**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-Q**

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

 

**For the transitionperiodfrom                  to                  **

**Commission filenumber 001-32542**

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

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

 

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

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

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

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

 

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

The number of shares of the registrant’s common stockoutstanding as of November 6, 2006 was 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. FinancialStatements (Unaudited)**

**KKR Financial Corp. and Subsidiaries****Consolidated Balance Sheets****(Unaudited)****(Amounts in thousands, except shareinformation)**
| ** **                                                                                                                                                                                 | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                 | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Cash and cash  equivalents                                                                                                                                                                 |       | $                            | 2,302      |                        | $          | 16,110 |   |
| Restricted cash and  cash equivalents                                                                                                                                                      |       | 215,860                      |       | 80,223                      |       |
| Securities  available-for-sale, $8,226,780 and $5,910,399 pledged as collateral as of  September 30, 2006 and December 31, 2005, respectively                                         |       | 8,727,159                    |       | 6,149,506                   |       |
| Loans, net of allowance  for loan losses of $1,500 as of September 30, 2006 and December 31, 2005                                                                                     |       | 8,117,619                    |       | 8,846,341                   |       |
| Loans held for sale                                                                                                                                                                        |       | 606,134                      |       | —                      |       |
| Derivative assets                                                                                                                                                                          |       | 67,207                       |       | 58,898                      |       |
| Interest receivable                                                                                                                                                                        |       | 83,445                       |       | 59,993                      |       |
| Principal receivable                                                                                                                                                                       |       | 24,162                       |       | 7,108                       |       |
| Non-marketable equity  securities                                                                                                                                                          |       | 165,429                      |       | 52,500                      |       |
| Investment in  unconsolidated affiliate                                                                                                                                                    |       | 40,204                       |       | —                      |       |
| Income tax receivable                                                                                                                                                                      |       | 861                          |       | —                      |       |
| Other assets                                                                                                                                                                               |       | 55,045                       |       | 19,861                      |       |
| **Total  assets**                                                                                                                                                                          |       | $                            | 18,105,427 |                        | $          | 15,290,540 |   |
| **Liabilities**                                                                                                                                                                            | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Repurchase agreements                                                                                                                                                                      |       | $                            | 4,985,923  |                        | $          | 9,761,258 |   |
| Collateralized loan  obligation senior secured notes                                                                                                                                       |       | 2,252,500                    |       | 1,500,000                   |       |
| Asset-backed secured  liquidity notes                                                                                                                                                      |       | 8,190,682                    |       | 2,008,069                   |       |
| Secured revolving  credit facility                                                                                                                                                         |       | 292,213                      |       | 54,000                      |       |
| Secured demand loan                                                                                                                                                                        |       | 41,658                       |       | 40,511                      |       |
| Junior subordinated  notes                                                                                                                                                                 |       | 257,743                      |       | —                      |       |
| Payable for securities  purchases                                                                                                                                                          |       | 275,622                      |       | 196,315                     |       |
| Accounts payable,  accrued expenses and other liabilities                                                                                                                                  |       | 69,067                       |       | 45,925                      |       |
| Accrued interest  payable                                                                                                                                                                  |       | 27,410                       |       | 21,415                      |       |
| Related party payable                                                                                                                                                                      |       | 6,226                        |       | 3,673                       |       |
| Income tax liability                                                                                                                                                                       |       | 1,029                        |       | 2,763                       |       |
| Derivative liabilities                                                                                                                                                                     |       | 2,948                        |       | 1,465                       |       |
| **Total  liabilities**                                                                                                                                                                     |       | 16,403,021                   |       | 13,635,394                  |       |
| **Stockholders’ Equity**                                                                                                                                                              | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Preferred stock, $0.01  par value, 50,000,000 shares authorized and none issued and outstanding at  September 30, 2006 and December 31, 2005                                          |       | —                       |       | —                      |       |
| Common stock, $0.01 par  value, 250,000,000 shares authorized and 80,464,713 and 80,374,061 shares  issued and outstanding at September 30, 2006 and December 31, 2005,  respectively |       | 805                          |       | 804                         |       |
| Additional  paid-in-capital                                                                                                                                                                |       | 1,663,222                    |       | 1,639,996                   |       |
| Accumulated other  comprehensive income                                                                                                                                                    |       | 52,159                       |       | 18,344                      |       |
| Accumulated deficit                                                                                                                                                                        |       | (13,780                      | )          | (3,998                      | )          |
| **Total  stockholders’ equity**                                                                                                                                                       |       | 1,702,406                    |       | 1,655,146                   |       |
| **Total liabilities and  stockholders’ equity**                                                                                                                                       |       | $                            | 18,105,427 |                        | $          | 15,290,540 |   |

 

See condensed notes to consolidated financialstatements.

2

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**KKR Financial Corp. andSubsidiariesConsolidated Statements of Operations(Unaudited)(Amounts in thousands, except per share information)**
| ** **                                                                   | ** ** | **For the three  months ended  September 30, 2006** | ** ** | **For the three  months ended  September 30, 2005** | ** ** | **For the nine  months ended  September 30, 2006** | ** ** | **For the nine  months ended  September 30, 2005** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| **Net investment income:**                                                   | ** ** | ** **                                                                   | ** ** | ** **                                                                   | ** ** | ** **                                                                  | ** ** | ** **                                                                  | ** ** |
| Securities interest  income                                                  |       | $                                                                            | 108,771    |                                                                         | $          | 50,917                                                                      |       | $                                                                           | 282,745    |   | $ | 120,835 |   |
| Loan interest income                                                         |       | 141,585                                                                      |       | 63,869                                                                       |       | 396,789                                                                     |       | 95,859                                                                      |       |
| Dividend income                                                              |       | 945                                                                          |       | 985                                                                          |       | 2,740                                                                       |       | 2,452                                                                       |       |
| Other interest income                                                        |       | 2,736                                                                        |       | 816                                                                          |       | 6,388                                                                       |       | 2,013                                                                       |       |
| Total investment income                                                      |       | 254,037                                                                      |       | 116,587                                                                      |       | 688,662                                                                     |       | 221,159                                                                     |       |
| Interest expense                                                             |       | (199,365                                                                     | )          | (77,532                                                                      | )          | (531,022                                                                    | )          | (146,262                                                                    | )          |
| Equity in income of  unconsolidated affiliate                                |       | 914                                                                          |       | —                                                                       |       | 914                                                                         |       | —                                                                      |       |
| Provision for loan  losses                                                   |       | —                                                                       |       | (1,300                                                                       | )          | —                                                                      |       | (1,300                                                                      | )          |
| Net investment income                                                        |       | 55,586                                                                       |       | 37,755                                                                       |       | 158,554                                                                     |       | 73,597                                                                      |       |
| **Other income:**                                                            | ** ** | ** **                                                                   | ** ** | ** **                                                                   | ** ** | ** **                                                                  | ** ** | ** **                                                                  | ** ** |
| Net realized and  unrealized gain (loss) on derivatives and foreign exchange |       | 509                                                                          |       | 13                                                                           |       | 3,818                                                                       |       | (36                                                                         | )          |
| Net realized gain on  investments                                            |       | 2,781                                                                        |       | 1,730                                                                        |       | 4,920                                                                       |       | 2,881                                                                       |       |
| Fee and other income                                                         |       | 2,268                                                                        |       | 136                                                                          |       | 2,941                                                                       |       | 1,731                                                                       |       |
| Total other income                                                           |       | 5,558                                                                        |       | 1,879                                                                        |       | 11,679                                                                      |       | 4,576                                                                       |       |
| **Non-investment expenses:**                                                 | ** ** | ** **                                                                   | ** ** | ** **                                                                   | ** ** | ** **                                                                  | ** ** | ** **                                                                  | ** ** |
| Related party  management compensation                                       |       | 19,759                                                                       |       | 14,331                                                                       |       | 47,977                                                                      |       | 33,070                                                                      |       |
| Professional services                                                        |       | 1,096                                                                        |       | 1,432                                                                        |       | 2,591                                                                       |       | 2,617                                                                       |       |
| Loan servicing expense                                                       |       | 3,626                                                                        |       | 1,369                                                                        |       | 11,342                                                                      |       | 1,999                                                                       |       |
| Insurance expense                                                            |       | 211                                                                          |       | 275                                                                          |       | 709                                                                         |       | 708                                                                         |       |
| Directors expenses                                                           |       | 333                                                                          |       | 368                                                                          |       | 1,081                                                                       |       | 719                                                                         |       |
| General and  administrative expenses                                         |       | 3,050                                                                        |       | 2,630                                                                        |       | 7,713                                                                       |       | 4,107                                                                       |       |
| Total non-investment  expenses                                               |       | 28,075                                                                       |       | 20,405                                                                       |       | 71,413                                                                      |       | 43,220                                                                      |       |
| Income before income  tax expense                                            |       | 33,069                                                                       |       | 19,229                                                                       |       | 98,820                                                                      |       | 34,953                                                                      |       |
| Income tax expense                                                           |       | 453                                                                          |       | 775                                                                          |       | 885                                                                         |       | 1,881                                                                       |       |
| Net income                                                                   |       | $                                                                            | 32,616     |                                                                         | $          | 18,454                                                                      |       | $                                                                           | 97,935     |   | $ | 33,072 |   |
| Net income per common  share:                                                |       |                                                                         |       |                                                                         |       |                                                                        |       |                                                                        |       |
| Basic                                                                        |       | $                                                                            | 0.42       |                                                                         | $          | 0.24                                                                        |       | $                                                                           | 1.26       |   | $ | 0.63 |   |
| Diluted                                                                      |       | $                                                                            | 0.41       |                                                                         | $          | 0.24                                                                        |       | $                                                                           | 1.25       |   | $ | 0.62 |   |
| Weighted-average number  of common shares outstanding:                       |       |                                                                         |       |                                                                         |       |                                                                        |       |                                                                        |       |
| Basic                                                                        |       | 78,463                                                                       |       | 77,486                                                                       |       | 77,957                                                                      |       | 52,681                                                                      |       |
| Diluted                                                                      |       | 79,578                                                                       |       | 78,492                                                                       |       | 78,559                                                                      |       | 53,519                                                                      |       |
| Distributions declared per common share                                      |       | $                                                                            | 0.49       |                                                                         | $          | —                                                                      |       | $                                                                           | 1.34       |   | $ | 0.65 |   |

 

See condensed notes toconsolidated financial statements.

3

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** **

**KKR Financial Corp. andSubsidiariesConsolidated Statement of Changes in Stockholders’ Equity(Unaudited)(Amounts in thousands)**
| ** **                                                        | ** ** | **Shares of  Common  Stock** | ** ** | **Common  Stock at  Par  Value** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** | **Accumulated  Deficit** | ** ** | **Comprehensive  Income (Loss)** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------------|------------|---------------------------------------|------------|----------------------------------|------------|-----------------------------------------------|------------|--------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| **Balance at January 1, 2006**                                    |       | 80,374                            |       | $                                     | 804        |                             | $          | 1,639,996                                     |       | $                        | 18,344     |                                  | $          | (3,998                                | )          |   |   | $ | 1,655,146 |   |
| Net income                                                        |       | —                            |       | —                                |       | —                           |       | —                                        |       | 97,935                   |       | $                                     | 97,935     |                                  | 97,935     |   |
| Net change in  unrealized gain on cash flow hedges                |       | —                            |       | —                                |       | —                           |       | 8,349                                         |       | —                   |       | 8,349                                 |       | 8,349                                 |       |
| Net change in  unrealized loss on securities available-for-sale   |       | —                            |       | —                                |       | —                           |       | 25,466                                        |       | —                   |       | 25,466                                |       | 25,466                                |       |
| Comprehensive income                                              |       |                              |       |                                  |       |                             |       |                                          |       |                     |       | $                                     | 131,750    |                                  |       |   |
| Cash distributions on  common stock                               |       | —                            |       | —                                |       | —                           |       | —                                        |       | (107,717                 | )          |                                  |       | (107,717                              | )          |
| Exercise of stock  options by Manager                             |       | 58                                |       | 1                                     |       | 1,149                            |       | —                                        |       | —                   |       |                                  |       | 1,150                                 |       |
| Grant of restricted  common stock to Directors                    |       | 33                                |       | —                                |       | 163                              |       | —                                        |       | —                   |       |                                  |       | 163                                   |       |
| Amortization of  restricted common stock and common stock options |       | —                            |       | —                                |       | 21,914                           |       | —                                        |       | —                   |       |                                  |       | 21,914                                |       |
| **Balance at September 30, 2006**                                 |       | 80,465                            |       | $                                     | 805        |                             | $          | 1,663,222                                     |       | $                        | 52,159     |                                  | $          | (13,780                               | )          |   |   | $ | 1,702,406 |   |

 

See condensed notes to consolidated financialstatements.

4

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**KKR Financial Corp. andSubsidiariesConsolidated Statements of Cash Flows(Unaudited)(Amounts in thousands)**
| ** **                                                                     | ** ** | **Nine months ended  September 30, 2006** | ** ** | **Nine months ended  September 30, 2005** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| **Cash flows from operating  activities:**                                     | ** ** | ** **                                                    | ** ** | ** **                                                    | ** ** |
| Net income                                                                     |       | $                                                             | 97,935     |                                                          | $          | 33,072 |   |
| Adjustments to  reconcile net income to cash provided by operating activities: |       |                                                          |       |                                                          |       |
| Unrealized gain  on derivative positions                                       |       | (30                                                           | )          | (890                                                          | )          |
| Realized (gain)  loss on equity short positions                                |       | (52                                                           | )          | 32                                                            |       |
| Increase in  allowance for loan losses                                         |       | —                                                        |       | 1,300                                                         |       |
| Net realized and  unrealized gain on foreign exchange                          |       | (1,177                                                        | )          | —                                                        |       |
| Share-based  compensation                                                      |       | 22,077                                                        |       | 19,509                                                        |       |
| Net gain on sale  of securities available-for-sale                             |       | (3,721                                                        | )          | (1,140                                                        | )          |
| Net gain on sale  of loans                                                     |       | (1,199                                                        | )          | (1,773                                                        | )          |
| Depreciation and  amortization                                                 |       | 1,838                                                         |       | 4,683                                                         |       |
| Deferred income  tax (benefit) expense                                         |       | (704                                                          | )          | 341                                                           |       |
| Equity in income  of unconsolidated affiliate                                  |       | (914                                                          | )          | —                                                        |       |
| Changes in assets and  liabilities:                                            |       |                                                          |       |                                                          |       |
| Interest  receivable                                                           |       | (24,338                                                       | )          | (43,424                                                       | )          |
| Income tax  receivable                                                         |       | (861                                                          | )          | —                                                        |       |
| Other assets                                                                   |       | (4,214                                                        | )          | (21,382                                                       | )          |
| Related party  payable                                                         |       | 2,553                                                         |       | 1,648                                                         |       |
| Accounts  payable, accrued expenses and other liabilities                      |       | 22,163                                                        |       | 49,132                                                        |       |
| Income tax  liability                                                          |       | —                                                        |       | —                                                        |       |
| Accrued interest  payable                                                      |       | 5,994                                                         |       | 24,326                                                        |       |
| Net cash  provided by operating activities                                     |       | 115,350                                                       |       | 65,434                                                        |       |
| **Cash flows from investing  activities:**                                     | ** ** | ** **                                                    | ** ** | ** **                                                    | ** ** |
| Purchase of securities  available-for-sale                                     |       | (4,275,448                                                    | )          | (4,973,742                                                    | )          |
| Principal payments on  securities available-for-sale                           |       | 1,587,225                                                     |       | 990,259                                                       |       |
| Proceeds from sale of  securities available-for-sale                           |       | 207,090                                                       |       | 325,328                                                       |       |
| Purchase of loans                                                              |       | (2,243,255                                                    | )          | (7,009,666                                                    | )          |
| Principal payments on  loans                                                   |       | 2,016,162                                                     |       | 372,723                                                       |       |
| Proceeds from sale of  loans                                                   |       | 347,761                                                       |       | 96,536                                                        |       |
| Purchases of  non-marketable equity securities                                 |       | (117,621                                                      | )          | —                                                        |       |
| Proceeds from  non-marketable equity securities                                |       | 4,692                                                         |       | —                                                        |       |
| Proceeds from sale of  derivatives                                             |       | 973                                                           |       | —                                                        |       |
| Net additions to  restricted cash and cash equivalents                         |       | (135,637                                                      | )          | (81,965                                                       | )          |
| Additions of property  and equipment                                           |       | (5,132                                                        | )          | (480                                                          | )          |
| Investment in unconsolidated  affiliate                                        |       | (39,290                                                       | )          | —                                                        |       |
| Net cash used in  investing activities                                         |       | (2,652,480                                                    | )          | (10,281,007                                                   | )          |
| **Cash flows from financing  activities:**                                     | ** ** | ** **                                                    | ** ** | ** **                                                    | ** ** |
| Net proceeds from  issuance of common shares                                   |       | —                                                        |       | 848,817                                                       |       |
| Net proceeds from  exercise of common stock options                            |       | 1,150                                                         |       | —                                                        |       |
| Proceeds from  borrowings:                                                     |       |                                                          |       |                                                          |       |
| Repurchase  agreements                                                         |       | 137,020,004                                                   |       | 71,582,429                                                    |       |
| Asset-backed  secured liquidity notes                                          |       | 48,574,575                                                    |       | —                                                        |       |
| Collateralized  loan obligation senior secured notes                           |       | 752,500                                                       |       | 773,000                                                       |       |
| Secured  revolving credit facility                                             |       | 2,436,777                                                     |       | —                                                        |       |
| Secured demand  loan                                                           |       | 4,996,717                                                     |       | 12,636                                                        |       |
| Junior  subordinated notes                                                     |       | 250,000                                                       |       | —                                                        |       |
| Other capitalized financing  costs                                             |       | (39,192                                                       | )          | —                                                        |       |
| Purchase of interest  rate derivatives                                         |       | —                                                        |       | (10,106                                                       | )          |
| Repayments of  borrowings:                                                     |       |                                                          |       |                                                          |       |
| Repurchase agreements                                                          |       | (141,795,339                                                  | )          | (62,909,693                                                   | )          |
| Asset-backed  secured liquidity notes                                          |       | (42,372,020                                                   | )          | —                                                        |       |
| Secured demand  loan                                                           |       | (2,198,564                                                    | )          | —                                                        |       |
| Secured  revolving credit facility                                             |       | (4,995,569                                                    | )          | —                                                        |       |
| Distributions on common  stock                                                 |       | (107,717                                                      | )          | (26,651                                                       | )          |
| Net cash provided  by financing activities                                     |       | 2,523,322                                                     |       | 10,270,432                                                    |       |
| **Net (decrease) increase in cash  and cash equivalents**                      |       | (13,808                                                       | )          | 54,859                                                        |       |
| **Cash and cash equivalents at  beginning of period**                          |       | 16,110                                                        |       | 7,219                                                         |       |
| **Cash and cash equivalents at  end of period**                                |       | $                                                             | 2,302      |                                                          | $          | 62,078 |   |
| **Supplemental cash flow  information:**                                       | ** ** | ** **                                                    | ** ** | ** **                                                    | ** ** |
| Cash paid for interest                                                         |       | $                                                             | 987,072    |                                                          | $          | 121,937 |   |
| Cash paid for taxes                                                            |       | $                                                             | 3,518      |                                                          | $          | — |   |
| **Non-cash investing and  financing activities:**                              | ** ** | ** **                                                    | ** ** | ** **                                                    | ** ** |
| Payable for securities  purchases                                              |       | $                                                             | 275,622    |                                                          | $          | 26,860 |   |
| Issuance of restricted  common stock                                           |       | $                                                             | 163        |                                                          | $          | 42,405 |   |
| Transfers of loans held for investment to held for sale                        |       | $                                                             | 606,134    |                                                          | $          | 32,000 |   |

See condensed notes toconsolidated financial statements.

5

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**KKR Financial Corp. and Subsidiaries**

**Condensed Notes to Consolidated FinancialStatements (Unaudited)**

**Note 1.Organization**

KKRFinancial Corp., and its subsidiaries, (collectively, the “Company” or “KKRFinancial”) is a specialty finance company that invests in multiple assetclasses and uses leverage with the objective of generating competitiveleveraged risk-adjusted returns. The Company currently makes investments in thefollowing asset classes: (i) residential mortgage loans andmortgage-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.

TheCompany was organized as a Maryland corporation on July 7, 2004, andcommenced operations on August 12, 2004 (“Inception”). KKR FinancialAdvisors LLC (the “Manager”) manages the Company pursuant to a managementagreement (the “Management Agreement”). The Manager is an affiliate of KohlbergKravis Roberts & Co. L.P. (“KKR”). The Company is taxed as a real estate investment trust (“REIT”) and isrequired to comply with the provisions of the Internal Revenue Code of 1986, asamended (the “Code”), with respect thereto.

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

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

**Basis of Presentation**

Theaccompanying condensed consolidated financial statements have been prepared inconformity with accounting principles generally accepted in the United Statesof America (“GAAP”). The consolidated financial statements include the accountsof the Company, its taxable REIT subsidiaries, its qualified REIT subsidiaries,consolidated residential mortgage loan securitization trusts where the Companyis the primary beneficiary, and entities established to complete 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. For additional information, see “Consolidation” below.

Descriptionsof the significant accounting policies of the Company are included in Note 2 tothe consolidated financial statements contained in the Company’s 2005 AnnualReport on Form 10-K.  There have been nosignificant changes to these policies during the nine months ended September30, 2006.  See description of newlyadopted and newly applicable accounting policies below.  The Company’s results for any interim periodare not necessarily indicative of results for a full year or any other interimperiod.

**Use of Estimates**

Thepreparation of financial statements in conformity with GAAP requires managementto make certain estimates and assumptions that could affect the amountsreported in the Company’s consolidated financial statements and accompanyingnotes. Actual results could differ from management’s estimates.

6

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**Consolidation**

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

KKRFinancial CLO 2005-1, Ltd. (“CLO 2005-1”), KKR Financial CLO 2005-2, Ltd. (“CLO2005-2”), KKR Financial CLO 2006-1, Ltd. (“CLO 2006-1”), KKR Financial CLO2006-2, Ltd. (“CLO 2006-2”), and KKR Financial CDO 2005-1, Ltd. (“CDO 2005-1”),are entities established to complete secured financing transactions.  These entities are VIEs and are notconsidered to be qualifying special-purpose entities (“QSPE”) as defined byStatement of Financial Accounting Standards No. 140, Accounting forTransfers and Servicing of Financial Assets and Extinguishments of Liabilities(“SFAS No. 140”). The Company has determined it is the primary beneficiaryof these entities and has included the accounts of these entities in theseconsolidated financial statements. Additionally, the Company is the primary beneficiary of six residentialmortgage loan securitization trusts that are not considered to be QSPEs underSFAS No. 140 and the Company has therefore included the accounts of theseentities in these consolidated financial statements.

Allinter-company balances and transactions have been eliminated in consolidation.

**TrustPreferred Securities**

Trustsformed by the Company for the sole purpose of issuing trust preferredsecurities are not consolidated by the Company in accordance with FIN 46R asthe Company has determined that it is not the primary beneficiary of suchtrusts. The Company’s investment in the common securities of such trusts isincluded in other assets on the Company’s consolidated financial statements.

**Recent Accounting Pronouncements**

InFebruary 2006, the FASB issued SFAS No. 155, *Accountingfor Certain Hybrid Financial Instruments*. Key provisions of SFASNo. 155 include: (1) a broad fair value measurement option forcertain hybrid financial instruments that contain an embedded derivative thatwould otherwise require bifurcation; (2) clarification that only thesimplest separations of interest payments and principal payments qualify forthe exception afforded to interest-only strips and principal-only strips fromderivative accounting under paragraph 14 of SFAS No. 133, *Accounting for Derivative Instruments and Hedging Activities,*thereby narrowing such exception; (3) a requirement that beneficialinterests in securitized financial assets be analyzed to determine whether theyare freestanding derivatives or whether they are hybrid instruments thatcontain embedded derivatives requiring bifurcation; (4) clarification thatconcentrations of credit risk in the form of subordination are not embeddedderivatives; and (5) elimination of the prohibition on a QSPE holdingpassive derivative financial instruments that pertain to beneficial intereststhat are or contain a derivative financial instrument. In general, thesechanges will reduce the operational complexity associated with bifurcatingembedded derivatives, and increase the number of beneficial interests insecuritization transactions, including interest-only strips and principal-onlystrips, required to be accounted for in accordance with SFAS No. 133. TheCompany is required to adopt SFAS No. 155 in the first quarter of 2007 and iscurrently assessing the impact that it will have on its consolidated financialstatements. 

In June 2006, theFASB issued Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes — an interpretation of FASB Statement No. 109* (“FIN48”).  FIN 48 clarifies the accountingfor uncertainty in income taxes recognized in an enterprise’s financialstatements in accordance with FASB Statement No. 109, *Accountingfor Income Taxes*.  FIN 48prescribes a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return.  The Company isrequired to adopt FIN 48 in the first quarter of 2007 and is currentlyassessing the impact that it will have on its consolidated financialstatements.

In September 2006, theFASB issued SFAS No. 157, *Fair Value Measurements*.This statement defines fair value, establishes a framework for measuring fairvalue in GAAP and expands disclosures about fair value measurements.  SFAS No. 157 does not require any new fairvalue measurements.  The Company is requiredto adopt SFAS No. 157 in the first quarter of 2007 and does not expect theadoption of SFAS No. 157 to have a material impact on its consolidatedfinancial statements.

In September 2006,the SEC issued SAB No. 108, “Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements” (“SAB No. 108”). SAB No. 108 requires a dual evaluation approach –evaluation of an error from both a balance sheet perspective and results ofoperations perspective – when quantifying and evaluating the materiality of amisstatement.  The guidance in SAB No.108 musts be applied to annual financial statements for fiscal years endingafter November 15, 2006. The Company does not expect the adoption of SAB No.108 to have a material impact on its consolidated financial statements.

7

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**Note 3. Earnings perShare**

TheCompany calculates basic net income per common share by dividing net income forthe period by the weighted-average number of shares of its outstanding commonstock for the period. Diluted net income per common share takes into accountthe effect of dilutive instruments, such as common stock options and unvestedrestricted common stock, but uses the average share price for the period indetermining the number of incremental shares that are to be added to theweighted-average number of shares of its outstanding common stock. Thefollowing table presents a reconciliation of basic and diluted net income percommon share for the three and nine month periods ended September 30, 2006 and2005 (amounts in thousands, except per share information):
| ** **                                                                | ** ** | **Three months ended  September 30, 2006** | ** ** | **Three months ended  September 30, 2005** | ** ** | **Nine months ended  September 30, 2006** | ** ** | **Nine months ended  September 30, 2005** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| **Basic:**                                                                | ** ** | ** **                                                     | ** ** | ** **                                                     | ** ** | ** **                                                    | ** ** | ** **                                                    | ** ** |
| Net income                                                                |       | $                                                              | 32,616     |                                                           | $          | 18,454                                                        |       | $                                                             | 97,935     |   | $ | 33,072 |   |
| Weighted-average number  of common shares outstanding                     |       | 78,463                                                         |       | 77,486                                                         |       | 77,957                                                        |       | 52,681                                                        |       |
| Basic net income per  common share                                        |       | $                                                              | 0.42       |                                                           | $          | 0.24                                                          |       | $                                                             | 1.26       |   | $ | 0.63 |   |
| **Diluted:**                                                              | ** ** | ** **                                                     | ** ** | ** **                                                     | ** ** | ** **                                                    | ** ** | ** **                                                    | ** ** |
| Net income                                                                |       | $                                                              | 32,616     |                                                           | $          | 18,454                                                        |       | $                                                             | 97,935     |   | $ | 33,072 |   |
| Weighted-average number  of common shares outstanding                     |       | 78,463                                                         |       | 77,486                                                         |       | 77,957                                                        |       | 52,681                                                        |       |
| Plus: Incremental  shares from assumed conversion of dilutive instruments |       | 1,115                                                          |       | 1,006                                                          |       | 602                                                           |       | 838                                                           |       |
| Adjusted  weighted-average number of common shares outstanding            |       | 79,578                                                         |       | 78,492                                                         |       | 78,559                                                        |       | 53,519                                                        |       |
| Diluted net income per common share                                       |       | $                                                              | 0.41       |                                                           | $          | 0.24                                                          |       | $                                                             | 1.25       |   | $ | 0.62 |   |

 

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

Thefollowing table summarizes the Company’s securities classified asavailable-for-sale as of September 30, 2006, which are carried at estimatedfair value (amounts in thousands):
| **Description**                         | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
|-----------------------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| Residential mortgage-backed  securities |       | $                   | 7,851,638  |                         | $          | 20,453                        |       | $                              | (39,886    | ) | $ | 7,832,205 |   |
| Asset-backed securities                 |       | 31,257              |       | 410                          |       | —                        |       | 31,667                         |       |
| Corporate securities                    |       | 776,992             |       | 26,508                       |       | (6,906                        | )          | 796,594                        |       |
| Common and preferred  stocks            |       | 69,002              |       | 1,288                        |       | (3,597                        | )          | 66,693                         |       |
| Total                                   |       | $                   | 8,728,889  |                         | $          | 48,659                        |       | $                              | (50,389    | ) | $ | 8,727,159 |   |

 

Thefollowing table shows the gross unrealized losses and fair value of the Company’ssecurities investments, aggregated by length of time that the individualsecurities have been in a continuous unrealized loss position, at September 30,2006 (amounts in thousands):
| ** **                              | ** ** | **Less Than 12 months** | ** ** | **12 Months or More** | ** ** | **Total**           | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|---------------------|------------|
| **Description**                         | ** ** | **Fair Value**                    | ** ** | **Unrealized  Loss**                 | ** ** | **Fair Value** | ** ** | **Unrealized  Loss** | ** ** | **Fair Value** | ** ** | **Unrealized  Loss** | ** ** |
| Residential mortgage-backed  securities |       | $                                      | —     |                                 | $          | —              |       | $ | 1,910,792 |   | $ | (39,886 | ) | $ | 1,910,792 |   | $ | (39,886 | ) |
| Corporate securities                    |       | 17,334                                 |       | (5,110                               | )          | 116,576             |       | (1,796 | ) | 133,910 |   | (6,906 | ) |
| Common and preferred  stocks            |       | 30,263                                 |       | (3,363                               | )          | 12,200              |       | (234 | ) | 42,463 |   | (3,597 | ) |
| Total                                   |       | $                                      | 47,597     |                                 | $          | (8,473              | )          | $ | 2,039,568 |   | $ | (41,916 | ) | $ | 2,087,165 |   | $ | (50,389 | ) |

 

Theunrealized losses in the above table are temporary impairments due to marketfactors and are not reflective of credit deterioration.  The Company has performed credit analyses inrelation to these investments and has determined that the carrying value ofthese investments are fully recoverable over their expected holding period. Asthe Company has the intent and ability to hold these investments untilrecovery, unrealized losses are not considered to be other-than-temporaryimpairments.

8

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Thefollowing table summarizes the Company’s securities classified asavailable-for-sale as of December 31, 2005, which are carried at estimatedfair value (amounts in thousands):
| **Description**                         | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
|-----------------------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| Residential mortgage-backed  securities |       | $                   | 5,566,783  |                         | $          | 9,893                         |       | $                              | (38,838    | ) | $ | 5,537,838 |   |
| Commercial  mortgage-backed securities  |       | 83,001              |       | 94                           |       | (183                          | )          | 82,912                         |       |
| Asset-backed securities                 |       | 21,846              |       | 73                           |       | —                        |       | 21,919                         |       |
| Corporate securities                    |       | 457,932             |       | 7,829                        |       | (5,926                        | )          | 459,835                        |       |
| Common and preferred  stock             |       | 47,158              |       | 232                          |       | (388                          | )          | 47,002                         |       |
| Total                                   |       | $                   | 6,176,720  |                         | $          | 18,121                        |       | $                              | (45,335    | ) | $ | 6,149,506 |   |

 

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

Duringthe three and nine months ended September 30, 2006, the Company’s grossrealized gains from the sales of securities were $3.0 million and $5.1 million,respectively. The Company had gross realized losses of $1.1 million and $1.2million from the sales of securities during the three and nine months endedSeptember 30, 2006, respectively. During the three and nine months endedSeptember 30, 2005, the Company’s gross realized gains from the sales ofsecurities were $0.3 million and $1.1 million, respectively. The Company had nogross realized losses from the sales of securities during the three and ninemonths ended September 30, 2005.

Note 7to these condensed consolidated financial statements describes the Company’sborrowings under which the Company has pledged securities available-for-salefor borrowings under repurchase agreements, asset-backed secured liquiditynotes, and all other secured financing transactions. The following tablesummarizes the estimated fair value of securities pledged as collateral underrepurchase agreements, asset-backed secured liquidity notes, and all othersecured financing transactions as of September 30, 2006 (amounts in thousands):

 
| ** **                                                                     | ** ** | **Residential  Mortgage-Backed  Securities** | ** ** | **Commercial  Mortgage-Backed  Securities** | ** ** | **Corporate  Securities (1)** | ** ** | **Common and  Preferred Stocks** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|------------------------------------|------------|--------------------------------------------|------------|
| Pledged as collateral  for borrowings under repurchase agreements              |       | $                                            | 2,095,358  |                                        | $          | —                             |       | $                                          | 234,757    |   | $ | — |   |
| Pledged as collateral  for asset-backed secured liquidity notes                |       | 5,404,296                                    |       | —                                      |       | —                             |       | —                                     |       |
| Pledged as collateral  for borrowings under secured revolving credit facility  |       | —                                       |       | —                                      |       | 33,530                             |       | —                                     |       |
| Pledged as collateral  for borrowings under secured demand loan                |       | —                                       |       | —                                      |       | —                             |       | 47,000                                     |       |
| Pledged as collateral  for collateralized loan obligation senior secured notes |       | —                                       |       | —                                      |       | 411,839                            |       | —                                     |       |
| Total                                                                          |       | $                                            | 7,499,654  |                                        | $          | —                             |       | $                                          | 680,126    |   | $ | 47,000 |   |

----

(1)    Includes asset-backedsecurities.

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

 
| ** **                                                                     | ** ** | **Residential  Mortgage-Backed  Securities** | ** ** | **Commercial  Mortgage-Backed  Securities** | ** ** | **Corporate  Securities (1)** | ** ** | **Common and  Preferred Stocks** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|------------------------------------|------------|--------------------------------------------|------------|
| Pledged as collateral  for borrowings under repurchase agreements              |       | $                                            | 4,534,257  |                                        | $          | 65,352                             |       | $                                          | 286,365    |   | $ | — |   |
| Pledged as collateral  for asset-backed secured liquidity notes                |       | 720,370                                      |       | —                                      |       | —                             |       | —                                     |       |
| Pledged as collateral  for borrowings under secured revolving credit facility  |       | —                                       |       | —                                      |       | 82,888                             |       | —                                     |       |
| Pledged as collateral  for borrowings under secured demand loan                |       | —                                       |       | —                                      |       | —                             |       | 45,057                                     |       |
| Pledged as collateral  for collateralized loan obligation senior secured notes |       | —                                       |       | 5,021                                       |       | 171,089                            |       | —                                     |       |
| Total                                                                          |       | $                                            | 5,254,627  |                                        | $          | 70,373                             |       | $                                          | 540,342    |   | $ | 45,057 |   |

----

(1)    Includes asset-backedsecurities.

9

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**Note 5.Loans**

As ofSeptember 30, 2006, nine corporate loans and eleven commercial real estateloans were classified as held for sale by the Company.  Accordingly, these loans are recorded at thelower of cost or estimated fair value on the Company’s consolidated balancesheet. Of the 20 loans classified as held for sale, none had an estimated fairvalue that was below amortized cost.

Thefollowing table summarizes the Company’s loans as of September 30, 2006(amounts in thousands):
| ** **                                                | ** ** | **Principal** | ** ** | **Unamortized  Premium/(Discount)** | ** ** | **Net  Amortized Cost** | ** ** |
|-----------------------------------------------------------|------------|---------------|------------|-------------------------------------|------------|------------------------------|------------|
| Residential mortgage  loans                               |       | $             | 5,370,078  |                                | $          | 18,496                       |       | $ | 5,388,574 |   |
| Corporate loans                                           |       | 2,637,249     |       | (3,889                              | )          | 2,633,360                    |       |
| Commercial real estate  loans                             |       | 96,529        |       | 656                                 |       | 97,185                       |       |
| Allowance for loan  losses for residential mortgage loans |       | (1,500        | )          | —                              |       | (1,500                       | )          |
| Total loans held  for investment                          |       | 8,102,356     |       | 15,263                              |       | 8,117,619                    |       |
| Loans held for sale                                       |       | 609,286       |       | (3,152                              | )          | 606,134                      |       |
| Total loans, net of  allowance for loan losses            |       | $             | 8,711,642  |                                | $          | 12,111                       |       | $ | 8,723,753 |   |

 

Thefollowing table summarizes of the Company’s loans as of December 31, 2005(amounts in thousands):
| ** **                                                | ** ** | **Principal** | ** ** | **Unamortized  Premium/(Discount)** | ** ** | **Net  Amortized Cost** | ** ** |
|-----------------------------------------------------------|------------|---------------|------------|-------------------------------------|------------|------------------------------|------------|
| Residential mortgage  loans                               |       | $             | 6,405,701  |                                | $          | 23,121                       |       | $ | 6,428,822 |   |
| Corporate loans                                           |       | 1,900,385     |       | (3,108                              | )          | 1,897,277                    |       |
| Commercial real estate  loans                             |       | 522,750       |       | (1,008                              | )          | 521,742                      |       |
| Allowance for loan  losses for residential mortgage loans |       | (1,500        | )          | —                              |       | (1,500                       | )          |
| Total loans held  for investment                          |       | 8,827,336     |       | 19,005                              |       | 8,846,341                    |       |
| Loans held for sale                                       |       | —        |       | —                              |       | —                       |       |
| Total loans, net of  allowance for loan losses            |       | $             | 8,827,336  |                                | $          | 19,005                       |       | $ | 8,846,341 |   |

 

Note 7to these condensed consolidated financial statements describes the Company’sborrowings under which the Company has pledged loans for borrowings underrepurchase agreements, asset-backed secured liquidity notes, and all othersecured financing transactions. The following table summarizes the carryingvalue of loans pledged as collateral under repurchase agreements, asset-backedsecured liquidity notes, and all other secured financing transactions as ofSeptember 30, 2006 (amounts in thousands):
| ** **                                                                     | ** ** | **Residential  Mortgage Loans** | ** ** | **Corporate Loans** | ** ** | **Commercial Real  Estate Loans** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|
| Pledged as collateral  for borrowings under repurchase agreements              |       | $                                    | 2,264,048  |                     | $          | 487,307                                     |       | $ | 209,050 |   |
| Pledged as collateral  for asset-backed secured liquidity notes                |       | 3,098,827                            |       | —                   |       | —                                      |       |
| Pledged as collateral  for borrowings under secured revolving credit facility  |       | —                               |       | 202,149                  |       | —                                      |       |
| Pledged as collateral  for collateralized loan obligation senior secured notes |       | —                               |       | 2,340,193                |       | 96,419                                      |       |
| Total                                                                          |       | $                                    | 5,362,875  |                     | $          | 3,029,649                                   |       | $ | 305,469 |   |

 

10

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Thefollowing table summarizes the carrying value of loans pledged as collateralunder repurchase agreements, asset-backed secured liquidity notes, and allother secured financing transactions as of December 31, 2005 (amounts inthousands):
| ** **                                                                     | ** ** | **Residential  Mortgage Loans** | ** ** | **Corporate Loans** | ** ** | **Commercial Real  Estate Loans** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|
| Pledged as collateral  for borrowings under repurchase agreements              |       | $                                    | 4,904,779  |                     | $          | 155,167                                     |       | $ | 370,950 |   |
| Pledged as collateral  for asset-backed secured liquidity notes                |       | 1,366,300                            |       | —                   |       | —                                      |       |
| Pledged as collateral  for borrowings under secured revolving credit facility  |       | —                               |       | 59,965                   |       | 10,000                                      |       |
| Pledged as collateral  for collateralized loan obligation senior secured notes |       | —                               |       | 1,614,309                |       | 140,792                                     |       |
| Total                                                                          |       | $                                    | 6,271,079  |                     | $          | 1,829,441                                   |       | $ | 521,742 |   |

 

**ResidentialMortgage Loans**

**During the year endedDecember 31, 2005, the Company purchased $5.9 billion of securities inconnection with five securitization transactions backed by $4.5 billion ofresidential hybrid adjustable rate mortgage (“ARM”) loans and $1.4 billion ofresidential ARM loans. In each of the five securitization transactions, theCompany purchased all of the securities issued, including the subordinate classes.Included in the $5.9 billion of securities purchased were $0.4 billion of loanscontributed to the securitization transactions by the Company, resulting in anet purchase by the Company of $5.5 billion of securities. Of the $5.9 billionof securities purchased, approximately 96% were rated AAA byStandard & Poor’s Ratings Service (“Standard & Poor’s” or “S&P”).Each of the special-purpose entities that issued the securities are notconsidered qualifying special-purpose entities as defined by SFAS No. 140and are treated as VIEs under FIN 46R. The Company has determined that it isthe primary beneficiary of each of the special-purpose entities that issued thesecurities; accordingly, the Company recorded its investments as loans and notsecurities.**

**During September 2005,the Company securitized $959.2 million of residential ARM loans and retainedall of the securities issued in the securitization transaction, including thesubordinate classes. While the Company retained all of the securities, whichare legal assets of the Company, the loans transferred in this securitizationare owned by a special purpose entity and the loans are not available to theCompany, its creditors or stockholders. Of the $959.2 million of securitiesissued, approximately $908.8 million, or 95%, were rated AAA byStandard & Poor’s. While the Company transferred the loans to aseparate bankruptcy-remote legal entity, the Company did not account for thetransaction as a sale as the securitization transaction did not meet thecriteria for sales treatment under SFAS No. 140. Accordingly, the Companydid not record a gain or loss in connection with the securitization transactionand accounts for the transferred assets as loans on its consolidated balancesheet.**

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

| Delinquency Status | ** ** | **Number of Loans** | ** ** | **Principal Amount** | ** ** |
|-------------------------|------------|-------------------------------|------------|---------------------------|------------|
| 30 to 59 days           |       | 65                            |       | $                         | 21,700     |   |
| 60 to 89 days           |       | 10                            |       | 3,481                     |       |
| 90 days or more         |       | 9                             |       | 2,215                     |       |
| In foreclosure          |       | 12                            |       | 2,698                     |       |
| Total                   |       | 96                            |       | $                         | 30,094     |   |

 

Thefollowing table summarizes the delinquency statistics of residential mortgageloans as of December 31, 2005 (dollar amounts in thousands):

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

 

11

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As ofSeptember 30, 2006, two of the residential mortgage loans owned by the Companywith an outstanding balance of  $0.5million (not included in the table above) were real estate owned (“REO”) as aresult of foreclose on delinquent loans. For each of the two loans, the estimated fair value of the underlyingproperty exceeds the outstanding loan balance and the Company has therefore notrecorded a charge against the Company’s allowance for loan losses, and the loanshave been reclassified from loans to other assets on the Company’s balancesheet at the lower of cost or estimated fair value.  There was no REO as of December 31, 2005.

As ofSeptember 30, 2006, the Company had twenty-one loans that were either 90 daysor greater past due or in foreclosure and placed on non-accrual status.  During the three and nine months endedSeptember 30, 2006 the Company did not recognize approximately $0.1 million and$0.2 million, respectively, in interest income for loans that were either innon-accrual status or classified as REO.

Thefollowing table summarizes the changes in the allowance for loan losses for theCompany’s residential mortgage loan portfolio during the nine months endedSeptember 30, 2006 (amounts in thousands):

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

 

**Corporateand Commercial Real Estate Loans**

As ofSeptember 30, 2006 and December 31, 2005, no corporate or commercial realestate loans were delinquent and as of September 30, 2006 and December 31, 2005,the Company had not recorded an allowance for loan losses for its commercialreal estate or corporate loan portfolios. In reviewing the Company’s portfolioof commercial real estate loans and corporate loans, the Company determinedthat no loans were impaired as of September 30, 2006 or December 31,2005.  The Company considers a loan to beimpaired when, based on current information and events, management believes itis probable that the Company will be unable to collect all amounts due pursuantto the contractual terms of the loan agreement.

**Note 6.Investment in Unconsolidated Affiliate**

**As of September 30, 2006, theCompany’s investment in an unconsolidated affiliate consisted of a 49.9%limited partnership interest in KFH.** The remaining 50.1% ofKFH is owned by three private investment funds (collectively, the “KKRStrategic Capital Funds”) and the general partner of the KKR Strategic CapitalFunds.  The KKR Strategic Capital Fundsare managed by an affiliate of the Company’s Manager and the KFH generalpartner is 100% owned by the Company’s Manager. The Company’s investment in KFH is accounted for under the equitymethod. Under the equity method, the Company’s initial investment is recordedat cost and is subsequently adjusted to recognize the Company’s share of KFH’searnings or losses. Distributions received reduce the carrying amount of theinvestment.

**KFH was formed during thethird quarter of 2006 and is the primary beneficiary of four special purposeentities formed during the third quarter of 2006 to complete secured borrowingtransactions to finance certain investments in corporate loans and securities.The special purpose entities are KKR Financial CLO 2007-1, Ltd., KKR FinancialCLO 2007-2, Ltd., KKR Financial CLO 2007-3, Ltd., and KKR Financial CLO 2007-4,Ltd.  As of September 30, 2006, KFH had$456.4 million in assets consisting of $452.1 million of corporate loans, $2.9 millionof interest receivable, and $1.4 million of cash.  As of September 30, 2006, KFH had liabilitiestotaling $375.9 million consisting of $373.5 million of borrowings underrepurchase agreements, $2.1 million of interest payable, and $0.3 million ofother payables.  During the quarter endedSeptember 30, 2006, KFH had net income of $1.8 million consisting of $3.9million of interest income, and $2.1 million of interest expense.**

**Note 7.Borrowings**

TheCompany leverages its portfolio of securities and loans through the use ofrepurchase agreements, asset-backed secured liquidity notes, warehousefacilities, demand loans, and securitization transactions structured as securedfinancings. Each of the borrowing vehicles used by the Company bears interestat floating rates based on a spread above the London InterBank Offered Rate (“LIBOR”)or asset-backed secured liquidity note interest rates.

Certaininformation with respect to the Company’s borrowings as of September 30, 2006is summarized in the following table (amounts in thousands):

12

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| ** **                            | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted  Average  Borrowing  Rate** | ** ** | **Weighted  Average  Remaining  Maturity  (in days)** | ** ** | **Fair Value  of Collateral (1)** | ** ** |
|---------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------------|------------|
| Repurchase agreements                 |       | $                           | 4,378,758  |                                   | 5.41       | %                                                          | 21         |                                             | $          | 4,530,483 |   |
| Demand loan                           |       | 41,658                      |       | 5.88                                   |       | 2                                                          |       | 47,000                                           |       |
| Secured revolving  credit facility    |       | 292,213                     |       | 6.08                                   |       | 17                                                         |       | 237,533                                          |       |
| Asset-backed secured  liquidity notes |       | 8,190,682                   |       | 5.35                                   |       | 20                                                         |       | 8,491,528                                        |       |
| CLO 2005-1 senior  secured notes      |       | 773,000                     |       | 5.78                                   |       | 3,861                                                      |       | 980,207                                          |       |
| CLO 2005-2 senior  secured notes      |       | 752,000                     |       | 5.67                                   |       | 4,075                                                      |       | 943,162                                          |       |
| CLO 2006-1 senior  secured notes      |       | 727,500                     |       | 5.73                                   |       | 4,347                                                      |       | 934,188                                          |       |
| CDO 2005-1 repurchase  agreements     |       | 137,927                     |       | 6.43                                   |       | 18                                                         |       | 213,136                                          |       |
| CLO 2006-2 repurchase  agreements     |       | 469,238                     |       | 5.98                                   |       | 23                                                         |       | 537,353                                          |       |
| Junior subordinated  notes            |       | 257,743                     |       | 7.74                                   |       | 10,903                                                     |       | —                                           |       |
| Total                                 |       | $                           | 16,020,719 |                                   |       |                                                       |       |                                             | $          | 16,914,590 |   |

 

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(1)    Collateral for borrowings consists ofsecurities available-for-sale, loans, and marketable equity securities.

Certaininformation with respect to the Company’s borrowings as of December 31,2005 is summarized in the following table (amounts in thousands):
| ** **                            | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted  Average  Borrowing  Rate** | ** ** | **Weighted  Average  Remaining  Maturity  (in days)** | ** ** | **Fair Value  of Collateral (1)** | ** ** |
|---------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------------|------------|
| Repurchase agreements                 |       | $                           | 9,303,622  |                                   | 4.33       | %                                                          | 24         |                                             | $          | 9,472,231 |   |
| Demand loan                           |       | 40,511                      |       | 4.63                                   |       | 13                                                         |       | 45,057                                           |       |
| Secured revolving  credit facility    |       | 54,000                      |       | 5.38                                   |       | 13                                                         |       | 152,241                                          |       |
| Asset-backed secured  liquidity notes |       | 2,008,069                   |       | 4.42                                   |       | 14                                                         |       | 2,080,072                                        |       |
| CLO 2005-1 senior  secured notes      |       | 773,000                     |       | 4.49                                   |       | 4,134                                                      |       | 996,681                                          |       |
| CLO 2005-2 senior  secured notes      |       | 727,000                     |       | 4.59                                   |       | 4,348                                                      |       | 946,969                                          |       |
| CLO 2006-1 repurchase  agreements     |       | 193,835                     |       | 4.86                                   |       | 5                                                          |       | 436,756                                          |       |
| CDO 2005-1 repurchase  agreements     |       | 263,801                     |       | 5.47                                   |       | 18                                                         |       | 388,783                                          |       |
| Total                                 |       | $                           | 13,363,838 |                                   |       |                                                       |       |                                             | $          | 14,518,790 |   |

 

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(1)    Collateral for borrowings consists ofsecurities available-for-sale, loans, and marketable equity securities.

OnMarch 30, 2005, the Company closed CLO 2005-1, a $1.0 billion CLOtransaction that provides financing for investments in corporate loans andcertain other loans and securities. The investments owned by CLO 2005-1collateralize the CLO 2005-1 debt, and as a result, those investments are notavailable to the Company, its creditors or stockholders. CLO 2005-1 issued atotal of $773.0 million of senior secured notes at par to investors. Inaddition, the Company retained $148.0 million of rated mezzanine notes and$85.5 million of unrated subordinated notes issued by CLO 2005-1.

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

DuringApril 2005, the Company formed CDO 2005-1 and began borrowing on a$300.0 million warehouse facility, in the form of a repurchase agreement,to purchase commercial real estate obligations. The repurchase facility bearsinterest at a rate of 30-day LIBOR plus 1.10% and as of September 30, 2006,there was $137.9 million outstanding. During the three month period ended September 30, 2006, the Companydetermined that it would not pursue a collateralized debt transaction issued byCDO 2005-1 and during October 2006 the Company exercised its option to convertthe warehouse facility into a $300 million term credit facility that terminateson March 31, 2008.

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OnSeptember 30, 2005, the Company closed a $5.0 billion asset-backedsecured liquidity note facility. This facility provides the Company with analternative source of funding for its residential mortgage-backed securities byissuing asset-backed secured liquidity notes that are rated A-1+, P-1, and F1+,by Standard & Poor’s, Moody’s Investors Service (“Moody’s”), and FitchInc., respectively. Issuances of asset-backed secured liquidity notes arerecorded as borrowings on the Company’s consolidated balance sheet. As of September30, 2006, the Company had $4.7 billion of asset-backed secured liquidity notesunder this facility outstanding.

OnNovember 3, 2005, the Company closed CLO 2005-2, its second $1.0 billionCLO transaction that provides financing for investments consisting of corporateloans and certain other loans and securities. The investments that are owned byCLO 2005-2 collateralize the CLO 2005-2 debt, and as a result, thoseinvestments are not available to the Company, its creditors or stockholders.CLO 2005-2 issued a total of $752.0 million of senior secured notes at par toinvestors. In addition, the Company retained $168.0 million of rated mezzaninenotes and $98.5 million of unrated subordinate notes issued by CLO 2005-2.

Thesenior notes issued to investors by CLO 2005-2 consist of the following threeclasses of notes: (i) $545.0 million of class A-1 notes bearinginterest at three-month LIBOR plus 0.26%; (ii) $57.0 million ofclass B notes bearing interest at three-month LIBOR plus 0.43%; and(iii) $150.0 million of class A-2 Delayed Draw notes bearinginterest on the drawn amount at three-month LIBOR plus 0.26%. All of the notesissued by CLO 2005-2 mature on November 26, 2017, though the Company hasthe right to call the notes at par any time after November 2009.

DuringDecember 2005, the Company formed CLO 2006-2 and executed a $450.0 millionwarehouse facility, in the form of a repurchase agreement, to finance thepurchase of corporate loans and certain other loans and securities. This facilitywas subsequently amended to increase the total commitment amount to $630.0million in September 2006.  Therepurchase facility bears interest at a rate of 30-day LIBOR plus 0.60% and asof September 30, 2006 there was $469.2 million outstanding.

DuringMarch 2006, the Company formed KKR Financial Capital Trust I (“Trust I”) forthe sole purpose of issuing trust preferred securities. On March 28, 2006,Trust I issued preferred securities to unaffiliated investors for grossproceeds of $50.0 million and common securities to the Company for $1.6million. The combined proceeds were invested by Trust I in $51.6 million ofjunior subordinated notes issued by the Company. The junior subordinated notesare the sole assets of Trust I and mature on April 30, 2036, but are callableon or after April 30, 2011. Interest is payable quarterly at a fixed rate of7.64% (ten-year LIBOR plus 2.45%) through March 2016 and thereafter at afloating rate equal to three-month LIBOR plus 2.65%.

OnMarch 30, 2006, the Company closed its second $5.0 billion asset-backedsecured liquidity note facility. This facility provides the Company with analternative source of funding for its residential mortgage-backed securities byissuing asset-backed secured liquidity notes that are rated A-1+, P-1, and F1+,by Standard & Poor’s, Moody’s, and Fitch Inc., respectively. As ofSeptember 30, 2006, the Company had $3.5 billion in borrowings outstandingunder this facility.

DuringJune 2006, the Company formed KKR Financial Capital Trust II (“Trust II”) forthe sole purpose of issuing trust preferred securities. On June 2, 2006, TrustII issued preferred securities to unaffiliated investors for gross proceeds of$50.0 million and common securities to the Company for $1.6 million. Thecombined proceeds were invested by Trust II in $51.6 million of juniorsubordinated notes issued by the Company. The junior subordinated notes are thesole assets of Trust II and mature on July 30, 2036, but are callable on orafter July 30, 2011. Interest is payable quarterly at a fixed rate of 8.09%(ten-year LIBOR plus 2.45%) through July 2016 and thereafter at a floating rateequal to three-month LIBOR plus 2.65%.

During June 2006,the Company’s $275.0 million secured revolving credit facility matured and wasreplaced with a $375.0 million three year senior secured revolving creditfacility.  During September 2006, 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 senior secured revolving credit facility matures in June 2009 andconsists of two tranches.  Outstandingborrowings under the senior secured revolving credit facility bear interest ateither (i) an alternate base rate per annum equal to the greater of (a) the primerate in effect on such day, and (b) the federal funds in effect on such dayplus 0.50%, or (ii) an interest rate per annum equal to the LIBOR rate for theapplicable interest period plus 0.50% for borrowings under tranche A of thefacility and 0.75% for borrowings under tranche B of the facility. As ofSeptember 30, 2006, the Company had $292.2 million in****borrowingsoutstanding under tranche B of this facility.

14

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DuringAugust 2006, the Company formed KKR Financial Capital Trust III (“Trust III”)for the 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 the Company. The junior subordinated notesare the sole assets of Trust III and mature on October 30, 2036, but arecallable on or after October 30, 2011. Interest is payable quarterly at afloating rate equal to three-month LIBOR plus 2.35%.

DuringSeptember 2006, the Company formed KKR Financial Capital Trust IV (“Trust IV”)for the sole purpose of issuing trust preferred securities. On September 15,2006, Trust IV issued preferred securities to unaffiliated investors for grossproceeds of $15.0 million and common securities to the Company for $0.5million. The combined proceeds were invested by Trust IV in $15.5 million ofjunior subordinated notes issued by the Company. The junior subordinated notesare the sole assets of Trust IV and mature on October 30, 2036, but arecallable on or after October 30, 2011. Interest is payable quarterly at afloating rate equal to three-month LIBOR plus 2.35%.

OnSeptember 19, 2006, the Company closed CLO 2006-1, its third $1.0 billion CLOtransaction that provides financing for investments consisting of corporateloans and certain other loans and securities. The investments that are owned byCLO 2006-1 collateralize the CLO 2006-1 debt, and as a result, those investmentsare not available to the Company, its creditors or stockholders. CLO 2006-1issued a total of $727.5 million of senior secured notes at par to investors.In addition, the Company retained $145.5 million of rated mezzanine notes and$144.0 million of unrated subordinate notes issued by CLO 2006-1.

Thesenior notes issued to investors by CLO 2006-1 consist of the following fiveclasses of notes as follows: (i) $334.0 million of class A-1senior notes bearing interest at three-month LIBOR plus 0.28%; (ii) $207.0 millionof class A-2a senior notes bearing interest at three-month LIBOR plus0.24%; (iii) $69.0 million of class A-2b senior notes bearinginterest at three-month LIBOR plus 0.40%; (iv) $43.0 million of class B seniornotes bearing interest at three-month LIBOR plus 0.50%; and (v) $74.5 millionof class C mezzanine notes bearing interest at three-month LIBOR plus 0.95%.All of the notes issued by CLO 2006-1 mature on August 25, 2018, though theCompany has the right to call the notes at par any time after August 2010.

DuringSeptember 2006, the Company formed KKR Financial Capital Trust V (“Trust V”)for the sole purpose of issuing trust preferred securities. On September 29,2006, Trust V issued preferred securities to unaffiliated investors for grossproceeds of $50.0 million and common securities to the Company for $1.6million. The combined proceeds were invested by Trust V in $51.6 million ofjunior subordinated notes issued by the Company. The junior subordinated notesare the sole assets of Trust V and mature on October 30, 2036, but are callableon or after October 30, 2011. Interest is payable quarterly at a fixed rate of7.395% through October 2016 and thereafter at a floating rate equal tothree-month LIBOR plus 2.25%.

**Note 8.Derivative Financial Instruments**

TheCompany enters into derivative financial instruments to hedge all or a portionof the interest rate risk associated with its borrowings under repurchaseagreements and asset-backed secured liquidity notes.  The Company designates these financialinstruments as cash flow hedges. Additionally, the Company entered into aninterest rate swap during the third quarter of 2006 that is designated as afair value hedge of a portfolio of fixed rate commercial real estate loans. TheCompany also purchases derivative financial instruments for investing purposeswhich include investment financing arrangements (total rate of return swaps)whereby the Company receives the sum of all interest, fees and any positive economicchange in value amounts from a reference asset with a specified notional amountand pays interest on such notional plus any negative change in value amountsfrom such asset.  The counterparties tothe Company’s derivative agreements are major financial institutions with whichthe Company and its affiliates may also have other financial relationships. Inthe event of nonperformance by the counterparties, the Company is potentiallyexposed to losses. The counterparties to the Company’s derivative agreementshave investment grade ratings and as a result the Company does not anticipatethat any of the counterparties will fail to fulfill their obligations.

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

15

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|                                | ** ** | **As of  September 30, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|--------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| **Cash Flow Hedges:**          |       |                                         |       |                                        |       |
| Interest rate  corridors       |       | $                                            | 14,548     |                                        | $          | 14,762 |   |
| Interest rate  swaps           |       | 48,179                                       |       | 40,796                                      |       |
| **Fair Value Hedges:**         | ** ** | ** **                                   | ** ** | ** **                                  | ** ** |
| Interest rate  swap            |       | (581                                         | )          | —                                      |       |
| **Free-Standing Derivatives:** | ** ** | ** **                                   | ** ** | ** **                                  | ** ** |
| Interest rate  swaptions       |       | 113                                          |       | 879                                         |       |
| Interest rate  swaps           |       | —                                       |       | 198                                         |       |
| Credit default  swaps          |       | (185                                         | )          | 71                                          |       |
| Total rate of  return swaps    |       | 2,185                                        |       | 727                                         |       |
| Net fair value                 |       | $                                            | 64,259     |                                        | $          | 57,433 |   |

 

**Note 9.Accumulated Other Comprehensive Income**

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

|                                                         | ** ** | **As of  September 30, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| Net unrealized losses  on available-for-sale securities |       | $                                            | (1,749     | )                                           | $          | (27,215 | ) |
| Net unrealized gains on  cash flow hedges               |       | 53,908                                       |       | 45,559                                      |       |
| Accumulated other comprehensive income                  |       | $                                            | 52,159     |                                        | $          | 18,344 |   |

 

Thechanges in the components of other comprehensive income (loss) were as follows(amounts in thousands):
| ** **                                                              | ** ** | **Three months  ended  September 30, 2006** | ** ** | **Three months  ended  September 30, 2005** | ** ** | **Nine months  ended  September 30, 2006** | ** ** | **Nine months  ended  September 30, 2005** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Unrealized gains on  securities available-for-sale:                     |       |                                                       |       |                                                       |       |                                                      |       |                                                      |       |
| Unrealized holding  gains (losses) arising during period                |       | $                                                          | 25,259     |                                                       | $          | (30,023                                                   | )          | $                                                         | 21,745     |   | $ | (37,648 | ) |
| Reclassification  adjustments for gains (losses) realized in net income |       | 1,857                                                      |       | (325                                                       | )          | 3,721                                                     |       | (1,140                                                    | )          |
| Unrealized gains  (losses) on securities available-for-sale             |       | 27,116                                                     |       | (30,348                                                    | )          | 25,466                                                    |       | (38,788                                                   | )          |
| Unrealized (losses) gains  on cash flow hedges                          |       | (64,044                                                    | )          | 27,430                                                     |       | 8,349                                                     |       | 23,886                                                    |       |
| Other comprehensive income (loss)                                       |       | $                                                          | (36,928    | )                                                          | $          | (2,918                                                    | )          | $                                                         | 33,815     |   | $ | (14,902 | ) |

 

**Note 10.Stock Options and Restricted Stock**

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

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

Thefollowing table summarizes restricted common stock transactions:

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|                                                                         | ** ** | **Manager** | ** ** | **Directors** | ** ** | **Total**  | ** ** |
|-------------------------------------------------------------------------|------------|-------------|------------|---------------|------------|------------|------------|
| **Unvested shares as of January 1, 2006** |       | 2,670,911   |       | 28,321        |       | 2,699,232  |       |
| Issued                                                                  |       | —      |       | 33,152        |       | 33,152     |       |
| Vested                                                                  |       | (1,022,956  | )          | (28,321       | )          | (1,051,277 | )          |
| Forfeited                                                               |       | —      |       | —        |       | —     |       |
| **Unvested shares as of September 30, 2006**                            |       | 1,647,955   |       | 33,152        |       | 1,681,107  |       |

 

Theshares of restricted common stock granted to the directors were valued usingthe fair market value at the time of grant, which was $21.30, $24.90, and$20.00 per common share, for the shares of restricted common stock granted in2006, 2005, and 2004, respectively. Pursuant to SFAS No. 123(R), theCompany is required to value any unvested shares of restricted common stockgranted to the Manager at the current market price. The Company valued theunvested restricted common stock at $24.54 and $22.24 per share at September30, 2006 and September 30, 2005, respectively. There were $18.6 million and $46.1 million of total unrecognized compensationcosts related to unvested restricted common stock granted as of September 30,2006 and 2005, respectively.  As ofSeptember 30, 2006 the cost is expected to be recognized over a weightedaverage period of 1.2 years.

The followingtable summarizes common stock option transactions:

|                                          | ** ** | **Number  of Options** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|------------------------------------------|------------|-----------------------------|------------|------------------------------------------------|------------|
| **Outstanding as of January 1,  2006**   |       | 1,989,779                   |       | $                                              | 20.00      |   |
| Granted                                  |       | —                      |       | —                                         |       |
| Exercised                                |       | (57,500                     | )          | 20.00                                          |       |
| Forfeited                                |       | —                      |       | —                                         |       |
| **Outstanding as of September 30, 2006** |       | 1,932,279                   |       | $                                              | 20.00      |   |

 

57,500common stock options were exercised during the nine months ended September 30,2006.  No common stock options wereexercised during the nine months ended September 30, 2005.  As of September 30, 2006 and 2005, 1,269,020and 663,260 common stock options were exercisable, respectively. The commonstock options are valued using the Black-Scholes model using the followingassumptions:

|                | ** ** | **As of  September 30, 2006** | ** ** | **As of  September 30, 2005** | ** ** |
|----------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| Expected life  |       | 7.9 years                                    |       | 8.9 years                                    |       |
| Discount rate  |       | 4.65                                         | %          | 4.43                                         | %          |
| Volatility     |       | 17                                           | %          | 20                                           | %          |
| Dividend yield |       | 9                                            | %          | 9                                            | %          |

 

Theestimated fair value of the common stock options was $1.72 and $1.46 atSeptember 30, 2006 and 2005, respectively. There were $0.3 million and $1.0million of total unrecognized compensation costs related to unvested commonstock options granted as of September 30, 2006 and 2005, respectively.  The cost is expected to be recognized over aweighted average period of five months at September 30, 2006.

Forthe three and nine months ended September 30, 2006 and 2005, the components ofshare-based compensation expense are as follows (amounts in thousands):
| ** **                                      | ** ** | **For the three  months ended  September 30, 2006** | ** ** | **For the three  months ended  September 30, 2005** | ** ** | **For the nine  months ended  September 30, 2006** | ** ** | **For the nine  months ended  September 30, 2005** | ** ** |
|-------------------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| Options granted to  Manager                     |       | $                                                                            | 813        |                                                                         | $          | 38                                                                          |       | $                                                                           | 304        |   | $ | 1,615 |   |
| Restricted shares  granted to Manager           |       | 9,230                                                                        |       | 7,191                                                                        |       | 21,316                                                                      |       | 17,634                                                                      |       |
| Restricted shares  granted to certain directors |       | 108                                                                          |       | 199                                                                          |       | 457                                                                         |       | 260                                                                         |       |
| Total share-based compensation expense          |       | $                                                                            | 10,151     |                                                                         | $          | 7,428                                                                       |       | $                                                                           | 22,077     |   | $ | 19,509 |   |

 

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**Note 11.** ManagementAgreement and Related Party Transactions

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

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

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

Forthe three and nine months ended September 30, 2006, the Company incurred$7.2 million and $21.6 million in base management fees and $2.5 millionand $4.8 million in management incentive fees, respectively. In addition, theCompany recognized share-based compensation expense related to common stockoptions and restricted common stock granted to the Manager of $10.0 million and$21.6 million for the three and nine months ended September 30, 2006,respectively (see Note 10). The Company also reimbursed the Manager $1.5million and $4.3 million for expenses for the three and nine months endedSeptember 30, 2006, respectively. The Company incurred base management fees of$7.1 million and $13.8 million, respectively, and reimbursed the Managerfor expenses of $1.5 million and $3.2 million, respectively, for the three andnine months ended September 30, 2005. The Company incurred no managementincentive fees for the three and nine months ended September 30, 2005. Inaddition, the Company recognized share-based compensation expense related to commonstock options and restricted common stock granted to the Manager of$7.2 million and $19.3 million for the three and nine months endedSeptember 30, 2005, respectively. Base management fees incurred and share-basedcompensation expense relating to common stock options and restricted commonstock granted to the Manager are included in related party managementcompensation on the consolidated statements of operations. Expenses incurred bythe Manager and reimbursed by the Company are reflected in the respectiveconsolidated statement of operations non-investment expense category based onthe nature of the expense.

Anaffiliate of the Company’s Manager has entered into separate managementagreements with the respective investment vehicles for CLO 2005-1, CLO 2005-2,and CLO 2006-1 and is entitled to receive fees for the services performed ascollateral manager. For the three and nine month periods ended September 30,2006, the collateral manager has waived approximately $2.7 million and $7.6 millionof management fees, respectively, related to the above CLOs for the three andnine month periods ended September 30, 2005, the collateral manager haswaived approximately $1.2 million and $2.4 million of managementfees, respectively, related to the above CLOs. The waivers for CLO 2005-1, CLO2005-2, and CLO 2006-1 expire in January 2007, and February 2007, and November2006,****respectively.  There are no assurances that the collateralmanager will waive such management fees subsequent to those dates.

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

During the secondquarter of 2006, the Company invested $40.7 million in the common equity of CapmarkFinancial Group. Inc. (“Capmark”). Capmark is controlled by an investor groupthat includes KKR, an affiliate of the Manager. As of September 30, 2006, theCompany held investments in KKR affiliated companies consisting of $110.8million of non-marketable equity securities, $215.2 million of securitiesavailable-for-sale and $653.3 million of corporate loans.

During the thirdquarter of 2006, the Company purchased thirteen corporate loans and twocorporate securities with an aggregate purchase price of $474.8 million, plusaccrued and unpaid interest, and the Company simultaneously sold, forsettlement in October 2006, all fifteen investments for an aggregate salesprice of $474.8 million, plus accrued and unpaid interest, to KKR StrategicCapital Funds. During the period beginning on the Company’s purchase settlementdate and ending on the sales settlement date the Company earned 100% of theincome on the respective investments and the KKR Strategic Capital Fundsassumed all of the credit risk and market risk on the respectiveinvestments.  During the quarter endedSeptember 30, 2006, the Company earned net interest income of approximately$2.4 million during the period that the Company owned and funded the fifteeninvestments.

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**Note 12.** Subsequent Event

OnNovember 2, 2006, the Company’s Board of Directors declared a cash distributionfor the three months ended September 30, 2006 on the Company’s common stock of$0.52 per share, payable on November 30, 2006 to stockholders of record as ofthe close of business on November 16, 2006.

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

*Except where the context suggests otherwise, the terms“we,” “us” and “our” refer to KKR Financial Corp. and its subsidiaries. Thefollowing management’s discussion and analysis of financial condition andresults of operations (“MD&A”) is intended to assist the reader inunderstanding our business. The MD&A is provided as a supplement to, andshould be read in conjunction with, our Condensed Consolidated FinancialStatements and accompanying notes included in this Quarterly Report on Form10-Q and our Consolidated Financial Statements and accompanying notes includedin our Annual Report on Form 10-K for the year ended December 31, 2005.*

**ForwardLooking Statements**

Certaininformation contained in this Quarterly Report on Form 10-Q constitutes “forward-looking”statements within the meaning of Section 27A of the Securities Act of 1933and Section 21E of the Securities Exchange Act of 1934 that are based onour current expectations, estimates and projections. Pursuant to thosesections, we may obtain a “safe harbor” for forward-looking statements byidentifying those and by accompanying those statements with cautionary statements,which identify factors that could cause actual results to differ from thoseexpressed in the forward-looking statements. Statements that are not historicalfacts, 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 eventscould differ materially from those addressed in forward-looking statements dueto a number of factors including, but not limited to, changes in interest ratesand market values, changes in prepayment rates, general economic conditions,and other 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 notundertake, and specifically disclaim, any obligation to publicly release theresult of any revisions that may be made to any forward-looking statements toreflect the occurrence of anticipated or unanticipated events or circumstancesafter the date of such statements.

**Executive Overview**

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

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***Cash Distributionsto Stockholders***

OnNovember 2, 2006, our Board of Directors declared a cash distribution for the threemonths ended September 30, 2006 on our common stock of $0.52 per common share.The distribution will be payable on November 30, 2006 to stockholders of recordas of the close of business on November 16, 2006.

***InvestmentPortfolio***

As ofSeptember 30, 2006 our investment portfolio totaled $17.6 billion, representingan increase of 17.3% from $15.0 billion as of December 31, 2005. As ofSeptember 30, 2006, our investment portfolio primarily consisted of residentialmortgage loans and securities totaling $13.2 billion, corporate loans andsecurities totaling $3.9 billion, commercial real estate loans and securitiestotaling $305.7 million, marketable equity securities consisting of preferredand common stock totaling $66.7 million, and investments in non-marketableequity securities totaling $165.4 million.

***Funding Activities***

OnMarch 30, 2006, we closed our second $5.0 billion asset-backed securedliquidity note facility. This facility provides us with an alternative sourceof funding our residential mortgage-backed securities by issuing asset-backedsecured liquidity notes that are rated A-1+, P-1, and F1+, by Standard &Poor’s Ratings Service, or Standard & Poor’s, Moody’s Investors Service, orMoody’s, and Fitch Inc., respectively. At September 30, 2006, we had $3.5billion in borrowings outstanding under this facility.

DuringMarch 2006, we formed KKR Financial Capital Trust I (“Trust I”) for the solepurpose of issuing and selling trust preferred securities. On March 28, 2006,Trust I issued preferred securities to unaffiliated investors for grossproceeds of $50.0 million and common securities to us for $1.6 million. Thecombined proceeds were invested by Trust I in $51.6 million of junior subordinatednotes issued by us. The junior subordinated notes are the sole assets of TrustI and mature on April 30, 2036, but are callable on or after April 30, 2011.Interest is payable quarterly at a fixed rate of 7.64% (ten-year LIBOR plus2.45%) through March 2016 and thereafter at a floating rate equal tothree-month LIBOR plus 2.65%.

DuringJune 2006, we formed KKR Financial Capital Trust II (“Trust II”) for the solepurpose of issuing trust preferred securities. On June 2, 2006, Trust II issuedpreferred securities to unaffiliated investors for gross proceeds of $50.0million and common securities to us for $1.6 million. The combined proceedswere invested by Trust II in $51.6 million of junior subordinated notes issuedby us. The junior subordinated notes are the sole assets of Trust II and matureon July 30, 2036, but are callable on or after July 30, 2011. Interest ispayable quarterly at a fixed rate of 8.09% (ten-year LIBOR plus 2.45%) throughJuly 2016 and thereafter at a floating rate equal to three-month LIBOR plus2.65%.

DuringJune 2006, our $275.0 million secured revolving credit facility matured and wasreplaced with a $375.0 million three year senior secured revolving creditfacility. During September 2006, the facility was amended to increase the totalcommitment amount to $800.0 million with the option to further increase thecommitment amount to $900.0 million at any time so long as no default or eventof default on the facility has occurred and subject to addition of new lenders,increases in the commitments of existing lenders, or a combination thereof. Thenew senior secured revolving credit facility matures in June 2009 and consistsof two tranches.** **Outstandingborrowings under the senior secured revolving credit facility bear interest ateither (i) an alternate base rate per annum equal to the greater of (a) theprime rate in effect on such day, and (b) the federal funds in effect on suchday plus 0.50%, or (ii) an interest rate per annum equal to the LIBOR rate forthe applicable interest period plus 0.50% for borrowings under tranche A of thefacility and 0.75% for borrowings under tranche B of the facility. As ofSeptember 30, 2006, we had $292.2 million in borrowings outstanding undertranche B of this facility.

DuringAugust 2006, we formed KKR Financial Capital Trust III (“Trust III”) for thesole purpose of issuing trust preferred securities. On August 10, 2006, TrustIII issued preferred securities to unaffiliated investors for gross proceeds of$85.0 million and common securities to the Company for $2.6 million. Thecombined proceeds were invested by Trust III in $87.6 million of juniorsubordinated notes issued by us. The junior subordinated notes are the soleassets of Trust III and mature on October 30, 2036, but are callable on orafter October 30, 2011. Interest is payable quarterly at a floating rate equalto three-month LIBOR plus 2.35%.

DuringSeptember 2006, we formed KKR Financial Capital Trust IV (“Trust IV”) for thesole purpose of issuing trust preferred securities. On September 15, 2006,Trust IV issued preferred securities to unaffiliated investors for grossproceeds of $15.0 million and common securities to the Company for $0.5million. The combined proceeds were invested by Trust IV in $15.5 million ofjunior subordinated notes issued by us. The junior subordinated notes are thesole assets of Trust IV and mature on October 30, 2036, but are callable on orafter October 30, 2011. Interest is payable quarterly at a floating rate equalto three-month LIBOR plus 2.35%.

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OnSeptember 19, 2006, we closed CLO 2006-1, our third $1.0 billion CLOtransaction that provides financing for investments consisting of corporateloans and certain other loans and securities. The investments that are owned byCLO 2006-1 collateralize the CLO 2006-1 debt, and as a result, thoseinvestments are not available to us, our creditors or stockholders. CLO 2006-1issued a total of $727.5 million of senior secured notes at par to investors.In addition, we retained $145.5 million of rated mezzanine notes and $144.0million of unrated subordinate notes issued by CLO 2006-1.

Thesenior notes issued to investors by CLO 2006-1 consist of the following fiveclasses of notes: (i) $334.0 million of class A-1 senior notesbearing interest at three-month LIBOR plus 0.28%; (ii) $207.0 millionof class A-2a senior notes bearing interest at three-month LIBOR plus0.24%; (iii) $69.0 million of class A-2b senior notes bearinginterest at three-month LIBOR plus 0.40%; (iv) $43.0 million of class B seniornotes bearing interest at three-month LIBOR plus 0.50%; and (v) $74.5 millionof class C mezzanine notes bearing interest at three-month LIBOR plus 0.95%.All of the notes issued by CLO 2006-1 mature on August 25, 2018, though we havethe right to call the notes at par any time after August 2010.

DuringSeptember 2006, we formed KKR Financial Capital Trust V (“Trust V”) for thesole purpose of issuing trust preferred securities. On September 29, 2006,Trust V issued preferred securities to unaffiliated investors for grossproceeds of $50.0 million and common securities to the Company for $1.6million. The combined proceeds were invested by Trust V in $51.6 million ofjunior subordinated notes issued by us. The junior subordinated notes are thesole assets of Trust V and mature on October 30, 2036, but are callable on orafter October 30, 2011. Interest is payable quarterly at a fixed rate of 7.395%through October 2016 and thereafter at a floating rate equal to three-monthLIBOR plus 2.25%.

**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 the Audit Committee of our Board or Directors.

***RevenueRecognition***

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

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

As ofSeptember 30, 2006, unamortized purchase premiums and unaccreted purchasediscounts on our investment portfolio totaled $30.7 million and $(42.7)million, respectively.

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***Share-BasedPayment***

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

Becausewe remeasure the amount of compensation costs associated with the unvestedrestricted common stock and unvested common stock options that we issued to ourManager as of each reporting period, our share-based compensation expensereported in our consolidated financial statements will change based on themarket price of our common stock as of each remeasurement date and this mayresult in earnings volatility. For the three and nine months ended September30, 2006, share-based compensation totaled $10.2 million and $22.1 million,respectively. As of September 30, 2006, substantially all of the non-vestedcommon stock options and restricted common stock issued that is subject to SFASNo. 123(R) is subject to remeasurement.

***Classifications ofInvestment Securities***

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

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

Ourpolicies permit us to enter into derivative contracts, including interest rateswaps, interest rate corridors, interest rate swaptions, interest ratestraddles, and credit and currency derivatives. We use interest ratederivatives to manage interest rate risk. We formally document relationshipsbetween our hedging instruments and our hedged transactions as of the inceptiondate of the hedge, including (i) our risk management objective and hedgestrategy, (ii) the risk that we are hedging, (iii) the hedginginstruments, consisting of the derivative instruments that comprise the hedge,(iv) the hedged transaction, consisting of the recognized or forecastedtransaction that we are hedging, (v) the method that we used to assess thehedge’s effectiveness on a retrospective and prospective basis, and(vi) the methodology that we will use to measure hedge ineffectiveness. Onthe date that we enter into an interest rate derivative transaction wedesignate the interest rate derivative as (i) a hedge of a forecastedtransaction or of the variability of cash flows related to a recognizedliability (“cash flow hedge”) (ii) a hedge of the exposure to changes in thefair value of a recognized asset or liability, or of an unrecognized firmcommitment (“fair value hedge”), or (iii) held for trading (“tradinginstrument”).

Forour cash flow hedges, we record and report our hedge instruments at estimatedfair value on our balance sheet and record the changes in their estimated fairvalue in accumulated other comprehensive income. Changes in these amounts arereclassified to our statements of operations over the effective hedge period asthe hedged item affects earnings. Our cash flow hedge instrument must be “highlyeffective,” as defined in SFAS No. 133, in achieving offsetting changes inthe hedged item attributable to the risk that we are hedging in order toqualify for initial and recurring hedge accounting treatment. We recognize anyhedge ineffectiveness related to our cash flow hedges as a component ofinterest expense during the period in which it occurs. Prior to the end of thespecified cash flow hedge period, the effective portion of our hedge instrumentgains and losses is recorded in other accumulated comprehensive income. Theestimated fair values of our hedge instruments are based on market pricesprovided by dealers that make markets in such hedging instruments. For our cashflow hedges, we are required to discontinue hedge accounting prospectively whenwe determine that (i) the hedging instruments are no longer effective inoffsetting changes in the cash flows of a hedged transaction, (ii) it isno longer probable that the forecasted transaction will occur, or(iii) the designation of the hedging instruments as hedges is no longerpermitted or appropriate.

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We arenot required to account for our derivative contracts using hedge accounting asdescribed above. If we decide not to designate the derivative contracts ashedges or if we fail to fulfill the criteria necessary to qualify for hedgeaccounting, then the changes in the estimated fair values of our derivativecontracts would affect periodic earnings immediately potentially resulting inthe increased volatility of our earnings. The qualification requirements forhedge accounting are complex and as a result we must evaluate, designate, andthoroughly document each hedge transaction at inception and perform ineffectivenessanalysis and prepare related documentation at inception and on a recurringbasis thereafter. As of September 30, 2006, the estimated fair value of ourderivatives totaled $64.3 million. As of September 30, 2006, the estimated fairvalue of interest rate derivatives accounted for as cash flow hedges totaledapproximately $62.7 million and the net unrealized gain on such cash flowhedges totaled approximately $53.9 million, which amount is recorded inaccumulated other comprehensive income in the consolidated statements ofchanges in stockholders’ equity. As of September 30, 2006, the estimated fairvalue of the interest rate derivative accounted for as a fair value hedgetotaled approximately $(0.6) million.  Asa result of the fair value hedge, commercial real estate loans classified asheld for sale were increased by $0.6 million at September 30, 2006 and for thethree month period ended September 30, 2006, there was no ineffectiveness.

***Impairments***

Weevaluate our investment securities portfolio for impairment as of each quarterend or more frequently if we become aware of any material information thatwould lead us to believe that an investment may be impaired. We evaluatewhether the investment is considered impaired and whether the impairment is other-than-temporary.If we make a determination that the impairment is other-than-temporary, werecognize an impairment loss equal to the difference between the amortized costbasis and the estimated fair value of the investment. We consider many factorsin determining whether the impairment of an investment is other-than-temporary,including but not limited to the length of time the security has had a declinein estimated fair value below its amortized cost, the amount of the loss, theintent and our financial ability to hold the investment for a period of timesufficient for a recovery in its estimated fair value, recent events specificto the issuer or industry, external credit ratings and recent downgrades insuch ratings. As of September 30, 2006, we had aggregate unrealized losses onour securities classified as available-for-sale of approximately $50.4 million,which if not recovered may result in the recognition of future losses.

***Allowance for LoanLosses***

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

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

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**Recent AccountingPronouncements**

InFebruary 2006, the FASB issued SFAS No. 155, *Accountingfor Certain Hybrid Financial Instruments*. Key provisions of SFASNo. 155 include: (1) a broad fair value measurement option forcertain hybrid financial instruments that contain an embedded derivative thatwould otherwise require bifurcation; (2) clarification that only thesimplest separations of interest payments and principal payments qualify forthe exception afforded to interest-only strips and principal-only strips fromderivative accounting under paragraph 14 of SFAS No. 133*,**Accounting for DerivativeInstruments and Hedging Activities,* thereby narrowing such exception;(3) a requirement that beneficial interests in securitized financialassets be analyzed to determine whether they are freestanding derivatives orwhether they are hybrid instruments that contain embedded derivatives requiringbifurcation; (4) clarification that concentrations of credit risk in theform of subordination are not embedded derivatives; and (5) elimination ofthe prohibition on a QSPE holding passive derivative financial instruments thatpertain to beneficial interests that are or contain a derivative financialinstrument. In general, these changes will reduce the operational complexityassociated with bifurcating embedded derivatives, and increase the number ofbeneficial interests in securitization transactions, including interest-onlystrips and principal-only strips, required to be accounted for in accordancewith SFAS No. 133. SFAS No. 155 is required to be adopted by us in thefirst quarter of 2007. We do not expect that the adoption of SFAS No. 155will have a material effect on our consolidated financial statements.

In June 2006, theFASB issued Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes — an interpretation of FASB Statement No. 109* (“FIN48”).  FIN 48 clarifies the accountingfor uncertainty in income taxes recognized in an enterprise’s financialstatements in accordance with FASB Statement No. 109, *Accountingfor Income Taxes*.  FIN 48prescribes a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return. We are required to adopt FIN 48 in the first quarter of2007 and we currently assessing the impact that it will have on ourconsolidated financial statements.

In September 2006,the FASB issued SFAS No. 157, *Fair Value Measurements*.This statement defines fair value, establishes a framework for measuring fairvalue in GAAP and expands disclosures about fair value measurements.  SFAS No. 157 does not require any new fairvalue measurements.  We are required toadopt SFAS No. 157 in the first quarter of 2007 and we do not expect theadoption of SFAS No. 157 to have a material impact on our consolidatedfinancial statements.

In September 2006,the SEC issued SAB No. 108, “Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements” (“SAB No. 108”). SAB No. 108 requires a dual evaluation approach –evaluation of an error from both a balance sheet perspective and results ofoperations perspective – when quantifying and evaluating the materiality of amisstatement.  The guidance in SAB No.108 musts be applied to annual financial statements for fiscal years endingafter November 15, 2006. We do not expect the adoption of SAB No. 108 to have amaterial impact on our consolidated financial statements.

**Results of Operations**

**For the Three and NineMonths Ended September 30, 2006 compared to the Three and Nine Months EndedSeptember 30, 2005**

*Summary*

Ournet income for the three and nine months ended September 30, 2006 totaled$32.6 million (or $0.41 per diluted share) and $97.9 million (or $1.25 perdiluted share), respectively, as compared to net income of $18.5 million (or$0.24 per diluted share) and $33.1 million (or $0.62 per diluted share) for thethree and nine months ended September 30, 2005. During the nine months endedSeptember 30, 2006, our investment portfolio increased by 17.3% from$15.0 billion as of December 31, 2005 to $17.6 billion as ofSeptember 30, 2006.

*Net Investment Income*

Thefollowing table presents the components of our net investment income for thethree and nine months ended September 30, 2006 and 2005:

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**Comparative NetInvestment Income Components (Amounts in thousands)**

** **
| ** **                                                            | ** ** | **For the three  months ended  September 30,  2006** | ** ** | **For the three  months ended  September 30,  2005** | ** ** | **For the nine  months ended  September 30,  2006** | ** ** | **For the nine  months ended  September 30,  2005** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| Investment Income:                                                    |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Residential  mortgage loans and securities interest income            |       | $                                                                        | 162,564    |                                                                     | $          | 80,101                                                                  |       | $                                                                       | 464,096    |   | $ | 154,535 |   |
| Corporate loans  and securities interest income                       |       | 80,298                                                                   |       | 29,020                                                                   |       | 192,223                                                                 |       | 55,329                                                                  |       |
| Commercial real  estate loans and securities interest income          |       | 7,518                                                                    |       | 6,575                                                                    |       | 23,045                                                                  |       | 12,375                                                                  |       |
| Other interest  income                                                |       | 2,736                                                                    |       | 818                                                                      |       | 6,388                                                                   |       | 2,015                                                                   |       |
| Common and preferred  stock dividend income                           |       | 945                                                                      |       | 985                                                                      |       | 2,740                                                                   |       | 126                                                                     |       |
| Net  premium/discount (amortization) accretion                        |       | (24                                                                      | )          | (912                                                                     | )          | 170                                                                     |       | (3,221                                                                  | )          |
| Total investment  income                                              |       | 254,037                                                                  |       | 116,587                                                                  |       | 688,662                                                                 |       | 221,159                                                                 |       |
| Interest Expense:                                                     |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Repurchase  agreements interest expense                               |       | 80,454                                                                   |       | 62,810                                                                   |       | 284,220                                                                 |       | 122,989                                                                 |       |
| Collateralized  loan obligation senior secured notes interest expense |       | 23,498                                                                   |       | 14,153                                                                   |       | 61,883                                                                  |       | 22,669                                                                  |       |
| Asset-backed  secured liquidity notes interest expense                |       | 101,482                                                                  |       | —                                                                   |       | 195,280                                                                 |       | —                                                                  |       |
| Secured  revolving credit facility interest expense                   |       | 3,303                                                                    |       | —                                                                   |       | 6,172                                                                   |       | —                                                                  |       |
| Demand loan  interest expense                                         |       | 615                                                                      |       | —                                                                   |       | 1,692                                                                   |       | —                                                                  |       |
| Junior  subordinated notes interest expense                           |       | 3,109                                                                    |       | —                                                                   |       | 4,477                                                                   |       | —                                                                  |       |
| Other interest  expense                                               |       | 1,077                                                                    |       | (35                                                                      | )          | 2,651                                                                   |       | —                                                                  |       |
| Interest rate  swap and corridor interest expense, net                |       | (14,173                                                                  | )          | 604                                                                      |       | (25,353                                                                 | )          | 604                                                                     |       |
| Total interest  expense                                               |       | 199,365                                                                  |       | 77,532                                                                   |       | 531,022                                                                 |       | 146,262                                                                 |       |
| Equity in income of  unconsolidated affiliate                         |       | 914                                                                      |       | —                                                                   |       | 914                                                                     |       | —                                                                  |       |
| Provision for loan losses                                             |       | —                                                                   |       | (1,300                                                                   | )          | —                                                                  |       | (1,300                                                                  | )          |
| Net investment income                                                 |       | $                                                                        | 55,586     |                                                                     | $          | 37,755                                                                  |       | $                                                                       | 158,554    |   | $ | 73,597 |   |

 

**As presented in the tableabove, our net investment income increased by $17.8 million and $85.0 millionfor the three and nine months ended September 30, 2006, respectively, comparedto the three and nine months ended September 30, 2005. The change from 2005 to2006 is primarily attributable to the increase in our investment portfoliosince September 30, 2005. As of September 30, 2006, we held $17.6 billion ininvestments in loans, securities available-for-sale, and non-marketable equitysecurities and had borrowings outstanding totaling $16.0 billion. Incomparison, as of September 30, 2005, investments in loans, securitiesavailable-for-sale and non-marketable equity securities totaled $12.5 billionand borrowings outstanding totaled $11.0 billion.**

**Net investment incomeincludes $0.9 million of equity in income of unconsolidated affiliate.** As of September 30,2006, we had an investment in an unconsolidated affiliate consisting of a 49.9%limited partnership interest in KKR Financial Holdings I, L.P (“KFH”).  KFH was formed duringthe third quarter of 2006 and is the primary beneficiary of four specialpurpose entities formed during the third quarter of 2006 to complete securedborrowing transactions to finance certain investments in corporate loans andsecurities. The special purpose entities are KKR Financial CLO 2007-1, Ltd.,KKR Financial CLO 2007-2, Ltd., KKR Financial CLO 2007-3, Ltd., and KKRFinancial CLO 2007-4, Ltd. As of September 30, 2006, KFH had $456.4 million inassets consisting of $452.1 million of corporate loans, $23.4 million ofcorporate securities, $2.9 million of interest receivable and $1.4 million ofcash.  As of September 30, 2006, KFH hadliabilities totaling $375.9 million and consisting of $373.5 million ofborrowings under repurchase agreements, $2.1 million of interest payable, and$0.3 million of other payables. During the quarter ended September 30, 2006,KFH had net income of $1.8 million consisting of $3.9 million of interestincome, and $2.1 million of interest expense.

During the thirdquarter of 2006, we purchased thirteen corporate loans and two corporatesecurities with an aggregate purchase price of $474.8 million, plus accrued andunpaid interest, and we simultaneously sold, for settlement in October 2006,all fifteen investments for an aggregate sales price of $474.8 million, plusaccrued and unpaid interest, to the KKR Strategic Capital Funds. During theperiod beginning on our purchase settlement date and ending on the salessettlement date we earned 100% of the income on the respective investments andthe KKR Strategic Capital Funds assumed all of the credit risk and market riskon the respective investments.  Duringthe quarter ended September 30, 2006, we earned net interest income ofapproximately $2.4 million during the period that we owned and funded thefifteen investments.

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*Other Income*

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

**Comparative Other IncomeComponents (Amounts in thousands)**
| ** **                                                                     | ** ** | **For the three  months ended  September 30,  2006** | ** ** | **For the three  months ended  September 30,  2005** | ** ** | **For the nine  months ended  September 30,  2006** | ** ** | **For the nine  months ended  September 30,  2005** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| Net realized and  unrealized gain (loss) on derivatives and foreign exchange:  |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Interest rate  swaptions                                                       |       | $                                                                        | (113       | )                                                                        | $          | 27                                                                      |       | $                                                                       | (55        | ) | $ | (167 | ) |
| Interest rate  swaps                                                           |       | —                                                                   |       | 147                                                                      |       | 152                                                                     |       | 379                                                                     |       |
| Credit default  swaps                                                          |       | (460                                                                     | )          | 72                                                                       |       | (384                                                                    | )          | 351                                                                     |       |
| Foreign exchange  forwards                                                     |       | —                                                                   |       | 58                                                                       |       | —                                                                  |       | 2,086                                                                   |       |
| Total rate of  return swaps                                                    |       | 1,222                                                                    |       | 159                                                                      |       | 2,929                                                                   |       | 159                                                                     |       |
| REIT shorts                                                                    |       | —                                                                   |       | 24                                                                       |       | —                                                                  |       | 24                                                                      |       |
| Foreign exchange  translation                                                  |       | (140                                                                     | )          | (474                                                                     | )          | 1,176                                                                   |       | (2,868                                                                  | )          |
| Total realized  and unrealized gain (loss) on derivatives and foreign exchange |       | 509                                                                      |       | 13                                                                       |       | 3,818                                                                   |       | (36                                                                     | )          |
| Net realized gain on  investments                                              |       | 2,781                                                                    |       | 1,730                                                                    |       | 4,920                                                                   |       | 2,881                                                                   |       |
| Fee and other income                                                           |       | 2,268                                                                    |       | 136                                                                      |       | 2,941                                                                   |       | 1,731                                                                   |       |
| Total other income                                                             |       | $                                                                        | 5,558      |                                                                     | $          | 1,879                                                                   |       | $                                                                       | 11,679     |   | $ | 4,576 |   |

 

Aspresented in the table above, other income totaled $5.6 million and $11.7million for the three and nine months ended September 30, 2006, respectively,as compared to $1.9 million and $4.6 million for the three and nine monthsended September 30, 2005, respectively. The increase in total other income fromthe prior period is primarily attributable to increased investment activitysince September 30, 2005.

*Non-InvestmentExpenses*

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

**ComparativeNon-Investment Expense Components (Amounts in thousands)**
| ** **                              | ** ** | **For the three  months ended  September 30,  2006** | ** ** | **For the three  months ended  September 30,  2005** | ** ** | **For the nine  months ended  September 30,  2006** | ** ** | **For the nine  months ended  September 30,  2005** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| Related party  management compensation: |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Base management  fees                   |       | $                                                                        | 7,218      |                                                                     | $          | 7,101                                                                   |       | $                                                                       | 21,591     |   | $ | 13,821 |   |
| Incentive fee                           |       | 2,498                                                                    |       | —                                                                   |       | 4,766                                                                   |       | —                                                                  |       |
| Share-based  compensation               |       | 10,043                                                                   |       | 7,230                                                                    |       | 21,620                                                                  |       | 19,249                                                                  |       |
| Related party management  compensation  |       | 19,759                                                                   |       | 14,331                                                                   |       | 47,977                                                                  |       | 33,070                                                                  |       |
| Professional services                   |       | 1,096                                                                    |       | 1,432                                                                    |       | 2,591                                                                   |       | 2,617                                                                   |       |
| Loan servicing expense                  |       | 3,626                                                                    |       | 1,369                                                                    |       | 11,342                                                                  |       | 1,999                                                                   |       |
| Insurance expense                       |       | 211                                                                      |       | 275                                                                      |       | 709                                                                     |       | 708                                                                     |       |
| Directors expenses                      |       | 333                                                                      |       | 368                                                                      |       | 1,081                                                                   |       | 719                                                                     |       |
| General and administrative  expenses    |       | 3,050                                                                    |       | 2,630                                                                    |       | 7,713                                                                   |       | 4,107                                                                   |       |
| Total non-investment expenses           |       | $                                                                        | 28,075     |                                                                     | $          | 20,405                                                                  |       | $                                                                       | 71,413     |   | $ | 43,220 |   |

 

Aspresented in the table above, our non-investment expenses increased by $7.7million and $28.2 million for the three and nine months ended September 30,2006, respectively, compared to the three and nine months ended September 30,2005. The increase in non-investment expenses from the prior period isprimarily attributable to our growth since September 30, 2005. The significantcomponents of non-investment expense are described below.

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

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

*Income Tax Provision*

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

KKRTRS Holdings, Inc., our domestic taxable REIT subsidiary, is taxed as aregular subchapter C corporation under the provisions of the Code. KKR TRSHoldings, Inc. was formed to make, from time to time, certain investmentsthat would not be REIT qualifying investments if made directly by us, and toearn income that would not be REIT qualifying income if earned directly by us.For the three and nine months ended September 30, 2006, KKR TRSHoldings, Inc. had pre-tax net income of $1.2 million and $2.2 million,respectively, and the provision for income taxes totaled $0.5 million and $0.9million, respectively. As of September 30, 2006, KKR TRS Holdings, Inc.had an income tax receivable of $0.9 million and a deferred tax liability of$0.7 million.

KKRFinancial CLO 2005-1, Ltd., KKR Financial CLO 2005-2, Ltd., KKRFinancial CDO 2005-1, Ltd., KKR Financial CLO 2006-1, Ltd., KKR Financial CLO2006-2, Ltd., KKR Financial CLO 2007-1, Ltd., and KKR Financial CLO 2007-2,Ltd. are foreign taxable REIT subsidiaries that were established to facilitatesecuritization transactions structured as secured financing transactions. KKRTRS Holdings, Ltd., a new subsidiary formed in July 2006 to make, from time totime, certain investments, is also a foreign taxable REIT subsidiary. Theforeign taxable REIT subsidiaries are organized as exempted companiesincorporated with limited liability under the laws of the Cayman Islands, andare generally exempt from federal and state income tax at the corporate entitylevel because they restrict their activities in the United States to trading instock and securities for their own account. Therefore, despite their status astaxable REIT subsidiaries, they generally will not be subject to corporateincome tax on their earnings, and no provisions for income taxes for the threeand nine months ended September 30, 2006 were recorded; however, we willgenerally be required to include their current taxable income in ourcalculation of 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 September 30, 2006 and December 31,2005, classified by interest rate type. Carrying value is the value thatinvestments are recorded on our consolidated balance sheets and is estimatedfair value for securities and amortized cost for loans held for investment andthe lower of amortized cost or market value for loans held for sale. Estimatedfair values set forth in the tables below are based on dealer quotes and/ornationally recognized pricing services.

Thetable below summarizes our investment portfolio as of September 30, 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                                  |       | $                       | 1,591,073  |                    | $          | 1,591,073                      |       | $                                                      | 1,585,833  |   | 9.0 | % |
| Residential ARM  Securities                            |       | 5,912,596               |       | 5,897,061               |       | 5,912,596                      |       | 33.6                                                   |       |
| Corporate Loans                                        |       | 2,969,867               |       | 2,969,867               |       | 2,982,141                      |       | 17.0                                                   |       |
| Corporate Debt  Securities                             |       | 367,397                 |       | 359,074                 |       | 367,397                        |       | 2.1                                                    |       |
| Commercial Real Estate  Loans                          |       | 226,768                 |       | 226,768                 |       | 226,768                        |       | 1.3                                                    |       |
| Commercial Real Estate  Debt Securities                |       | —                  |       | —                  |       | —                         |       | —                                                 |       |
| Total Floating  Rate                                   |       | 11,067,701              |       | 11,043,843              |       | 11,074,735                     |       | 63.0                                                   |       |
| **Hybrid Rate:**                                       | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                             | ** ** |
| Residential Hybrid ARM  Loans                          |       | 3,797,501               |       | 3,797,501               |       | 3,774,839                      |       | 21.4                                                   |       |
| Residential Hybrid ARM  Securities                     |       | 1,919,609               |       | 1,954,577               |       | 1,919,609                      |       | 10.9                                                   |       |
| Total Hybrid  Rate                                     |       | 5,717,110               |       | 5,752,078               |       | 5,694,448                      |       | 32.3                                                   |       |
| **Fixed Rate:**                                        | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                             | ** ** |
| Corporate Loans                                        |       | 61,157                  |       | 61,157                  |       | 61,221                         |       | 0.3                                                    |       |
| Corporate Debt  Securities                             |       | 460,864                 |       | 449,175                 |       | 460,864                        |       | 2.6                                                    |       |
| Commercial Real Estate  Loans                          |       | 78,887                  |       | 78,887                  |       | 80,396                         |       | 0.5                                                    |       |
| Commercial Real Estate  Debt Securities                |       | —                  |       | —                  |       | —                         |       | —                                                 |       |
| Total Fixed Rate                                       |       | 600,908                 |       | 589,219                 |       | 602,481                        |       | 3.4                                                    |       |
| **Marketable and Non-Marketable  Equity Securities:**  | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                             | ** ** |
| Common and Preferred  Stock                            |       | 66,693                  |       | 69,002                  |       | 66,693                         |       | 0.4                                                    |       |
| Non-Marketable Equity  Securities                      |       | 165,429                 |       | 165,429                 |       | 165,429                        |       | 0.9                                                    |       |
| Total Marketable  and Non-Marketable Equity Securities |       | 232,122                 |       | 234,431                 |       | 232,122                        |       | 1.3                                                    |       |
| Total                                                  |       | $                       | 17,617,841 |                    | $          | 17,619,571                     |       | $                                                      | 17,603,786 |   | 100.0 | % |

 

As ofSeptember 30, 2006, the aggregate amortized cost value of the Company’sinvestment portfolio exceeded the aggregate estimated fair value of itsportfolio by $15.8 million and, as of the same date, the Company hadunrealized gains totaling $53.9 million related to its cash flow hedges,as defined under SFAS No. 133. As of September 30, 2006, the aggregate netunamortized purchase discount related to the Company’s investment portfolio was$12.1 million.

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Thetable below summarizes our investment portfolio as of December 31, 2005,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                                  |       | $                       | 2,175,929  |                    | $          | 2,175,929                      |       | $                                                      | 2,163,932  |   | 14.4 | % |
| Residential ARM  Securities                            |       | 3,375,434               |       | 3,369,763               |       | 3,375,434                      |       | 22.5                                                   |       |
| Corporate Loans                                        |       | 1,872,277               |       | 1,872,277               |       | 1,886,372                      |       | 12.6                                                   |       |
| Corporate Debt  Securities                             |       | 279,280                 |       | 277,030                 |       | 279,280                        |       | 1.9                                                    |       |
| Commercial Real Estate  Loans                          |       | 486,096                 |       | 486,096                 |       | 485,775                        |       | 3.2                                                    |       |
| Commercial Real Estate  Debt Securities                |       | 63,032                  |       | 63,168                  |       | 63,032                         |       | 0.4                                                    |       |
| Total Floating  Rate                                   |       | 8,252,048               |       | 8,244,263               |       | 8,253,825                      |       | 55.0                                                   |       |
| **Hybrid Rate:**                                       | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                             | ** ** |
| Residential Hybrid ARM  Loans                          |       | 4,252,893               |       | 4,252,893               |       | 4,224,234                      |       | 28.1                                                   |       |
| Residential Hybrid ARM  Securities                     |       | 2,162,404               |       | 2,197,020               |       | 2,162,404                      |       | 14.4                                                   |       |
| Total Hybrid  Rate                                     |       | 6,415,297               |       | 6,449,913               |       | 6,386,638                      |       | 42.5                                                   |       |
| **Fixed Rate:**                                        | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                             | ** ** |
| Corporate Loans                                        |       | 25,000                  |       | 25,000                  |       | 25,000                         |       | 0.2                                                    |       |
| Corporate Debt  Securities                             |       | 202,474                 |       | 202,748                 |       | 202,474                        |       | 1.3                                                    |       |
| Commercial Real Estate  Loans                          |       | 35,646                  |       | 35,646                  |       | 35,657                         |       | 0.2                                                    |       |
| Commercial Real Estate  Debt Securities                |       | 19,880                  |       | 19,833                  |       | 19,880                         |       | 0.1                                                    |       |
| Total Fixed Rate                                       |       | 283,000                 |       | 283,227                 |       | 283,011                        |       | 1.8                                                    |       |
| **Marketable and Non-Marketable  Equity Securities:**  | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                             | ** ** |
| Common and Preferred  Stock                            |       | 47,002                  |       | 47,158                  |       | 47,002                         |       | 0.3                                                    |       |
| Non-Marketable Equity  Securities                      |       | 52,500                  |       | 52,500                  |       | 52,500                         |       | 0.4                                                    |       |
| Total Marketable and  Non-Marketable Equity Securities |       | 99,502                  |       | 99,658                  |       | 99,502                         |       | 0.7                                                    |       |
| Total                                                  |       | $                       | 15,049,847 |                    | $          | 15,077,061                     |       | $                                                      | 15,022,976 |   | 100.0 | % |

 

As ofDecember 31, 2005, the aggregate amortized cost value of the Company’sinvestment portfolio exceeded the aggregate estimated fair value of itsportfolio by $54.1 million and, as of the same date, the Company hadunrealized gains totaling $45.6 million related to its cash flow hedges,as defined under SFAS No. 133. As of December 31, 2005, the aggregatenet unamortized purchase discount related to the Company’s investment portfoliowas $6.7 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 the useof both Moody’s and Standard & Poor’s ratings, and Moody’s weightedaverage rating factor, or WARF. WARF is the quantitative equivalent of Moody’straditional rating categories (e.g., Ba1, Ba2, etc.) and is used by Moody’s inits credit enhancement calculations for securitization transactions. Bymonitoring both Moody’s and Standard & Poor’s ratings and Moody’s WARFwe can monitor trends and changes in the credit ratings of our investmentportfolio. For residential mortgage loans and residential mortgage-backedsecurities we monitor the credit quality of the underlying borrowers bymonitoring trends and changes in the underlying borrowers’ FICO® scores. Borrowers with lower FICO® scores default more frequently than borrowerswith higher FICO® scores. For residential and

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commercialreal estate mortgage loans and mortgage-backed securities we monitor trends andchanges in LTV ratios. Increases in LTV ratios are likely to result in higherrealized credit losses when borrowers default.

*Securities Available-for-Sale*

Thefollowing table summarizes the par value of our investment securities portfolioby investment class stratified by Moody’s and Standard & Poor’sratings category as of September 30, 2006:

**Investment Securities (Amounts in thousands)**
| **Ratings Category**    | ** ** | **Residential  ARM Securities** | ** ** | **Residential  Hybrid ARM  Securities** | ** ** | **Corporate  Debt  Securities** | ** ** | **Total** | ** ** |
|------------------------------|------------|--------------------------------------|------------|----------------------------------------------|------------|---------------------------------|------------|-----------|------------|
| Aaa/AAA                      |       | $                                    | 5,852,330  |                                         | $          | 1,890,774                       |       | $         | —     |   | $ | 7,743,104 |   |
| Aa1/AA+ through  Aa3/AA-     |       | 16,367                               |       | 28,426                                       |       | —                          |       | 44,793    |       |
| A1/A+ through  A3/A-         |       | 11,799                               |       | 18,089                                       |       | —                          |       | 29,888    |       |
| Baa1/BBB+  through Baa3/BBB- |       | 8,374                                |       | 9,668                                        |       | 21,258                          |       | 39,300    |       |
| Ba1/BB+ through  Ba3/BB-     |       | 4,187                                |       | 3,876                                        |       | 138,000                         |       | 146,063   |       |
| B1/B+ through  B3/B-         |       | 3,045                                |       | 2,584                                        |       | 329,815                         |       | 335,444   |       |
| Caa1/CCC+ and  lower         |       | —                               |       | —                                       |       | 213,505                         |       | 213,505   |       |
| Non-Rated                    |       | 6,834                                |       | 6,456                                        |       | 121,500                         |       | 134,790   |       |
| Total                        |       | $                                    | 5,902,936  |                                         | $          | 1,959,873                       |       | $         | 824,078    |   | $ | 8,686,887 |   |

 

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

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

 

*Loans*

Ourresidential mortgage loan portfolio totaled $5.4 billion as of September 30,2006 and $6.4 billion as of December 31, 2005. As of September 30, 2006 weowned two real estate properties acquired through foreclosure.  The outstanding loan balance of $0.5 million(not included in the following table) was reclassified from loans to otherassets on our balance sheet, and the estimated fair value of the real estateproperty exceeds the outstanding loan balance and therefore we have notrecorded a charge against our allowance for loan losses.  As of December 31, 2005, we did not ownany real estate properties that we had acquired through foreclosure.

As ofSeptember 30, 2006, we had twenty-one loans that were 90 days or greater pastdue or in foreclosure and placed on non-accrual status.  During the quarter ended September 30, 2006,we did not recognize approximately $0.1 million in interest income for loans innon-accrual status or that were classified as real estate owned.

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Theweighted average original FICO® score and weighted average original LTV ratioof our residential ARM loan portfolio were 738 and 68.8%, respectively, as ofSeptember 30, 2006. As of December 31, 2005, the weighted average originalFICO® score and weighted average LTV ratio of ourresidential ARM loan portfolio were 737 and 67.2%, respectively. As ofSeptember 30, 2006 our residential ARM loan investment portfolio did not haveany material concentrations in investor owned properties, multi-unit housingproperties, condominium properties and/or cooperative properties. A materialportion of our residential ARM loans are non-conforming mortgage loans, not dueto credit quality, but because the mortgage loans have balances that exceed themaximum balances necessary to qualify as a conforming mortgage loan.

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

 

| Delinquency Status | ** ** | **Number of Loans** | ** ** | **Principal Amount** | ** ** |
|-------------------------|------------|-------------------------------|------------|---------------------------|------------|
| 30 to 59 days           |       | 65                            |       | $                         | 21,700     |   |
| 60 to 89 days           |       | 10                            |       | 3,481                     |       |
| 90 days or more         |       | 9                             |       | 2,215                     |       |
| In foreclosure          |       | 12                            |       | 2,698                     |       |
| Total                   |       | 96                            |       | $                         | 30,094     |   |

 

Thefollowing table summarizes the delinquency statistics of residential mortgageloans as of December 31, 2005 (dollar amounts in thousands):

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

 

Thefollowing table summarizes the changes in the allowance for loan losses for ourresidential mortgage loan portfolio during the three and nine month periodsended September 30, 2006 (amounts in thousands):

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

 

Ourcorporate loan portfolio totaled $3.0 billion as of September 30, 2006 and$1.9 billion as of December 31, 2005. Our corporate loan portfolioconsists of debt obligations of corporations, partnerships and other entitiesin the form of first and second lien loans, mezzanine loans and bridge loans.As of September 30, 2006, we classified nine corporate loans totaling $397.7million as held for sale.  Accordingly,these loans are recorded at the lower of cost or market on our consolidatedbalance sheet. Of the nine loans classified as held for sale, no loss wasrecognized as the carrying value of the loans did not exceed fair value as ofSeptember 30, 2006.

Weperformed an allowance for loan losses analysis as of September 30, 2006 andDecember 31, 2005, and we have made the determination that no allowancefor loan losses was required for our corporate loan portfolio as of September30, 2006 or December 31, 2005.

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

**Corporate Loans (Amounts in thousands)**

| Ratings Category        | ** ** | **As of  September 30, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                      |       | $                                            | —     |                                        | $          | — |   |
| Aa1/AA+ through  Aa3/AA-     |       | —                                       |       | —                                      |       |
| A1/A+ through  A3/A-         |       | —                                       |       | —                                      |       |
| Baa1/BBB+  through Baa3/BBB- |       | 32,413                                       |       | 2,000                                       |       |
| Ba1/BB+ through  Ba3/BB-     |       | 1,571,874                                    |       | 673,644                                     |       |
| B1/B+ through  B3/B-         |       | 1,201,473                                    |       | 1,095,368                                   |       |
| Caa1/CCC+ and  lower         |       | 45,650                                       |       | 21,547                                      |       |
| Non-rated                    |       | 185,634                                      |       | 107,826                                     |       |
| Total                        |       | $                                            | 3,037,044  |                                        | $          | 1,900,385 |   |

 

Ourcommercial real estate loan portfolio totaled $305.7 million and$521.7 million as of September 30, 2006 and December 31, 2005,respectively. Our commercial real estate loan portfolio consists of senior,mezzanine, and bridge loans that are secured by commercial real estate. As ofSeptember 30, 2006, we classified eleven commercial real estate loans totaling$208.4 million as held for sale. Accordingly, these loans are recorded at the lower of cost or market onour consolidated balance sheet. Of the eleven loans classified as held forsale, no loss was recognized as the carrying value of the loans did not exceedfair value as of September 30, 2006.

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

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

**Commercial Real EstateLoans (Amounts in thousands)**

| Ratings Category        | ** ** | **As of  September 30, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                      |       | $                                            | —     |                                        | $          | — |   |
| Aa1/AA+ through  Aa3/AA-     |       | —                                       |       | —                                      |       |
| A1/A+ through  A3/A-         |       | —                                       |       | —                                      |       |
| Baa1/BBB+  through Baa3/BBB- |       | —                                       |       | —                                      |       |
| Ba1/BB+ through  Ba3/BB-     |       | 5,063                                        |       | 60,929                                      |       |
| B1/B+ through  B3/B-         |       | 91,465                                       |       | 75,000                                      |       |
| Caa1/CCC+ and  lower         |       | —                                       |       | 50,000                                      |       |
| Non-rated                    |       | 209,492                                      |       | 336,821                                     |       |
| Total                        |       | $                                            | 306,020    |                                        | $          | 522,750 |   |

 

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**Asset RepricingCharacteristics**

*Summary*

Thetable below summarizes the repricing characteristics of our investmentportfolio as of September 30, 2006 and December 31, 2005, and isclassified by interest rate type:

**Investment Portfolio (Amounts in thousands)**
| ** **                              | ** ** | **As of September 30, 2006** | ** ** | **As of December 31, 2005** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                              | ** ** | **Amortized Cost**                          | ** ** | **Portfolio Mix**                          | ** ** | **Amortized Cost** | ** ** | **Portfolio Mix** | ** ** |
| **Floating  Rate:**                     |       |                                             |       |                                            |       |   |   |   |   |
| Residential ARM  Loans                  |       | $                                                | 1,591,073  |                                            | 9.2        | % | $ | 2,175,929 |   | 14.5 | % |
| Residential ARM  Securities             |       | 5,897,061                                        |       | 33.8                                            |       | 3,369,763 |   | 22.5 |   |
| Corporate Loans                         |       | 2,969,867                                        |       | 17.1                                            |       | 1,872,277 |   | 12.5 |   |
| Corporate Debt  Securities              |       | 359,074                                          |       | 2.1                                             |       | 277,030 |   | 1.9 |   |
| Commercial Real  Estate Loans           |       | 226,768                                          |       | 1.3                                             |       | 486,096 |   | 3.2 |   |
| Commercial Real  Estate Debt Securities |       | —                                           |       | —                                          |       | 63,168 |   | 0.4 |   |
| Total Floating Rate                     |       | 11,043,843                                       |       | 63.5                                            |       | 8,244,263 |   | 55.0 |   |
| **Hybrid  Rate:**                       |       |                                             |       |                                            |       |   |   |   |   |
| Residential  Hybrid ARM Loans           |       | 3,797,501                                        |       | 21.9                                            |       | 4,252,893 |   | 28.4 |   |
| Residential  Hybrid ARM Securities      |       | 1,954,577                                        |       | 11.2                                            |       | 2,197,020 |   | 14.7 |   |
| Total Hybrid Rate                       |       | 5,752,078                                        |       | 33.1                                            |       | 6,449,913 |   | 43.1 |   |
| **Fixed  Rate:**                        |       |                                             |       |                                            |       |   |   |   |   |
| Corporate Loans                         |       | 61,157                                           |       | 0.4                                             |       | 25,000 |   | 0.2 |   |
| Corporate Debt  Securities              |       | 449,175                                          |       | 2.5                                             |       | 202,748 |   | 1.4 |   |
| Commercial Real  Estate Loans           |       | 78,887                                           |       | 0.5                                             |       | 35,646 |   | 0.2 |   |
| Commercial Real  Estate Debt Securities |       | —                                           |       | —                                          |       | 19,833 |   | 0.1 |   |
| Total Fixed Rate                        |       | 589,219                                          |       | 3.4                                             |       | 283,227 |   | 1.9 |   |
| Total                                   |       | $                                                | 17,385,140 |                                            | 100.0      | % | $ | 14,977,403 |   | 100.0 | % |

 

Thetable above excludes marketable equity securities with a fair value of $66.7million and amortized cost of $69.0 million, and non-marketable equitysecurities with a fair value of $165.4 million and amortized cost of $165.4million as of September 30, 2006.  Alsoexcluded are marketable equity securities with a fair value of $47.0 millionand amortized cost of $47.2 million, and non-marketable equity securities witha fair value of $52.5 million and amortized cost of $52.5 million as ofDecember 31, 2005.

*Residential ARM Securities*

As ofSeptember 30, 2006, substantially all of our residential ARM securities werecomprised of one-month LIBOR floating rate securities that reprice monthly andwere subject to a weighted average maximum net interest rate of 11.85% which wasmaterially above the then current weighted average net coupon of 6.29%. Ourrepricing risk on our portfolio of residential ARM securities increasesmaterially if interest rates increase to a level where the weighted averagecoupon rate approaches the weighted average maximum net interest rate of 11.85%because the weighted average coupon is subject to a maximum rate, or cap, whichis approximately equal to the weighted average maximum interest rate of 11.85%.

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

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ResidentialHybrid ARM Securities

As ofSeptember 30, 2006, all of our residential hybrid ARM securities had underlyingmortgage loans that were originated as 5/1 hybrid ARM loans. As of September30, 2006, we owned 100% of the securities that represent 100% of the beneficialinterest in the 5/1 hybrid ARM loans underlying our portfolio of hybrid ARMsecurities. When the underlying residential hybrid mortgage loans convert fromfixed rate to floating rate, the underlying mortgage loans will have aninterest rate based on one-year LIBOR or one-year constant maturity treasuryindex, or CMT, depending upon if the underlying mortgage loan is a LIBOR- orCMT-based mortgage loan. On the date that the residential hybrid ARM loansconvert from a fixed rate to a floating rate loan, which we refer to as theroll date, our portfolio of residential hybrid ARM loans will have a weightedaverage coupon that is the sum of (i) the post-roll date index, and(ii) the weighted average post-roll date net margin. As of September 30,2006, all of the mortgage loans underlying our residential hybrid ARMsecurities had a post-roll date index reset frequency of one year with 34%based on six-month or one-year LIBOR and 66% based on one-year CMT. Ourrepricing risk on our portfolio of residential hybrid ARM loans increasesmaterially if interest rates increase to a level where, subsequent to the rolldate, the weighted average net coupon rate approaches the weighted average postroll date maximum net interest rate of 9.43% because the post roll dateweighted 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 net coupon on the portfolio of residentialhybrid securities is 4.18% as of September 30, 2006. As of September 30, 2006,the weighted average months until roll date for the mortgage loans underlyingour residential hybrid ARM securities was 27.

As ofDecember 31, 2005, all of our residential hybrid ARM securities hadunderlying mortgage loans that were originated as 5/1 hybrid ARM loans. As ofDecember 31, 2005, we owned 100% of the securities that represent 100% ofthe beneficial interest in the 5/1 hybrid ARM loans underlying our portfolio ofhybrid ARM securities.  As ofDecember 31, 2005, all of the mortgage loans underlying our residentialhybrid ARM securities had a post-roll date index reset frequency of one yearwith 35% based on six-month or one-year LIBOR and 65% based on one-yearCMT.  Our repricing risk on our portfolioof residential hybrid ARM loans increases materially if interest rates continueto increase to a level where, subsequent to the roll date, the weighted averagenet coupon rate approaches the weighted average post roll date maximum net interestrate of 9.43% because the post roll date weighted average net coupon is subjectto a maximum rate, or cap, which is approximately equal to the weighted averagepost roll date maximum net interest rate or 9.43%. The weighted average couponon the portfolio of residential hybrid securities is 4.13% as ofDecember 31, 2005. As of December 31, 2005, the weighted averagemonths until roll date for the mortgage loans underlying our residential hybridARM securities was 36.

*Residential ARM Loans*

As ofSeptember 30, 2006, all of our residential ARM loans were comprised ofone-month LIBOR floating rate loans that reprice monthly and were subject to aweighted average maximum net interest rate of****11.92%,which was well above the then current weighted average net coupon of****6.41%. Our repricing risk on our portfolio of residentialARM loans increases materially if interest rates continue to increase to alevel where the weighted average net coupon rate approaches the weightedaverage maximum interest rate of 11.92% because the weighted average coupon issubject to a maximum rate, or cap, which is approximately equal to the weightedaverage maximum interest rate of 11.92%.

As ofDecember 31, 2005, all of our residential ARM loans were comprised ofone-month LIBOR floating rate loans that reprice monthly and were subject to aweighted average maximum net interest rate of****11.90%,which was well above the then current weighted average net coupon of****5.05%. Our repricing risk on our portfolio of residentialARM loans increases materially if interest rates continue to increase to alevel where the weighted average net coupon rate approaches the weightedaverage maximum interest rate of 11.90% because the weighted average coupon issubject to a maximum rate, or cap, which is approximately equal to the weightedaverage maximum interest rate of 11.90%.

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*Residential Hybrid ARMLoans*

As ofSeptember 30, 2006, all of our residential hybrid ARM loans were originated aseither 3/1 or 5/1 hybrid ARM loans. When the loans convert from fixed rate tofloating rate, the underlying mortgage loans will have an interest rate basedon one-year LIBOR or one-year CMT. On the date that the residential hybrid ARMloans convert from a fixed rate to a floating rate loan, which we refer to asthe roll date, our portfolio of residential hybrid ARM loans will have aweighted average coupon that is the sum of (i) the post-roll date index,and (ii) the weighted average post-roll date net margin. As of September30, 2006, all of our residential hybrid ARM loans had a post-roll date indexreset frequency of one-year with 46% based on six-month or one-year LIBOR and54% based on one-year CMT. Our repricing risk on our portfolio of residentialhybrid ARM loans increases materially if interest rates increase to a levelwhere, subsequent to the roll date, the weighted average net coupon rateapproaches the weighted average post-roll date maximum net interest rate of10.12%****because the post-roll date weightedaverage net coupon is subject to a maximum rate, or cap, which is approximatelyequal to the weighted average post-roll date maximum net interest rate of10.12%. The weighted average net coupon on the portfolio of residential hybridloans was 4.85% as of September 30, 2006. As of September 30, 2006, theweighted average months until roll date for the mortgage loans underlying ourresidential hybrid ARM securities was 36.

As ofDecember 31, 2005, all of our residential hybrid ARM loans were originatedas either 3/1 or 5/1 hybrid ARM loans. As of December 31, 2005, all of our residential hybrid ARM loanshad a post-roll date index reset frequency of one-year with 43% based onsix-month or one-year LIBOR and 57% based on one-year CMT.  Our repricing risk on our portfolio of residentialhybrid ARM loans increases materially if interest rates continue to increase toa level where, subsequent to the roll date, the weighted average net couponrate approaches the weighted average post-roll date maximum net interest rateof 10.13%****because the post-roll date weightedaverage net coupon is subject to a maximum rate, or cap, which is approximatelyequal to the weighted average post-roll date maximum net interest rate or10.13%. The weighted average net coupon on the portfolio of residential hybridloans was 4.85% as of December 31, 2005. As of December 31, 2005, theweighted average months until roll date for the mortgage loans underlying ourresidential hybrid ARM securities was 44.

*Corporate Loans andSecurities*

All ofour floating rate corporate loans and securities have index reset frequenciesof less than twelve months with the majority of the loans resetting at leastquarterly. The weighted average coupon on our floating rate corporate loans andsecurities was 8.13% and 7.12% as of September 30, 2006 and December 31,2005, respectively. As of September 30, 2006 and December 31, 2005, theweighted average years to maturity of our floating rate corporate loans andsecurities was 6.0 years and 6.3 years, respectively.

As ofSeptember 30, 2006, our fixed rate corporate debt securities had a weightedaverage coupon of 9.62% and a weighted average years to maturity of****6.3 years, as compared to 10.58% and 8.7 years,respectively, as of December 31, 2005.

*Commercial Real EstateLoans and Securities*

All ofour floating rate commercial real estate loans and securities have index resetfrequencies of less than twelve months. The weighted average coupon on ourfloating rate commercial real estate loans and securities was 8.99% and 8.70%as of September 30, 2006 and December 31, 2005, respectively. As ofSeptember 30, 2006 and December 31, 2005, the weighted average years tomaturity of our floating rate commercial real estate loans and securities was****1.7** **years and3.7 years, respectively.

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As ofSeptember 30, 2006, our fixed rate commercial real estate loans and securitieshad a weighted average coupon of 7.74% and a weighted average years to maturityof 7.0 years, as compared to 7.95% and 7.7 years, respectively, as of December31, 2005.

**Portfolio Purchases**

Wepurchased $3.0 billion and $6.5 billion par amount of investments duringthe three and nine months ended September 30, 2006, respectively, compared to$6.5 billion and $11.9 billion par amount of investments during the three andnine months ended September 30, 2005, 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  September 30, 2006** | ** ** | **Three months ended  September 30, 2005** | ** ** | **Nine months ended  September 30, 2006** | ** ** | **Nine months ended  September 30, 2005** | ** ** |
|-----------------------------------------|------------|----------------------------------------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                              | ** ** | **Par Amount**                                            | ** ** | **%**                                                          | ** ** | **Par Amount**                                           | ** ** | **%**                                                         | ** ** | **Par Amount** | ** ** | **%** | ** ** | **Par Amount** | ** ** | **%** | ** ** |
| Securities:                             |       |                                                           |       |                                                           |       |                                                          |       |                                                          |       |   |   |   |   |   |   |   |   |
| Residential ARM  Securities             |       | $                                                              | 1,953,539  |                                                           | 64.7       | %                                                             | $          | 886,566                                                       |       | 13.5 | % | $ | 3,817,806 |   | 58.5 | % | $ | 1,625,771 |   | 13.7 | % |
| Residential  Hybrid ARM Securities      |       | —                                                         |       | —                                                         |       | —                                                        |       | —                                                        |       | — |   | — |   | 2,935,532 |   | 24.7 |   |
| Corporate Debt  Securities              |       | 167,500                                                        |       | 5.6                                                            |       | 180,315                                                       |       | 2.8                                                           |       | 507,516 |   | 7.7 |   | 398,820 |   | 3.3 |   |
| Commercial Real  Estate Debt Securities |       | —                                                         |       | —                                                         |       | 52,315                                                        |       | 0.8                                                           |       | — |   | — |   | 62,315 |   | 0.5 |   |
| Total Securities Principal Balance      |       | 2,121,039                                                      |       | 70.3                                                           |       | 1,119,196                                                     |       | 17.1                                                          |       | 4,325,322 |   | 66.2 |   | 5,022,438 |   | 42.2 |   |
| Loans:                                  |       |                                                           |       |                                                           |       |                                                          |       |                                                          |       |   |   |   |   |   |   |   |   |
| Residential ARM  Loans                  |       | —                                                         |       | —                                                         |       | 956,970                                                       |       | 14.6                                                          |       | 125,552 |   | 1.9 |   | 1,393,471 |   | 11.7 |   |
| Residential  Hybrid ARM Loans           |       | —                                                         |       | —                                                         |       | 3,717,560                                                     |       | 56.9                                                          |       | — |   | — |   | 3,717,560 |   | 31.2 |   |
| Corporate Loans                         |       | 877,356                                                        |       | 29.1                                                           |       | 509,673                                                       |       | 7.8                                                           |       | 2,063,858 |   | 31.6 |   | 1,426,374 |   | 12.0 |   |
| Commercial Real  Estate Loans           |       | 17,000                                                         |       | 0.6                                                            |       | 235,450                                                       |       | 3.6                                                           |       | 17,000 |   | 0.3 |   | 342,200 |   | 2.9 |   |
| Total Loans Principal Balance           |       | 894,356                                                        |       | 29.7                                                           |       | 5,419,653                                                     |       | 82.9                                                          |       | 2,206,410 |   | 33.8 |   | 6,879,605 |   | 57.8 |   |
| Grand Total  Principal Balance          |       | $                                                              | 3,015,395  |                                                           | 100.0      | %                                                             | $          | 6,538,849                                                     |       | 100.0 | % | $ | 6,531,732 |   | 100.0 | % | $ | 11,902,043 |   | 100.0 | % |

 

Thetable above excludes purchases of $8.5 million (purchase cost) of marketableequity securities and $26.0 million (purchase cost) of non-marketableequity securities during the three months ended September 30, 2006, and $35.7 million(purchase cost) of marketable equity securities and $117.6 million (purchasecost) of non-marketable equity securities during the nine months endedSeptember 30, 2006.  The table alsoexcludes $24.7 million (purchase cost) and $0 million (purchase cost) ofmarketable equity securities and non-marketable equity securities,respectively, during the nine months ended September 30, 2005.  There were no purchases of marketable equitysecurities or non-marketable equity securities in the three months endedSeptember 30, 2005.

**Stockholders’ Equity**

Ourstockholders’ equity at each of September 30, 2006 and December 31, 2005totaled $1.7 billion. Included in our stockholders’ equity as of September 30,2006 and December 31, 2005 is accumulated other comprehensive income totaling****$52.2 million and $18.3 million, respectively.

Ouraverage stockholders’ equity and return on average stockholders’ equity for thethree and nine months ended September 30, 2006 were $1.7 billion and 7.5%, and$1.7 billion and 7.7%, respectively.  Ouraverage stockholders’ equity and return on average stockholders’ equity for thethree and nine months ended September 30, 2005 were $1.6 billion and 4.5%, and$1.0 billion and 4.2%, respectively. Return on average stockholders’ equity is defined as net income dividedby weighted average stockholders’ equity.

Ourbook value per common share as of September 30, 2006 and December 31, 2005was $21.16 and $20.59, respectively, and were computed based on 80,464,713 and80,374,061 shares issued and outstanding as September 30, 2006 andDecember 31, 2005, respectively.

OnNovember 2, 2006, our Board of Directors declared a cash distribution of$0.52 per share for the three months ended September 30, 2006 tostockholders of record as of the close of business on November 16, 2006. Thedistribution is payable on November 30, 2006. The aggregate amount of thedistribution,****$41.8 million, exceeds netincome for the quarter by $9.2 million.

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**Liquidity and CapitalResources**

Wemanage our liquidity with the intention of providing the continuing ability tofund our operations and fulfill our commitments on a timely and cost-effectivebasis. We believe that our liquidity level is in excess of that necessary tosufficiently enable us to meet our anticipated liquidity requirementsincluding, but not limited to, funding our purchases of investments, requiredcash payments and additional collateral under our borrowings and our derivativetransactions, required periodic cash payments related to our derivativetransactions, payment of fees and expenses related to our Management Agreement,payment of general corporate expenses and general corporate capitalexpenditures and distributions to our stockholders. As of September 30, 2006,pursuant to the Management Agreement, we owed our Manager $6.2 million forthe payment of management fees and reimbursable expenses pursuant to theManagement Agreement.

Anincrease in prepayment rates substantially above our expectations could,however, cause a temporary liquidity shortfall due to the timing of thenecessary margin calls on the financing arrangements and the actual receipt ofthe cash related to principal paydowns. In addition, any material event that impacts capital marketsparticipants may also impair our ability 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 onsubstantially similar terms, it may have an adverse effect on our business andresults of operations. Upon liquidation, holders of our debt securities andlenders with respect to other borrowings, as well as any holders of preferredstock that we may issue in the future, will receive a distribution of ouravailable assets prior to holders of our common stock.

Thedecisions by investors and lenders to enter into equity and financingtransactions with us will depend upon a number of factors, including ourhistorical and projected financial performance, compliance with the terms ofour current credit arrangements, industry and market trends, the availabilityof capital and our investors’ and lenders’ policies and rates applicablethereto, and the relative attractiveness of alternative investment or lendingopportunities.

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 ourpledged investments, which would result in our recognition of such losses andreduced 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.

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**Sources of Funds**

*SecuritizationTransactions*

OnMarch 30, 2006, we closed our second $5.0 billion asset-backed securedliquidity note facility. This facility provides us with an alternative sourceof funding our residential mortgage-backed securities by issuing asset-backedsecured liquidity notes that are rated A-1+, P-1, and F1+, by Standard &Poor’s, Moody’s and Fitch Inc, respectively. Issuances of asset-backed securedliquidity notes are recorded as borrowings on our Consolidated Balance Sheet.At September 30, 2006, $3.5 billion was outstanding under this facility and atotal of $8.2 billion outstanding under both our asset-backed secured liquiditynote facilities.

Inpreparation for future securitization transactions, during the year endedDecember 31, 2005 we formed KKR Financial CDO 2005-1, Ltd. (“CDO2005-1”), and KKR Financial CLO 2006-2, Ltd. (“CLO 2006-2”). CLO 2006-2 will beused to provide secured financing principally for the purchase of corporate andcommercial real estate loans and securities. CLO 2006-2 has executed a $450.0million warehouse facility, in the form of a repurchase agreement. This facilitywas amended to increase the total commitment amount to $630.0 million inSeptember 2006.  At September 30, 2006,there was $469.2 million outstanding under this facility. The borrowings bearinterest at a rate of 30-day LIBOR plus 0.65%. During October 2006, wedetermined that we would no longer pursue a securitization of commercial realestate investments from CDO 2005-1 and therefore converted the existing $300.0million warehouse facility into a credit facility that terminates on March 31,2008. At September 30, 2006 there was $137.9 million outstanding underthis facility that bears interest at a rate of 30-day LIBOR plus 1.10%.

*RepurchaseAgreements*

As ofSeptember 30, 2006, we had $4.4 billion outstanding on repurchasefacilities with six counterparties with a weighted average effective rate of5.41% and a weighted average remaining term to maturity of 21****days. Because we borrow under repurchase agreements basedon the estimated 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 decline as a result of adverse changes ininterest rates or credit spreads.

*SecuredCredit Facility*

DuringJune 2006 our $275.0 million secured revolving credit facility matured and wasreplaced with a $375.0 million three year senior secured revolving creditfacility. During September 2006, the facility was amended to increase the totalcommitment amount to $800.0 million with the option to further increase thecommitment amount to $900.0 million at any time so long as no default or eventof default on the facility has occurred and subject to addition of new lenders,increases in the commitments of existing lenders, or a combination thereof.****The new senior secured revolving credit facility matures inJune 2009 and consists of two tranches.****Outstandingborrowings under the senior secured revolving credit facility bear interest ateither (i) an alternate base rate per annum equal to the greater of (a) theprime rate in effect on such day, and (b) the federal funds in effect on suchday plus 0.50%, or (ii) an interest rate per annum equal to the LIBOR rate forthe applicable interest period plus 0.50% for borrowings under tranche A of thefacility and 0.75% for borrowings under tranche B of the facility. As ofSeptember 30, 2006, we had $292.2 million in borrowings outstanding undertranche B of this facility.

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*JuniorSubordinated Notes*

DuringMarch 2006, we formed 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 payable quarterly at afixed rate of 7.64% (ten-year LIBOR plus 2.45%) through March 2016 andthereafter at a floating rate equal to three-month LIBOR plus 2.65%.

DuringJune 2006, we formed Trust II for the sole purpose of issuing trust preferredsecurities. On June 2, 2006, Trust II issued preferred securities tounaffiliated investors for gross proceeds of $50.0 million and commonsecurities to the Company for $1.6 million. The combined proceeds were investedby Trust II in $51.6 million of junior subordinated notes issued by us. Thejunior subordinated notes are the sole assets of Trust II and mature on July30, 2036, but are callable on or after July 30, 2011. Interest is payablequarterly at a fixed rate of 8.09% (ten-year LIBOR plus 2.45%) through July2016 and thereafter at a floating rate equal to three-month LIBOR plus 2.65%.

DuringAugust 2006, we formed Trust III for the sole purpose of issuing trustpreferred securities. On August 10, 2006, Trust III issued preferred securitiesto unaffiliated investors for gross proceeds of $85.0 million and commonsecurities to the Company for $2.6 million. The combined proceeds were investedby Trust III in $87.6 million of junior subordinated notes issued by us. Thejunior subordinated notes are the sole assets of Trust III and mature onOctober 30, 2036, but are callable on or after October 30, 2011. Interest ispayable quarterly at a floating rate equal to three-month LIBOR plus 2.35%.

DuringSeptember 2006, we formed Trust IV for the sole purpose of issuing trustpreferred securities. On September 15, 2006, Trust IV issued preferredsecurities to unaffiliated investors for gross proceeds of $15.0 million andcommon securities to the Company for $0.5 million. The combined proceeds wereinvested by Trust IV in $15.5 million of junior subordinated notes issued byus. The junior subordinated notes are the sole assets of Trust IV and mature onOctober 30, 2036, but are callable on or after October 30, 2011. Interest ispayable quarterly at a floating rate equal to three-month LIBOR plus 2.35%.

DuringSeptember 2006, we formed Trust V for the sole purpose of issuing trustpreferred securities. On September 29, 2006, Trust V issued preferredsecurities to unaffiliated investors for gross proceeds of $50.0 million andcommon securities to the Company for $1.6 million. The combined proceeds wereinvested by Trust V in $51.6 million of junior subordinated notes issued by us.The junior subordinated notes are the sole assets of Trust V and mature onOctober 30, 2036, but are callable on or after October 30, 2011. Interest ispayable quarterly at a fixed rate of 7.395% through October 2016 and thereafterat a floating rate equal to three-month LIBOR plus 2.25%.

*Off-BalanceSheet Commitments*

As ofSeptember 30, 2006, we had committed to purchase corporate loans with aggregatecommitments totaling $373.9 million. In a typical corporate loan orcommercial real estate loan syndication, there is a delay between the time weare informed of our allocable portion of such loan and the actual funding ofsuch loan.

As of September 30, 2006, we had purchased orparticipated in corporate loan delayed draw transactions with aggregatecommitments totaling $0.5 million. In a delayed draw transaction, we have madeavailable to the borrower a stated amount to be drawn as needed within aspecified future period of time.

**REIT Matters**

As ofSeptember 30, 2006, we believe that we qualified as a REIT under the provisionsof the Code. The Code requires that at the end of each calendar quarter atleast 75% of our total assets must be “real estate assets” as defined in theCode. The Code also requires that each year at least 75% of our gross incomecome from real estate sources and 95% of our gross income come from real estatesources and certain other passive sources itemized in the Code, such asdividends and interest. As of September 30, 2006, we believe that we were incompliance with such requirements. As of September 30, 2006, we also believethat we met all of the REIT requirements regarding the ownership of our commonstock and the distributions of our taxable income.

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Tomaintain our status as a REIT for federal income tax purposes, we are requiredto declare and pay dividends amounting to at least 90% of our taxable incomefor each year. In addition, for each taxable year, to avoid certain federalexcise taxes, we are required to declare and pay dividends amounting to certaindesignated percentages of our taxable income by the end of such taxable year.Because we expect to make distributions based on taxable income, we expect thatour distributions may at times be more or less than our reported earningscomputed in accordance with GAAP.

Totaltaxable income and REIT taxable income are non-GAAP financial measurements, anddo not purport to be an alternative to reported net income determined inaccordance with GAAP as a measure of operating performance or to cash flowsfrom operating activities determined in accordance with GAAP as a measure ofliquidity. Total taxable income is the aggregate amount of taxable incomegenerated by us and by our domestic and foreign taxable REIT subsidiaries. REITtaxable income excludes the undistributed taxable income of our domestictaxable REIT subsidiary, which is not included in REIT taxable income untildistributed to us. There is no requirement that our domestic taxable REITsubsidiary distribute its earnings to us. REIT taxable income, however,includes the taxable income of our foreign taxable REIT subsidiaries because wewill generally be required to recognize and report their taxable income on acurrent basis. These non-GAAP financial measurements are important because weare structured as a REIT and the Code requires that we pay substantially all ofour taxable income in the form of distributions to our stockholders. Thenon-GAAP financial measurements of total taxable income and REIT taxable incomeare critical in the determination of the amount of the minimum distributionsthat we must pay to our stockholders so as to comply with the rules setforth in the Code. Because not all companies use identical calculations, thispresentation of total taxable income and REIT taxable income may not becomparable to other similarly titled measures prepared and reported by othercompanies. The table below reconciles the differences between reported netincome and total taxable income and REIT taxable income for the three and ninemonths ended September 30, 2006 and 2005:

**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  September 30, 2006** | ** ** | **Three  months ended  September 30, 2005** | ** ** | **Estimated for the  nine months ended  September 30, 2006** | ** ** | **Nine  months ended  September 30, 2005** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                            | ** ** | **Amount**                                                                                  | ** ** | **Per  Share**                                             | ** ** | **Amount**                                                                                 | ** ** | **Per  Share**                                            | ** ** | **Amount** | ** ** | **Per  Share** | ** ** | **Amount** | ** ** | **Per  Share** | ** ** |
| **Reported  net income**                                              |       | $                                                                                           | 32,616     |                                                       | $          | 0.41                                                                                       |       | $                                                         | 18,454     |   | $ | 0.24 |   | $ | 97,935 |   | $ | 1.25 |   | $ | 33,072 |   | $ | 0.62 |   |
| Interest income  and expense                                          |       | (2,830                                                                                      | )          | (0.04                                                      | )          | 48                                                                                         |       | —                                                    |       | 2,462 |   | 0.03 |   | 145 |   | — |   |
| Share-based  compensation                                             |       | 10,150                                                                                      |       | 0.13                                                       |       | 7,428                                                                                      |       | 0.09                                                      |       | 22,077 |   | 0.28 |   | 19,509 |   | 0.36 |   |
| Vesting of  restricted common stock                                   |       | (14,211                                                                                     | )          | (0.18                                                      | )          | —                                                                                     |       | —                                                    |       | (14,211 | ) | (0.18 | ) | — |   | — |   |
| Foreign currency  translation (gains) and losses                      |       | (124                                                                                        | )          | —                                                     |       | (203                                                                                       | )          | —                                                    |       | (1,324 | ) | (0.02 | ) | 2,332 |   | 0.05 |   |
| Tax gains on  sales of investments to affiliates                      |       | 2,729                                                                                       |       | 0.03                                                       |       | 19                                                                                         |       | —                                                    |       | 4,287 |   | 0.05 |   | 3,758 |   | 0.07 |   |
| Realized and  unrealized derivative gains and losses                  |       | (1,424                                                                                      | )          | (0.02                                                      | )          | (285                                                                                       | )          | (0.01                                                     | )          | (1,963 | ) | (0.02 | ) | (459 | ) | (0.01 | ) |
| Book/tax year end  difference adjustment for CLOs/CDOs                |       | —                                                                                      |       | —                                                     |       | —                                                                                     |       | —                                                    |       | 8,168 |   | 0.10 |   | — |   | — |   |
| Provision for  loan losses                                            |       | —                                                                                      |       | —                                                     |       | 1,300                                                                                      |       | 0.02                                                      |       | — |   | — |   | 1,300 |   | 0.02 |   |
| Lease abandonment  expense                                            |       | (19                                                                                         | )          | —                                                     |       | 795                                                                                        |       | 0.01                                                      |       | 89 |   | — |   | 795 |   | 0.01 |   |
| Other                                                                 |       | 183                                                                                         |       | 0.01                                                       |       | 144                                                                                        |       | —                                                    |       | 506 |   | 0.01 |   | 274 |   | 0.01 |   |
| Income tax  expense                                                   |       | 453                                                                                         |       | 0.01                                                       |       | 775                                                                                        |       | 0.01                                                      |       | 885 |   | 0.01 |   | 1,881 |   | 0.04 |   |
| **Total  taxable income**                                             |       | 27,523                                                                                      |       | 0.35                                                       |       | 28,475                                                                                     |       | 0.36                                                      |       | 118,911 |   | 1.51 |   | 62,607 |   | 1.17 |   |
| Undistributed  taxable (income) of domestic taxable REIT subsidiary   |       | (448                                                                                        | )          | (0.01                                                      | )          | (1,709                                                                                     | )          | (0.02                                                     | )          | (2,456 | ) | (0.03 | ) | (3,781 | ) | (0.07 | ) |
| **REIT  taxable income**                                              |       | $                                                                                           | 27,075     |                                                       | $          | 0.34                                                                                       |       | $                                                         | 26,766     |   | $ | 0.34 |   | $ | 116,455 |   | $ | 1.48 |   | $ | 58,826 |   | $ | 1.10 |   |
| **Number  of common shares outstanding:**                             | ** ** | ** **                                                                                  | ** ** | ** **                                                 | ** ** | ** **                                                                                 | ** ** | ** **                                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Weighted-average diluted  common shares outstanding during the period |       | 79,578                                                                                      |       |                                                       |       | 78,492                                                                                     |       |                                                      |       | 78,559 |   |   |   | 53,519 |   |   |   |

 

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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 results ofoperations, 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. Pursuant to this policy, on November 2, 2006, ourBoard of Directors declared a cash distribution for the three months endedSeptember 30, 2006 of $0.52 per common share to our stockholders of record asof the close of business on November 16, 2006. This distribution is payable onNovember 30, 2006. The aggregate amount of the distribution is $41.8 million.Neither the payment of this distribution nor the existence of our distributionpolicy guarantees that we will make future distributions to our stockholders ofany particular level, or at all. In addition, the amount of this distributiondoes not constitute any kind of projection as to the amount of futuredistributions, if any.

**Exemption from Regulationunder the Investment Company Act**

Weintend to operate our business so as to be excluded from regulation under theInvestment Company Act. Because we conduct some of our business throughwholly-owned subsidiaries, we must ensure not only that we qualify for anexclusion or exemption from regulation under the Investment Company Act, butalso that each of our subsidiaries so qualifies.

ForKKR Financial Corp. itself, we will be relying on a provision designed forcompanies that do not issue redeemable securities and are primarily engaged inthe business of purchasing or otherwise acquiring mortgages and other liens onand interests in real estate.

TheSecurities and Exchange Commission (“SEC”) has not promulgated rules toaddress precisely what is required for a company to be considered “primarilyengaged in the business of purchasing or otherwise acquiring mortgages andother liens on and interests in real estate.” A series of no-action lettersissued by the Division of Investment Management (the “Division”) of the SEC,however, reflects the view that at least 55% of a company’s assets must consistof mortgage loans and other assets that are considered the functionalequivalent of mortgage loans for purposes of the Investment Company Act(collectively, “qualifying real estate assets”), and an additional 25% of acompany’s assets must consist of real estate-related assets, leaving no morethan 20% of the company’s assets in miscellaneous assets. These no-actionletters also indicate what types of assets can be considered qualifying realestate assets. No-action letters issued by the Division are not binding exceptas they relate to the companies to whom they are addressed, so investors shouldbe aware that the Division may change its position regarding what assets mightconstitute qualifying real estate assets at any time. If the Division were tochange its position, we might be required to change our investment strategy tocomply with any new guidance provided by the Division. We cannot predictwhether such a change would be adverse to us.

Basedon the no-action letters issued by the Division, we classify our investment inresidential mortgage loans as qualifying real estate assets, as long as theloans are “fully secured” by an interest in real estate. That is, if theloan-to-value ratio of the loan is equal to or less than 100%, then we considerthe mortgage loan a qualifying real estate asset. We do not consider loans withloan-to-value ratios in excess of 100% to be qualifying real estate assets forthe 55% test, but only real estate-related assets for the 25% test.

Wealso consider agency whole pool certificates to be qualifying real estateassets. An agency whole pool certificate is a certificate issued or guaranteedas to principal and interest by federally chartered entities such as the FederalNational Mortgage Association, better known as “Fannie Mae,” the Federal HomeLoan Mortgage Corporation, better known as “Freddie Mac,” and, in the case ofthe Government National Mortgage Association, better known as “Ginnie Mae,” bythe U.S. government, that represents the entire beneficial interest in theunderlying 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 the 25%test.

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

Inseveral such instances, we own all of the securities issued by the relatedsecuritization trust. There are no other owners of the securities, and thus weview our investment, economically, as an investment in mortgage loans ratherthan an investment in mortgage-backed securities. For these transactions, weclassify our entire investment as an investment in qualifying real estateassets for purposes of the 55% test.

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Inanother instance, we own the most subordinate class of securities issued in thesecuritization, designated Class B-6, the class that is most likely to absorblosses on the related pool of mortgage loans, and we have the right to decidewhether to foreclose upon defaulted mortgage loans. Thus, based on a series ofno-action letters, we classify this investment as an investment in qualifyingreal estate assets for purposes of the 55% test. In addition to our ownershipof Class B-6 in this securitization, we also own all of the other subordinatedclasses in the securitization: Classes B-5, B-4, B-3, B-2, B-1 and M. All ofthe subordinate classes could have been issued as a single subordinate class,but to obtain varying ratings on the classes and to increase the liquidity ofour holdings, our subordinate interest was divided into separate classes.Losses on the mortgage loans, to the extent they exceed the principal balanceof the Class B-6, are allocated to Class B-5, B-4, B-3, B-2, B-1 and M, in thatorder. If losses 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 havethe right to decide whether to foreclose on defaulted mortgage loans. Thisright continues throughout the subordinate classes, such that the owner of themost subordinate class that is outstanding at any time has foreclosure rights.Because we own 100% of each class of subordinate securities in this structure,and each such class carries with it the right to foreclose if it ever becomesthe most subordinate class in the structure, we classify all of these subordinatesecurities as qualifying real estate assets for purposes of the 55% test. If wewere to sell all or a portion of any of those subordinated classes, we wouldrecharacterize the remaining portion of that class, together with any classessenior to that class, as real estate-related assets for the 25% test, ratherthan qualifying real estate assets for the 55% test. We own a portion of asenior class issued in this same securitization, but because it is not asubordinated class, we do not consider it a qualifying real estate asset forpurposes of the 55% test, but merely a real estate-related asset for purposesof the 25% test.

Wewill use this same analysis to determine whether to classify investments wemake in the future as qualifying real estate assets. If we acquire securitiesthat, collectively, are expected to receive all of the principal and interestpaid on the related pool of underlying mortgage loans (less fees, such asservicing and trustee fees, and expenses of the securitization), and we have foreclosurerights with respect to those mortgage loans, then we will consider thosesecurities, collectively, to be qualifying real estate assets. If anotherentity acquires any of the securities that are expected to receive cash flowfrom the underlying mortgage loans, then we will consider whether we have theunilateral right to foreclose on the underlying loans and whether ourinvestment is a first loss position to decide whether it should be classifiedas a qualifying real estate asset. If we own more than one subordinate class,then, to determine the classification of the subordinate classes that we ownother than the first loss class, we would consider whether such classes arecontiguous with the first loss class (with no other classes absorbing losses afterthe first loss class and before any other subordinate classes that we own),whether we own the entire amount of each such class and whether we wouldcontinue to have the unilateral right to foreclose in connection with each suchclass if the more subordinate classes were no longer outstanding. If theanswers to any of these questions is no, then we would not classify thatparticular class, or classes senior to that class, as a qualifying real estateasset.

To theextent that our investments in mortgage-backed securities do not constitutequalifying real estate assets for the 55% test, they will be classified as realestate-related assets for purposes of the 25% test. We do not expect that ourinvestments in corporate leveraged loans, high yield corporate bonds, or equitywill constitute qualifying real estate or real estate-related assets. Instead,they will constitute miscellaneous assets, which can constitute no more than20% of our assets.

Webelieve that we have satisfied the tests with respect to our assets, measuredon an unconsolidated basis, since the first anniversary of our initial privateplacement of our common stock in August 2004. It is not entirely settled,however, that the tests are to be measured on an unconsolidated basis. To theextent the SEC provides further guidance on how to measure assets for thesetests, we will adjust our measurement techniques.

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

Wehave not received a no-action letter from the Division regarding how ourinvestment strategy fits within the exclusion from regulation under theInvestment Company Act that we are using. To the extent that the Divisionprovides more specific or different guidance regarding the treatment of assetsas qualifying real estate assets or real estate-related assets, we may berequired to adjust our investment strategy accordingly. Any additional guidancefrom the Division could provide additional flexibility to us, or it couldfurther inhibit our ability to pursue the investment strategy we have chosen.

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

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 ofour investments 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 September 30, 2006 and December 31, 2005 (amounts inthousands):

**Derivative Fair Value**
| ** **                      | ** ** | **As of  September 30, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|---------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| **Cash  Flow Hedges:**          | ** ** | ** **                                   | ** ** | ** **                                  | ** ** |
| Interest rate corridors         |       | $                                            | 14,548     |                                        | $          | 14,762 |   |
| Interest rate swaps             |       | 48,179                                       |       | 40,796                                      |       |
| **Fair  Value Hedges:**         | ** ** | ** **                                   | ** ** | ** **                                  | ** ** |
| Interest rate swaps             |       | (581                                         | )          | —                                      |       |
| **Free-Standing  Derivatives:** | ** ** | ** **                                   | ** ** | ** **                                  | ** ** |
| Interest rate swaptions         |       | 113                                          |       | 879                                         |       |
| Interest rate swaps             |       | —                                       |       | 198                                         |       |
| Credit default swaps            |       | (185                                         | )          | 71                                          |       |
| Total rate of return swaps      |       | 2,185                                        |       | 727                                         |       |
| Net fair value                  |       | $                                            | 64,259     |                                        | $          | 57,433 |   |

 

*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 borrowingagreements to have a range of different maturities, terms, amortizations andinterest rate adjustment periods; and

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

**Item 3.         Quantitative and QualitativeDisclosures 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.

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**Item 4.         Controls and Procedures**

Underthe supervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, we conducted anevaluation of the effectiveness of the design and operation of our disclosurecontrols and procedures, as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended, as of theend of the period covered by this report (the “Evaluation Date”). Based on thisevaluation, our principal executive officer and principal financial officerconcluded as of the Evaluation Date that our disclosure controls and procedureswere effective such that the information relating to us, including ourconsolidated subsidiaries, required to be disclosed in our SEC reports(i) is recorded, processed, summarized and reported within the timeperiods specified in SEC rules and forms, and (ii) is accumulated andcommunicated to our management, including our principal executive and principalfinancial officer, as appropriate to allow timely decisions regarding requireddisclosure.

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

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

We areactively remediating the identified reportable conditions. Specifically,subsequent to March 8, 2005, we hired individuals to fill the positions ofChief Accounting Officer; Controller; Treasurer; Assistant Controller; andFinancial Analysis Manager and during the second quarter of 2006 our Directorof Tax was appointed Chief Financial Officer and replaced our Chief Operating Officerin this role. We are also enhancing our internal control structure to ensureproper segregation of duties and the timely recording of transactions andtimely preparation of reconciliations as we continue to prepare for compliancewith Section 404 of the Sarbanes-Oxley Act of 2002. Due to the recentlyannounced one-year delay in the required compliance schedule fornon-accelerated filers, we will be required to issue a management report on ourassessment of internal controls over financial reporting in our Annual Reporton Form 10-K for the year ended December 31, 2006.

Therewere no other changes in our internal control over financial reportingidentified in connection with the foregoing evaluation that occurred during thethree months ended September 30, 2006 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

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**PART II.OTHER INFORMATION**

**Item1.         *LegalProceedings***

None.

**Item 1A.      *Risk Factors***

Therehave been no material changes in our risk factors from those disclosed in our AnnualReport on Form 10-K for the year ended December 31, 2005.

**Item2*.         UnregisteredSales of Equity Securities and Use of Proceeds***

None.

**Item3.         *DefaultsUpon Senior Securities***

None.

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

None.

**Item5.         *OtherInformation***

None.

**Item6.         *Exhibits***

 
| 31.1* |   | Chief Executive Officer Certification of the  Quarterly Financial Statements |
|-------|--------|------------------------------------------------------------------------------|
| 31.2* |   | Chief Financial Officer Certification of the Quarterly  Financial Statements |
| 32*   |   | Certification Pursuant to 18 U.S.C. Section 1350                             |

----

*       Filedherewith.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, KKR Financial Corp. has duly caused this report to be signed onits behalf by the undersigned, thereunto duly authorized.
|                         |       | KKR Financial Corp.                                                   |
|-------------------------|------------|-----------------------------------------------------------------------|
|                    |       |                                                                  |
| Signature               | ** ** | **Title**                                                             |
| ** **              |       |                                                                  |
| /s/ SATURNINO S. FANLO  |       | Chief Executive Officer (Principal Executive  Officer)                |
| **Saturnino S. Fanlo**  | ** ** | ** **                                                            |
| ** **              | ** ** | ** **                                                            |
| /s/ JEFFREY B. VAN HORN |       | Chief Financial Officer (Principal Financial and  Accounting Officer) |
| **Jeffrey B. Van Horn** |       |                                                                  |
| ** **              |       |                                                                  |
| Date: November  8, 2006 |       |                                                                  |

 

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