIT, but is expected to be treated a pass-throughentity for U.S. federal income tax purposes. The Conversion Transaction willresult in each share of currently issued and outstanding KKR Financial Corp.common stock being converted into one common share (a “common share”)representing a limited liability company interest in Holdings.  We expect that the Conversion Transactionwill be consummated on May 4, 2007.  Foradditional information concerning the Conversion Transaction, you should reviewthe registration statement on Form S-4, as amended, filed by Holdings with theSecurities and Exchange Commission (the “SEC”), which may be obtained free ofcharge on the SEC website at www.sec.gov.

Weexpect that the Conversion Transaction will provide Holdings with theflexibility over time to take the capital that we currently have invested inreal estate related investments and reallocate that capital to non real estate relatedinvestments.  We also understand that Holdingsintends over time to allocate significantly more capital to non real estate relatedinvestments, which are expected to be comprised principally of (1) debtobligations and (2) marketable and non-marketable equity securities which willconsist primarily of private equity investments.  To the extent that Holdings is successfulexecuting this strategy, it will result in changes in Holdings’ assets,business and operations when compared to our historical assets, business andoperations. 

Weunderstand that Holdings is evaluating various alternatives to reducing itsreal estate related investments after the Conversion Transaction, includingallowing real estate related assets to pay down in the ordinary course orselling real estate related assets.  Webelieve that, if Holdings were to allow its real estate-related assets toliquidate in the ordinary course, the reallocation of capital would occur overthree or four years, although it might take longer absent other liquidationstrategies.  Also, there can be noassurance that, if Holdings were to attempt to sell real estate related assets,it would be successful in selling those assets within the time period or forthe price it desired, or at all.

Inaddition, Holdings has not elected to be treated as a REIT for U.S. federalincome tax purposes and will therefore not be subject to those provisions ofthe Code that require us to distribute substantially all of our taxable incomein the form of distributions to stockholders in order to maintain our qualificationas a REIT.  Nonetheless, we understandthat Holdings currently intends to distribute approximately 75% to 95% of itstaxable income to its shareholders. However, distributions by Holdings must be approved by, and will besubject to the sole discretion of, its board of directors and will be subjectto various considerations including, but not limited to, its financialperformance, liquidity requirements, distribution restrictions contained in itscurrent or future financing facilities, its distribution yield relative to itspeers and other relevant factors identified by its board of directors.

***Cash Distributions to Stockholders***

OnMay 3, 2007, our Board of Directors declared a cash distribution for anaggregate amount of $45.1 million for the three months ended March 31, 2007 onour common stock. The distribution is payable on May 31, 2007 to our common stockholdersof record as of the close of business on May 17, 2007.  However, assuming that the ConversionTransaction is consummated on May 4, 2007, our sole common stockholder afterthat date will be Holdings and this cash distribution will therefore be paid toHoldings.  Accordingly, we expect thatthe board of directors of Holdings will declare a cash distribution in the sameaggregate amount payable on May 31, 2007 to the persons who are the recordholders of its common shares as of the close of business on May 17, 2007.  Based on the number of common shares ofHoldings that we expect will be issued in the Conversion Transaction, we expectthat Holdings will pay a distribution of $0.56 on each of its common shares onMay 31, 2007.

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***Investment Portfolio***

As ofMarch 31, 2007 our investment portfolio totaled $16.1 billion, representing adecrease of 6% from $17.1 billion as of December 31, 2006. As of March 31,2007, our investment portfolio primarily consisted of residential mortgageloans and securities totaling $11.9 billion, corporate loans and securitiestotaling $3.9 billion, commercial real estate loans and securities totaling$137.5 million, and marketable equity securities consisting of preferred andcommon stock totaling $89.0 million. In addition, we held investments innon-marketable equity securities totaling $173.8 million as of March 31, 2007.

**Critical Accounting Policies**

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.

***RevenueRecognition***

We account for interest income on our investmentsusing the effective yield method. For investments purchased at par, theeffective yield is the contractual coupon rate on the investment. Unamortizedpremiums and discounts on non-residential mortgage-backed securities arerecognized in interest income over the contractual life, adjusted for actualprepayments, of the securities using the effective interest method. Forsecurities representing beneficial interests in securitizations that are nothighly rated (i.e., subordinate tranches of residential mortgage-backedsecurities), unamortized premiums and discounts are recognized over 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.

Interest income on loans includes interest at statedcoupon rates adjusted for accretion of purchase discounts and the amortizationof purchase premiums. For corporate and commercial real estate loans,unamortized premiums and discounts are recognized in interest income over the contractuallife, adjusted for actual prepayments, of the loans using the effectiveinterest method. For residential mortgage loans, unamortized premiums anddiscounts are recognized over the contractual life, adjusted for estimatedprepayments using the effective interest method.

As of March 31, 2007, unamortized purchasepremiums and unaccreted purchase discounts on our investment portfolio totaled$25.5 million and $41.0 million, respectively.

Upon adoption ofSFAS No. 159, *The Fair Value Option for Financial Assetsand Financial Liabilities—Including an amendment of FASB Statement No. 115*(“SFAS No. 159”) as of January 1, 2007 as disclosed below under “Recent AccountingPronouncements”, we carry our investments in residential mortgage-backedsecurities and residential mortgage loans at fair value with changes in fairvalue recorded in income.

***Share-BasedCompensation***

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

Because we remeasure the amount of compensation costsassociated with the unvested restricted common stock and unvested common stockoptions that we issued to our Manager as of each reporting period, our share-basedcompensation expense reported in our consolidated financial statements willchange based on the estimated fair value of our common stock and this mayresult in earnings volatility. For the quarter ended March 31, 2007, share-basedcompensation totaled $5.8 million. As of March 31, 2007, substantially allof the non-vested common stock options and restricted common stock issued thatis subject to SFAS No. 123(R) is subject to remeasurement. As ofMarch 31, 2007, a $1 increase in the price of our common stock wouldhave increased our future share-based compensation expense by approximately$1.9 million and this future share-based compensation expense would berecognized over the remaining vesting periods of our outstanding restrictedcommon stock and common stock options. As of March 31, 2007, futureunamortized share-based compensation totaled $11.8 million, of which$8.5 million, $3.2 million, and $0.1 million will be recognized in 2007,2008, and 2009, respectively.

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***Accounting forDerivative Instruments and Hedging Activities***

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

We formally document at inception our hedgerelationships, including identification of the hedging instruments and thehedged items, our risk management objectives, strategy for undertaking thehedge transaction and our evaluation of effectiveness of its hedgedtransactions. Periodically, as required by SFAS No. 133, *Accounting for Derivative Instruments and HedgingActivities*, as amended and interpreted (“SFAS No. 133”), wealso formally assesses whether the derivative it designated in each hedgingrelationship is expected to be and has been highly effective in offsettingchanges in estimated fair values or cash flows of the hedged item using eitherthe dollar offset or the regression analysis method. If we determine that aderivative is not highly effective as a hedge, we discontinue hedge accounting.

We are not required to account for our derivativecontracts using hedge accounting as described above. If we decide not todesignate the derivative contracts as hedges or if we fail to fulfill thecriteria necessary to qualify for hedge accounting, then the changes in theestimated fair values of our derivative contracts would immediately affectperiodic earnings, potentially resulting in the increased volatility of ourearnings. The qualification requirements for hedge accounting are complex andas a result we must evaluate, designate, and thoroughly document each hedgetransaction at inception and perform ineffectiveness analysis and preparerelated documentation at inception and on a recurring basis thereafter. As ofMarch 31, 2007, the estimated fair value of our derivatives totaled $45.6million.

***Impairments***

We evaluate our investment portfolio for impairment asof each quarter end or more frequently if we become aware of any materialinformation that would lead us to believe that an investment may be impaired.We evaluate whether the investment is considered impaired and whether theimpairment is other-than-temporary. If we make a determination that theimpairment is other-than-temporary, we recognize an impairment loss equal tothe difference between the amortized cost basis and the estimated fair value ofthe investment. We consider many factors in determining whether the impairmentof an investment is 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 loss, our intent and our financial ability tohold the investment for a period of time sufficient for a recovery in itsestimated fair value, recent events specific to the issuer or industry,external credit ratings and recent downgrades in such ratings.

**Recent AccountingPronouncements**

In February 2006, the FASB issued SFASNo. 155, *Accounting for Certain Hybrid FinancialInstruments* (“SFAS No. 155”). 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*,* thereby narrowing such exception; (3) a requirementthat beneficial interests in securitized financial assets be analyzed todetermine whether they are freestanding derivatives or whether they are hybridinstruments that contain embedded derivatives requiring bifurcation;(4) clarification that concentrations of credit risk in the form ofsubordination are not embedded derivatives; and (5) elimination of theprohibition on a QSPE holding passive derivative financial instruments thatpertain to beneficial interests that are or contain a derivative financialinstrument. In general, these changes will reduce the operational complexityassociated with bifurcating embedded derivatives, and increase the number ofbeneficial interests in securitization transactions, including interest-onlystrips and principal-only strips, required to be accounted for in accordancewith SFAS No. 133. We adopted SFAS No. 155 as of the beginning of 2007 andthe adoption of SFAS No. 155 did not have a material impact on our consolidatedfinancial statements.

In June 2006, the FASB issued InterpretationNo. 48, *Accounting for Uncertainty in IncomeTaxes—an interpretation of FASB Statement No. 109* (“FIN 48”).FIN 48 clarifies the accounting for uncertainty in income taxes recognized inan enterprise’s financial statements in accordance with FASB StatementNo. 109, *Accounting for Income Taxes*. FIN48 prescribes a recognition threshold and measurement attribute for thefinancial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. We adopted FIN 48 as of the beginning of2007 and the adoption of FIN 48 did not have a material impact on ourconsolidated financial statements.

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In September 2006, the FASB issued SFASNo. 157, *Fair Value Measurements*(“SFASNo. 157”). This statement defines fair value, establishes a framework formeasuring fair value in GAAP and expands disclosures about fair valuemeasurements. SFAS No. 157 does not require any new fair valuemeasurements. We adopted SFAS No. 157 as of the beginning of 2007 and theadoption of SFAS No. 157 did not have a material impact on the manner inwhich the Company measures the fair value of its financial instruments, but didresult in certain additional disclosures, which are contained in Note 13of our condensed consolidated financial statements.

In February 2007, FASB issued SFAS No. 159.This statement permits entities to choose to measure many financial instrumentsand certain other items at fair value (i.e., the fair value option). Theelection to use the fair value option is available when an entity firstrecognizes a financial asset or financial liability or upon entering into afirm commitment.  Subsequent changes infair value must be recorded in earnings. Additionally, SFAS No. 159 allows for a one-time election for existingpositions upon adoption, with the transition adjustment recorded to beginningretained earnings.

We adopted SFAS No. 159 as of the beginning of 2007and elected to apply the fair value option for our investments in residentialmortgage loans and residential mortgage-backed securities. Additionally, weintend to consistently apply the election of the fair value option to anyfuture residential mortgage investments. We have elected the fair value optionfor our residential mortgage investments for the purpose of enhancing thetransparency of our financial condition as fair value is consistent with how wemanages the risks of residential mortgage investments. The transitionadjustment to beginning accumulated deficit that was recorded as of January 1,2007 due to the adoption of SFAS No. 159 was a loss of $55.7 million.  The following table presents informationabout the eligible instruments for which the Company elected the fair valueoption and for which transition adjustments was recorded as of January 1, 2007(amounts in thousands):
| ** **                                                  | ** ** | **Carrying Value at  January 1, 2007** | ** ** | **Transition Adjustment to  Accumulated Deficit  Gain/(Loss)** | ** ** | **Carrying Value at  January 1, 2007  (After Adoption of  SFAS No. 159)** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|
| Residential  mortgage loans                                 |       | $                                                          | 5,109,261  |                                                                          | $          | (35,653                                                                                                           | )          | $ | 5,073,608 |   |
| Allowance for  loan losses                                  |       | (1,500                                                     | )          | 1,500                                                                         |       | —                                                                                                            |       |
| Residential  mortgage-backed securities (1)                 |       | 7,536,196                                                  |       | (21,575                                                                       | )          | 7,536,196                                                                                                         |       |
| Cumulative effect of  the adoption of the fair value option |       |                                                       |       | $                                                                             | (55,728    | )                                                                                                                 |       |   |
|                                                             |            |                                                            |            |                                                                               |            |                                                                                                                   |            |  |  |  |

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(1)             Priorto January 1, 2007, residential mortgage-backed securities were classified asavailable-for-sale and carried at fair value. Accordingly, the election of the fair value option for mortgage-backedsecurities did not change their carrying value and resulted in areclassification from accumulated other comprehensive income to beginningaccumulated deficit.

**Resultsof Operations**

**Quarter ended March 31, 2007 compared to quarter ended March31, 2006**

*Summary*

Ournet income for the quarter ended March 31, 2007 totaled $48.4 million (or$0.60 per diluted share) as compared to net income of $30.4 million (or $0.38per diluted share) for the quarter ended March 31, 2006.

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*Net Investment Income*

Thefollowing table presents the components of our net investment income for thequarters ended March 31, 2007 and 2006:

**Comparative Net Investment IncomeComponents (Amounts in thousands)**
| ** **                                                            | ** ** | **For the three  months ended  March 31, 2007** | ** ** | **For the three  months ended  March 31, 2006** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| Investment  Income:                                                   |       |                                                                     |       |                                                                     |       |
| Residential mortgage loans and securities interest  income            |       | $                                                                        | 163,706    |                                                                     | $          | 146,130 |   |
| Corporate loans and securities interest income                        |       | 82,385                                                                   |       | 50,414                                                                   |       |
| Commercial real estate loans and securities interest  income          |       | 2,852                                                                    |       | 8,638                                                                    |       |
| Other interest income                                                 |       | 2,687                                                                    |       | 1,845                                                                    |       |
| Common and preferred stock dividend income                            |       | 974                                                                      |       | 883                                                                      |       |
| Net premium/discount (amortization) accretion                         |       | 407                                                                      |       | (112                                                                     | )          |
| Total investment income                                               |       | 253,011                                                                  |       | 207,798                                                                  |       |
| Interest  Expense:                                                    |       |                                                                     |       |                                                                     |       |
| Repurchase agreements interest expense                                |       | 55,212                                                                   |       | 106,062                                                                  |       |
| Collateralized loan obligation senior secured notes  interest expense |       | 32,060                                                                   |       | 17,965                                                                   |       |
| Asset-backed secured liquidity notes interest  expense                |       | 117,497                                                                  |       | 31,476                                                                   |       |
| Secured revolving credit facility interest expense                    |       | 988                                                                      |       | 750                                                                      |       |
| Demand loan interest expense                                          |       | 604                                                                      |       | 504                                                                      |       |
| Junior subordinated notes interest expense                            |       | 4,985                                                                    |       | 32                                                                       |       |
| Other interest expense                                                |       | 634                                                                      |       | 941                                                                      |       |
| Interest rate swaps interest expense, net                             |       | (11,914                                                                  | )          | (1,167                                                                   | )          |
| Total interest expense                                                |       | 200,066                                                                  |       | 156,563                                                                  |       |
| Net investment income                                                 |       | $                                                                        | 52,945     |                                                                     | $          | 51,235 |   |

 

Aspresented in the table above, our net investment income increased by $1.7million for the quarter ended March 31, 2007 compared to the quarter endedMarch 31, 2006. The change from 2006 to 2007 is primarily attributable to theincrease in our investment portfolio since March 31, 2006. As of March 31,2007, we held $16.0 billion in investments in loans, securitiesavailable-for-sale, and trading securities and had borrowings outstandingtotaling $15.0 billion. In comparison, as of March 31, 2006, investments inloans and securities available-for-sale totaled $15.4 billion and borrowingsoutstanding totaled $13.5 billion.

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*Other Income*

Thefollowing table presents the components of our other income for the quartersended March 31, 2007 and March 31, 2006:

**Comparative Other Income Components (Amounts in thousands)**
| ** **                                                                 | ** ** | **For the three  months ended  March 31, 2007** | ** ** | **For the three  months ended  March 31, 2006** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| Net realized and  unrealized gain on derivatives and foreign exchange:     |       |                                                                     |       |                                                                     |       |
| Interest rate swaptions                                                    |       | $                                                                        | (16        | )                                                                        | $          | 33 |   |
| Interest rate swaps                                                        |       | —                                                                   |       | 161                                                                      |       |
| Credit default swaps                                                       |       | (42                                                                      | )          | (258                                                                     | )          |
| Total rate of return swaps                                                 |       | 6,767                                                                    |       | (300                                                                     | )          |
| Common stock warrants                                                      |       | 430                                                                      |       | —                                                                   |       |
| Foreign exchange translation                                               |       | (1                                                                       | )          | 374                                                                      |       |
| Total realized and unrealized gain on derivatives  and foreign exchange    |       | 7,138                                                                    |       | 10                                                                       |       |
| Net realized  gain on investments                                          |       | 6,944                                                                    |       | 1,448                                                                    |       |
| Net unrealized  gain on trading securities and loans carried at fair value |       | 2,769                                                                    |       | —                                                                   |       |
| Fee and other  income                                                      |       | 2,048                                                                    |       | 215                                                                      |       |
| Total other income                                                         |       | $                                                                        | 18,899     |                                                                     | $          | 1,673 |   |

 

Aspresented in the table above, other income totaled $18.9 million for thequarter ended March 31, 2007 as compared to $1.7 million for the quarterended March 31, 2006. The increase in total other income is primarilyattributable to increased net realized gains on the sale of investments,increased use of total rate of return swaps to finance investments, and theinclusion of the changes in the fair value of residential mortgage-backedsecurities and residential mortgage loans in income due to the adoption of SFASNo. 159.

*Non-Investment Expenses*

Thefollowing table presents the components of our non-investment expenses for thequarters ended March 31, 2007 and March 31, 2006:

**Comparative Non-Investment ExpenseComponents (Amounts in thousands)**
| ** **                              | ** ** | **For the three  months ended  March 31, 2007** | ** ** | **For the three  months ended  March 31, 2006** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| Related party  management compensation: |       |                                                                     |       |                                                                     |       |
| Base management fees                    |       | $                                                                        | 7,196      |                                                                     | $          | 7,158 |   |
| Incentive fee                           |       | 6,371                                                                    |       | 673                                                                      |       |
| Share-based compensation                |       | 5,732                                                                    |       | 6,609                                                                    |       |
| Related party  management compensation  |       | 19,299                                                                   |       | 14,440                                                                   |       |
| Professional  services                  |       | 541                                                                      |       | 947                                                                      |       |
| Loan servicing  expense                 |       | 3,263                                                                    |       | 3,996                                                                    |       |
| Insurance  expense                      |       | 194                                                                      |       | 224                                                                      |       |
| Directors  expenses                     |       | 320                                                                      |       | 373                                                                      |       |
| General and  administrative expenses    |       | 6,008                                                                    |       | 2,228                                                                    |       |
| Total non-investment  expenses          |       | $                                                                        | 29,625     |                                                                     | $          | 22,208 |   |

 

As presented in the table above, our non-investmentexpenses increased by $7.4 million for the three months ended March 31, 2007compared to the three months ended March 31, 2006. The significant componentsof non-investment expense are described below.

27

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Management compensation to related parties consists ofbase management fees payable to our Manager pursuant to the ManagementAgreement, incentive management fees, and share-based compensation related torestricted common stock and common stock options granted to our Manager. Thebase management fee payable was calculated in accordance with the ManagementAgreement and is based on an annual rate of 1.75% times our “equity” as definedin the Management Agreement. Our Manager is also entitled to an incentive feeprovided that our quarterly “net income,” as defined in the ManagementAgreement, before the incentive fee exceeds a defined return hurdle.

General and administrative expenses consist ofexpenses incurred by our Manager on our behalf that are reimbursable to ourManager pursuant to the Management Agreement. Professional services expensesconsist of legal, accounting and other professional services. Loan servicingexpense consists of fixed servicing fees paid to third-party servicers. Theincrease in non-investment expense is primarily due to the increased incentivefee expense for the first quarter of 2007 compared to the first quarter of2006, which is directly related to our increase in net income (as defined inthe Management Agreement) for the first quarter of 2007 compared to the firstquarter of 2006, and our decision to terminate an existing $300.0 millioncredit facility entered into by KKR Financial CDO 2005-1, Ltd., which resultedin the write-off of approximately $2.2 million of capitalized costs related tothis facility.

*Income Tax Provision*

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

KKR TRS Holdings Inc. (“TRS Inc.”), our domestictaxable REIT subsidiary, is taxed as a regular subchapter C corporation underthe provisions of the Code. TRS Inc. was formed to make, from time to time,certain investments that would not be REIT qualifying investments if madedirectly by us, and to earn income that would not be REIT qualifying income ifearned directly by us. For the quarter ended March 31, 2007, TRS Inc. hadpre-tax net income of $1.9 million and the provision for income taxes totaled $0.8 million.As of March 31, 2007, TRS Inc. had an income tax liability of $0.6 million.

KKR Financial CLO 2005-1, Ltd., KKR Financial CLO 2005-2,Ltd., KKR Financial CLO 2006-1 Ltd., and KKR Financial CLO 2006-2 Ltd., areforeign taxable REIT subsidiaries that were established to facilitatesecuritization transactions, structured as secured financing transactions, andKKR TRS Holdings, Ltd., is a foreign taxable REIT subsidiary that was formed tomake from time to time, certain foreign investments. They are organized as exemptedcompanies incorporated with limited liability under the laws of the CaymanIslands, and are generally exempt from federal and state income tax at thecorporate entity level because they restrict their activities in the UnitedStates to trading in stock and securities for their own account. Therefore,despite their status as taxable REIT subsidiaries, they generally will not besubject to corporate income tax on their earnings, and no provisions for incometaxes for the quarter ended March 31, 2007 were recorded; however, we aregenerally required to include their current taxable income in our calculationof REIT taxable income.

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**Financial Condition**

**Summary**

Thetables below summarize the carrying value, amortized cost, and estimated fairvalue of our investment portfolio as of March 31, 2007 and December 31, 2006,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 residential mortgage loans and amortized cost for corporate andcommercial real estate loans held for investment and the lower of amortizedcost or market value for loans held for sale. Estimated fair values set forthin the tables below are based on dealer quotes and/or nationally recognizedpricing services.

Thetable below summarizes our investment portfolio as of March 31, 2007 classifiedby interest rate type:

**InvestmentPortfolio(Amounts in thousands)**
| ** **                                                    | ** ** | **Carrying Value** | ** ** | **Amortized Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Portfolio Mix %  by Fair Value** | ** ** |
|---------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|--------------------------------|------------|--------------------------------------------------------|------------|
| **Floating Rate:**                                            |       |                    |       |                    |       |                           |       |                                                   |       |
| Residential Adjustable  Rate Mortgage (“ARM”) Loans |       | $                       | 1,294,678  |                    | $          | 1,311,889                      |       | $                                                      | 1,294,678  |   | 8.0 | % |
| Residential ARM  Securities                                   |       | 5,229,852               |       | 5,218,304               |       | 5,229,852                      |       | 32.4                                                   |       |
| Corporate Loans                                               |       | 3,067,020               |       | 3,067,020               |       | 3,090,999                      |       | 19.1                                                   |       |
| Corporate Debt  Securities                                    |       | 266,917                 |       | 258,004                 |       | 266,917                        |       | 1.7                                                    |       |
| Commercial Real Estate  Loans                                 |       | 105,328                 |       | 105,328                 |       | 106,118                        |       | 0.6                                                    |       |
| Total Floating  Rate                                          |       | 9,963,795               |       | 9,960,545               |       | 9,988,564                      |       | 61.8                                                   |       |
| **Hybrid Rate:**                                              |       |                    |       |                    |       |                           |       |                                                   |       |
| Residential Hybrid ARM  Loans                                 |       | 3,550,466               |       | 3,569,558               |       | 3,550,466                      |       | 21.9                                                   |       |
| Residential Hybrid ARM  Securities                            |       | 1,803,242               |       | 1,832,947               |       | 1,803,242                      |       | 11.2                                                   |       |
| Total Hybrid  Rate                                            |       | 5,353,708               |       | 5,402,505               |       | 5,353,708                      |       | 33.1                                                   |       |
| **Fixed Rate:**                                               |       |                    |       |                    |       |                           |       |                                                   |       |
| Corporate Loans                                               |       | 25,000                  |       | 25,000                  |       | 24,570                         |       | 0.2                                                    |       |
| Corporate Debt  Securities                                    |       | 492,311                 |       | 468,738                 |       | 492,311                        |       | 3.0                                                    |       |
| Commercial Real Estate  Debt Securities                       |       | 32,133                  |       | 32,000                  |       | 32,133                         |       | 0.2                                                    |       |
| Total Fixed Rate                                              |       | 549,444                 |       | 525,738                 |       | 549,014                        |       | 3.4                                                    |       |
| **Marketable and Non-Marketable  Equity Securities:**         |       |                    |       |                    |       |                           |       |                                                   |       |
| Common and Preferred  Stock                                   |       | 88,979                  |       | 84,561                  |       | 88,979                         |       | 0.6                                                    |       |
| Non-Marketable Equity  Securities                             |       | 173,823                 |       | 173,823                 |       | 173,823                        |       | 1.1                                                    |       |
| Total Marketable and  Non-Marketable Equity Securities        |       | 262,802                 |       | 258,384                 |       | 262,802                        |       | 1.7                                                    |       |
| Total                                                         |       | $                       | 16,129,749 |                    | $          | 16,147,172                     |       | $                                                      | 16,154,088 |   | 100.0 | % |

 

As of March 31, 2007, the aggregate fair value of ourinvestment portfolio exceeded the aggregate amortized cost value of our portfolioby $6.9 million and, as of the same date, we had unrealized gains totaling$32.7 million related to our cash flow hedges, as defined under SFASNo. 133. As of March 31, 2007, the aggregate net unamortized purchasediscount related to our investment portfolio was $15.5 million.

 

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

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

 

As ofDecember 31, 2006, the aggregate fair value of our investment portfolioexceeded the aggregate amortized cost value of our portfolio by$4.7 million and, as of the same date, we had unrealized gains totaling$50.8 million related to our cash flow hedges, as defined under SFASNo. 133. As of December 31, 2006, the aggregate net unamortizedpurchase discount related to our investment portfolio was $17.3 million.

**Asset Quality**

*Asset Quality 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 Investor Services (“Moody’s”) and Standard &Poor’s Ratings Service (“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 generally default more frequently thanborrowers with higher FICO® scores. For residential and commercial real estatemortgage loans and mortgage-backed securities we monitor trends and changes in loanto value, or LTV, ratios. Increases in LTV ratios are likely to result inhigher realized credit losses when borrowers default.

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*Investment Securities*

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, 2007:

**InvestmentSecurities(Amounts in thousands)**
| **Ratings Category**    | ** ** | **Residential  ARM Securities** | ** ** | **Residential  Hybrid ARM  Securities** | ** ** | **Corporate  Debt  Securities** | ** ** | **Commercial  Real Estate Debt  Securities** | ** ** | **Total** | ** ** |
|------------------------------|------------|--------------------------------------|------------|----------------------------------------------|------------|---------------------------------|------------|--------------------------------------------------------|------------|-----------|------------|
| Aaa/AAA                      |       | $                                    | 5,181,416  |                                         | $          | 1,769,651                       |       | $                                                      | —     |      | $          | — |   | $ | 6,951,067 |   |
| Aa1/AA+ through  Aa3/AA-     |       | 13,803                               |       | 28,245                                       |       | —                          |       | —                                                 |       | 42,048    |       |
| A1/A+ through  A3/A-         |       | 9,951                                |       | 17,974                                       |       | —                          |       | —                                                 |       | 27,925    |       |
| Baa1/BBB+  through Baa3/BBB- |       | 7,062                                |       | 9,627                                        |       | 18,385                          |       | —                                                 |       | 35,074    |       |
| Ba1/BB+ through  Ba3/BB-     |       | 3,531                                |       | 3,852                                        |       | 142,500                         |       | 32,000                                                 |       | 181,883   |       |
| B1/B+ through  B3/B-         |       | 2,568                                |       | 2,568                                        |       | 347,315                         |       | —                                                 |       | 352,451   |       |
| Caa1/CCC+ and  lower         |       | —                               |       | —                                       |       | 175,500                         |       | —                                                 |       | 175,500   |       |
| Non-Rated                    |       | 5,740                                |       | 6,413                                        |       | 56,336                          |       | —                                                 |       | 68,489    |       |
| Total                        |       | $                                    | 5,224,071  |                                         | $          | 1,838,330                       |       | $                                                      | 740,036    |      | $          | 32,000 |   | $ | 7,834,437 |   |

 

The following table shows the par value of our debtinvestment securities portfolio by investment class stratified by Moody’s andStandard & Poor’s ratings category as of December 31, 2006:

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

 

*Loans*

Our residential mortgage loan portfolio totaled $4.8billion as of March 31, 2007 and $5.1 billion as of December 31, 2006. Asof March 31, 2007, we owned eight real estate properties acquired throughforeclosure. The outstanding loan balance of $1.2 million with respect to theseeight properties (not included in the following table) was reclassified fromloans to other assets on our balance sheet. As the estimated fair value of theseeight properties approximates the outstanding loan balance we have not recordeda charge against our allowance for loan losses.

Theweighted average original FICO® score and weighted average original LTV ratioof our residential mortgage loan portfolio were 739 and 68.4%, respectively, asof March 31, 2007. As of December 31, 2006, the weighted averageoriginal FICO® score and weighted average LTV ratio of our residential mortgageloan portfolio were 739 and 68.6%, respectively. As of March 31, 2007 ourresidential mortgage loan portfolio did not have any material concentrations ininvestor owned properties, multi-unit housing properties, condominiumproperties and/or cooperative properties. A material portion of our residentialmortgage loans are non-conforming mortgage loans, not due to credit quality,but because the mortgage loans have balances that exceed the maximum balancesnecessary to qualify as a conforming mortgage loan.

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The following table summarizes the delinquencystatistics of residential mortgage loans as of March 31, 2007 (dollar amountsin thousands):

| Delinquency Status | ** ** | **Number of Loans** | ** ** | **Principal Amount** | ** ** |
|-------------------------|------------|-------------------------------|------------|---------------------------|------------|
| 30 to 59 days           |       | 82                            |       | $                         | 33,321     |   |
| 60 to 89 days           |       | 22                            |       | 6,583                     |       |
| 90 days or more         |       | 22                            |       | 7,332                     |       |
| In foreclosure          |       | 23                            |       | 6,681                     |       |
| Total                   |       | 149                           |       | $                         | 53,917     |   |

 

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

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

 

Upon adoption of SFAS No. 159 as of January 1, 2007,we elected the fair value option for our investments in residential mortgageloans.  Prior to the election of the fairvalue option for our investments in residential mortgage loans, the loans werecarried at net unamortized cost less an allowance for loan losses. As ofJanuary 1, 2007, we recorded a transition adjustment to adjust the carryingvalue of our portfolio of residential mortgage loans to fair value and reverseour allowance for loan losses for our residential mortgage loan portfolio as ofJanuary 1, 2007.  The followingtable summarizes the changes in the allowance for loan losses for ourresidential mortgage loan portfolio during the three months ended March 31,2007 (amounts in thousands):

| Balance, beginning of period                                  |   | $      | 1,500  |   |
|---------------------------------------------------------------|--------|--------|--------|--------|
| Transition to  SFAS No. 159 adjustment to accumulated deficit |   | (1,500 | )      |
| Balance, end of period                                        |   | $      | — |   |

 

Ourcorporate loan portfolio totaled $3.1 billion as of March 31, 2007 and$3.2 billion as of December 31, 2006. Our corporate loan portfolioconsists of debt obligations of corporations, partnerships and other entitiesin the form of first and second lien loans, mezzanine loans and bridge loans.

Weperformed an allowance for loan losses analysis as of March 31, 2007 andDecember 31, 2006, and we have made the determination that no allowancefor loan losses was required for our corporate loan portfolio as of March 31,2007 or December 31, 2006.

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The following table summarizes the par value of ourcorporate loan portfolio stratified by Moody’s and Standard & Poor’sratings category as of March 31, 2007 and December 31, 2006:

**Corporate Loans(Amounts in thousands)**

| Ratings Category        | ** ** | **As of  March 31, 2007** | ** ** | **As of  December 31, 2006** | ** ** |
|------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                      |       | $                                        | —     |                                        | $          | — |   |
| Aa1/AA+ through  Aa3/AA-     |       | —                                   |       | —                                      |       |
| A1/A+ through  A3/A-         |       | —                                   |       | —                                      |       |
| Baa1/BBB+  through Baa3/BBB- |       | 22,342                                   |       | 77,326                                      |       |
| Ba1/BB+ through  Ba3/BB-     |       | 1,677,214                                |       | 1,764,598                                   |       |
| B1/B+ through  B3/B-         |       | 1,133,105                                |       | 1,153,856                                   |       |
| Caa1/CCC+ and  lower         |       | 108,629                                  |       | 93,340                                      |       |
| Non-Rated                    |       | 157,304                                  |       | 143,294                                     |       |
| Total                        |       | $                                        | 3,098,594  |                                        | $          | 3,232,414 |   |

 

Ourcommercial real estate loan portfolio totaled $105.3 million and$108.7 million as of March 31, 2007 and December 31, 2006,respectively.

Weperformed an allowance for loan losses analysis as of March 31, 2007 andDecember 31, 2006, and we have made the determination that no allowancefor loan losses was required for our commercial real estate loan portfolio asof March 31, 2007 or December 31, 2006.

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, 2007 and December 31, 2006:

**Commercial RealEstate Loans(Amounts in thousands)**

| Ratings Category        | ** ** | **As of  March 31, 2007** | ** ** | **As of  December 31, 2006** | ** ** |
|------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                      |       | $                                        | —     |                                        | $          | — |   |
| Aa1/AA+ through  Aa3/AA-     |       | —                                   |       | —                                      |       |
| A1/A+ through  A3/A-         |       | —                                   |       | —                                      |       |
| Baa1/BBB+  through Baa3/BBB- |       | —                                   |       | —                                      |       |
| Ba1/BB+ through  Ba3/BB-     |       | 15,000                                   |       | 2,908                                       |       |
| B1/B+ through  B3/B-         |       | 90,412                                   |       | 90,882                                      |       |
| Caa1/CCC+ and  lower         |       | —                                   |       | —                                      |       |
| Non-Rated                    |       | —                                   |       | 15,000                                      |       |
| Total                        |       | $                                        | 105,412    |                                        | $          | 108,790 |   |

 

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**Asset Repricing Characteristics**

*Summary*

The table below summarizes the repricingcharacteristics of our investment portfolio as of March 31, 2007 andDecember 31, 2006, and is classified by interest rate type:

**InvestmentPortfolio(Amounts in thousands)**
| ** **                              | ** ** | **As of March 31, 2007** | ** ** | **As of December 31, 2006** | ** ** |
|-----------------------------------------|------------|----------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                              | ** ** | **Amortized Cost**                      | ** ** | **Portfolio Mix**                          | ** ** | **Amortized Cost** | ** ** | **Portfolio Mix** | ** ** |
| **Floating Rate:**                      |       |                                         |       |                                            |       |   |   |   |   |
| Residential ARM Loans                   |       | $                                            | 1,311,889  |                                            | 8.3        | % | $ | 1,441,959 |   | 8.6 | % |
| Residential ARM  Securities             |       | 5,218,304                                    |       | 32.8                                            |       | 5,662,830 |   | 33.6 |   |
| Corporate Loans                         |       | 3,067,020                                    |       | 19.3                                            |       | 3,200,567 |   | 19.0 |   |
| Corporate Debt  Securities              |       | 258,004                                      |       | 1.6                                             |       | 344,650 |   | 2.0 |   |
| Commercial Real Estate  Loans           |       | 105,328                                      |       | 0.7                                             |       | 108,693 |   | 0.6 |   |
| Total Floating  Rate                    |       | 9,960,545                                    |       | 62.7                                            |       | 10,758,699 |   | 63.8 |   |
| **Hybrid Rate:**                        |       |                                         |       |                                            |       |   |   |   |   |
| Residential Hybrid ARM  Loans           |       | 3,569,558                                    |       | 22.5                                            |       | 3,667,302 |   | 21.8 |   |
| Residential Hybrid ARM  Securities      |       | 1,832,947                                    |       | 11.5                                            |       | 1,894,941 |   | 11.2 |   |
| Total Hybrid  Rate                      |       | 5,402,505                                    |       | 34.0                                            |       | 5,562,243 |   | 33.0 |   |
| **Fixed Rate:**                         |       |                                         |       |                                            |       |   |   |   |   |
| Corporate Loans                         |       | 25,000                                       |       | 0.2                                             |       | 25,000 |   | 0.1 |   |
| Corporate Debt  Securities              |       | 468,738                                      |       | 2.9                                             |       | 486,321 |   | 2.9 |   |
| Commercial Real Estate  Debt Securities |       | 32,000                                       |       | 0.2                                             |       | 32,000 |   | 0.2 |   |
| Total Fixed Rate                        |       | 525,738                                      |       | 3.3                                             |       | 543,321 |   | 3.2 |   |
| Total                                   |       | $                                            | 15,888,788 |                                            | 100.0      | % | $ | 16,864,263 |   | 100.0 | % |

 

The table above excludes marketable equity securitieswith a fair value of $89.0 million and amortized cost of $84.6 million, andnon-marketable equity securities with a fair value of $173.8 million andamortized cost of $173.8 million as of March 31, 2007. The table abovealso excludes marketable equity securities with a fair value of $69.0 millionand amortized cost of $68.1 million, and non-marketable equity securities witha fair value of $166.3 million and amortized cost of $166.3 million as ofDecember 31, 2006.

*Residential ARM Securities*

As of March 31, 2007 and December 31, 2006,substantially all of our residential ARM securities were comprised of one-monthLIBOR floating rate securities that reprice monthly and were subject to aweighted average maximum net interest rate of 11.83% and 11.83%, respectively,which was materially above the then current weighted average net coupon of6.47% and 6.46%, respectively. Our repricing risk on our portfolio ofresidential ARM securities increases materially if interest rates continue toincrease to a level where the weighted average coupon rate approaches theweighted average maximum net interest rate, because the weighted average couponis subject to a maximum rate, or cap, which is approximately equal to theweighted average maximum interest rate of 11.83% at both March 31, 2007and December 31, 2006.

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*Residential Hybrid ARM Securities*

As of March 31, 2007 and December 31, 2006,all of our residential hybrid ARM securities had underlying mortgage loans thatwere originated as 5/1 hybrid ARM loans. As of March 31, 2007 andDecember 31, 2006, 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 six-month or one-year LIBOR or one-year constantmaturity treasury index, or CMT, depending upon if the underlying mortgage loanis a LIBOR- or CMT-based mortgage loan. On the date that the residential hybridARM loans convert from a fixed rate to a floating rate loan, which we refer toas the 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, 2007 and December 31, 2006, all of the mortgage loansunderlying our residential hybrid ARM securities had a post-roll date indexreset frequency of one year with 34% and 34%, respectively, and based on six-monthor one-year LIBOR and 66% and 66%, respectively, 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 was 4.18% and 4.18% as of March 31, 2007 andDecember 31, 2006, respectively. As of March 31, 2007 andDecember 31, 2006, the weighted average months until roll date for themortgage loans underlying our residential hybrid ARM securities was 21 and 24,respectively.

*Residential ARM Loans*

As of March 31, 2007 and December 31, 2006,all of our residential ARM loans were comprised of one-month LIBOR floatingrate loans that reprice monthly and were subject to a weighted average maximumnet interest rate of 11.93% and 11.92%, respectively, which was well above thethen current weighted average net coupon of 6.40% and 6.43%, respectively. Ourrepricing risk on our portfolio of residential ARM loans increases materiallyif interest rates continue to increase to a level where the weighted averagenet coupon rate approaches the weighted average maximum interest rate, becausethe weighted average coupon is subject to a cap which is approximately equal tothe weighted average maximum interest rate of 11.93% and 11.92%, respectively, asof March 31, 2007 and December 31, 2006.

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*Residential Hybrid ARM Loans*

As of March 31, 2007 and December 31, 2006, allof our residential hybrid ARM loans were originated as either 3/1 or 5/1 hybridARM loans. When the loans convert from fixed rate to floating rate, theunderlying mortgage loans will have an interest rate based on six-month or 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, 2007and December 31, 2006, all of our residential hybrid ARM loans had apost-roll date index reset frequency of one-year with 45% and 46%,respectively, based on six-month or one-year LIBOR and 55% and 54%,respectively, based on one-year CMT. Our repricing risk on our portfolio ofresidential hybrid ARM loans increases materially if interest rates continue toincrease to a level where, subsequent to the roll date, the weighted averagenet coupon rate approaches the weighted average post-roll date maximum netinterest rate, because the post-roll date weighted average net coupon issubject to a cap which is approximately equal to the weighted average post-rolldate maximum net interest rate of 10.13%. The weighted average net couponon the portfolio of residential hybrid loans was 4.85% and 4.85% as of March31, 2007 and December 31, 2006, respectively. As of March 31, 2007 andDecember 31, 2006, the weighted average months until roll date for themortgage loans underlying our residential hybrid ARM securities was 31 and 33,respectively.

*Corporate Loans and Securities*

All of our floating rate corporate loans andsecurities have index reset frequencies of less than twelve months with themajority of the loans resetting at least quarterly. The weighted average couponon our floating rate corporate loans and securities was 8.11% and 8.00% as ofMarch 31, 2007 and December 31, 2006, respectively. As of both March 31,2007 and December 31, 2006, the weighted average years to maturity of ourfloating rate corporate loans and securities was 5.9 years and 6.0 years,respectively.

As of March 31, 2007, our fixed rate corporatedebt securities had a weighted average coupon of 9.78% and a weighted averageyears to maturity of 6.2 years, as compared to 9.75% and 6.3 years,respectively, as of December 31, 2006.

*Commercial Real Estate Loans andSecurities*

All of our floating rate commercial real estate loansand securities have index reset frequencies of less than twelve months. Theweighted average coupon on our floating rate commercial real estate loans andsecurities was 8.16% and 8.42% as of March 31, 2007 and December 31, 2006,respectively. As of March 31, 2007 and December 31, 2006, the weightedaverage years to maturity of our floating rate commercial real estate loans andsecurities was 2.3 years and 2.5 years, respectively.

As of March 31, 2007 our fixed rate commercial realestate loans and securities had a weighted average coupon of 7.12% and aweighted average years to maturity of 29.7 years, as compared to 7.12% and29.9 years, respectively, as of December 31, 2006.

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**Portfolio Purchases**

Wepurchased $0.4 billion and $1.9 billion par amount of investments duringthe quarters ended March 31, 2007 and March 31, 2006, respectively.

Thetable below summarizes our investment portfolio purchases for the periodsindicated and includes the par amount, or face amount, of the securities andloans that were purchased:

**InvestmentPortfolio Purchases(Amounts in thousands)**
| ** **                         | ** ** | **Three months ended  March 31, 2007** | ** ** | **Three months ended  March 31, 2006** | ** ** |
|------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                         | ** ** | **Par Amount**                                        | ** ** | **%**                                                      | ** ** | **Par Amount** | ** ** | **%** | ** ** |
| Securities:                        |       |                                                       |       |                                                       |       |   |   |   |   |
| Residential ARM  Securities        |       | $                                                          | —     |                                                       | —     |   | $ | 1,063,776 |   | 56.2 | % |
| Corporate Debt Securities          |       | 34,000                                                     |       | 9.2                                                        |       | 127,769 |   | 6.8 |   |
| Marketable  Equity Securities      |       | 17,728                                                     |       | 4.9                                                        |       | 10,375 |   | 0.5 |   |
| Non-Marketable  Equity Securities  |       | 7,500                                                      |       | 2.1                                                        |       | 50,936 |   | 2.7 |   |
| Total Securities Principal Balance |       | 59,228                                                     |       | 16.2                                                       |       | 1,252,856 |   | 66.2 |   |
| Loans:                             |       |                                                       |       |                                                       |       |   |   |   |   |
| Residential ARM  Loans             |       | 17,706                                                     |       | 4.9                                                        |       | 99,498 |   | 5.3 |   |
| Corporate Loans                    |       | 287,687                                                    |       | 78.9                                                       |       | 538,883 |   | 28.5 |   |
| Total Loans Principal Balance      |       | 305,393                                                    |       | 83.8                                                       |       | 638,381 |   | 33.8 |   |
| Grand Total  Principal Balance     |       | $                                                          | 364,621    |                                                       | 100.0      |   | $ | 1,891,237 |   | 100.0 | % |

 

**Stockholders’ Equity**

Our stockholders’ equity at each of March 31, 2007 andDecember 31, 2006 totaled $1.7 billion. Included in our stockholders’equity as of March 31, 2007 and December 31, 2006 is accumulated othercomprehensive income totaling $77.9 million and $70.5 million,respectively.

Our average stockholders’ equity and return on averagestockholders’ equity for the quarter ended March 31, 2007 were$1.7 billion and 11.4%, compared to $1.7 billion and 7.4%, for the quarterended March 31, 2006. Return on average stockholders’ equity is defined as netincome divided by weighted average stockholders’ equity.

Our book value per common share as of March 31, 2007and December 31, 2006 was $20.95 and $21.42, respectively, and werecomputed based on 80,464,713 shares issued and outstanding as March 31,2007 and December 31, 2006, respectively.

On May 3, 2007, our Board of Directors declared anaggregate cash distribution of $45.1 million for the quarter ended March 31,2007 to stockholders of record on May 17, 2007. The distribution ispayable on May 31, 2007, see “Executive Overview.”  Net income for the quarter of $48.4 millionexceeded the aggregate amount of the distribution of $45.1 million by$3.3 million.

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**Liquidity and Capital Resources**

Wemanage our liquidity with the intention of providing the continuing ability tofund our operations and fulfill our commitments on a timely and cost-effectivebasis. Based on changes in our working capital, for any given period the cashflows provided by operating activities may be less than the cumulativedistributions paid on our shares for such period and such shortfall, if any,may be funded through the issuance of unsecured indebtedness or through theborrowing of additional amounts through the pledging of certain of ourassets.  Our board of directors considersavailable liquidity when declaring distributions to shareholders.

 We believe that our liquidity level and accessto additional funding is in excess of that necessary to enable us to meet ouranticipated liquidity requirements including, but not limited to, funding ourpurchases of investments, required cash payments and additional collateralunder our borrowings and our derivative transactions, required periodic cashpayments related to our derivative transactions, payment of fees and expensesrelated to our Management Agreement, payment of general corporate expenses andgeneral corporate capital expenditures and distributions to our stockholders. Asof March 31, 2007, we owed our Manager $10.2 million for the payment ofmanagement fees and reimbursable expenses pursuant to the Management Agreement.

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

Ourability to meet our long-term liquidity and capital resource requirements maybe subject to our ability to obtain additional debt financing and equitycapital. We may increase our capital resources through offerings of equitysecurities (possibly including common stock and one or more classes ofpreferred stock), commercial paper, medium-term notes, securitizationtransactions structured as secured financings, and senior or subordinatednotes. If we are unable to renew, replace or expand our sources of financing onacceptable terms, it may have an adverse effect on our business and results ofoperations and our ability to make distributions to stockholders. Upon liquidation,holders of our debt securities and lenders with respect to other borrowingswill receive, and any holders of preferred stock that we may issue in thefuture may receive, a distribution of our available assets prior to holders ofour common stock. The decisions by investors and lenders to enter into equity,and financing transactions with us will depend upon a number of factors,including our historical and projected financial performance, compliance withthe terms of our current credit arrangements, industry and market trends, theavailability of capital and our investors’ and lenders’ policies and ratesapplicable thereto, and the relative attractiveness of alternative investmentor lending opportunities.

Anymaterial event that impacts capital markets participants may also impair ourability to access additional liquidity and we may therefore be required to sellsome or all of our portfolio investments in order to maintain sufficientliquidity. Such sales may be at prices lower than the carrying value of our investments,which would result in our recognition of such losses and reduced income.

Inorder to continue to qualify as a REIT and to eliminate corporate income taxeson the income we distribute to our stockholders, we are required to distribute90% to 100% of our ordinary taxable income and short-term capital gains on anannual basis. However, Holdings has not elected to be treated as a REIT forU.S. federal income tax purposes and, as a result, will not be subject to anysimilar requirement to make distributions to its shareholders, although weunderstand that Holdings’ currently intends to distribute approximately 75% to95% of its taxable income to its shareholders. However, distributions by Holdings must be approved by, and will be subjectto the sole discretion of, its board of directors and will be subject tovarious considerations including, but not limited to, its financialperformance, liquidity requirements, distribution restrictions contained in itscurrent or future financing facilities, its distribution yield relative to itspeers and other relevant factors identified by its board of directors.

**Sources of Funds**

*Securitization Transactions*

On March 30, 2006, we closed our second $5.0billion asset-backed secured liquidity note facility. This facility provides uswith an alternative source of funding our investments in residentialmortgage-backed securities by issuing asset-backed secured liquidity notes thatare rated A-1+, P-1, and F1+, by Standard & Poor’s,Moody’s and Fitch Inc, respectively. Issuances of asset-backed securedliquidity notes are recorded as borrowings on our consolidated balance sheets.At March 31, 2007, we had $4.1 billion of asset-backed secured liquidity notesoutstanding under this facility.

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On September 19, 2006, we closed CLO 2006-1,our third $1.0 billion CLO transaction that provides us with securedfinancing for investments consisting of corporate loans and certain other loansand securities. The investments that are owned by CLO 2006-1collateralize the CLO 2006-1 debt, and as a result, thoseinvestments are not available to us, our creditors or stockholders.CLO 2006-1 issued a total of $727.5 million of senior secured notesat par to investors and we retained $145.5 million of rated mezzanine notes and$144.0 million of unrated subordinated notes issued by CLO 2006-1. Therated mezzanine notes consist of $12.5 million rated A2/A, $67.0 million ratedBaa3/BBB, $48.0 million rated Ba3/BB, and $18.0 million rated B3/B. All of thenotes issued mature on August 25, 2018; however, we have the right to callthe notes at par any time after August 2010.

*Repurchase Agreements*

As of March 31, 2007, we had $3.6 billionoutstanding on repurchase facilities with four counterparties with a weightedaverage effective rate of 5.43% and a weighted average remaining term tomaturity of 22 days. Because we borrow under repurchase agreements based on theestimated fair value of our pledged investments, and because changes ininterest rates can negatively impact the valuation of our pledged investments,our ongoing ability to borrow under our repurchase facilities may be limitedand our lenders may initiate margin calls in the event interest rates change orthe value of our pledged securities declines as a result of adverse changes ininterest rates or credit spreads.

*Secured Credit Facility*

During June 2006 our $275.0 million securedrevolving credit facility matured and was replaced with a $375.0 million threeyear senior secured revolving credit facility. During September 2006, thefacility was amended to increase the total commitment amount to $800.0 millionwith the option to further increase the commitment amount to $900.0 million atany time so long as no default or event of default on the facility has occurredand subject to addition of new lenders, increases in the commitments ofexisting lenders, or a combination thereof. The new senior secured revolvingcredit facility matures in June 2009 and consists of two tranches.Outstanding borrowings under the senior secured revolving credit facility bearinterest at either (i) an alternate base rate per annum equal to thegreater of (a) the prime rate in effect on such day, and (b) thefederal funds rate in effect on such day plus 0.50%, or (ii) an interestrate per annum equal to the LIBOR rate for the applicable interest period plus0.50% for borrowings under tranche A of the facility and 0.75% for borrowingsunder tranche B of the facility. As of March 31, 2007, we had $25.2 million inborrowings outstanding under tranche B of this facility.

*Junior Subordinated Notes*

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

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

DuringAugust 2006, we formed KKR Financial Capital Trust III (“Trust III”) forthe sole purpose of issuing trust preferred securities. On August 10,2006, Trust III issued preferred securities to unaffiliated investors for grossproceeds of $85.0 million and common securities to the Company for $2.6million. The combined proceeds were invested by Trust III in $87.6 million ofjunior subordinated notes issued by us. The junior subordinated notes are thesole assets of Trust III and mature on October 30, 2036, but are callableon or after October 30, 2011. Interest is payable quarterly at a floatingrate equal to three-month LIBOR plus 2.35%.

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

During September 2006, we formed KKR FinancialCapital Trust V (“Trust V”) for the sole purpose of issuing trust preferred securities.On September 29, 2006, Trust V issued preferred securities to unaffiliatedinvestors for gross proceeds of $50.0 million and common securities to us for$1.6 million. The combined proceeds were invested by Trust V in $51.6 millionof junior subordinated notes issued by us. The junior subordinated notes arethe sole assets of Trust V and mature on October 30, 2036, but arecallable on or after October 30, 2011. Interest is payable quarterly at afixed rate of 7.395% through October 2016 and thereafter at a floatingrate equal to three-month LIBOR plus 2.25%.

*CapitalUtilization and Leverage*

As ofMarch 31, 2007 and December 31, 2006, we had stockholders’ equity totaling$1.7 billion, and our leverage was 8.9 times and 9.1 times, respectively.

*Off-Balance*Sheet Commitments

TheCompany participates in certain financing arrangements, including bridgefacilities and delayed draw facilities, whereby the Company is committed toprovide funding at the discretion of the borrower up to a specific predeterminedamount. As of March 31, 2007 the Company had unfunded financingcommitments totaling $340.7 million.

**REIT Matters**

As of March 31, 2007, we believe that we qualified asa REIT under the provisions of the Code. The Code requires, among other things,that at the end of each calendar quarter at least 75% of our total assets mustbe “real estate assets” as defined in the Code. The Code also requires thateach year at least 75% of our gross income come from real estate sources and95% of our gross income come from real estate sources and certain other passivesources itemized in the Code, such as dividends and interest. As of March 31,2007, we believe that we were in compliance with such requirements. As of March31, 2007, we also believe that we met all of the REIT requirements regardingthe ownership of our common stock and the distributions of our taxable income. However,the sections of the Code and the corresponding U.S. Treasury Regulations thatrelate to qualification and taxation as a REIT are highly technical andcomplex, and our qualification and taxation as a REIT depend upon our abilityto meet various qualification tests imposed under the Code (such as thosedescribed above), including through actual annual operating results, assetcomposition, distribution levels and diversity of stock ownership. Accordingly,no assurance can be given that we have been organized and have operated, orwill continue to be organized and operate, in a manner so as to qualify orremain qualified as a REIT.

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

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Total taxable income is the aggregate amount oftaxable income generated by us and by our domestic and foreign taxable REITsubsidiaries. REIT taxable income excludes the undistributed taxable income ofour domestic taxable REIT subsidiary, which is not included in REIT taxableincome until distributed to us. There is no requirement that our domestictaxable REIT subsidiary distribute its earnings to us. REIT taxable income,however, includes the taxable income of our foreign taxable REIT subsidiariesbecause we will generally be required to recognize and report their taxableincome on a current basis. These non-GAAP financial measurements areimportant because we are structured as a REIT and the Code requires that we paysubstantially all of our taxable income in the form of distributions to ourstockholders. The non-GAAP financial measurements of total taxable income andREIT taxable income are important in the determination of the amount of theminimum distributions that we must pay to our stockholders so as to comply withthe rules set forth in the Code. Because not all companies use identicalcalculations, this presentation of total taxable income and REIT taxable incomemay not be comparable to other similarly titled measures prepared and reportedby other companies. The table below reconciles the differences between reportednet income and total taxable income and REIT taxable income for the quartersended March 31, 2007 and 2006: 

**Reconciliation ofReported 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, 2007** | ** ** | **Estimated  for the three   months ended  March 31, 2006** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **Amount**                                                                                | ** ** | **Per  Share**                                                                            | ** ** | **Amount** | ** ** | **Per  Share** | ** ** |
| **Reported  net income**                                                   |       | $                                                                                         | 48,424     |                                                                                      | $          | 0.60 |   | $ | 30,388 |   | $ | 0.38 |   |
| Book/tax  differences adjustment for residential mortgage portfolio        |       | (374                                                                                      | )          | —                                                                                    |       | 2,093 |   | 0.03 |   |
| Share-based  compensation                                                  |       | 5,838                                                                                     |       | 0.07                                                                                      |       | 6,783 |   | 0.09 |   |
| Vesting of  restricted common stock                                        |       | (140                                                                                      | )          | —                                                                                    |       | — |   | — |   |
| Foreign exchange  gains and losses                                         |       | 1                                                                                         |       | —                                                                                    |       | (374 | ) | — |   |
| Gains on sales  of assets to and among taxable REIT subsidiaries           |       | 364                                                                                       |       | 0.01                                                                                      |       | 888 |   | 0.01 |   |
| Realized and  unrealized derivative gains and losses                       |       | (430                                                                                      | )          | (0.01                                                                                     | )          | 1,416 |   | 0.02 |   |
| Book/tax  difference adjustment for foreign taxable REIT subsidiaries |       | 13,205                                                                                    |       | 0.16                                                                                      |       | 8,168 |   | 0.10 |   |
| Other                                                                      |       | (204                                                                                      | )          | —                                                                                    |       | 204 |   | — |   |
| Income tax  expense                                                        |       | 776                                                                                       |       | 0.01                                                                                      |       | 312 |   | — |   |
| **Total  taxable income**                                                  |       | 67,460                                                                                    |       | 0.84                                                                                      |       | 49,878 |   | 0.63 |   |
| Undistributed  taxable income of domestic taxable REIT subsidiary          |       | (1,471                                                                                    | )          | (0.02                                                                                     | )          | (2,184 | ) | (0.03 | ) |
| **REIT  taxable income**                                                   |       | $                                                                                         | 65,989     |                                                                                      | $          | 0.82 |   | $ | 47,694 |   | $ | 0.60 |   |
| **Number  of common shares outstanding:**                                  | ** ** | ** **                                                                                | ** ** | ** **                                                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Weighted-average  diluted common shares outstanding during the period |       | 80,257                                                                                    |       |                                                                                      |       | 79,314 |   |   |   |

 

Ourboard of directors has adopted a policy to distribute to our stockholdersamounts required to maintain our status as a REIT and to avoid federal excisetaxes, in each case as discussed above. This distribution policy takes intoaccount a number of factors, including, but not limited to, our actual resultsof operations, our financial condition and our total taxable income and REITtaxable income. The actual amount and timing of distributions, if any, will beat the discretion of our board of directors and may not be in even amountsthroughout our fiscal year. In that regard, Holdings has not elected to betreated as a REIT for U.S. federal income tax purposes and will therefore notbe subject to those provisions of the Code that require us to distributesubstantially all of our taxable income in the form of distributions tostockholders in order to maintain our qualification as a REIT.  See “Executive Overview”.

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**Exemption fromRegulation under the Investment Company Act**

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

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

The Securities and Exchange Commission (“SEC”) has notpromulgated rules to address precisely what is required for a company tobe considered “primarily engaged in the business of purchasing or otherwiseacquiring mortgages and other liens on and interests in real estate.” A seriesof no-action letters issued by the Division of Investment Management (the“Division”) of the SEC, however, reflects the view that at least 55% of acompany’s assets must consist of mortgage loans and other assets that areconsidered the functional equivalent of mortgage loans for purposes of theInvestment Company Act (collectively, “qualifying real estate assets”), and anadditional 25% of a company’s assets must consist of real estate-relatedassets, leaving no more than 20% of the company’s assets in miscellaneousassets. These no-action letters also indicate what types of assets can beconsidered qualifying real estate assets. No-action letters issued by theDivision are not binding except as they relate to the companies to whom theyare addressed, so investors should be aware that the Division may change itsposition regarding, among other things, what assets might constitute qualifyingreal estate assets at any time. If the Division were to change its position, wemight be required to change our investment strategy to comply with any newguidance provided by the Division. We cannot predict whether such a changewould be adverse to us.

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

We also consider agency whole pool certificates to bequalifying real estate assets. An agency whole pool certificate is acertificate issued or guaranteed as to principal and interest by federallychartered entities such as Fannie Mae, Freddie Mac, and, in the case of GinnieMae, by the U.S. government, that represents the entire beneficial interest inthe underlying pool of mortgage loans. By contrast, an agency certificate thatrepresents less than the entire beneficial interest in the underlying mortgageloans is not considered to be a qualifying real estate asset for purpose of the55% test, but constitutes a real estate-related asset for purposes of the25% test.

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

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

In another instance, we own the most subordinate classof securities issued in the securitization, designated Class B-6,the class that is most likely to absorb losses on the related pool of mortgageloans, and we have the right to decide whether to foreclose upon defaultedmortgage loans. Thus, based on a series of no-action letters, we classify thisinvestment as an investment in qualifying real estate assets for purposes ofthe 55% test. In addition to our ownership of Class B-6 in thissecuritization, we also own all of the other subordinated classes in thesecuritization: Classes B-5, B-4, B-3, B-2, B-1and M. All of the subordinate classes could have been issued as a singlesubordinate class, but to obtain varying ratings on the classes and to increasethe liquidity of our holdings, our subordinate interest was divided intoseparate classes. Losses on the mortgage loans, to the extent they exceed theprincipal balance of the Class B-6, are allocated to Class B-6,B-5, B-4, B-3, B-2, B-1 and M, in that order. Iflosses are so great that the principal balance of Class B-6 isreduced to zero, then we, as the owner of the Class B-5 securities,would have the right to decide whether to foreclose on defaulted mortgage loans.This right continues throughout the subordinate classes, such that the owner ofthe most subordinate class that is outstanding at any time has foreclosurerights. Because we own 100% of each class of subordinate securities in thisstructure, and each such class carries with it the right to foreclose if itever becomes the most subordinate class in the structure, we classify all ofthese subordinate securities as qualifying real estate assets for purposes ofthe 55% test. If we were to sell all or a portion of any of those subordinatedclasses, we would recharacterize the remaining portion of that class, togetherwith any classes senior to that class, as real estate-related assets for the25% test, rather than qualifying real estate assets for the 55% test. We own aportion of a senior class issued in this same securitization, but because it isnot a subordinated class, we do not consider it a qualifying real estate assetfor purposes of the 55% test, but merely a real estate-related asset forpurposes of the 25% test.

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

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

We believe that we have satisfied the tests withrespect to our assets, measured on an unconsolidated basis, since the firstanniversary of our initial private placement of our common stock inAugust 2004. It is not entirely settled, however, that the tests are to bemeasured on an unconsolidated basis. To the extent the SEC provides furtherguidance on how to measure assets for these tests, we will adjust ourmeasurement techniques.

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

We have not received a no-action letter from theDivision regarding how our investment strategy fits within the exclusion fromregulation under the Investment Company Act that we are using. To the extentthat the Division provides more specific or different guidance regarding thetreatment of assets as qualifying real estate assets or real estate-relatedassets, we may be required to adjust our investment strategy accordingly. Anyadditional guidance from the Division could provide additional flexibility tous, or it could further inhibit our ability to pursue the investment strategywe have chosen.

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**Quantitative and Qualitative Disclosures About Market Risk**

**Market Risks**

*Currency Risks*

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

*Inflation Risks*

Ourinvestment portfolio comprises the majority of our assets and our investmentsare financial in nature. Changes in interest rates and credit spreads may havea material adverse impact on our financial condition, results of operations andliquidity. Changes in interest rates do not necessarily correlate withinflation rates or changes in inflation rates.

*Interest Rate Risk*

Webelieve that our primary market risk is interest rate risk. Interest rate riskis defined as the sensitivity of our current and future earnings to interestrate volatility, variability of spread relationships, the difference inrepricing intervals between our assets and liabilities and the effect thatinterest rates may have on our cash flows and the prepayment rates experiencedon our investments that have imbedded borrower optionality. The objective ofinterest rate risk management is to achieve earnings, preserve capital andachieve liquidity by minimizing the negative impacts of changing interestrates, asset and liability mix, and prepayment activity.

We areexposed to basis risk between our investments and our borrowings. Our floatingrate investments and our variable rate borrowings do not reset on the same dayor with the same frequency and, as a result, we are exposed to basis risk withrespect to index reset frequency. Our floating rate investments may reprice onindices that are different than the indices that are used to price our variablerate borrowings and, as a result, we are exposed to basis risk with respect torepricing index. The basis risks noted above, in addition to other forms ofbasis risk that exist between our investments and borrowings, may be materialand could negatively impact future net interest margins.

Interestrate risk impacts our interest income, interest expense, prepayments, and thefair value of our investments, interest rate derivatives, and liabilities. Wemanage interest rate risk and make interest rate risk decisions by evaluatingour projected earnings under selected interest rate scenarios. We also usestatic measures of interest rate risk including duration. During periods ofincreasing interest rates we are biased to purchase investments that arefloating rate and we have had that bias since our inception. We manage ourinterest rate risk using various techniques ranging from the purchase offloating rate investments to the use of interest rate derivatives. We generallyfund our variable rate investments with variable rate borrowings with similarinterest rate reset frequencies. We generally fund our fixed rate and ourhybrid investments with short-term variable rate borrowings and we may useinterest rate derivatives to hedge the variability of the cash flows associatedwith our existing or forecasted variable rate borrowings. Hedging activitiesare complex and accounting for interest rate derivatives as fair value or cashflow hedges in accordance with SFAS No. 133 is difficult. We may not beable to execute certain hedging strategies because we are a REIT and there arecomplex rules regarding how our hedges impact our compliance with the REITrequirements.

Prepaymentswill impact the average lives of our fixed rate and hybrid investments and, asa result, we are exposed to the risk that the amount of variable rateborrowings that we have swapped from floating rate to fixed rate is materiallydifferent than we expected because the average life of the fixed rate or hybridinvestment has either extended or contracted. If the difference is material, wemay have to adjust the amount of our interest rate derivative position and suchaction could generate a loss if we terminated any of the interest ratederivatives or it may negatively impact our future earnings if we have toincrease our interest rate derivative positions because the average lives of ourinvestments have extended.

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Theperiodic and lifetime interest rate caps contained in our residential ARM loansand securities may limit the repricing of our residential ARM loans andsecurities and, as a result, we are exposed to the risk that repricing of ourinvestments is limited by the respective caps and our variable rate borrowingsdo not have any similar such caps. As a result our income on the investmentsthat are subject to the periodic and lifetime cap would remain constant whileour cost of financing using variable rate debt would increase. The periodic andlifetime interest rate caps may negatively impact future net interest marginsand the fair values of our residential ARM loan and security investments.

Thefollowing table summarizes the estimated net fair value of our derivativeinstruments held at March 31, 2007 and December 31, 2006 (amounts inthousands):

**Derivative FairValue**

|                                 | ** ** | **As of  March 31, 2007** | ** ** | **As of  December 31, 2006** | ** ** |
|---------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **Notional**                             | ** ** | **Fair Value**                         | ** ** | **Notional** | ** ** | **Fair Value** | ** ** |
| **Cash  Flow Hedges:**          |       |                                     |       |                                        |       |   |   |   |   |
| Interest rate corridors         |       | $                                        | 728,465    |                                        | $          | 10,638 |   | $ | 702,369 |   | $ | 13,591 |   |
| Interest rate swaps             |       | 4,264,167                                |       | 29,248                                      |       | 4,567,828 |   | 45,314 |   |
| **Fair  Value Hedges:**         |       |                                     |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | 32,000                                   |       | (562                                        | )          | 32,000 |   | 13 |   |
| **Free-Standing  Derivatives:** |       |                                     |       |                                        |       |   |   |   |   |
| Interest rate swaptions         |       | 31,000                                   |       | 60                                          |       | 31,000 |   | 75 |   |
| Credit default swaps—long  |       | 56,614                                   |       | (185                                        | )          | 3,000 |   | 179 |   |
| Credit default swaps—short |       | 315,614                                  |       | (271                                        | )          | 275,000 |   | (797 | ) |
| Total rate of return swaps      |       | 343,670                                  |       | 6,218                                       |       | 222,647 |   | 2,343 |   |
| Common stock warrants           |       | —                                   |       | 430                                         |       | — |   | — |   |
| Net fair value                  |       | $                                        | 5,771,530  |                                        | $          | 45,576 |   | $ | 5,833,844 |   | $ | 60,718 |   |

 

*Risk Management*

To theextent consistent with maintaining our REIT status, we seek to manage ourinterest rate risk exposure to protect our investment portfolio and relatedborrowings against the effects of major interest rate changes. We generallyseek to manage our interest rate risk by:

·       Changing the mix between our floating rateinvestments and our fixed rate investments;

·       Monitoring and adjusting, if necessary, thereset index and interest rates related to our investments and our borrowings;

·       Attempting to structure our borrowing agreementsto have a range of different maturities, terms, amortizations and interest rateadjustment periods; and

·       Using interest rate derivatives to adjust theinterest rate sensitivity of our investment portfolio and our borrowings.

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

Seediscussion of quantitative and qualitative disclosures about market risk in “Quantitativeand Qualitative Disclosures About Market Risk” section of Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

**Item 4.**                          Controlsand Procedures

The Company’s management evaluated, with theparticipation of the Company’s principal executive and principal financialofficer, the effectiveness of the Company’s disclosure controls and procedures(as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Actof 1934, as amended (the “Exchange Act”)) as of March 31, 2007. Based on theirevaluation, the Company’s principal executive and principal financial officerconcluded that the Company’s disclosure controls and procedures as of March 31,2007 were designed and were functioning effectively to provide reasonableassurance that the information required to be disclosed by the Company inreports filed under the Exchange Act is (i) recorded, processed,summarized, and reported within the time periods specified in the SEC’s rulesand forms, and (ii) accumulated and communicated to management, includingthe principal executive and principal financial officers, as appropriate, toallow timely decisions regarding disclosure. 

There has been no change in the Company’s internalcontrol over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f)under the Exchange Act) that occurred during the Company’s quarter ended March31, 2007, that has materially affected, or is reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

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**PART II.OTHER INFORMATION**

**Item1.**                       *Legal Proceedings*

None.

**Item1A.**                 *Risk Factors*

Youshould carefully consider the risks discussed under “Risk Factors” in the Company’s Form 10-K for fiscalyear ended December 31, 2006 (the “Form 10-K”) as filed with the Securities andExchange Commission (the “SEC”). These risks, as will as other mattersdiscussed in this Form 10-Q, the Form 10-K and other reports and proxystatements that the Company has filed with the SEC, could materially and adverselyaffect its  business, financial conditionand results of operations. The risks described in the  Form 10-K are not the only risks the Companyfaces.

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

None.

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

None.

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

None.

**Item5.**                          *Other Information*

None.

**Item 6.**                          *Exhibits*
| 31.1* |   | Chief Executive Officer Certification                  |
|-------|--------|--------------------------------------------------------|
| 31.2* |   | Chief Financial Officer Certification                  |
| 32*   |   | Certification Pursuant to 18 U.S.C.  Section 1350 |

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*                    Suchregistration statement was originally filed with the Securities and ExchangeCommission on April 15, 2005.

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, KKR Financial Corp.has duly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.
|                         |       | KKR Financial Corp.                                                   |
|-------------------------|------------|-----------------------------------------------------------------------|
|                    |       |                                                                  |
| **Signature**           | ** ** | **Title**                                                             |
| ** **              | ** ** | ** **                                                            |
| /s/ SATURNINO S. FANLO  |       | Chief Executive Officer (Principal Executive  Officer)                |
| **Saturnino S. Fanlo**  |       |                                                                  |
| ** **              | ** ** | ** **                                                            |
| /s/ JEFFREY B. VAN HORN |       | Chief Financial Officer (Principal Financial and  Accounting Officer) |
| **Jeffrey B. Van Horn** |       |                                                                  |
| ** **              | ** ** | ** **                                                            |
| Date: May 3,  2007      |       |                                                                  |

 

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