**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

| **(Mark One)**                                                                                                                                   |
|--------------------------------------------------------------------------------------------------------------------------------------------------|
| x                                                                                                                                                | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| **For the quarterly period ended  March 31, 2008**                                                                                          |
| **or**                                                                                                                                           |
| o                                                                                                                                                | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| **For the transition period from         to         ** |

 

**Commission file number: 001-33437**

 

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**KKR FINANCIAL HOLDINGS LLC**

(Exact name of registrant as specified in itscharter)

 

| **Delaware**                                                    | ** ** | **11-3801844**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                            |       |                                  |
| **555 California Street, 50th Floor  San Francisco, CA**   | ** ** | **94104**                             |
| (Address of principal executive offices)                        |       | (Zip Code)                            |

 

Registrant’s telephone number, including areacode: **(415) 315-3620**

 

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Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. x Yes  o No

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See the definitions of “large accelerated filer,” “accelerated filer”and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

 
| Large  accelerated filer x                |   | Accelerated  filer o         |
|------------------------------------------------|--------|-----------------------------------|
| Non-accelerated filer o                   |   | Smaller  reporting company o |
| (Do not check if a smaller reporting  company) |   |                              |

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Act). o Yes x No

 

The number of shares of the registrant’s common shares outstanding asof April 25, 2008 was 150,843,151.

 

 

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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                                                                                    |
|                        |                                                                                             |  |  |

 

2

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**PART I. FINANCIAL INFORMATION**

 

**Item 1. FinancialStatements**

 

**KKR Financial Holdings LLC and Subsidiaries Condensed Consolidated Balance Sheets(Unaudited)(Amounts in thousands, except share information)**

** **
| ** **                                                                                                                                                                                  | ** ** | **As of  March 31, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| **Assets**                                                                                                                                                                                  |       |                                     |       |                                        |       |
| Cash and cash equivalents                                                                                                                                                                   |       | $                                        | 210,689    |                                        | $          | 524,080 |   |
| Restricted cash and cash equivalents                                                                                                                                                        |       | 1,063,336                                |       | 1,063,528                                   |       |
| Securities available-for-sale, $1,066,033  and $1,346,247 pledged as collateral as of March 31, 2008 and  December 31, 2007, respectively                                         |       | 1,107,558                                |       | 1,359,541                                   |       |
| Loans, net of allowance for loan losses of  $25,000 as of March 31, 2008 and December 31, 2007                                                                                    |       | 8,919,293                                |       | 8,634,208                                   |       |
| Loans held for sale                                                                                                                                                                         |       | 67,880                                   |       | —                                      |       |
| Derivative assets                                                                                                                                                                           |       | 32,577                                   |       | 18,737                                      |       |
| Interest and principal receivable                                                                                                                                                           |       | 120,542                                  |       | 147,597                                     |       |
| Non-marketable equity securities                                                                                                                                                            |       | 20,084                                   |       | 20,084                                      |       |
| Reverse repurchase agreements                                                                                                                                                               |       | 14,911                                   |       | 69,840                                      |       |
| Other assets                                                                                                                                                                                |       | 109,081                                  |       | 79,304                                      |       |
| Assets of discontinued operations                                                                                                                                                           |       | 3,770,536                                |       | 7,129,106                                   |       |
| **Total assets**                                                                                                                                                                            |       | $                                        | 15,436,487 |                                        | $          | 19,046,025 |   |
| **Liabilities**                                                                                                                                                                             |       |                                     |       |                                        |       |
| Repurchase agreements                                                                                                                                                                       |       | $                                        | 2,397,771  |                                        | $          | 2,639,960 |   |
| Collateralized loan obligation senior  secured notes                                                                                                                                        |       | 6,148,964                                |       | 5,948,610                                   |       |
| Collateralized loan obligation junior  secured notes to affiliates                                                                                                                          |       | 525,420                                  |       | 525,420                                     |       |
| Secured revolving credit facility                                                                                                                                                           |       | 129,319                                  |       | 156,669                                     |       |
| Secured demand loan                                                                                                                                                                         |       | 16,176                                   |       | 24,151                                      |       |
| Convertible senior notes                                                                                                                                                                    |       | 300,000                                  |       | 300,000                                     |       |
| Junior subordinated notes                                                                                                                                                                   |       | 329,908                                  |       | 329,908                                     |       |
| Subordinated notes to affiliates                                                                                                                                                            |       | 167,752                                  |       | 152,574                                     |       |
| Accounts payable, accrued expenses and  other liabilities                                                                                                                                   |       | 32,420                                   |       | 7,390                                       |       |
| Accrued interest payable                                                                                                                                                                    |       | 122,303                                  |       | 103,557                                     |       |
| Accrued interest payable to affiliates                                                                                                                                                      |       | 65,859                                   |       | 44,121                                      |       |
| Related party payable                                                                                                                                                                       |       | 4,881                                    |       | 9,694                                       |       |
| Securities sold, not yet purchased                                                                                                                                                          |       | 30,727                                   |       | 100,394                                     |       |
| Derivative liabilities                                                                                                                                                                      |       | 137,287                                  |       | 46,754                                      |       |
| Liabilities of discontinued operations                                                                                                                                                      |       | 3,519,354                                |       | 7,012,284                                   |       |
| **Total liabilities**                                                                                                                                                                       |       | 13,928,141                               |       | 17,401,486                                  |       |
| **Shareholders’ Equity**                                                                                                                                                               |       |                                     |       |                                        |       |
| Preferred shares, no par value, 50,000,000  shares authorized and none issued and outstanding at March 31, 2008 and  December 31, 2007                                            |       | —                                   |       | —                                      |       |
| Common shares, no par value, 250,000,000  shares authorized, and 116,343,151 and 115,248,990 shares issued and outstanding at  March 31, 2008 and December 31, 2007, respectively |       | —                                   |       | —                                      |       |
| Paid-in-capital                                                                                                                                                                             |       | 2,167,796                                |       | 2,167,156                                   |       |
| Accumulated other comprehensive loss                                                                                                                                                        |       | (250,441                                 | )          | (157,245                                    | )          |
| Accumulated deficit                                                                                                                                                                         |       | (409,009                                 | )          | (365,372                                    | )          |
| **Total shareholders’ equity**                                                                                                                                                         |       | 1,508,346                                |       | 1,644,539                                   |       |
| **Total liabilities and shareholders’ equity**                                                                                                                                         |       | $                                        | 15,436,487 |                                        | $          | 19,046,025 |   |

 

See notes to condensedconsolidated financial statements.

 

3

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**KKR Financial Holdings LLC andSubsidiaries Condensed Consolidated Statements of Operations(Unaudited)(Amounts in thousands, except per share information)**

** **
| ** **                                                                                                    | ** ** | **For the three  months ended  March 31, 2008** | ** ** | **For the three  months ended  March 31, 2007** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| **Net investment income:**                                                                                    |       |                                                                     |       |                                                                     |       |
| Loan interest income                                                                                          |       | $                                                                        | 169,509    |                                                                     | $          | 66,635 |   |
| Securities interest income                                                                                    |       | 37,260                                                                   |       | 20,011                                                                   |       |
| Dividend income                                                                                               |       | 816                                                                      |       | 974                                                                      |       |
| Other interest income                                                                                         |       | 11,044                                                                   |       | 2,577                                                                    |       |
| Total investment income                                                                                       |       | 218,629                                                                  |       | 90,197                                                                   |       |
| Interest expense                                                                                              |       | (117,709                                                                 | )          | (54,282                                                                  | )          |
| Interest expense to affiliates                                                                                |       | (27,817                                                                  | )          | —                                                                   |       |
| Net investment income                                                                                         |       | 73,103                                                                   |       | 35,915                                                                   |       |
| **Other (loss) income:**                                                                                      |       |                                                                     |       |                                                                     |       |
| Net realized and unrealized (loss) gain on  investments                                                       |       | (6,773                                                                   | )          | 7,024                                                                    |       |
| Net realized and unrealized (loss) gain on  derivatives and foreign exchange                                  |       | (47,016                                                                  | )          | 7,138                                                                    |       |
| Other income                                                                                                  |       | 4,955                                                                    |       | 2,049                                                                    |       |
| Total other (loss) income                                                                                     |       | (48,834                                                                  | )          | 16,211                                                                   |       |
| **Non-investment expenses:**                                                                                  |       |                                                                     |       |                                                                     |       |
| Related party management compensation                                                                         |       | 9,159                                                                    |       | 19,298                                                                   |       |
| General, administrative and directors  expenses                                                               |       | 4,473                                                                    |       | 6,263                                                                    |       |
| Professional services                                                                                         |       | 1,857                                                                    |       | 541                                                                      |       |
| Total non-investment expenses                                                                                 |       | 15,489                                                                   |       | 26,102                                                                   |       |
| Income from continuing operations before  equity in income of unconsolidated affiliate and income tax expense |       | 8,780                                                                    |       | 26,024                                                                   |       |
| Equity in income of unconsolidated  affiliate                                                                 |       | —                                                                   |       | 6,981                                                                    |       |
| Income from continuing operations before  income tax expense                                                  |       | 8,780                                                                    |       | 33,005                                                                   |       |
| Income tax expense                                                                                            |       | —                                                                   |       | 776                                                                      |       |
| Income from continuing operations                                                                             |       | 8,780                                                                    |       | 32,229                                                                   |       |
| Income from discontinued operations                                                                           |       | 5,203                                                                    |       | 16,195                                                                   |       |
| Net income                                                                                                    |       | $                                                                        | 13,983     |                                                                     | $          | 48,424 |   |
| Net income per common share:                                                                                  |       |                                                                     |       |                                                                     |       |
| Basic                                                                                                         |       |                                                                     |       |                                                                     |       |
| Income per share from continuing operations                                                                   |       | $                                                                        | 0.08       |                                                                     | $          | 0.40 |   |
| Income per share from discontinued  operations                                                                |       | $                                                                        | 0.04       |                                                                     | $          | 0.20 |   |
| Net income per share                                                                                          |       | $                                                                        | 0.12       |                                                                     | $          | 0.60 |   |
| Diluted                                                                                                       |       |                                                                     |       |                                                                     |       |
| Income per share from continuing operations                                                                   |       | $                                                                        | 0.08       |                                                                     | $          | 0.39 |   |
| Income per share from discontinued  operations                                                                |       | $                                                                        | 0.04       |                                                                     | $          | 0.20 |   |
| Net income per share                                                                                          |       | $                                                                        | 0.12       |                                                                     | $          | 0.59 |   |
| Weighted-average number of common shares  outstanding:                                                        |       |                                                                     |       |                                                                     |       |
| Basic                                                                                                         |       | 115,048                                                                  |       | 80,239                                                                   |       |
| Diluted                                                                                                       |       | 115,599                                                                  |       | 81,728                                                                   |       |
| Distributions declared per common share                                                                       |       | $                                                                        | 0.50       |                                                                     | $          | 0.54 |   |

 

See notes to condensedconsolidated financial statements.

 

4

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**KKR Financial Holdings LLC andSubsidiariesCondensed Consolidated Statement of Changes in Shareholders’ Equity(Unaudited)(Amounts in thousands)**

** **
| ** **                                                      | ** ** | **Common  Shares** | ** ** | **Paid-In  Capital** | ** ** | **Accumulated Other  Comprehensive  Loss** | ** ** | **Accumulated  Deficit** | ** ** | **Comprehensive  Loss** | ** ** | **Total  Shareholders’  Equity** | ** ** |
|-----------------------------------------------------------------|------------|--------------------|------------|----------------------|------------|-------------------------------------------------|------------|--------------------------|------------|-------------------------|------------|---------------------------------------|------------|
| **Balance at  January 1, 2008**                                 |       | 115,249            |       | $                    | 2,167,156  |                                            | $          | (157,245                 | )          | $                       | (365,372   | )                                     |       |   | $ | 1,644,539 |   |
| Net income                                                      |       | —             |       | —               |       | —                                          |       | 13,983                   |       | $                       | 13,983     |                                  | 13,983     |   |
| Net change in unrealized loss on cash flow  hedges              |       | —             |       | —               |       | (18,237                                         | )          | —                   |       | (18,237                 | )          | (18,237                               | )          |
| Net change in unrealized loss on securities  available-for-sale |       | —             |       | —               |       | (74,959                                         | )          |                     |       | (74,959                 | )          | (74,959                               | )          |
| Comprehensive loss                                              |       |               |       |                 |       |                                            |       |                     |       | $                       | (79,213    | )                                     |       |   |
| Cash distributions on common shares                             |       | —             |       | —               |       | —                                          |       | (57,620                  | )          |                    |       | (57,620                               | )          |
| Cancellation of restricted common shares                        |       | (3                 | )          | —               |       | —                                          |       | —                   |       |                    |       | —                                |       |
| Grant of restricted common shares to the  Manager               |       | 1,097              |       | —               |       | —                                          |       | —                   |       |                    |       | —                                |       |
| Amortization of restricted common shares                        |       | —             |       | 640                  |       | —                                          |       | —                   |       |                    |       | 640                                   |       |
| **Balance at March 31, 2008**                              |       | 116,343            |       | $                    | 2,167,796  |                                            | $          | (250,441                 | )          | $                       | (409,009   | )                                     |       |   | $ | 1,508,346 |   |

 

See notes to condensedconsolidated financial statements.

 

5

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**KKR Financial Holdings LLC and SubsidiariesCondensed****Consolidated Statements of Cash Flows(Unaudited)(Amounts in thousands)**

** **
| ** **                                                                                                        | ** ** | **For the three  months ended  March 31, 2008** | ** ** | **For the three  months ended  March 31, 2007** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| **Cash flows from operating activities:**                                                                         |       |                                                                     |       |                                                                     |       |
| Net income                                                                                                        |       | $                                                                        | 13,983     |                                                                     | $          | 48,424 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities:                                |       |                                                                     |       |                                                                     |       |
| Net realized and unrealized loss (gain) on  derivatives, foreign exchange, and securities sold, not yet purchased |       | 50,710                                                                   |       | (7,138                                                                   | )          |
| Write-off of debt issuance costs                                                                                  |       | —                                                                   |       | 2,247                                                                    |       |
| Lower of cost or estimated fair value  adjustment on loans held for sale                                          |       | 4,002                                                                    |       | —                                                                   |       |
| Share-based compensation                                                                                          |       | 640                                                                      |       | 5,838                                                                    |       |
| Net unrealized loss (gain) on trading  securities, whole loans, and liabilities at fair value                     |       | (9,014                                                                   | )          | (2,769                                                                   | )          |
| Net realized loss (gain) on sales of  investments                                                                 |       | 10,512                                                                   |       | (6,944                                                                   | )          |
| Depreciation and net amortization                                                                                 |       | (6,080                                                                   | )          | 2,136                                                                    |       |
| Deferred income tax expense                                                                                       |       | —                                                                   |       | 276                                                                      |       |
| Equity in income of unconsolidated  affiliate                                                                     |       | —                                                                   |       | (6,981                                                                   | )          |
| Changes in assets and liabilities:                                                                                |       |                                                                     |       |                                                                     |       |
| Interest receivable                                                                                               |       | 27,763                                                                   |       | 6,445                                                                    |       |
| Other assets                                                                                                      |       | (8,756                                                                   | )          | 597                                                                      |       |
| Related party payable                                                                                             |       | (4,813                                                                   | )          | 3,321                                                                    |       |
| Accounts payable, accrued expenses and  other liabilities                                                         |       | (31,035                                                                  | )          | 794                                                                      |       |
| Accrued interest payable                                                                                          |       | 17,688                                                                   |       | 5,172                                                                    |       |
| Accrued interest payable to affiliates                                                                            |       | 21,738                                                                   |       | —                                                                   |       |
| Net cash provided by operating activities                                                                         |       | 87,338                                                                   |       | 51,418                                                                   |       |
| **Cash flows from investing activities:**                                                                         |       |                                                                     |       |                                                                     |       |
| Principal payments from investments                                                                               |       | 544,309                                                                  |       | 1,013,982                                                                |       |
| Proceeds from sale of investments                                                                                 |       | 280,658                                                                  |       | 308,964                                                                  |       |
| Purchases of investments                                                                                          |       | (786,223                                                                 | )          | (367,907                                                                 | )          |
| Net proceeds, purchases, and settlements of  derivatives                                                          |       | 10,769                                                                   |       | 2,687                                                                    |       |
| Net change in reverse repurchase agreements                                                                       |       | 54,929                                                                   |       | —                                                                   |       |
| Net additions to restricted cash and cash  equivalents                                                            |       | (15,494                                                                  | )          | (153,052                                                                 | )          |
| Additions of leasehold improvements and  equipment                                                                |       | —                                                                   |       | (62                                                                      | )          |
| Investment in unconsolidated affiliate                                                                            |       | —                                                                   |       | (16,885                                                                  | )          |
| Net cash provided by investing activities                                                                         |       | 88,948                                                                   |       | 787,727                                                                  |       |
| **Cash flows from financing activities:**                                                                         |       |                                                                     |       |                                                                     |       |
| Net change in repurchase agreements,  secured revolving credit facility, and secured demand loan                  |       | (359,522                                                                 | )          | (914,759                                                                 | )          |
| Net change in asset-backed secured  liquidity notes                                                               |       | (136,596                                                                 | )          | 117,184                                                                  |       |
| Repayment of mortgage-backed securities                                                                           |       | (150,954                                                                 | )          | —                                                                   |       |
| Issuance of collateralized loan obligation  senior secured notes                                                  |       | 200,000                                                                  |       | —                                                                   |       |
| Issuance of subordinated notes to  affiliates                                                                     |       | 15,177                                                                   |       | —                                                                   |       |
| Distributions on common shares                                                                                    |       | (57,620                                                                  | )          | (43,451                                                                  | )          |
| Other capitalized costs                                                                                           |       | (162                                                                     | )          | 52                                                                       |       |
| Net cash used in financing activities                                                                             |       | (489,677                                                                 | )          | (840,974                                                                 | )          |
| **Net decrease in cash and cash equivalents**                                                                     |       | (313,391                                                                 | )          | (1,829                                                                   | )          |
| **Cash and cash equivalents at beginning of period**                                                              |       | 524,080                                                                  |       | 5,125                                                                    |       |
| **Cash and cash equivalents at end of period**                                                                    |       | $                                                                        | 210,689    |                                                                     | $          | 3,296 |   |
| **Supplemental cash flow information:**                                                                           |       |                                                                     |       |                                                                     |       |
| Cash paid for interest                                                                                            |       | $                                                                        | 172,505    |                                                                     | $          | 205,076 |   |
| Cash paid for income taxes                                                                                        |       | $                                                                        | —     |                                                                     | $          | 500 |   |
| **Non-cash investing and financing  activities:**                                                                 |       |                                                                     |       |                                                                     |       |
| Net payable (receivable) for securities  purchased (sold)                                                         |       | $                                                                        | 22,596     |                                                                     | $          | (1,494 | ) |
| Issuance of restricted common shares                                                                              |       | $                                                                        | 15,939     |                                                                     | $          | — |   |
| Distributions of securities to the asset-backed  secured liquidity noteholders                                    |       | $                                                                        | 3,623,049  |                                                                     | $          | — |   |

 

See notes to condensedconsolidated financial statements.

 

6

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**KKR Financial Holdings LLC and Subsidiaries**

 

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

 

**Note 1. Organization**

 

KKR Financial Holdings LLC together with its subsidiaries (the “Company”or “KKR Financial”) is a specialty finance company that uses leverage with theobjective of generating competitive risk-adjusted returns. The Company investsin financial assets primarily consisting of corporate loans and securities,including senior secured and unsecured loans, mezzanine loans, high yieldcorporate bonds, distressed and stressed debt securities, marketable andnon-marketable equity securities, and credit default and total rate of returnswaps. The Company also makes opportunistic investments in other asset classesfrom time to time.

 

KKR Financial Holdings LLC is a Delaware limited liability companyand was organized on January 17, 2007. KKR Financial Holdings LLC isthe successor to KKR Financial Corp. (the “REIT Subsidiary”), a Marylandcorporation. KKR Financial Corp. was originally incorporated in the State ofMaryland in July 2004 and elected to be treated as a real estateinvestment trust (“REIT”) for U.S. federal income tax purposes. On May 4,2007, KKR Financial completed a restructuring transaction (the “RestructuringTransaction”), pursuant to which the REIT Subsidiary became a subsidiary of KKRFinancial and each outstanding share of the REIT Subsidiary’s common stock wasconverted into one of KKR Financial’s common shares, which are publicly tradedon the New York Stock Exchange (“NYSE”) under the symbol “KFN”. KKR Financialintends to continue to operate so as to qualify as a partnership, and not as anassociation or publicly traded partnership that is taxable as a corporation,for U.S. federal income tax purposes. The Restructuring Transaction has beenaccounted for as a reorganization of entities under common control whereby theconsolidated assets and liabilities of the Company were recorded at thehistorical cost of the REIT Subsidiary, as reflected on its condensedconsolidated financial statements. The Company is considered the REITSubsidiary’s successor for accounting purposes, and the REIT Subsidiary’scondensed consolidated financial statements for prior periods are the Company’shistorical condensed consolidated financial statements presented herein.

 

KKR Financial Advisors LLC (the “Manager”), a wholly ownedsubsidiary of KKR Financial LLC, manages the Company pursuant to amanagement agreement (the “Management Agreement”). The Company, KKRFinancial LLC, and the Manager are affiliates of Kohlberg Kravis Roberts & Co. L.P.(“KKR”).

 

**Note 2. Summary of SignificantAccounting Policies**

 

**Basis of Presentation**

 

The accompanying condensed consolidated financial statements have beenprepared in conformity with accounting principles generally accepted in theUnited States of America (“GAAP”). The condensed consolidated financialstatements include the accounts of the Company, consolidated residentialmortgage loan securitization trusts where the Company is the primarybeneficiary, 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’s residential mortgageinvestment operations, the REIT Subsidiary and KKR Financial Holdings II, LLC (“KFHII”) are presented as discontinued operations for financial statement purposes.See Note 3 for further discussion on discontinued operations.

 

These financial statements should be read in conjunction with theconsolidated financial statements and notes thereto for the year ended December31, 2007 included in the Company’s Form 10-K. The Company’s results for anyinterim period are not necessarily indicative of results for a full year or anyother interim period. In the opinion of management, all normal recurringadjustments have been included for a fair statement of this interim financialinformation.

** **

**Use of Estimates**

 

The preparation of financial statements in conformity with GAAPrequires management to make estimates and assumptions that affect the amountsreported in the Company’s condensed consolidated financial statements andaccompanying notes. Actual results could differ from management’s estimates.

 

**Consolidation**

 

The Company consolidates all non-variable interest entities in which itholds a greater than 50 percent voting interest. The Company alsoconsolidates all variable interest entities (“VIEs”) for which it is consideredto be the primary beneficiary pursuant to Financial Accounting Standards 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 

 

7

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VIE. Anenterprise is the primary beneficiary if it absorbs a majority of the VIE’sexpected losses, receives a majority of the VIE’s expected residual returns, orboth.

 

KKR Financial CLO 2005-1, Ltd. (“CLO 2005-1”), KKR Financial CLO2005-2, Ltd. (“CLO 2005-2”), KKR Financial CLO 2006-1, Ltd. (“CLO2006-1”), KKR Financial CLO 2007-1, Ltd. (“CLO 2007-1”), KKR Financial CLO2007-A, Ltd. (“CLO 2007-A”), KKR Financial CLO 2007-4, Ltd. (“CLO 2007-4”), KKRFinancial CLO 2008-1, Ltd. (“CLO 2008-1”), and Wayzata Funding LLC (“Wayzata”),are entities established to complete secured financing transactions. Theseentities are VIEs and are not considered to be qualifying special-purposeentities (“QSPE”) as defined by Statement of Financial Accounting Standards  (“SFAS”) No. 140, *Accounting for Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities* (“SFAS No. 140”). TheCompany has determined it is the primary beneficiary of these entities and hasincluded the accounts of these entities in these condensed consolidatedfinancial statements. Additionally, the Company is the primary beneficiary ofsix residential mortgage loan securitization trusts that are not considered tobe QSPEs under SFAS No. 140 and the Company has therefore included theaccounts of these entities in these condensed consolidated financialstatements.

 

All inter-company balances and transactions have been eliminated inconsolidation.

 

**Fair Value of Financial Instruments**

 

Effective January 1, 2007, the Company adopted SFAS No. 157, *Fair Value Measurements* (“SFAS No. 157”),which requires additional disclosures about the Company’s assets andliabilities that are measured at fair value.

 

As defined in SFAS No. 157, fair value is the price that would bereceived to sell an asset or paid to transfer a liability in an orderlytransaction between market participants at the measurement date. Whereavailable, fair value is based on observable market prices or parameters, orderived from such prices or parameters. Where observable prices or inputs arenot available, valuation models are applied. These valuation techniques involvesome level of management estimation and judgment, the degree of which isdependent on the price transparency for the instruments or market and theinstruments’ complexity for disclosure purposes. Beginning in January 2007,assets and liabilities recorded at fair value in the consolidated balancesheets are categorized based upon the level of judgment associated with theinputs used to measure their value. Hierarchical levels, as defined in SFAS No. 157and directly related to the amount of subjectivity associated with the inputsto fair valuations of these assets and liabilities, are as follows:

 

Level 1: Inputs are unadjusted, quoted prices in active marketsfor identical assets or liabilities at the measurement date.

 

The types of assets carried at level 1 fair value generally areequity securities listed in active markets.

 

Level 2: Inputs other than quoted prices included in level 1that are observable for the asset or liability, either directly or indirectly.Level 2 inputs include quoted prices for similar instruments in activemarkets, and inputs other than quoted prices that are observable for the assetor liability.

 

Fair value assets and liabilities that are generally included in thiscategory are certain corporate debt securities, and certain financial instrumentsclassified as derivatives where the fair value is based on observable marketinputs.

 

Level 3: Inputs are unobservable inputs for the asset orliability, and include situations where there is little, if any, marketactivity for the asset or liability. In certain cases, the inputs used tomeasure fair value may fall into different levels of the fair value hierarchy.In such cases, the level in the fair value hierarchy within which the fairvalue measurement in its entirety falls has been determined based on the lowestlevel input that is significant to the fair value measurement in its entirety.The Company’s assessment of the significance of a particular input to the fairvalue measurement in its entirety requires judgment, and considers factors specificto the asset.

 

Generally, assets and liabilities carried at fair value and included inthis category are certain corporate debt securities and certain derivatives.

 

The availability of observable inputs can vary depending on thefinancial asset or liability and is affected by a wide variety of factors,including, for example, the type of product, whether the product is new,whether the product is traded on an active exchange or in the secondary market,and the current market condition. To the extent that valuation is based on 

 

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models orinputs that are less observable or unobservable in the market, thedetermination of fair value requires more judgment. Accordingly, the degree ofjudgment exercised by the Company in determining fair value is greatest forinstruments categorized in level 3. In certain cases, the inputs used tomeasure fair value may fall into different levels of the fair value hierarchy.In such cases, for disclosure purposes, the level in the fair value hierarchywithin which the fair value measurement in its entirety falls is determinedbased on the lowest level input that is significant to the fair valuemeasurement in its entirety.

 

Fair value is a market-based measure considered from the perspective ofa market participant who holds the asset or owes the liability rather than anentity-specific measure. Therefore, even when market assumptions are notreadily available, the Company’s own assumptions are set to reflect those thatmanagement believes market participants would use in pricing the asset orliability at the measurement date.

 

Many financial assets and liabilities have bid and ask prices that canbe observed in the marketplace. Bid prices reflect the highest price that theCompany and others are wiling to pay for an asset. Ask prices represent thelowest price that the Company and others are willing to accept for an asset.For financial assets and liabilities whose inputs are based on bid-ask prices,the Company does not require that fair value always be a predetermined point inthe bid-ask range. The Company’s policy is to allow for mid-market pricing andadjusting to the point within the bid-ask range that meets the Company’s bestestimate of fair value.

 

Assets that are valued using level 3 of the fair value hierarchyprimarily consist of certain corporate debt securities and certainover-the-counter (“OTC”) derivative contracts. The valuation techniques usedfor these are described below.

 

*Corporate Debt Securities:*Corporate debt securities are initially valued at transaction price and aresubsequently valued using market data for similar instruments (e.g., recenttransactions or broker quotes), comparisons to benchmark derivative indices ormovements in underlying credit spreads.

 

*OTC Derivative Contracts:*OTC derivative contracts include forward, swap and option contracts related tointerest rates, foreign currencies, credit standing of reference entities, andequity prices. The fair value of OTC derivative contracts can be modeled usinga series of techniques, including closed-form analytic formulae, such as theBlack-Scholes option-pricing model, and simulation models or a combinationthereof. Many pricing models do not entail material subjectivity because themethodologies employed do not necessitate significant judgment, and the pricinginputs are observed from actively quoted markets, as is the case for genericinterest rate swap and option contracts.

 

**Cash and Cash Equivalents**

 

Cash and cash equivalents include cash on hand, cash held in banks andhighly liquid investments with original maturities of three months or less.Interest income earned on cash and cash equivalents is recorded in otherinterest income.

 

**Restricted Cash and Cash Equivalents**

 

Restricted cash and cash equivalents represent amounts that are held bythird parties under certain of the Company’s financing and derivativetransactions. Interest income earned on restricted cash and cash equivalents isrecorded in other interest income.

 

**Securities Available-for-Sale**

 

The Company classifies its investments in securities asavailable-for-sale as the Company may sell them prior to maturity and does nothold them principally for the purpose of selling them in the near term. Theseinvestments are carried at estimated fair value, with unrealized gains andlosses reported in accumulated other comprehensive income (loss). Estimatedfair values are based on quoted market prices, when available, or on estimatesprovided by independent pricing sources or dealers who make markets in suchsecurities. Upon the sale of a security, the realized net gain or loss iscomputed on a weighted-average cost basis.

 

The Company monitors its available-for-sale securities portfolio forimpairments. A loss is recognized when it is determined that a decline in theestimated fair value of a security below its amortized cost isother-than-temporary. The Company considers many factors in determining whetherthe impairment of a security is deemed to be other-than-temporary, including,but not limited to, the length of time the security has had a decline inestimated fair value below its amortized cost, 

 

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the amount ofthe unrealized loss, the intent and ability of the Company to hold the securityfor a period of time sufficient for a recovery in value, recent events specificto the issuer or industry, external credit ratings and recent changes in suchratings.

 

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

 

**Non-marketable Equity Securities**

 

Non-marketable equity securities consist primarily of private equityinvestments. These investments are accounted for under the cost method. TheCompany reviews these investments quarterly for possible other-than-temporaryimpairment. The Company reduces the carrying value of the investment andrecognizes a loss when the Company considers a decline in estimated fair valuebelow the cost basis of the security to be other-than-temporary.

 

**Securities Sold, Not Yet Purchased**

 

Securities sold, not yet purchased consist of equity and debtsecurities that the Company has sold, but did not own prior to the sale. Inorder to facilitate a short sale, the Company borrows the securities fromanother party and delivers the securities to the buyer. The Company will berequired to “cover” its short sale in the future through the purchase of the securityin the market at the prevailing market price and deliver it to the counterpartyfrom which it borrowed. The Company is exposed to a loss to the extent that thesecurity price increases during the time from when the Company borrowed thesecurity to when the Company purchases it in the market to cover the shortsale. Changes in the value of these securities are reflected in net realizedand unrealized gain on investments on the Company’s condensed consolidatedstatements of operations.

 

**Loans**

 

The Company purchases participations and assignments in corporateleveraged loans in the primary and secondary market. Loans are held forinvestment and the Company initially records loans at their purchase prices.The Company subsequently accounts for loans based on their outstandingprincipal plus or minus unaccreted purchase discounts and unamortized purchasepremiums. In certain instances, where the credit fundamentals underlying aparticular loan have materially changed in such a manner that the Company’s expectedreturn may decrease, the Company may elect to sell a loan held for investment.Interest income on loans includes interest at stated coupon rates adjusted foraccretion of purchase discounts and the amortization of purchase premiums. Forcorporate loans, unamortized premiums and unaccreted discounts are recognizedin interest income over the contractual life, adjusted for actual prepayments,of the loans using the effective interest method.

 

**Loans Held for Sale**

 

Loans held forsale consist of corporate leveraged loans that the Company has determined to nolonger hold for investment. Loans held for sale are stated at lower of cost or estimatedfair value.  Estimated fair value isestimated using dealer quotes and/or nationally recognized pricing services.

 

**Allowance for Loan Losses**

 

The Company’s allowance for estimated loan losses represents itsestimate of probable credit losses inherent in the loan portfolio as of thebalance sheet date. When determining the adequacy of the allowance for loanlosses, the Company considers historical and industry loss experience, economicconditions and trends, the estimated fair values of its loans, credit qualitytrends and other factors that it determines are relevant. Additions to theallowance for loan losses are charged to current period earnings through theprovision for loan losses. The Company’s allowance for loan losses consists oftwo components, an allocated component and an unallocated component. Amountsdetermined to be uncollectible are charged directly to the allowance for loanlosses.

 

The allocated component of the Company’s allowance for loan lossesconsists of individual loans that are impaired and for which the estimatedallowance for loan losses is determined in accordance with SFAS No. 114, *Accounting by Creditors for Impairment of a Loan.*The Company considers a loan to be impaired when, based on current informationand events, it believes it is probable that it will be unable to collect allamounts due to it based on the contractual terms of the loan. An impaired loanmay be left on accrual status during the period the Company is pursuingrepayment of the loan; however, the loan is placed on non-accrual status atsuch time as: (i) management believes that scheduled debt service paymentsmay not be paid when contractually due; (ii) the loan becomes 90 daysdelinquent; (iii) management determines the

 

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borrower is incapable of, orhas ceased efforts toward, curing the cause of the impairment; or (iv) thenet realizable value of the underlying collateral securing the loan decreasesbelow the Company’s carrying value of such loan. While on non-accrual status,previously recognized accrued interest is reversed and interest income isrecognized only upon actual receipt.

 

The unallocated component of the Company’s allowance for loan losses isdetermined in accordance with SFAS No. 5, *Accountingfor Contingencies*. This component of the allowance for loan lossesrepresents the Company’s estimate of losses inherent, but unidentified, in itsportfolio as of the balance sheet date. The unallocated component of theallowance for loan losses is estimated based upon a review of the Company’sloan portfolio’s risk characteristics, risk grouping of loans in the portfoliobased upon estimated probability of default and severity of loss based on loantype, and consideration of general economic conditions and trends.

 

**Leasehold Improvements and Equipment**

 

Leasehold improvements and equipment are carried at cost lessdepreciation and amortization and reviewed for impairment whenever events orchanges in circumstances indicate that the carrying amount of the assets mightnot be recoverable. Equipment is depreciated using the straight-line methodover the estimated useful lives of the respective assets of three years.Leasehold improvements are amortized on a straight-line basis over the shorterof their estimated useful lives or lease terms. Leasehold improvements andequipment, net of accumulated depreciation and amortization, are included inother assets.

 

**Borrowings**

 

The Company finances the acquisition of its investments, includingloans and securities available-for-sale, primarily through the use of securedborrowings in the form of securitization transactions structured as securedfinancings, repurchase agreements, warehouse facilities, demand loans, andother secured and unsecured borrowings. The Company recognizes interest expenseon all borrowings on an accrual basis.

 

**Trust Preferred Securities**

 

Trusts formed by the Company for the sole purpose of issuing trustpreferred securities are not consolidated by the Company in accordance withFIN 46R as the Company has determined that it is not the primarybeneficiary of such trusts. The Company’s investment in the common securitiesof such trusts is included in other assets on the Company’s condensedconsolidated financial statements.

 

**Derivative Financial Instruments**

 

The Company recognizes all derivatives at estimated fair value. On thedate the Company enters into a derivative contract, the Company designates anddocuments each derivative contract as one of the following at the time thecontract is executed: (i) a hedge of a recognized asset or liability (“fairvalue” hedge); (ii) a hedge of a forecasted transaction or of thevariability of cash flows to be received or paid related to a recognized assetor liability (“cash flow” hedge); (iii) a hedge of a net investment in a foreignoperation; or (iv) a derivative instrument not designated as a hedginginstrument (“free-standing derivative”). For a fair value hedge, the Companyrecords changes in the estimated fair value of the derivative and, to theextent that it is effective, changes in the fair value of the hedged asset orliability attributable to the hedged risk, in the current period earnings inthe same financial statement category as the hedged item. For a cash flowhedge, the Company records changes in the estimated fair value of thederivative to the extent that it is effective in other comprehensive (loss)income. The Company subsequently reclassifies these changes in estimated fairvalue to net income in the same period(s) that the hedged transactionaffects earnings in the same financial statement category as the hedged item.For free-standing derivatives, the Company reports changes in the fair valuesin current period other income.

 

The Company formally documents at inception its hedge relationships,including identification of the hedging instruments and the hedged items, itsrisk management objectives, strategy for undertaking the hedge transaction andthe Company’s evaluation of effectiveness of its hedged transactions.Periodically, as required by SFAS No. 133, *Accounting for Derivative Instruments and Hedging Activities*,as amended and interpreted (“SFAS No. 133”), the Company also formallyassesses whether the derivative it designated in each hedging relationship isexpected to be and has been highly effective in offsetting changes in estimatedfair values or cash flows of the hedged item using either the dollar offset orthe regression analysis method. If the Company determines that a derivative isnot highly effective as a hedge, it discontinues hedge accounting.

 

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**Foreign Currency**

 

The Company makes investments in non-U.S. dollar denominated securitiesand loans. As a result, the Company is subject to the risk of fluctuation inthe exchange rate between the U.S. dollar and the foreign currency in which itmakes an investment. In order to reduce the currency risk, the Company mayhedge the applicable foreign currency. All investments denominated in a foreigncurrency are converted to the U.S. dollar using prevailing exchange rates onthe balance sheet date. Income, expenses, gains and losses on investmentsdenominated in a foreign currency are converted to the U.S. dollar using theprevailing exchange rates on the dates when they are recorded. Foreign exchangegains and losses are recorded in the condensed consolidated statements ofoperations.

 

**Manager Compensation**

 

The Management Agreement provides for the payment of a base managementfee to the Manager, as well as an incentive fee if the Company’s financialperformance exceeds certain benchmarks. Additionally, the Management Agreementprovides for the Manager to be reimbursed for certain expenses incurred on theCompany’s behalf. See Note 12 for the specific terms of the computationand payment of the incentive fee. The base management fee and the incentive feeare accrued and expensed during the period for which they are earned by theManager.

 

**Share-Based Compensation**

 

The Company accounts for share-based compensation issued to itsdirectors and to its Manager using the fair value based methodology prescribedby SFAS No. 123(R), *Share-Based Payment*(“SFAS No. 123(R)”). Compensation cost related to restricted common sharesissued to the Company’s directors is measured at its estimated fair value atthe grant date, and is amortized and expensed over the vesting period on astraight-line basis. Compensation cost related to restricted common shares andcommon share options issued to the Manager is initially measured at estimatedfair value at the grant date, and is remeasured on subsequent dates to theextent the awards are unvested. The Company has elected to use the gradedvesting attribution and straight-line method pursuant to SFAS No. 123(R) toamortize compensation expense for the restricted common shares and common shareoptions granted to the Manager.

 

**Income Taxes**

 

The Company is no longer treated as a REIT for U.S. federal income taxpurposes; however, the Company intends to continue to operate so as to qualifyas a partnership, and not as an association or publicly traded partnership thatis taxable as a corporation, for U.S. federal income tax purposes. Therefore,the Company is not subject to U.S. federal income tax at the entity level, butis subject to limited state income taxes. Holders of the Company’s shares willbe required to take into account their allocable share of each item of theCompany’s income, gain, loss, deduction, and credit for the taxable year of theCompany ending within or with their taxable year.

 

The REIT Subsidiary elected, and KFH II will elect, to be taxed as aREIT and both are required to comply with the provisions of the InternalRevenue Code of 1986, as amended, (the “Code”), with respect thereto. The REITSubsidiary and KFH II are not subject to federal income tax to the extent that theycurrently distribute their income and satisfy certain asset, income andownership tests, and recordkeeping requirements. Even though the REITSubsidiary and KFH II qualified for federal taxation as REITs, they may besubject to some amount of federal, state, local and foreign taxes based on theirtaxable income.

 

KKR TRS Holdings, Ltd. (“TRS Ltd.”), CLO 2005-1, CLO 2005-2,CLO 2006-1, CLO 2007-1, CLO 2007-A, CLO 2007-4, CLO 2008-1 and Wayzata are notconsolidated for federal income tax return purposes. For financial reportingpurposes, current and deferred taxes are provided for on the portion ofearnings recognized by the Company with respect to its interest in KFN PEIVII, LLC (“PEI VII”), a domestic taxable corporate subsidiary, because it istaxed as a regular subchapter C corporation under the provisions of theCode.

 

Deferred income tax assets and liabilities are computed based ontemporary differences between the GAAP consolidated financial statements andthe federal income tax basis of assets and liabilities as of each consolidatedbalance sheet date. CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A,CLO 2007-4 and CLO 2008-1 are foreign taxable corporate subsidiaries that wereestablished to facilitate securitization transactions, structured as securedfinancing transactions, and TRS Ltd., is a foreign taxable corporatesubsidiary that was formed to make certain foreign investments from time totime. They are organized as exempted companies incorporated with limitedliability under the laws of the Cayman Islands, and are generally exempt fromfederal and state income tax at the corporate entity level because theyrestrict their activities in the United States to trading in stock andsecurities for their own account. However, the Company will generally berequired to include their current taxable income in its calculation of itstaxable income allocable to shareholders.

 

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**Earnings Per Share**

 

In accordance with SFAS No. 128, *Earningsper Share* (“SFAS No. 128”), the Company presents both basic anddiluted earnings per common share (“EPS”) in its condensed consolidatedfinancial statements and footnotes thereto. Basic earnings per common share (“BasicEPS”) excludes dilution and is computed by dividing net income or loss by theweighted-average number of common shares, including vested restricted commonshares, outstanding for the period. Diluted earnings per share (“Diluted EPS”)reflects the potential dilution of common share options and unvested restrictedcommon shares using the treasury method, and the potential dilution ofconvertible senior notes using the if-converted method, if they are notanti-dilutive. See Note 4 for earnings per common share computations.

 

A rights offering whose exercise price at issuance is less than thefair value of the stock is considered to have a bonus element, resulting in anadjustment of the prior period number of shares outstanding used to calculatebasic and diluted earnings per share. As a result of the $270.0 million commonshare rights offering that occurred during the third quarter of 2007, priorperiod weighted-average number of shares and earnings per share outstandinghave been adjusted to reflect the issuance at less than fair value.

 

**RecentAccounting Pronouncements**

 

In February 2008, the FASBissued FSP FAS 140-3, *Accounting for Transfersof Financial Assets and Repurchase Financing Transactions*(“FSP SFASNo. 140-3”). FSP SFAS No. 140-3 assumes that an initial transfer of afinancial asset and a repurchase financing are considered part of the samearrangement, or a linked transaction. However, if certain criteria are met, theinitial transfer and repurchase financing shall not be evaluated as a linkedtransaction and shall be evaluated separately under SFAS No. 140. FSP SFASNo. 140-3 is effective for repurchase financings in which the initialtransfer is entered into in fiscal years beginning after November 15, 2008and early adoption is not permitted. TheCompany does not expect the adoption of FSP SFAS No. 140-3 to have amaterial impact on its condensedconsolidated financial statements.

 

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In March 2008, the FASBissued SFAS No. 161, *Disclosures aboutDerivative Instruments and Hedging Activities, an Amendment of FASB Statement No. 133*(“SFAS No. 161”). SFAS No. 161 requires enhancedqualitative disclosures about objectives and strategies for using derivatives,quantitative disclosures about fair value amounts of gains and losses on derivativeinstruments, and disclosures about credit-risk-related contingent features inderivative agreements.  The additionaldisclosures required by SFAS No. 161 must be included in the Company’sconsolidated financial statements beginning with the first quarter of 2009.

 

**Note 3. Discontinued Operations**

 

In August 2007,the Company’s board of directors approved a plan to exit its residentialmortgage investment operations and sell the REIT Subsidiary. As of January 1,2008, the REIT Subsidiary’s assets and liabilities consisted solely of thoseheld by its two asset-backed commercial paper conduits (the “Facilities”).  During March 2008, the Company enteredinto an agreement with the holders of the secured liquidity notes (“SLNs”)issued by the Facilities (the “Noteholders”) in order to terminate theFacilities.  With respect to theagreement with the Noteholders, all of the residential mortgage-backedsecurities (“RMBS”) funded by the SLNs have been returned to the Noteholders insatisfaction of the SLNs and the Company has paid the Noteholders approximately$42.0 million in conjunction with this resolution. The Company had previouslyaccrued $36.5 million for contingencies related to resolution of the Facilitiesand as a consequence of this transaction, the Company recorded an incrementalcharge during the quarter ended March 31, 2008 of $5.5 million. Theagreement with the Noteholders resulted in approximately $3.6 billion paramount of RMBS being returned to the Noteholders in satisfaction ofapproximately $3.5 billion par amount of SLNs held by the Noteholders.Accordingly, the Company has removed the RMBS and SLNs that related to theFacilities from its condensed consolidated financial statements as of March 31,2008. Under the agreement with the Noteholders, the Company and its affiliateshave been released from any future obligations or liabilities to theNoteholders.

 

Separately,on March 31, 2008, the Company entered into a definitive agreement withRock Capital 2 LLC pursuant to which Rock Capital 2 LLC will acquire acontrolling interest in the REIT Subsidiary. This sale is expected to closeduring the second quarter of 2008 and is not expected to result in either again or loss.

 

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Throughthe aforementioned transactions combined with sales of residential mortgageassets during 2007, the Company has completed significant steps in its plan toterminate its residential mortgage investment operations. As of March 31, 2008,the Company’s remaining residential mortgage portfolio consisted of $324.4million of RMBS, of which $287.4 million was rated investment grade or higherand $37.0 million was rated below investment grade. Of the $324.4 million ofRMBS, $203.1 million represented interests in residential mortgagesecuritization trusts that were not structured as qualifying special-purposeentities under GAAP.  The Companyconsolidated these trusts as it was the primary beneficiary of these entitiesunder GAAP, and therefore reported total assets of $3.6 billion and totalliabilities of $3.4 billion for these trusts in discontinued operations as ofMarch 31, 2008, as shown in the table below. The Company accounts for itsresidential mortgage assets, consisting of RMBS and residential mortgage loans,and its residential mortgage liabilities, consisting of mortgage-backedsecurities issued, at estimated fair value with changes in estimated fair valueincluded in income from discontinued operations on the Company’s condensedconsolidated statements of operations.

 

Summarized financial information for discontinued operations is asfollows (amounts in thousands):

 
| ** **                        | ** ** | **As of  March 31, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|-----------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| **Assets**                        |       |                                     |       |                                        |       |
| Restricted cash                   |       | $                                        | 20,309     |                                        | $          | 4,622 |   |
| Trading securities, at fair value |       | 121,324                                  |       | 3,174,881                                   |       |
| Loans, at fair value              |       | 3,605,232                                |       | 3,921,323                                   |       |
| Interest and principal receivable |       | 15,625                                   |       | 18,603                                      |       |
| Other assets                      |       | 8,046                                    |       | 9,677                                       |       |
| Assets of discontinued operations |       | $                                        | 3,770,536  |                                        | $          | 7,129,106 |   |
|                                   |            |                                          |            |                                             |            |  |  |  |  |

 
| ** **                                           | ** ** | **As of  March 31, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|------------------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| **Liabilities**                                      |       |                                     |       |                                        |       |
| Repurchase agreements                                |       | $                                        | 82,464     |                                        | $          | 168,106 |   |
| Mortgage-backed securities issued, at fair  value    |       | 3,410,163                                |       | 3,169,353                                   |       |
| Asset-backed secured liquidity notes, at  fair value |       | —                                   |       | 3,519,860                                   |       |
| Secured revolving credit facility                    |       | 13,987                                   |       | 10,355                                      |       |
| Derivative liabilities                               |       | —                                   |       | 9,909                                       |       |
| Accounts payable, accrued expenses and  other        |       | 2,798                                    |       | 123,701                                     |       |
| Accrued interest payable                             |       | 9,942                                    |       | 11,000                                      |       |
| Liabilities of discontinued operations               |       | $                                        | 3,519,354  |                                        | $          | 7,012,284 |   |

 

The components of income from discontinued operations are as follows(amounts in thousands):

 
| ** **                          | ** ** | **Three months ended  March 31, 2008** | ** ** | **Three months ended  March 31, 2007** | ** ** |
|-------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| Net investment income               |       | $                                                          | 28,103     |                                                       | $          | 17,031 |   |
| Total other (loss) income           |       | (14,539                                                    | )          | 2,689                                                      |       |
| Non-investment expenses             |       | (8,361                                                     | )          | (3,525                                                     | )          |
| Income from discontinued operations |       | $                                                          | 5,203      |                                                       | $          | 16,195 |   |

 

The following table summarizes the delinquency statistics of theCompany’s residential mortgage loans as of March 31, 2008 and December 31,2007 (dollar amounts in thousands):

 
| ** **                  | ** ** | **March 31, 2008** | ** ** | **December 31, 2007** | ** ** |
|-----------------------------|------------|------------------------------|------------|---------------------------------|------------|
| **Delinquency Status** | ** ** | **Number of  Loans**    | ** ** | **Principal  Amount**           | ** ** | **Number of  Loans** | ** ** | **Principal  Amount** | ** ** |
| 30 to 59 days          |       | 63                           |       | $                               | 23,076     |   | 96 |   | $ | 30,163 |   |
| 60 to 89 days          |       | 25                           |       | 9,404                           |       | 18 |   | 6,151 |   |
| 90 days or more        |       | 45                           |       | 14,916                          |       | 43 |   | 14,045 |   |
| In foreclosure              |       | 52                           |       | 16,288                          |       | 38 |   | 11,800 |   |
| Total                       |       | 185                          |       | $                               | 63,684     |   | 195 |   | $ | 62,159 |   |

 

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Fair Value Disclosures

 

Assetsand liabilities recorded at fair value included in discontinued operations onthe condensed consolidated balance sheets are categorized based upon the levelof judgment associated with the inputs used to measure their value inaccordance with SFAS No. 157.  None ofthe financial assets or liabilities included in discontinued operations werevalued under level 1.  Mortgage-backedsecurities issued were valued under level 2. Mortgage loans and trading securities, consisting of mortgage-backedsecurities, were transferred to level 3 from level 2 in the first quarter of2008.  They were valued under level 3because the level 3 input was significant to the fair value measurement ofthese assets.

 

The following table presents information about the Company’s assets andliabilities included in discontinued operations measured at fair value on arecurring basis as of March 31, 2008, and indicates the fair valuehierarchy of the valuation techniques utilized by the Company to determine suchfair value (amounts in thousands):

 
| ** **                                        | ** ** | **Quoted Prices in Active  Markets for Identical  Assets (Level 1)** | ** ** | **Significant Other  Observable Inputs  (Level 2)** | ** ** | **Significant  Unobservable Inputs  (Level 3)** | ** ** | **Balance as of  March 31, 2008** | ** ** |
|---------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|-------------------------------------------------------|------------|
| **Assets:**                                       |       |                                                                                                    |       |                                                               |       |                                                      |       |                                                  |       |
| Trading securities, at fair value                 |       | $                                                                                                       | —     |                                                               | $          | —                                                    |       | $                                                     | 121,324    |   | $ | 121,324 |   |
| Loans, at fair value                              |       | —                                                                                                  |       | —                                                             |       | 3,605,232                                                 |       | 3,605,232                                             |       |
| Total                                             |       | $                                                                                                       | —     |                                                               | $          | —                                                    |       | $                                                     | 3,726,556  |   | $ | 3,726,556 |   |
| **Liabilities:**                                  |       |                                                                                                    |       |                                                               |       |                                                      |       |                                                  |       |
| Mortgage-backed securities issued, at fair  value |       | $                                                                                                       | —     |                                                               | $          | 3,410,163                                                 |       | $                                                     | —     |   | $ | 3,410,163 |   |
|                                                   |            |                                                                                                         |            |                                                                    |            |                                                           |            |                                                       |            |  |  |  |  |  |  |  |  |

 

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The following table presents additional information about assets andliabilities that are measured at fair value on a recurring basis for which theCompany has utilized significant unobservable inputs (level 3) todetermine fair value, for the three months ended March 31, 2008 (amountsin thousands):

 
| ** **                                                                                                                                                                             | ** ** | **Trading securities,  at fair value** | ** ** | **Loans, at fair  value** | ** ** | **Asset-backed  secured liquidity  notes** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------|------------|-------------------------------------------------|------------|
| Beginning balance as of January 1,  2008                                                                                                                                          |       | $                                                     | —     |                                | $          | —                                          |       | $ | (3,519,860 | ) |
| Total gains or losses (realized and  unrealized):                                                                                                                                      |       |                                                  |       |                                |       |                                            |       |
| Included in earnings                                                                                                                                                                   |       | —                                                |       | —                              |       | —                                          |       |
| Included in other comprehensive loss                                                                                                                                                   |       | —                                                |       | —                              |       | —                                          |       |
| Net transfers into level 3                                                                                                                                                        |       | 121,324                                               |       | 3,605,232                           |       | —                                          |       |
| Issuances                                                                                                                                                                              |       | —                                                |       | —                              |       | —                                          |       |
| Adjustments for termination of the  Facilities                                                                                                                                         |       | —                                                |       | —                              |       | 3,519,860                                       |       |
| Ending balance as of March 31, 2008                                                                                                                                               |       | $                                                     | 121,324    |                                | $          | 3,605,232                                       |       | $ | — |   |
| The amount of total gains or losses for the  period included in earnings attributable to the change in unrealized gains or  losses relating to assets still held at the reporting date |       | $                                                     | —     |                                | $          | —                                          |       | $ | — |   |

 

As of March 31, 2008, the Company did not have any assets orliabilities of discontinued operations measured at fair value on anon-recurring basis.

 

**Note 4. Earnings per Share**

 

The Company calculates basic net income per common share by dividingnet income for the period by the weighted-average shares of its common sharesoutstanding for the period. Diluted net income per common share is calculatedby dividing net income by the weighted-average number of common shares pluspotentially dilutive common shares outstanding during the period. Potentiallydilutive common shares include the assumed exercise of outstanding common shareoptions and assumed vesting of outstanding restricted common shares using thetreasury stock method, as well as the assumed conversion of convertible seniornotes using the if-converted method, if they are not anti-dilutive.

 

The following table presents a reconciliation of basic and diluted netincome per common share for the three months ended March 31, 2008 and 2007(amounts in thousands, except per share information):

 
| ** **                                                                               | ** ** | **Three months ended  March 31, 2008** | ** ** | **Three months ended  March 31, 2007** | ** ** |
|------------------------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| Income from continuing operations                                                        |       | $                                                          | 8,780      |                                                       | $          | 32,229 |   |
| Income from discontinued operations                                                      |       | 5,203                                                      |       | 16,195                                                     |       |
| Net income                                                                               |       | $                                                          | 13,983     |                                                       | $          | 48,424 |   |
| **Basic:**                                                                               |       |                                                       |       |                                                       |       |
| Basic weighted-average shares outstanding                                                |       | 115,048                                                    |       | 80,239                                                     |       |
| Income per share from continuing operations                                              |       | $                                                          | 0.08       |                                                       | $          | 0.40 |   |
| Income per share from discontinued  operations                                           |       | $                                                          | 0.04       |                                                       | $          | 0.20 |   |
| Net income per share                                                                     |       | $                                                          | 0.12       |                                                       | $          | 0.60 |   |
| **Diluted:**                                                                             |       |                                                       |       |                                                       |       |
| Basic weighted-average shares outstanding                                                |       | 115,048                                                    |       | 80,239                                                     |       |
| Dilutive effect of share options and  restricted common shares using the treasury method |       | 551                                                        |       | 1,489                                                      |       |
| Diluted weighted-average shares outstanding  (1)                                         |       | 115,599                                                    |       | 81,728                                                     |       |
| Income per share from continuing operations                                              |       | $                                                          | 0.08       |                                                       | $          | 0.39 |   |
| Income per share from discontinued  operations                                           |       | $                                                          | 0.04       |                                                       | $          | 0.20 |   |
| Net income per share                                                                     |       | $                                                          | 0.12       |                                                       | $          | 0.59 |   |

 

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| (1) |   | Potential  anti-dilutive common shares excluded from diluted income earnings per share  for the three months ended March 31, 2008 were 9,677,430 related to  convertible debt securities. There were no anti-dilutive common shares for  the three months ended March 31, 2007. |
|-----|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

17

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**Note 5. Securities Sold, Not Yet Purchased**

 

Securities sold, not yet purchased consist of equity and debtsecurities that the Company has sold short. As of March 31, 2008, theCompany had securities sold, not yet purchased with a cost basis of$34.4 million and accumulated net unrealized gain of $3.7 million. Asof December 31, 2007, the Company had securities sold, not yet purchasedwith a cost basis of $103.1 million and accumulated net unrealized gain of$2.7 million.

 

For the three months ended March 31, 2008, the Company had netrealized gains on securities sold, not yet purchased of $6.0 million andnet unrealized gains on securities sold, not yet purchased of $1.0 million.  There were no securities sold, not yetpurchased during the three months ended March 31, 2007.

 

**Note 6. Securities Available-for-Sale**

 

The following table summarizes the Company’s securities classified asavailable-for-sale as of March 31, 2008, which are carried at estimatedfair value (amounts in thousands):

 
| **Description**            | ** ** | **Amortized Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated Fair  Value** | ** ** |
|----------------------------|------------|-------------------------|------------|------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| Corporate securities       |       | $                       | 1,269,404  |                         | $          | 4,196                         |       | $                              | (194,764   | ) | $ | 1,078,836 |   |
| Common and preferred stock |       | 49,000                  |       | 68                           |       | (20,346                       | )          | 28,722                         |       |
| Total                      |       | $                       | 1,318,404  |                         | $          | 4,264                         |       | $                              | (215,110   | ) | $ | 1,107,558 |   |

 

The following table shows the gross unrealized losses and fair value ofthe Company’s available-for-sale securities, aggregated by length of time thatthe individual securities have been in a continuous unrealized loss position,as of March 31, 2008 (amounts in thousands):

 
| ** **                 | ** ** | **Less Than 12 months** | ** ** | **12 Months or More** | ** ** | **Total**      | ** ** |
|----------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|----------------|------------|
| **Description**            | ** ** | **Fair Value**                         | ** ** | **Unrealized  Losses**               | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| Corporate securities       |       | $                                      | 958,431    |                                 | $          | (194,728       | )          | $ | 7,107 |   | $ | (36 | ) | $ | 965,538 |   | $ | (194,764 | ) |
| Common and preferred stock |       | 21,028                                 |       | (15,071                              | )          | 7,158          |       | (5,275 | ) | 28,186 |   | (20,346 | ) |
| Total                      |       | $                                      | 979,459    |                                 | $          | (209,799       | )          | $ | 14,265 |   | $ | (5,311 | ) | $ | 993,724 |   | $ | (215,110 | ) |

 

The unrealized losses in the above table are temporary impairments dueto market factors and are not reflective of credit deterioration. The Companyhas performed credit analyses in relation to these investments and believes thecarrying value of these investments to be fully recoverable over their expectedholding period. Because the Company has the intent and ability to hold theseinvestments until recovery, the unrealized losses are not considered to beother-than-temporary impairments.

 

The following table summarizes the Company’s securities classified asavailable-for-sale as of December 31, 2007, which are carried at estimatedfair value (amounts in thousands):

 
| **Description**            | ** ** | **Amortized Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated Fair  Value** | ** ** |
|----------------------------|------------|-------------------------|------------|------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| Corporate securities       |       | $                       | 1,438,027  |                         | $          | 8,706                         |       | $                              | (134,969   | ) | $ | 1,311,764 |   |
| Common and preferred stock |       | 58,529                  |       | 24                           |       | (10,776                       | )          | 47,777                         |       |
| Total                      |       | $                       | 1,496,556  |                         | $          | 8,730                         |       | $                              | (145,745   | ) | $ | 1,359,541 |   |

 

18

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The following table showsthe gross unrealized losses and fair value of the Company’s available-for-salesecurities, aggregated by length of time that the individual securities havebeen in a continuous unrealized loss position, as of December 31, 2007 (amountsin thousands):

 
| ** **                 | ** ** | **Less Than 12 months** | ** ** | **12 Months or More** | ** ** | **Total**           | ** ** |
|----------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|---------------------|------------|
| **Description**            | ** ** | **Fair Value**                    | ** ** | **Unrealized  Losses**               | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| Corporate securities       |       | $                                      | 1,075,296  |                                 | $          | (134,969            | )          | $ | — |   | $ | — |   | $ | 1,075,296 |   | $ | (134,969 | ) |
| Common and preferred stock |       | 35,402                                 |       | (7,664                               | )          | 9,321               |       | (3,112 | ) | 44,723 |   | (10,776 | ) |
| Total                      |       | $                                      | 1,110,698  |                                 | $          | (142,633            | )          | $ | 9,321 |   | $ | (3,112 | ) | $ | 1,120,019 |   | $ | (145,745 | ) |

 

The unrealized losses in theabove table exclude one investment in a corporate security that was deemed tobe an other-than-temporary impairment for $5.9 million. The decline infair value was deemed to be other-than-temporary in the fourth quarter of 2007based on the Company’s intent to sell the security during 2008. This corporatesecurity was sold during the first quarter 2008 at approximately the same valueit was carried at as of December 31, 2007. When evaluating whether animpairment is other-than-temporary, the Company performs an analysis of theanticipated future cash flows and the ability and intent to hold the investmentfor a sufficient amount of time to recover the unrealized losses. Additionally,the Company considers the current events specific to the issuer or industryincluding widening credit spreads and external credit ratings, as well asinterest rate volatility.

 

All other unrealized lossesin the table above are considered to be temporary impairments due to marketfactors and are not reflective of credit deterioration. The Company hasperformed credit analyses in relation to these investments and believes thecarrying value of these investments to be fully recoverable over their expectedholding period. Because the Company has the intent and ability to hold theseinvestments until recovery, the related unrealized losses are not considered tobe other-than-temporary impairments.

 

During the three monthsended March 31, 2008, the Company had gross realized gains and losses fromthe sales of securities available-for-sale of $2.2 million and$11.3 million, respectively. During the three months ended March 31,2007, the Company had gross realized gains and losses from the sales ofsecurities available-for-sale of $4.7 million and $0.7 million,respectively. Note 8 to these condensed consolidated financial statementsdescribes the Company’s borrowings under which the Company has pledgedsecurities available-for-sale for borrowings under repurchase agreements andall other secured financing transactions. The following table summarizes theestimated fair value of securities available-for-sale pledged as collateralunder repurchase agreements and all other secured financing transactions as of March 31,2008 (amounts in thousands):

 
| ** **                                                                                                            | ** ** | **Corporate Securities** | ** ** | **Preferred Stock** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|--------------------------|------------|
| Pledged as collateral for borrowings under repurchase agreements                                                      |       | $                             | 392,179    |                     | $          | — |   |
| Pledged as collateral for borrowings under secured revolving credit  facility                                         |       | 24,260                        |       |                     |       |
| Pledged as collateral for borrowings under secured demand loan                                                        |       | —                        |       | 24,284                   |       |
| Pledged as collateral for collateralized loan obligation senior  secured notes and junior secured notes to affiliates |       | 607,609                       |       | —                   |       |
| Pledged as collateral for subordinated notes to affiliates                                                            |       | 17,701                        |       | —                   |       |
| Total                                                                                                                 |       | $                             | 1,041,749  |                     | $          | 24,284 |   |

 

The following tablesummarizes the estimated fair value of securities pledged as collateral underrepurchase agreements and all other secured financing transactions as of December 31,2007 (amounts in thousands):

 
| ** **                                                                                                            | ** ** | **Corporate Securities** | ** ** | **Preferred Stock** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|--------------------------|------------|
| Pledged as collateral for borrowings under repurchase agreements                                                      |       | $                             | 487,297    |                     | $          | — |   |
| Pledged as collateral for borrowings under secured revolving credit  facility                                         |       | 43,878                        |       | —                   |       |
| Pledged as collateral for borrowings under secured demand loan                                                        |       | —                        |       | 34,483                   |       |
| Pledged as collateral for collateralized loan obligation senior secured  notes and junior secured notes to affiliates |       | 762,776                       |       | —                   |       |
| Pledged as collateral for subordinated notes to affiliates                                                            |       | 17,813                        |       | —                   |       |
| Total                                                                                                                 |       | $                             | 1,311,764  |                     | $          | 34,483 |   |

 

19

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**Note 7. Loans and Allowance for Loan Losses**

 

The following tablesummarizes the Company’s loans as of March 31, 2008 and December 31,2007 (amounts in thousands):

 
|                                    |   | **March 31, 2008** |      | **December 31, 2007** |   |
|-----------------------------------------|--------|------------------------------|-----------|---------------------------------|--------|
| **Description**                         |   | **Principal**                |      | **Unamortized  Discount**       |   | **Estimated  Fair  Value  Adjustment** |   | **Net  Carrying  Value** |   | **Principal** |   | **Unamortized  Discount** |   | **Net  Carrying  Value** |   |
| Corporate loans held for investment (1) |   | $                            | 9,103,151 |                            | $      | (158,858 | ) | $ | — |   | $ | 8,944,293 |   | $ | 8,766,169 |   | $ | (106,961 | ) | $ | 8,659,208 |   |
| Corporate loans held for sale           |   | 77,082                       |      | (5,200                          | )      | (4,002 | ) | 67,880 |   | — |   | — |   | — |   |
| Total loans                             |   | $                            | 9,180,233 |                            | $      | (164,058 | ) | $ | (4,002 | ) | $ | 9,012,173 |   | $ | 8,766,169 |   | $ | (106,961 | ) | $ | 8,659,208 |   |

 

----

(1)     Excludes allowance for loan losses of $25.0million.

 

As of March 31, 2008,approximately $71.9 million of corporate loans were classified as held forsale.  The Company recorded a $4.0million charge to earnings related to these loans to adjust their carryingvalue to the lower of cost or estimated fair value. The Company had no loansheld for sale as of December 31, 2007. Note 8 to these condensed consolidated financial statementsdescribes the Company’s borrowings under which the Company has pledged loansfor borrowings under repurchase agreements and all other secured financingtransactions. The following table summarizes the carrying value of corporateloans pledged as collateral under repurchase agreements and all other securedfinancing transactions as of March 31, 2008 (amounts in thousands):

 
| Pledged as collateral for borrowings under repurchase agreements                                                      |   | $         | 1,908,721 |   |
|-----------------------------------------------------------------------------------------------------------------------|--------|-----------|-----------|--------|
| Pledged as collateral for borrowings under secured revolving credit  facility                                         |   | 52,189    |      |
| Pledged as collateral for collateralized loan obligation senior  secured notes and junior secured notes to affiliates |   | 6,869,260 |      |
| Pledged as collateral for subordinated notes to affiliates                                                            |   | 172,650   |      |
| Total                                                                                                                 |   | $         | 9,002,820 |   |

 

The following tablesummarizes the carrying value of corporate loans pledged as collateral underrepurchase agreements and all other secured financing transactions as of December 31,2007 (amounts in thousands):

 
| Pledged as collateral for borrowings under repurchase agreements                                                      |   | $         | 1,994,999 |   |
|-----------------------------------------------------------------------------------------------------------------------|--------|-----------|-----------|--------|
| Pledged as collateral for borrowings under secured revolving credit  facility                                         |   | 48,142    |      |
| Pledged as collateral for collateralized loan obligation senior  secured notes and junior secured notes to affiliates |   | 6,276,882 |      |
| Pledged as collateral for subordinated notes to affiliates                                                            |   | 27,886    |      |
| Total                                                                                                                 |   | $         | 8,347,909 |   |

 

The following tablesummarizes the changes in the allowance for loan losses for the Company’s corporateloan portfolio for the three months ended March 31, 2008 (amounts inthousands):

 
| Balance at January 1, 2008 |   | $      | 25,000 |   |
|---------------------------------|--------|--------|--------|--------|
| Provision for loan losses       |   | — |   |
| Charge-offs                     |   | — |   |
| Balance at March 31, 2008  |   | $      | 25,000 |   |

 

The $25.0 million allowancefor loan losses is unallocated as of March 31, 2008 as the Company has notdeemed any individual loans as being impaired as of that date. No provision forloan losses was recorded during the three months ended March 31, 2008 and March 31,2007.

 

20

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**Note 8. Borrowings**

 

The Company leverages itsportfolio of securities and loans through the use of repurchase agreements,warehouse facilities, demand loans, and securitization transactions structuredas secured financings.

 

Certain information withrespect to the Company’s borrowings as of March 31, 2008 is summarized inthe following table (dollar amounts in thousands):

 
| ** **                                       | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted  Average  Borrowing  Rate** | ** ** | **Weighted  Average  Remaining  Maturity (in  days)** | ** ** | **Fair Value  of Collateral(1)** | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|-------------------------------------------------------|------------|--------------------------------------------|------------|
| Repurchase agreements(2)                         |       | $                           | 2,397,771  |                                   | 3.24       | %                                                     | 60         |                                       | $          | 2,006,110 |   |
| Secured revolving credit facility(3)             |       | 129,319                     |       | 3.78                                   |       | 533                                                   |       | 62,879                                     |       |
| Secured demand loan                              |       | 16,176                      |       | 3.00                                   |       | 30                                                    |       | 24,284                                     |       |
| CLO 2005-1 senior secured notes                  |       | 831,577                     |       | 3.57                                   |       | 3,313                                                 |       | 822,528                                    |       |
| CLO 2005-2 senior secured notes                  |       | 808,087                     |       | 3.39                                   |       | 3,527                                                 |       | 843,398                                    |       |
| CLO 2006-1 senior secured notes                  |       | 727,500                     |       | 3.45                                   |       | 3,799                                                 |       | 883,848                                    |       |
| CLO 2007-1 senior secured notes                  |       | 2,368,500                   |       | 3.59                                   |       | 4,793                                                 |       | 2,443,204                                  |       |
| CLO 2007-1 junior secured notes to affiliates(4) |       | 431,292                     |       | —                                 |       | 4,793                                                 |       | 444,895                                    |       |
| CLO 2007-A senior secured notes                  |       | 1,213,300                   |       | 5.59                                   |       | 3,485                                                 |       | 1,193,870                                  |       |
| CLO 2007-A junior secured notes to affiliates(5) |       | 94,128                      |       | —                                 |       | 3,485                                                 |       | 92,621                                     |       |
| Wayzata senior secured notes                     |       | 200,000                     |       | 3.87                                   |       | 1,690                                                 |       | 181,504                                    |       |
| Convertible senior notes                         |       | 300,000                     |       | 7.00                                   |       | 1,567                                                 |       | —                                     |       |
| Junior subordinated notes                        |       | 329,908                     |       | 6.62                                   |       | 10,433                                                |       | —                                     |       |
| Subordinated notes to affiliates(6)              |       | 167,752                     |       | —                                 |       |                                                  |       | 169,887                                    |       |
| Total                                            |       | $                           | 10,015,310 |                                   |       |                                                  |       |                                       | $          | 9,169,028 |   |

 

----

(1)           Collateral forborrowings consists of securities available-for-sale and loans.

 

(2)           Includesrepurchase agreements of $499.3 million collateralized by retained ratedmezzanine notes and unrated subordinated notes issued by the Company’s CLO subsidiaries.

 

(3)           Excludes$14.0 million in borrowings classified as discontinued operations.Includes $100.0 million in borrowings collateralized by retained ratedmezzanine notes and unrated subordinated notes issued by the Company’s CLOsubsidiaries.

 

(4)           CLO 2007-1junior secured notes to affiliates consist of (x) $244.7 million ofmezzanine notes with a weighted average borrowing rate of 7.92% and (y) $186.6 millionof subordinated notes that do not have a contractual coupon rate, but insteadreceive a pro rata amount of the net distributions from CLO 2007-1.

 

(5)           CLO 2007-Ajunior secured notes to affiliates consist of (x) $79.0 million ofmezzanine notes with a weighted average borrowing rate of 10.88% and (y) $15.1 millionof subordinated notes that do not have a contractual coupon rate, but insteadreceive a pro rata amount of the net distributions from CLO 2007-A.

 

(6)           Subordinatednotes do not have a contractual coupon rate, but instead receive a pro rataamount of the net distributions from CLO 2007-4, CLO 2008-1 and Wayzata.

 

Certain information withrespect to the Company’s borrowings as of December 31, 2007 is summarizedin the following table (dollar amounts in thousands):

 
| ** **                                       | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted  Average  Borrowing  Rate** | ** ** | **Weighted  Average  Remaining  Maturity (in  days)** | ** ** | **Fair Value  of Collateral(1)** | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------|------------|
| Repurchase agreements(2)                         |       | $                           | 2,639,960  |                                   | 5.39       | %                                                          | 139        |                                       | $          | 2,469,114 |   |
| Secured revolving credit facility(3)             |       | 156,669                     |       | 5.65                                   |       | 540                                                        |       | 92,020                                     |       |
| Secured demand loan                              |       | 24,151                      |       | 5.00                                   |       | 31                                                         |       | 34,483                                     |       |
| CLO 2005-1 senior secured notes                  |       | 831,428                     |       | 5.39                                   |       | 3,404                                                      |       | 894,548                                    |       |
| CLO 2005-2 senior secured notes                  |       | 807,882                     |       | 5.34                                   |       | 3,618                                                      |       | 905,552                                    |       |
| CLO 2006-1 senior secured notes                  |       | 727,500                     |       | 5.39                                   |       | 3,890                                                      |       | 937,287                                    |       |
| CLO 2007-1 senior secured notes                  |       | 2,368,500                   |       | 5.39                                   |       | 4,884                                                      |       | 2,641,046                                  |       |
| CLO 2007-1 junior secured notes to affiliates(4) |       | 431,292                     |       | —                                 |       | 4,884                                                      |       | 480,922                                    |       |
| CLO 2007-A senior secured notes                  |       | 1,213,300                   |       | 5.57                                   |       | 3,576                                                      |       | 1,095,328                                  |       |
| CLO 2007-A junior secured notes to affiliates(5) |       | 94,128                      |       | —                                 |       | 3,576                                                      |       | 84,976                                     |       |
| Convertible senior notes                         |       | 300,000                     |       | 7.00                                   |       | 1,658                                                      |       | —                                     |       |
| Junior subordinated notes                        |       | 329,908                     |       | 7.54                                   |       | 10,524                                                     |       | —                                     |       |
| Subordinated notes to affiliates(6)              |       | 152,574                     |       | —                                 |       |                                                       |       | 163,437                                    |       |
| Total                                            |       | $                           | 10,077,292 |                                   |       |                                                       |       |                                       | $          | 9,798,713 |   |

 

21

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----

(1)           Collateral forborrowings consists of securities available-for-sale and loans.

 

(2)           Includesrepurchase agreements of $544.5 million collateralized by retained ratedmezzanine notes and unrated subordinated notes issued by the Company’s CLOsubsidiaries.

 

(3)           Excludes$10.4 million in borrowings classified as discontinued operations.Includes $100.0 million in borrowings collateralized by retained ratedmezzanine notes and unrated subordinated notes issued by the Company’s CLO subsidiaries.

 

(4)           CLO 2007-1junior secured notes to affiliates consist of (x) $244.7 million ofmezzanine notes with a weighted average borrowing rate of 9.72% and (y) $186.6 millionof subordinated notes that do not have a contractual coupon rate, but insteadreceive a pro rata amount of the net distributions from CLO 2007-1.

 

(5)           CLO 2007-Ajunior secured notes to affiliates consist of (x) $79.0 million ofmezzanine notes with a weighted average borrowing rate of 10.87% and (y) $15.1 millionof subordinated notes that do not have a contractual coupon rate, but insteadreceive a pro rata amount of the net distributions from CLO 2007-A.

 

(6)           Subordinatednotes do not have a contractual coupon rate, but instead receive a pro rataamount of the net distributions from CLO 2007-4, CLO 2008-1 and Wayzata.

 

**Note 9. Derivative Financial Instruments**

 

The Company enters intoderivative transactions in order to hedge its interest rate risk exposure tothe effects of interest rate changes. Additionally, the Company enters intoderivative transactions in the course of its investing. 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.

 

**Cash Flow and Fair Value Hedges**

 

The Company uses interestrate derivatives consisting of swaps to hedge a portion of the interest raterisk associated with its borrowings under CLO senior secured notes. The Companydesignates these financial instruments as cash flow hedges. The Company alsouses interest rate swaps to hedge all or a portion of the interest rate riskassociated with certain fixed interest rate investments. The Company designatesthese financial instruments as fair value hedges.

 

**Free-Standing Derivatives**

 

Free-standing derivativesare derivatives that the Company has entered into in conjunction with itsinvestment and risk management activities, but for which the Company has notdesignated the derivative contract as a hedging instrument for accountingpurposes. Such derivative contracts may include credit default swaps, foreignexchange contracts, and interest rate derivatives. Free-standing derivativesalso include investment financing arrangements (total rate of return swaps)whereby the Company receives the sum of all interest, fees and any positivechange in fair value amounts from a reference asset with a specified notionalamount and pays interest on such notional amount plus any negative change infair value amounts from such reference asset.

 

22

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The table below summarizesthe aggregate notional amount and estimated net fair value of the derivativeinstruments as of March 31, 2008 and December 31, 2007 (amounts inthousands):

 
| ** **                      | ** ** | **As of  March 31, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|---------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **Notional**                             | ** ** | **Fair Value**                         | ** ** | **Notional** | ** ** | **Fair Value** | ** ** |
| **Cash Flow Hedges:**           |       |                                     |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | $                                        | 383,333    |                                        | $          | (38,225 | ) | $ | 383,333 |   | $ | (19,018 | ) |
| **Fair Value Hedges:**          |       |                                     |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | 32,000                                   |       | (2,844                                      | )          | 32,000 |   | (1,212 | ) |
| **Free-Standing Derivatives:**  |       |                                     |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | 73,091                                   |       | 938                                         |       | 112,500 |   | 1,950 |   |
| Credit default swaps—long  |       | 66,000                                   |       | (2,762                                      | )          | 66,000 |   | (1,154 | ) |
| Credit default swaps—short |       | 196,820                                  |       | 25,090                                      |       | 268,000 |   | 12,613 |   |
| Total rate of return swaps      |       | 511,515                                  |       | (87,028                                     | )          | 442,204 |   | (21,998 | ) |
| Foreign exchange contracts      |       | 6,656                                    |       | 10                                          |       | 6,656 |   | 3 |   |
| Common stock warrants           |       | —                                   |       | 111                                         |       | — |   | 799 |   |
| Total                           |       | $                                        | 1,269,415  |                                        | $          | (104,710 | ) | $ | 1,310,693 |   | $ | (28,017 | ) |

 

For all hedges where hedgeaccounting is being applied, effectiveness testing and other procedures toensure the ongoing validity of the hedges are performed at least quarterly.During the three months ended March 31, 2008 and March 31, 2007, theCompany recognized an immaterial amount of ineffectiveness in income on thecondensed consolidated statements of operations.

 

**Note 10. Accumulated Other Comprehensive (Loss)Income**

 

The components ofaccumulated other comprehensive (loss) income were as follows (amounts inthousands):

 
| ** **                                                                                                                                                                          | ** ** | **As of  March 31, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Net unrealized losses on available-for-sale securities                                                                                                                              |       | $                                        | (213,186   | )                                           | $          | (159,802 | ) |
| Net unrealized losses on cash flow hedges                                                                                                                                           |       | (37,255                                  | )          | (19,018                                     | )          |
| Transition adjustment to accumulated deficit in conjunction with fair  value option election for residential mortgage-backed securities, currently  held as discontinued operations |       | —                                   |       | 21,575                                      |       |
| Accumulated other comprehensive loss                                                                                                                                                |       | $                                        | (250,441   | )                                           | $          | (157,245 | ) |

 

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

 
| ** **                                                                                     | ** ** | **Three months ended  March 31, 2008** | ** ** | **Three months ended  March 31, 2007** | ** ** |
|------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| Unrealized (losses) gains on securities available-for-sale:                                    |       |                                                       |       |                                                       |       |
| Unrealized holding (losses) gains arising during period                                        |       | $                                                          | (84,108    | )                                                          | $          | 6,914 |   |
| Reclassification adjustments for losses realized in net income                                 |       | 9,149                                                      |       | 17,767                                                     |       |
| Unrealized gains on available-for-sale securities from investment in  unconsolidated affiliate |       | —                                                     |       | 912                                                        |       |
| Unrealized (losses) gains on securities available-for-sale                                     |       | (74,959                                                    | )          | 25,593                                                     |       |
| Unrealized losses on cash flow hedges                                                          |       | (18,237                                                    | )          | (18,173                                                    | )          |
| Other comprehensive (loss) income                                                              |       | $                                                          | (93,196    | )                                                          | $          | 7,420 |   |

 

23

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**Note 11. Share Options and Restricted Shares**

 

The Company has adopted anamended and restated share incentive plan (the “2007 Share Incentive Plan”)that provides for the grant of qualified incentive common share options thatmeet the requirements of Section 422 of the Code, non-qualified common shareoptions, share appreciation rights, restricted common shares and othershare-based awards. The 2007 Share Incentive Plan was adopted on May 4,2007. Prior to the 2007 Share Incentive Plan, the Company had adopted the 2004Stock Incentive Plan that provided for the grant of qualified incentive commonstock options that met the requirements of Section 422 of the Code,non-qualified common stock options, stock appreciation rights, restrictedcommon stock and other share-based awards. The 2004 Stock Incentive Plan wasamended on May 26, 2005. The Compensation Committee of the board of directorsadministers the plan. Share options and other share-based awards may be grantedto the Manager, directors, officers and any key employees of the Manager and toany other individual or entity performing services for the Company.

 

The exercise price for anyshare option granted under the 2007 Share Incentive Plan may not be less than100% of the fair market value of the common shares at the time the common shareoption is granted. Each option to acquire a common share must terminate no morethan ten years from the date it is granted. As of March 31, 2008, the 2007Share Incentive Plan authorizes a total of 8,214,625 shares that may be used tosatisfy awards under the 2007 Share Incentive Plan. On February 19, 2008,the Compensation Committee of the board of directors granted the Manager, forfurther distribution to employees of the Manager who have no ownership interestin the Manager, 1,097,000 restricted common shares that vest on February 19,2011. The following table summarizes restricted common share transactions:

 
| ** **                                     | ** ** | **Manager** | ** ** | **Directors** | ** ** | **Total** | ** ** |
|------------------------------------------------|------------|-------------|------------|---------------|------------|-----------|------------|
| **Unvested shares as of January 1, 2008** |       | 625,000     |       | 72,657        |       | 697,657   |       |
| Issued                                         |       | 1,097,000   |       | —        |       | 1,097,000 |       |
| Vested                                         |       | —      |       | (16,120       | )          | (16,120   | )          |
| Cancelled                                      |       | —      |       | (2,839        | )          | (2,839    | )          |
| Forfeited                                      |       | —      |       | —        |       | —    |       |
| **Unvested shares as of March 31, 2008**  |       | 1,722,000   |       | 53,698        |       | 1,775,698 |       |

 

Pursuant to SFAS No. 123(R),the Company is required to value any unvested restricted common shares grantedto the Manager at the current market price. The Company valued the unvestedrestricted common shares granted to the Manager at $12.66 and $27.43 per shareat March 31, 2008 and March 31, 2007, respectively. There were$14.7 million and $11.6 million of total unrecognized compensationcosts related to unvested restricted common shares granted as of March 31,2008 and March 31, 2007, respectively.

 

The following tablesummarizes common share option transactions:

 
| ** **                                 | ** ** | **Number of  Options** | ** ** | **Weighted-Average  Exercise Price** | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|-------------------------------------------|------------|
| **Outstanding as of January 1, 2008** |       | 1,932,279                   |       | $                                         | 20.00      |   |
| Granted                                    |       | —                      |       | —                                    |       |
| Exercised                                  |       | —                      |       | —                                    |       |
| Forfeited                                  |       | —                      |       | —                                    |       |
| **Outstanding as of March 31, 2008**  |       | 1,932,279                   |       | $                                         | 20.00      |   |

 

As of March 31, 2008and December 31, 2007, 1,932,279 common share options were exercisable. Asof March 31, 2008 and December 31, 2007, the common share optionswere fully vested and expire in August 2014. For the three months ended March 31,2008 and 2007, the components of share-based compensation expense are asfollows (amounts in thousands):

 
| ** **                                     | ** ** | **Three months ended  March 31, 2008** | ** ** | **Three months  March 31, 2007** | ** ** |
|------------------------------------------------|------------|------------------------------------------------------------|------------|-------------------------------------------------|------------|
| Options granted to Manager                     |       | $                                                          | —     |                                            | $          | 622 |   |
| Restricted shares granted to Manager           |       | 462                                                        |       | 5,110                                           |       |
| Restricted shares granted to certain directors |       | 178                                                        |       | 106                                             |       |
| Total share-based compensation expense         |       | $                                                          | 640        |                                            | $          | 5,838 |   |

 

24

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**Note 12. Management Agreement and Related PartyTransactions**

 

The Manager manages theCompany’s day-to-day operations, subject to the direction and oversight of theCompany’s board of directors. The Management Agreement expires on December 31of each year, but is automatically renewed for a one-year term each December 31unless terminated upon the affirmative vote of at least two-thirds of theCompany’s independent directors, or by a vote of the holders of a majority ofthe Company’s outstanding common shares, based upon (1) unsatisfactoryperformance by the Manager that is materially detrimental to the Company or (2) adetermination that the management fee payable by the Manager is not fair,subject to the Manager’s right to prevent such a termination under thisclause (2) by accepting a mutually acceptable reduction of managementfees. The Manager must be provided 180 days prior notice of any suchtermination and will be paid a termination fee equal to four times the sum ofthe average annual base management fee and the average annual incentive fee forthe two 12-month periods immediately preceding the date of termination,calculated as of the end of the most recently completed fiscal quarter prior tothe date of termination.

 

The Management Agreementcontains certain provisions requiring the Company to indemnify the Manager withrespect to all losses or damages arising from acts not constituting bad faith,willful misconduct, or gross negligence. The Company has evaluated the impactof these guarantees on its condensed consolidated financial statements anddetermined that they are not material.

 

For the three months ended March 31,2008, the Company incurred $7.4 million in base management fees. Inaddition, the Company recognized share-based compensation expense related tocommon share options and restricted common shares granted to the Manager of$0.5 million for the three months ended March 31, 2008 (seeNote 11). The Company also reimbursed the Manager $2.5 million forexpenses for the three months ended March 31, 2008. For the three months ended March 31,2007, the Company incurred $7.2 million in base management fees. In addition,the Company recognized share-based compensation expense related to common stockoptions and restricted common stock granted to the Manager of $5.7 million forthe three months ended March 31, 2007 (see Note 11). The Company alsoreimbursed the Manager $1.7 million for expenses for the three months ended March 31,2007. Base management fees incurred and share-based compensation expenserelating to common share options and restricted common shares granted to theManager are included in related party management compensation on the consolidatedstatements of operations. Expenses incurred by the Manager and reimbursed bythe Company are reflected in the respective consolidated statements ofoperations, non-investment expense category based on the nature of the expense.

 

The Manager is waiving basemanagement fees related to the $230.4 million common share offering and$270.0 million common share rights offering that occurred during the thirdquarter of 2007 until such time as the Company’s common share closing price onthe NYSE is $20.00 or more for five consecutive trading days. Accordingly, theManager permanently waived approximately $2.2 million of base managementfees during the three months ended March 31, 2008.

 

No incentive fees wereearned by the Manager during the three months ended March 31, 2008, but$6.4 million were earned by the Manager during the three months ended March 31,2007. An affiliate of the Company’s Manager has entered into separatemanagement agreements with the respective investment vehicles for CLO 2005-1,CLO 2005-2, CLO 2006-1, CLO 2007-1, and CLO 2007-A and is entitled to receivefees for the services performed as collateral manager. The collateral managerhas permanently waived fees of approximately $8.7 million and$2.0 million, respectively, for the three months ended March 31, 2008and March 31, 2007. Beginning April 15, 2007, the collateral managerceased waiving fees for CLO 2005-1. The Company recorded an expense of$1.3 million for collateral management fees for CLO 2005-1 for the threemonths ended March 31, 2008. The collateral manager evaluates such waiverson a quarterly basis and there are no assurances that the collateral managerwill waive such management fees subsequent to March 31, 2008.

 

**Note 13. Fair Value Disclosure**

 

The following table presentsinformation about the Company’s assets and liabilities (including derivativesthat are presented net) measured at fair value on a recurring basis as of March 31,2008, and indicates the fair value hierarchy of the valuation techniquesutilized by the Company to determine such fair value (amounts in thousands):

 
| ** **                         | ** ** | **Quoted Prices in  Active Markets  for Identical Assets  (Level 1)** | ** ** | **Significant Other  Observable Inputs  (Level 2)** | ** ** | **Significant  Unobservable Inputs  (Level 3)** | ** ** | **Balance as of  March 31, 2008** | ** ** |
|------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|-------------------------------------------------------|------------|
| **Assets:**                        |       |                                                                                                |       |                                                               |       |                                                      |       |                                                  |       |
| Securities available-for-sale      |       | $                                                                                                   | 28,722     |                                                               | $          | 1,000,182                                                 |       | $                                                     | 78,654     |   | $ | 1,107,558 |   |
| Loans held for sale                |       | —                                                                                              |       | 67,880                                                             |       | —                                                    |       | 67,880                                                |       |
| Total                              |       | $                                                                                                   | 28,722     |                                                               | $          | 1,068,062                                                 |       | $                                                     | 78,654     |   | $ | 1,175,438 |   |
| **Liabilities:**                   |       |                                                                                                |       |                                                               |       |                                                      |       |                                                  |       |
| Derivatives, net                   |       | $                                                                                                   | —     |                                                               | $          | (105,759                                                  | )          | $                                                     | 1,049      |   | $ | (104,710 | ) |
| Securities sold, not yet purchased |       | (20,246                                                                                             | )          | (10,481                                                            | )          | —                                                    |       | (30,727                                               | )          |
| Total                              |       | $                                                                                                   | (20,246    | )                                                                  | $          | (116,240                                                  | )          | $                                                     | 1,049      |   | $ | (135,437 | ) |

 

25

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The following table presentsinformation about the Company’s assets and liabilities (including derivativesthat are presented net) measured at fair value on a recurring basis as of December 31,2007, and indicates the fair value hierarchy of the valuation techniquesutilized by the Company to determine such fair value (amounts in thousands):

 
| ** **                         | ** ** | **Quoted Prices in  Active Markets  for Identical Assets  (Level 1)** | ** ** | **Significant Other  Observable Inputs  (Level 2)** | ** ** | **Significant  Unobservable Inputs  (Level 3)** | ** ** | **Balance as of  December 31, 2007** | ** ** |
|------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| **Assets:**                        |       |                                                                                                |       |                                                               |       |                                                      |       |                                                     |       |
| Securities available-for-sale      |       | $                                                                                                   | 47,777     |                                                               | $          | 1,212,266                                                 |       | $                                                        | 99,498     |   | $ | 1,359,541 |   |
| ** **                         |       |                                                                                                |       |                                                               |       |                                                      |       |                                                     |       |
| **Liabilities:**                   |       |                                                                                                |       |                                                               |       |                                                      |       |                                                     |       |
| Derivatives, net                   |       | $                                                                                                   | —     |                                                               | $          | (28,819                                                   | )          | $                                                        | 802        |   | $ | (28,017 | ) |
| Securities sold, not yet purchased |       | (32,704                                                                                             | )          | (67,690                                                            | )          | —                                                    |       | (100,394                                                 | )          |
| Total                              |       | $                                                                                                   | (32,704    | )                                                                  | $          | (96,509                                                   | )          | $                                                        | 802        |   | $ | (128,411 | ) |
|                                    |            |                                                                                                     |            |                                                                    |            |                                                           |            |                                                          |            |  |  |  |  |  |  |  |  |

 

The following table presentsadditional information about assets, including derivatives, that are measuredat fair value on a recurring basis for which the Company has utilizedlevel 3 inputs to determine fair value, for the three months ended March 31,2008 (amounts in thousands):

 
| ** **                                                                                                                                                                                 | ** ** | **Fair Value Measurements Using Significant  Unobservable Inputs  (Level 3)** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                 | ** ** | **Securities  Available-For-Sale**                                                                          | ** ** | **Derivatives,  net** | ** ** |
| Beginning balance as of December 31, 2007                                                                                                                                             |       | $                                                                                                           | 99,498     |   | $ | 802 |   |
| Total gains or losses (realized and unrealized):                                                                                                                                           |       |                                                                                                        |       |   |   |
| Included in earnings                                                                                                                                                                       |       | —                                                                                                      |       | 764 |   |
| Included in other comprehensive loss                                                                                                                                                       |       | (3,504                                                                                                      | )          | — |   |
| Net transfers out of level 3                                                                                                                                                          |       | —                                                                                                      |       | — |   |
| Purchases, sales, other settlements and issuances, net                                                                                                                                     |       | (17,340                                                                                                     | )          | (517 | ) |
| Ending balance as of March 31, 2008                                                                                                                                                   |       | $                                                                                                           | 78,654     |   | $ | 1,049 |   |
| The amount of total gains or losses for the period included in  earnings attributable to the change in unrealized gains or losses relating to  assets still held at the reporting date (1) |       | $                                                                                                           | —     |   | $ | 764 |   |

 

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(1)                                  Amounts are included in net realized andunrealized gain (loss) on derivatives and foreign exchange in thecondensed consolidated statements of operations.

 

The following table presentsadditional information about assets, including derivatives that are measured atfair value on a recurring basis for which the Company has utilized level 3inputs to determine fair value, for the three months ended March 31, 2007(amounts in thousands):

 
| ** **                                                                                                                                                                                      | ** ** | **Fair Value Measurements Using Significant  Unobservable Inputs  (Level 3)** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                      | ** ** | **Securities  Available-For-Sale**                                                                          | ** ** | **Derivatives,  net** | ** ** |
| Beginning balance as of December 31, 2006                                                                                                                                                  |       | $                                                                                                           | 104,498    |   | $ | — |   |
| Total gains or losses (realized and unrealized):                                                                                                                                                |       |                                                                                                        |       |   |   |
| Included in earnings                                                                                                                                                                            |       | —                                                                                                      |       | 1,109 |   |
| Included in other comprehensive loss                                                                                                                                                            |       | 854                                                                                                         |       | — |   |
| Net transfers into level 3                                                                                                                                                                 |       | —                                                                                                      |       | — |   |
| Purchases, sales, other settlements and issuances, net                                                                                                                                          |       | —                                                                                                      |       | — |   |
| Ending balance as of March 31, 2007                                                                                                                                                        |       | $                                                                                                           | 105,352    |   | $ | 1,109 |   |
| The amount of total gains or losses for the period included in  earnings attributable to the change in unrealized gains or losses relating to  assets still held at the reporting date (1) |       | $                                                                                                           | —     |   | $ | 1,109 |   |

 

----

(1)                                  Amounts are included in net realized andunrealized gain (loss) on derivatives and foreign exchange in thecondensed consolidated statements of operations.

 

26

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As of March 31, 2008and December 31, 2007, the Company did not have any assets or liabilitiesmeasured at fair value on a non-recurring basis.

 

**Note 14. Subsequent Events**

 

On April 8, 2008, the Company consummated apublic offering of 34.5 million common shares at a price of $11.85 percommon share.  Net proceeds from thetransaction before expenses totaled $384.3 million, which the Company willuse for general corporate purposes.

 

On May 1, 2008, theCompany’s board of directors declared a cash distribution for the quarter endedMarch 31, 2008 on the Company’s common shares of $0.40 per share. Thedistribution is payable on May 30, 2008 to shareholders of record as ofthe close of business on May 15, 2008.

 

27

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**Item 2. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

 

*Unless otherwise expressly stated or the context suggestsotherwise, the terms “we,” “us” and “our” refer, as of dates and for periods onand after May 4, 2007 to KKR Financial Holdings LLC and its subsidiariesand, as of dates and for periods prior to May 4, 2007, to our predecessor,KKR Financial Corp., and its subsidiaries; “Manager” means KKR FinancialAdvisors LLC; “KKR” means Kohlberg Kravis Roberts & Co. L.P. and itsaffiliated companies (excluding portfolio companies that are minority ormajority owned or managed by funds associated with KKR); “Management Agreement”means the amended and restated management agreement between KKR FinancialHoldings LLC and the Manager. The following management’s discussion andanalysis (“MD&A”) is intended to assist the reader in understanding ourbusiness. The MD&A is provided as a supplement to, and should be read inconjunction with, our Condensed Consolidated Financial Statements andaccompanying notes included in this Quarterly Report on Form 10-Q and ourConsolidated Financial Statements and accompanying notes included in our AnnualReport on Form 10-K for the year ended December 31, 2007.*

 

**Forward Looking 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 cautionarystatements, which identify factors that could cause actual results to differfrom those expressed in the forward-looking statements. Statements that are nothistorical facts, including statements about our beliefs and expectations, areforward-looking statements. The words “believe,” “anticipate,” “intend,” “aim,”“expect,” “strive,” “plan,” “estimate,” and “project,” and similar wordsidentify forward-looking statements. Such statements are not guarantees offuture performance, events or results and involve potential risks anduncertainties. Accordingly, actual results and the timing of certain 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 not undertake, and specificallydisclaim, any obligation to publicly release the result of any revisions thatmay be made to any forward-looking statements to reflect the occurrence ofanticipated or unanticipated events or circumstances after the date of suchstatements.

 

**Executive Overview**

 

We are a specialty financecompany that uses leverage with the objective of generating competitiverisk-adjusted returns. We invest in financial assets primarily consisting ofcorporate loans and securities, including senior secured and unsecured loans,mezzanine loans, high yield corporate bonds, distressed and stressed debtsecurities, marketable and non-marketable equity securities, and credit defaultand total rate of return swaps. We also make opportunistic investments in otherasset classes from time to time.

 

Our objective is to providecompetitive returns to our investors through a combination of distributions andcapital appreciation. As part of our investment strategy, we seek to investopportunistically in those asset classes that can generate competitiveleveraged risk-adjusted returns, subject to maintaining our exemption fromregulation under the Investment Company Act of 1940, as amended (the “InvestmentCompany Act”).

 

Our income is generatedprimarily from (i) net interest income and dividend income, (ii) realizedand unrealized gains and losses on our derivatives that are not accounted foras hedges, (iii) realized gains and losses from the sales of investments, (iv) realizedand unrealized gains and losses on securities sold, not yet purchased, and (v) feeincome.

 

We are a Delaware limitedliability company and were organized on January 17, 2007. We are thesuccessor to KKR Financial Corp. (the “REIT Subsidiary”), a Marylandcorporation. The REIT Subsidiary was originally incorporated in the State ofMaryland on July 7, 2004 and elected to be treated as a real estateinvestment trust (“REIT”) for U.S. federal income tax purposes.

 

On May 4, 2007, wecompleted a restructuring transaction (the “Restructuring Transaction”),pursuant to which the REIT Subsidiary became our subsidiary and eachoutstanding share of the REIT Subsidiary’s common stock was converted into oneof our common shares, which are publicly traded on the New York Stock Exchange(“NYSE”) under the symbol 

 

28

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“KFN”. Although we have not elected to betreated as a REIT for U.S. federal income tax purposes, we intend to continueto operate so as to qualify as a partnership, and not as an association orpublicly traded partnership taxable as a corporation, for U.S. federal incometax purposes.

 

We manage our liquidity with the intention ofmaintaining the continuing ability to fund our operations and fulfill ourcommitments on a timely and cost-effective basis.  Based on changes in our working capital, forany given period, the cash flows provided by operating activities may be lessthan the cumulative distributions paid on our shares for such period and suchshortfall, if any, may be funded through the issuance of unsecured indebtednessor through the borrowing of additional amounts through the pledging of certain ofour assets.  Our board of directorsconsiders available liquidity when declaring distributions toshareholders.  As of March 31, 2008, wehad unrestricted cash and cash equivalents totaling $210.7 million.

 

We are managed by KKRFinancial Advisors LLC (our “Manager”) pursuant to a management agreement(the “Management Agreement”). The Manager is an affiliate of Kohlberg KravisRoberts & Co. L.P. (“KKR”).

 

***Discontinued Operations***

 

In August 2007, our board of directorsapproved a plan to exit our residential mortgage investment operations and sellthe REIT Subsidiary. As of January 1, 2008, the REIT Subsidiary’s assetsand liabilities consisted solely of those held by our two asset-backedcommercial paper conduits (the “Facilities”). During March 2008, we entered into an agreement with the holders ofthe secured liquidity notes (“SLNs”) issued by the Facilities (the “Noteholders”)in order to terminate the Facilities. With respect to the agreement with the Noteholders, all of theresidential mortgage-backed securities (“RMBS”) funded by the SLNs have beenreturned to the Noteholders in satisfaction of the SLNs and we have paid theNoteholders approximately $42.0 million in conjunction with this resolution. Wehad previously accrued $36.5 million for contingencies related to resolution ofthe Facilities and as a consequence of this transaction, we recorded anincremental charge during the quarter ended March 31, 2008 for $5.5million. The agreement with the Noteholders resulted in approximated $3.6billion par amount of RMBS being returned to the Noteholders in satisfaction ofapproximately $3.5 billion par amount of SLNs held by the Noteholders.Accordingly, we have removed the RMBS and SLNs that related to the Facilitiesfrom our condensed consolidated financial statements as of March 31, 2008.Under the agreement with the Noteholders, both we and our affiliates have beenreleased from any future obligations or liabilities to the Noteholders.

 

Separately, on March 31, 2008, we entered intoa definitive agreement with Rock Capital 2 LLC pursuant to which Rock Capital 2LLC will acquired a controlling interest in the REIT Subsidiary. This sale isexpected to close during the second quarter of 2008 and is not expected toresult in either a gain or loss.

 

Through the aforementioned transactions combined withsales of residential mortgage assets during 2007, we have completed significantsteps in our plan to terminate our residential mortgage investment operations.As of March 31, 2008, our remaining residential mortgage portfolio consists of$324.4 million of RMBS, of which $287.4 million is rated investment grade orhigher and $37.0 million is rated below investment grade. Of the $324.4 millionof RMBS, $203.1 million represents interests in residential mortgagesecuritization trusts that are not structured as qualifying special-purposeentities under GAAP.  We consolidatethese trusts as we are the primary beneficiary of these entities under GAAP,and therefore report total assets of $3.6 billion and total liabilities of $3.4billion for these trusts in discontinued operations. We account for our residentialmortgage assets, consisting of RMBS and residential mortgage loans, and ourresidential mortgage liabilities, consisting of mortgage-backed securitiesissued, at estimated fair value with changes in estimated fair value includedin income from discontinued operations on our condensed consolidated statementsof operations.

 

***Common Share Offering***

 

On April 8, 2008, we completed a public offeringof 34.5 million common shares at a price of $11.85 per common share. Netproceeds from the transaction before expenses totaled $384.3 million,which we will use for general corporate purposes.

 

***Cash Distributions to Shareholders***

 

On May 1, 2008, our boardof directors declared a cash distribution for the quarter ended March 31,2008 on our common shares of $0.40 per share. The distribution is payable onMay 30, 2008 to shareholders of record as of the close of business on May 15,2008.

 

***Investment Portfolio***

 

As of March 31, 2008,our investment portfolio totaled $10.1 billion, representing an increaseof 1% from $10.0 billion as of December 31, 2007. As of March 31,2008, our investment portfolio primarily consisted of corporate loans andcorporate debt securities totaling $10.1 billion and marketable equitysecurities consisting of preferred and common stock totaling$28.7 million. In addition, our investment portfolio included investmentsin non-marketable equity securities totaling $20.1 million as of March 31,2008.

 

29

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**Critical Accounting Policies**

 

Our condensed consolidatedfinancial statements are prepared by management in conformity with GAAP. Oursignificant accounting policies are fundamental to understanding our financialcondition and results of operations because some of these policies require thatwe make significant estimates and assumptions that may affect the value of ourassets or liabilities and financial results. We believe that certain of ourpolicies are critical because they require us to make difficult, subjective,and complex judgments about matters that are inherently uncertain. We havereviewed these critical accounting policies with our board of directors and ouraudit committee.

 

***Revenue Recognition***

 

We account for interestincome on our investments using the effective yield method. For investmentspurchased at par, the effective yield is the contractual coupon rate on theinvestment. Unamortized premiums and unaccreted discounts on non-residentialmortgage-backed securities are recognized in interest income over thecontractual life, adjusted for actual prepayments, of the securities using theeffective interest method. For securities representing beneficial interests insecuritizations that are not highly rated (i.e., subordinate tranches ofresidential mortgage-backed securities), unamortized premiums and unaccreted discountsare recognized over the contractual life, adjusted for estimated prepaymentsand estimated credit losses of the securities using the effective interestmethod. Actual prepayment and credit loss experience is reviewed quarterly andeffective yields are recalculated when differences arise between prepaymentsand credit losses originally anticipated compared to amounts actually receivedplus anticipated future prepayments.

 

Interest income on loansincludes interest at stated coupon rates adjusted for accretion of purchasediscounts and the amortization of purchase premiums. For corporate loans,unamortized premiums and unaccreted discounts are recognized in interest incomeover the contractual life, adjusted for actual prepayments, of the loans usingthe effective interest method.

 

As of March 31, 2008,unamortized purchase premiums and unaccreted purchase discounts on ourinvestment portfolio totaled $0.8 million and $189.5 million,respectively.

 

***Fair Value of Financial Instruments***

 

Effective January 1,2007, we adopted SFAS No. 157, *FairValue Measurements* (“SFAS No. 157”), which requires additionaldisclosures about our assets and liabilities that are measured at fair value.

 

As defined in SFAS No. 157,fair value is the price that would be received to sell an asset or paid totransfer a liability in an orderly transaction between market participants atthe measurement date. Where available, fair value is based on observable marketprices or parameters or derived from such prices or parameters. Whereobservable prices or inputs are not available, valuation models are applied.These valuation techniques involve some level of management estimation andjudgment, the degree of which is dependent on the price transparency for theinstruments or market and the instruments’ complexity for disclosure purposes.Beginning in January 2007, assets and liabilities recorded at fair valuein the consolidated balance sheets are categorized based upon the level ofjudgment associated with the inputs used to measure their value. Hierarchicallevels, as defined in SFAS No. 157 and directly related to the amount ofsubjectivity associated with the inputs to fair valuations of these assets andliabilities, are as follows:

 

Level 1: Inputs areunadjusted, quoted prices in active markets for identical assets or liabilitiesat the measurement date.

 

The types of assets carriedat level 1 fair value generally are equity securities listed in activemarkets.

 

Level 2: Inputs otherthan quoted prices included in level 1 that are observable for the assetor liability, either directly or indirectly. Level 2 inputs include quotedprices for similar instruments in active markets, and inputs other than quotedprices that are observable for the asset or liability.

 

Fair value assets andliabilities that are generally included in this category are certain corporatedebt securities and certain financial instruments classified as derivativeswhere the fair value is based on observable market inputs.

 

Level 3: Inputs areunobservable inputs for the asset or liability, and include situations wherethere is little, if any, market activity for the asset or liability. In certaincases, the inputs used to measure fair value may 

 

30

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fall into different levelsof the fair value hierarchy. In such cases, the level in the fair valuehierarchy within which the fair value measurement in its entirety falls hasbeen determined based on the lowest level input that is significant to the fairvalue measurement in its entirety. Our assessment of the significance of aparticular input to the fair value measurement in its entirety requiresjudgment, and considers factors specific to the asset.

 

Generally, assets andliabilities carried at fair value and included in this category are certaincorporate debt securities and certain derivatives.

 

The availability ofobservable inputs can vary depending on the financial asset or liability and isaffected by a wide variety of factors, including, for example, the type ofproduct, whether the product is new, whether the product is traded on an activeexchange or in the secondary market, and the current market condition. To theextent that valuation is based on models or inputs that are less observable orunobservable in the market, the determination of fair value requires morejudgment. Accordingly, the degree of judgment exercised by us in determiningfair value is greatest for instruments categorized in level 3. In certaincases, the inputs used to measure fair value may fall into different levels ofthe fair value hierarchy. In such cases, for disclosure purposes the level inthe fair value hierarchy within which the fair value measurement in its entiretyfalls is determined based on the lowest level input that is significant to thefair value measurement in its entirety.

 

Fair value is a market-basedmeasure considered from the perspective of a market participant who holds theasset or owes the liability rather than an entity-specific measure. Therefore,even when market assumptions are not readily available, our own assumptions areset to reflect those that market participants would use in pricing the asset orliability at the measurement date.

 

Many financial assets andliabilities have bid and ask prices that can be observed in the marketplace.Bid prices reflect the highest price that we and others are wiling to pay foran asset. Ask prices represent the lowest price that we and others are willingto accept for an asset. For financial assets and liabilities whose inputs arebased on bid-ask prices, we do not require that fair value always be apredetermined point in the bid-ask range. Our policy is to allow for mid-marketpricing and adjusting to the point within the bid-ask range that meets our bestestimate of fair value.

 

Assets that are valued usinglevel 3 of the fair value hierarchy primarily consist of certain corporate debtsecurities and certain over-the-counter (“OTC”) derivative contracts.  The valuation techniques used for these aredescribed below.

 

*Corporate Debt Securities:* Corporate debtsecurities are initially valued at transaction price and are subsequentlyvalued using market data for similar instruments (e.g., recent transactions orbroker quotes), comparisons to benchmark derivative indices or movements inunderlying credit spreads.

 

*OTC Derivative Contracts:* OTC derivativecontracts include forward, swap and option contracts related to interest rates,foreign currencies, credit standing of reference entities, and equity prices.The fair value of OTC derivative products can be modeled using a series oftechniques, including closed-form analytic formulae, such as the Black-Scholesoption-pricing model, and simulation models or a combination thereof. Manypricing models do not entail material subjectivity because the methodologiesemployed do not necessitate significant judgment, and the pricing inputs areobserved from actively quoted markets, as is the case for generic interest rateswap and option contracts.

 

***Share-Based Compensation***

 

We account for share-basedcompensation issued to members of our board of directors and our Manager usingthe fair value based methodology in accordance with SFAS No. 123(R), *Share-based Compensation* (“SFAS No. 123(R)”).We do not have any employees, although we believe that members of our board ofdirectors are deemed to be employees for purposes of interpreting and applyingaccounting principles relating to share-based compensation. We record as compensationcosts the restricted common shares that we issued to members of our board ofdirectors at estimated fair value as of the grant date and we amortize the costinto expense over the three-year vesting period using the straight-line method.We record compensation costs for restricted common shares and common shareoptions that we issued to our Manager at estimated fair value as of the grantdate and we remeasure the amount on subsequent reporting dates to the extentthe awards have not vested. Unvested restricted common shares are valued usingobservable secondary market prices. Unvested common share options are valuedusing the Black-Scholes model and assumptions based on observable market datafor comparable companies. We amortize compensation expense related to therestricted common share and common share options that we granted to our Managerusing the graded vesting attribution and straight-line method in accordancewith SFAS No. 123(R). As of March 31, 2008, the common share options werefully vested.

 

31

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Because we remeasure theamount of compensation costs associated with the unvested restricted commonshares and unvested common share options that we issued to our Manager as ofeach reporting period, our share-based compensation expense reported in ourcondensed consolidated financial statements will change based on the estimatedfair value of our common shares and this may result in earnings volatility. Forthe three months ended March 31, 2008, share-based compensation totaled$0.6 million. As of March 31, 2008, substantially all of thenon-vested restricted common shares issued that are subject to SFAS No. 123(R) aresubject to remeasurement. As of March 31, 2008, a $1 increase in the priceof our common shares would have increased our future share-based compensationexpense by approximately $1.7 million and this future share-basedcompensation expense would be recognized over the remaining vesting periods ofour outstanding restricted common shares and common share options. As of March 31,2008, future unamortized share-based compensation totaled $14.7 million, ofwhich $4.6 million, $4.8 million, and $5.3 million will berecognized in 2008, 2009, and beyond, respectively.

 

***Accounting for Derivative Instruments and Hedging Activities***

 

We recognize all derivativeson our condensed consolidated balance sheets at estimated fair value. On thedate we enter into a derivative contract, we designate and document eachderivative contract as one of the following at the time the contract isexecuted: (i) a hedge of a recognized asset or liability (“fair value”hedge); (ii) a hedge of a forecasted transaction or of the variability ofcash flows to be received or paid related to a recognized asset or liability (“cashflow” hedge); (iii) a hedge of a net investment in a foreign operation; or(iv) a derivative instrument not designated as a hedging instrument (“free-standingderivative”). For a fair value hedge, we record changes in the estimated fairvalue of the derivative and, to the extent that it is effective, changes in thefair value of the hedged asset or liability attributable to the hedged risk, inthe current period earnings in the same financial statement category as thehedged item. For a cash flow hedge, we record changes in the estimated fairvalue of the derivative to the extent that it is effective in othercomprehensive income. We subsequently reclassify these changes in estimatedfair value to net income in the same period(s) that the hedged transactionaffects earnings in the same financial statement category as the hedged item.For free-standing derivatives, we report changes in the fair values in currentperiod other (loss) income.

 

We formally document atinception our hedge relationships, including identification of the hedginginstruments and the hedged items, our risk management objectives, strategy forundertaking the hedge transaction and our evaluation of effectiveness of itshedged transactions. Periodically, as required by SFAS No. 133, *Accounting for Derivative Instruments and HedgingActivities*, as amended and interpreted (“SFAS No. 133”), wealso formally assesses whether the derivative designated in each hedgingrelationship is expected to be and has been highly effective in offsetting changesin estimated fair values or cash flows of the hedged item using either thedollar offset or the regression analysis method. If we determine that aderivative is not highly effective as a hedge, we discontinue hedge accounting.

 

We are not required toaccount for our derivative contracts using hedge accounting as described above.If we decide not to designate the derivative contracts as hedges or if we failto fulfill the criteria necessary to qualify for hedge accounting, then thechanges in the estimated fair values of our derivative contracts would affectperiodic earnings immediately potentially resulting in the increased volatilityof our earnings. The qualification requirements for hedge accounting arecomplex and as a result, we must evaluate, designate, and thoroughly documenteach hedge transaction at inception and perform ineffectiveness analysis andprepare related documentation at inception and on a recurring basis thereafter.As of March 31, 2008, the estimated fair value of our net derivativeliabilities totaled $104.7 million.

 

***Impairments***

 

We evaluate our investmentportfolio for impairment as of each quarter end or more frequently if we becomeaware of any material information that would lead us to believe that aninvestment may be impaired. We evaluate whether the investment is consideredimpaired and whether the impairment is other-than-temporary. If we make adetermination that the impairment is other-than-temporary, we recognize animpairment loss equal to the difference between the amortized cost basis andthe estimated fair value of the investment. Evaluating whether the impairmentof an investment is other-than-temporary requires significant judgment andrequires us to make certain estimates and assumptions. 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 March 31, 2008, we had aggregate unrealized losses onour securities classified as available-for-sale of approximately$215.1 million, which if not recovered may result in the recognition offuture losses. As of March 31, 2008, there were no impairments which weredetermined to be other-than-temporary which has been recorded in the condensed consolidatedstatements of operations.

 

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***Allowance for Loan Losses***

 

Our allowance for estimatedloan losses represents our estimate of probable credit losses inherent in theloan portfolio as of the balance sheet date. When determining the adequacy ofthe allowance for loan losses, we consider historical and industry lossexperience, economic conditions and trends, the estimated fair values of ourloans, credit quality trends and other factors that we determine are relevant.Additions to the allowance for loan losses are charged to current periodearnings through the provision for loan losses. Amounts determined to beuncollectible are charged directly to the allowance for loan losses. Ourallowance for loan losses consists of two components, an allocated componentand an unallocated component.

 

The allocated component ofour allowance for loan losses consists of individual loans that are impairedand for which the estimated allowance for loan losses is determined inaccordance with SFAS No. 114, *Accountingby Creditors for Impairment of a Loan.* We consider a loan to beimpaired when, based on current information and events, we believe it is probablethat we will be unable to collect all amounts due to us based on thecontractual terms of the loan. An impaired loan may be left on accrual statusduring the period we are pursuing repayment of the loan; however, the loan isplaced on non-accrual status at such time as: (i) we believe thatscheduled debt service payments may not be paid when contractually due; (ii) theloan becomes 90 days delinquent; (iii) we determine the borrower isincapable of, or has ceased efforts toward, curing the cause of the impairment;or (iv) the net realizable value of the underlying collateral securing theloan decreases below our carrying value of such loan. While on non-accrualstatus, previously recognized accrued interest is reversed and interest incomeis recognized only upon actual receipt.

 

The unallocated component ofour allowance for loan losses is determined in accordance with SFAS No. 5,*Accounting for Contingencies*.This component of the allowance for loan losses represents our estimate oflosses inherent, but unidentified, in our portfolio as of the balance sheetdate. The unallocated component of the allowance for loan losses is estimatedbased upon a review of our loan portfolio’s risk characteristics, risk groupingof loans in the portfolio based upon estimated probability of default andseverity of loss based on loan type, and consideration of general economicconditions and trends. As of March 31, 2008, our allowance for loan lossestotaled $25.0 million.

 

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** **

**Recent Accounting Pronouncements**

 

InFebruary 2008, the FASB issued FSP FAS 140-3, *Accountingfor Transfers of Financial Assets and Repurchase Financing Transactions*(“FSPSFAS No. 140-3”). FSP SFAS No. 140-3 assumes that an initial transferof a financial asset and a repurchase financing are considered part of the samearrangement, or a linked transaction. However, if certain criteria are met, theinitial transfer and repurchase financing shall not be evaluated as a linkedtransaction and shall be evaluated separately under SFAS No. 140. FSP SFASNo. 140-3 is effective for repurchase financings in which the initialtransfer is entered into in fiscal years beginning after November 15, 2008and early adoption is not permitted. We do not expect the adoption of FSP SFAS No. 140-3 to have amaterial impact on our condensedconsolidated financial statements.

 

InMarch 2008, the FASB issued SFAS No. 161, *Disclosuresabout Derivative Instruments and Hedging Activities, an Amendment of FASBStatement No. 133*(“SFAS No. 161”). SFAS No. 161requires enhanced qualitative disclosures about objectives and strategies forusing derivatives, quantitative disclosures about fair value amounts of gainsand losses on derivative instruments, and disclosures about credit-risk-relatedcontingent features in derivative agreements. The additional disclosuresrequired by SFAS No. 161 must be included in the Company’s consolidatedfinancial statements beginning with the first quarter of 2009.

 

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**Results of Operations**

 

**Three months ended March 31, 2008 compared tothree months ended March 31, 2007**

 

*Summary*

 

Our net income for the threemonths ended March 31, 2008 totaled $14.0 million (or $0.12 perdiluted share) as compared to net income of $48.4 million (or $0.59 perdiluted share) for the three months ended March 31, 2007. Income fromcontinuing operations for the three months ended March 31, 2008 totaled$8.8 million (or $0.08 per diluted common share) as compared to$32.2 million (or $0.39 per diluted common share) for the three monthsended March 31, 2007. The decrease in income from continuing operations of$23.4 million, or 73%, from 2007 to 2008 is primarily attributable to netrealized and unrealized losses on investments, derivatives and foreign exchangetotaling $53.8 million.

 

*NetInvestment Income*

 

The following table presentsthe components of our net investment income for the three months ended March 31,2008 and 2007:

 

**Comparative Net Investment Income Components**

**(Amounts in thousands)**

 
| ** **                                          | ** ** | **For the three months ended  March 31, 2008** | ** ** | **For the three months ended  March 31, 2007** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| Investment Income:                                  |       |                                                                         |       |                                                                         |       |
| Corporate loans and securities interest income      |       | $                                                                            | 199,403    |                                                                         | $          | 85,237 |   |
| Other interest income                               |       | 11,044                                                                       |       | 2,578                                                                        |       |
| Common and preferred stock dividend income          |       | 816                                                                          |       | 974                                                                          |       |
| Net discount accretion                              |       | 7,366                                                                        |       | 1,408                                                                        |       |
| Total investment income                             |       | 218,629                                                                      |       | 90,197                                                                       |       |
| Interest Expense:                                   |       |                                                                         |       |                                                                         |       |
| Repurchase agreements                               |       | 27,281                                                                       |       | 6,229                                                                        |       |
| Collateralized loan obligation senior secured notes |       | 74,517                                                                       |       | 40,891                                                                       |       |
| Secured revolving credit facility                   |       | 2,526                                                                        |       | 987                                                                          |       |
| Secured demand loan                                 |       | 323                                                                          |       | 604                                                                          |       |
| Convertible senior notes                            |       | 5,388                                                                        |       | —                                                                       |       |
| Junior subordinated notes                           |       | 5,755                                                                        |       | 4,984                                                                        |       |
| Other interest expense                              |       | 746                                                                          |       | 634                                                                          |       |
| Interest rate swaps                                 |       | 1,173                                                                        |       | (47                                                                          | )          |
| Total interest expense                              |       | 117,709                                                                      |       | 54,282                                                                       |       |
| Interest expense to affiliates                      |       | 27,817                                                                       |       | —                                                                       |       |
| Net investment income                               |       | $                                                                            | 73,103     |                                                                         | $          | 35,915 |   |

 

As presented in the tableabove, net investment income increased $37.2 million, or 103.6%, from 2007to 2008. The increase is primarily attributable to the additional investmentsin our investment portfolio during 2008. As of March 31, 2008, we held$10.1 billion of investments in loans and securities available-for-sale.In comparison, as of March 31, 2007, investments in loans and securitiesavailable-for-sale totaled $4.0 billion.

 

Net investment income in thetable above does not include equity in income of unconsolidated affiliate ofnil and $7.0 million for the three months ended March 31, 2008 and2007, respectively. Equity in income of unconsolidated affiliate reflects ourpro rata interest in the net income of a limited partnership that was formed tohold the subordinated interests in three entities formed to execute securedfinancing transactions in the form of CLOs.

 

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*Other (Loss)Income*

 

The following table presentsthe components of other (loss) income for the three months ended March 31,2008 and 2007:

 

**Comparative Other (Loss) Income Components**

**(Amounts in thousands)**

 
| ** **                                                                         | ** ** | **For the three months ended  March 31, 2008** | ** ** | **For the three months ended  March 31, 2007** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| Net realized and unrealized (loss) gain on derivatives and foreign  exchange:      |       |                                                                         |       |                                                                         |       |
| Interest rate swaptions                                                            |       | $                                                                            | —     |                                                                         | $          | (16 | ) |
| Interest rate swaps                                                                |       | 3,795                                                                        |       | —                                                                       |       |
| Credit default swaps                                                               |       | 13,289                                                                       |       | (42                                                                          | )          |
| Total rate of return swaps                                                         |       | (62,625                                                                      | )          | 6,767                                                                        |       |
| Common stock warrants                                                              |       | (688                                                                         | )          | 430                                                                          |       |
| Foreign exchange contracts                                                         |       | 6                                                                            |       | —                                                                       |       |
| Foreign exchange translation                                                       |       | (793                                                                         | )          | (1                                                                           | )          |
| Total net realized and unrealized (loss) gain on derivatives and  foreign exchange |       | (47,016                                                                      | )          | 7,138                                                                        |       |
| Net realized (loss) gain on investments                                            |       | (9,757                                                                       | )          | 7,024                                                                        |       |
| Net realized and unrealized gain on securities sold, not yet  purchased            |       | 6,986                                                                        |       | —                                                                       |       |
| Lower of cost or estimated fair value adjustment on loans held for  sale           |       | (4,002                                                                       | )          | —                                                                       |       |
| Other income                                                                       |       | 4,955                                                                        |       | 2,049                                                                        |       |
| Total other (loss) income                                                          |       | $                                                                            | (48,834    | )                                                                            | $          | 16,211 |   |

 

As presented in the tableabove, total other (loss) income totaled $(48.8) million for the threemonths ended March 31, 2008 as compared to $16.2 million for thethree months ended March 31, 2007. The change in total other (loss) incomeis primarily attributable to a $47.0 million net realized and unrealizedloss on derivatives and foreign exchange, of which $62.6 million wasrelated to total rate of return swaps, partially offset by gains on creditdefault swaps.

 

*Non-Investment Expenses*

 

The following table presentsthe components of non-investment expenses for the three months ended March 31,2008 and 2007:

 

**Comparative Non-Investment Expense Components**

**(Amounts in thousands)**

 
| ** **                             | ** ** | **For the three months ended  March 31, 2008** | ** ** | **For the three months ended  March 31, 2007** | ** ** |
|----------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| Related party management compensation: |       |                                                                         |       |                                                                         |       |
| Base management fees                   |       | $                                                                            | 7,433      |                                                                         | $          | 7,196 |   |
| Incentive fees                         |       | —                                                                       |       | 6,371                                                                        |       |
| Share-based compensation               |       | 462                                                                          |       | 5,731                                                                        |       |
| Collateral management fees             |       | 1,264                                                                        |       | —                                                                       |       |
| Related party management compensation  |       | 9,159                                                                        |       | 19,298                                                                       |       |
| Professional services                  |       | 1,857                                                                        |       | 541                                                                          |       |
| Insurance expense                      |       | 161                                                                          |       | 194                                                                          |       |
| Directors expenses                     |       | 401                                                                          |       | 320                                                                          |       |
| General and administrative expenses    |       | 3,911                                                                        |       | 5,749                                                                        |       |
| Total non-investment expenses          |       | $                                                                            | 15,489     |                                                                         | $          | 26,102 |   |

 

As presented in the tableabove, our non-investment expenses decreased by $10.6 million for thethree months ended March 31, 2008 compared to March 31, 2007. Thesignificant components of non-investment expense are described below.

 

Management compensation torelated parties consists of base management fees payable to our Managerpursuant to the Management Agreement, incentive fees, collateral managementfees, and share-based compensation related to restricted common shares andcommon share options granted to our Manager. The base management fee payablewas calculated in accordance with the Management Agreement and is based on anannual rate of 1.75% times our “equity” as defined in the Management Agreement.Our Manager is also entitled to a quarterly incentive fee provided that ourquarterly “net income,” 

 

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as defined in the ManagementAgreement, before the incentive fee exceeds a defined return hurdle. Incentivefees of nil and $6.4 million were earned by the Manager during the three monthsended March 31, 2008 and 2007, respectively.

 

General andadministrative expenses consist of expenses incurred by our Manager on ourbehalf that are reimbursable to our Manager pursuant to the ManagementAgreement. Professional services expenses consist of legal, accounting andother professional services. Directors’ expenses represent share-basedcompensation, as well as expenses and reimbursables due to the board ofdirectors for their services. The decrease in non-investment expense isprimarily due to a decrease in share-based compensation related to the vestingof restricted common shares and common share options granted to our Manager in2004, decline in estimated fair value of restricted common shares granted toour Manager in 2005, and the absence of incentive fees.

 

*Income Tax Provision*

 

After theRestructuring Transaction, we no longer elect to be treated as a REIT for U.S.federal income tax purposes; however, we intend to continue to operate so as toqualify as a partnership, and not as an association or publicly tradedpartnership that is taxable as a corporation, for U.S. federal income taxpurposes. Therefore, we generally are not subject to U.S. federal income tax atthe entity-level, but are subject to limited state income taxes. Holders of ourshares are required to take into account their allocable share of each item ofour income, gain, loss, deduction, and credit for our taxable year end endingwithin or with their taxable year.

 

The REIT Subsidiaryelected, and KKR Financial Holdings II, LLC (“KFH II”) will elect, to be taxedas a REIT and we believe that they have complied with the provisions of theInternal Revenue Code of 1986, as amended, (the “Code”), with respect thereto. TheREIT Subsidiary and KFH II are not subject to federal income tax to the extentthat they currently distribute their income and satisfy certain asset, incomeand ownership tests, and recordkeeping requirements.

 

KKR FinancialCLO 2005-1, Ltd. (“CLO 2005-1”), KKR FinancialCLO 2005-2, Ltd. (“CLO 2005-2”), KKR FinancialCLO 2006-1, Ltd. (“CLO 2006-1”), KKR Financial CLO 2007-1, Ltd.(“CLO 2007-1”), KKR Financial CLO 2007-A, Ltd. (“CLO 2007-A”), KKR FinancialCLO 2007-4, Ltd. (“CLO 2007-4”), and KKR Financial CLO 2008-1, Ltd. (“CLO2008-1”) are foreign taxable corporate subsidiaries that were established tofacilitate securitization transactions, structured as secured financingtransactions, and KKR TRS Holdings, Ltd. (“TRS Ltd.”), is a foreigntaxable corporate subsidiary that was formed to make certain foreigninvestments from time to time. They are organized as exempted companies incorporatedwith limited liability under the laws of the Cayman Islands, and are generallynot subject to federal and state income tax at the corporate entity levelbecause they restrict their activities in the United States to trading in stockand securities for their own account. Therefore, despite their status astaxable corporate subsidiaries, they generally will not be subject to corporateincome tax in our financial statements on their earnings, and no provisions forincome taxes for the three months ended March 31, 2008 and 2007 wererecorded; however, we are generally required to include their current taxableincome in our calculation of taxable income allocable to shareholders.

 

**Investment Portfolio**

 

*Summary*

 

The tablesbelow summarize the carrying value, amortized cost, and estimated fair value ofour investment portfolio as of March 31, 2008 and December 31, 2007,classified by interest rate type. Carrying value is the value that investmentsare recorded on our condensed consolidated balance sheets and is estimated fairvalue for securities, amortized cost for loans held for investment, and thelower of cost or estimated fair value for loans held for sale. Estimated fairvalues set forth in the tables below are based on dealer quotes and/ornationally recognized pricing services.

 

The tablebelow summarizes our investment portfolio as of March 31, 2008 classifiedby interest rate type:

 

**Investment Portfolio**

**(Dollar amounts in thousands)**

 
| ** **                                             | ** ** | **Carrying   Value** | ** ** | **Amortized   Cost** | ** ** | **Estimated   Fair Value** | ** ** | **Portfolio Mix   % by Fair Value** | ** ** |
|--------------------------------------------------------|------------|---------------------------|------------|---------------------------|------------|--------------------------------------|------------|--------------------------------------------------------------|------------|
| **Floating Rate:**                                     |       |                      |       |                      |       |                                 |       |                                                         |       |
| Corporate Loans                                        |       | $                         | 8,943,364  |                      | $          | 8,943,364                            |       | $                                                            | 8,049,728  |   | 87.1 | % |
| Corporate Debt Securities                              |       | 156,934                   |       | 201,704                   |       | 156,934                              |       | 1.7                                                          |       |
| Total Floating Rate                                    |       | 9,100,298                 |       | 9,145,068                 |       | 8,206,662                            |       | 88.8                                                         |       |
| **Fixed Rate:**                                        |       |                      |       |                      |       |                                 |       |                                                         |       |
| Corporate Loans                                        |       | 68,809                    |       | 68,809                    |       | 64,902                               |       | 0.7                                                          |       |
| Corporate Debt Securities                              |       | 921,902                   |       | 1,067,700                 |       | 921,902                              |       | 10.0                                                         |       |
| Total Fixed Rate                                       |       | 990,711                   |       | 1,136,509                 |       | 986,804                              |       | 10.7                                                         |       |
| **Marketable and Non-Marketable Equity  Securities:**  |       |                      |       |                      |       |                                 |       |                                                         |       |
| Common and Preferred Stock                             |       | 28,722                    |       | 49,000                    |       | 28,722                               |       | 0.3                                                          |       |
| Non-Marketable Equity Securities                       |       | 20,084                    |       | 20,084                    |       | 20,084                               |       | 0.2                                                          |       |
| Total Marketable and Non-Marketable Equity  Securities |       | 48,806                    |       | 69,084                    |       | 48,806                               |       | 0.5                                                          |       |
| Total(1)                                               |       | $                         | 10,139,815 |                      | $          | 10,350,661                           |       | $                                                            | 9,242,272  |   | 100.0 | % |

 

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(1)                                  Totalcarrying value excludes allowance for loan losses of $25.0 million.

 

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The scheduleabove excludes equity securities sold, not yet purchased, with a cost of $34.4 millionand for which we had accumulated net unrealized gains of $3.7 million asof March 31, 2008.

 

The tablebelow summarizes our investment portfolio as of December 31, 2007classified by interest rate type:

 

**Investment Portfolio**

**(Dollar amounts in thousands)**

 
| ** **                                             | ** ** | **Carrying   Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Portfolio Mix  % by Fair Value** | ** ** |
|--------------------------------------------------------|------------|---------------------------|------------|---------------------|------------|--------------------------------|------------|--------------------------------------------------------|------------|
| **Floating Rate:**                                     |       |                      |       |                |       |                           |       |                                                   |       |
| Corporate Loans                                        |       | $                         | 8,591,430  |                | $          | 8,591,430                      |       | $                                                      | 8,297,908  |   | 85.2 | % |
| Corporate Debt Securities                              |       | 200,341                   |       | 218,722             |       | 200,341                        |       | 2.0                                                    |       |
| Total Floating Rate                                    |       | 8,791,771                 |       | 8,810,152           |       | 8,498,249                      |       | 87.2                                                   |       |
| **Fixed Rate:**                                        |       |                      |       |                |       |                           |       |                                                   |       |
| Corporate Loans                                        |       | 67,778                    |       | 67,778              |       | 65,688                         |       | 0.7                                                    |       |
| Corporate Debt Securities                              |       | 1,111,423                 |       | 1,219,305           |       | 1,111,423                      |       | 11.4                                                   |       |
| Total Fixed Rate                                       |       | 1,179,201                 |       | 1,287,083           |       | 1,177,111                      |       | 12.1                                                   |       |
| **Marketable and Non-Marketable Equity  Securities:**  |       |                      |       |                |       |                           |       |                                                   |       |
| Common and Preferred Stock                             |       | 47,777                    |       | 58,529              |       | 47,777                         |       | 0.5                                                    |       |
| Non-Marketable Equity Securities                       |       | 20,084                    |       | 20,084              |       | 20,084                         |       | 0.2                                                    |       |
| Total Marketable and Non-Marketable Equity  Securities |       | 67,861                    |       | 78,613              |       | 67,861                         |       | 0.7                                                    |       |
| Total(1)                                               |       | $                         | 10,038,833 |                | $          | 10,175,848                     |       | $                                                      | 9,743,221  |   | 100.0 | % |

 

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(1)                                  Totalcarrying value excludes allowance for loan losses of $25.0 million.

 

The scheduleabove excludes equity securities sold, not yet purchased, with a cost of$103.1 million and for which we had accumulated net unrealized gains of$2.7 million as of December 31, 2007.

 

*CorporateLoans*

 

Our corporateloan portfolio totaled $9.0 billion as of March 31, 2008 and$8.7 billion as of December 31, 2007. 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 March 31, 2008, $8.9 billion, or 99.2%, of our corporate loanportfolio was floating rate and $0.1 billion, or 0.8%, was fixed rate.  As of December 31, 2007, $8.6 billion,or 99.2% of our corporate loan portfolio was floating rate and $0.1 billion, or0.8%, was fixed rate.

 

All of our corporate loans haveindex reset frequencies of less than twelve months with the majority resettingat least quarterly.  The weighted-averagecoupon on our floating rate corporate loans was 5.94% and 7.85% as of March 31,2008 and December 31, 2007, respectively, and the weighted-average spreadto London Interbank Offered Rates (“LIBOR”) of our floating rate corporate loanportfolio was 2.95% and 2.87% as of March 31, 2008 and December 31,2007, respectively. The weighted-average years to maturity of our floating ratecorporate loans was 5.5 years and 5.7 years as of March 31, 2008 and December 31,2007, respectively.

 

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As of March 31,2008, our fixed rate corporate loans had a weighted-average coupon of 11.06%and a weighted-average years to maturity of 5.6 years, as compared to 11.01%and 5.8 years, respectively, as of December 31, 2007.

 

As of March 31,2008 and December 31, 2007, there were no corporate loan balances placedon non-accrual status. We evaluate and monitor the asset quality of ourinvestment portfolio by performing detailed credit reviews and by monitoringkey credit statistics and trends. The key credit statistics and trends wemonitor to evaluate the quality of our investments include credit ratings ofboth our investments and the issuer, financial performance of the issuerincluding earnings trends, free cash flows of the issuer, debt service coverageratios of the issuer, financial leverage of the issuer, and industry trendsthat have or may impact the issuer’s current or future financial performanceand debt service ability. As of March 31, 2008, none of our corporate loaninvestments were delinquent on principal or interest payments and none of theinvestments were in default status. Our allowance for loan losses totaled $25.0million as of March 31, 2008 and December 31, 2007 and there were nocharge-offs or provisions for additional losses recorded during the quarterended March 31, 2008.

 

We recorded a$4.0 million charge to earnings during the quarter ended March 31, 2008for the lower of cost or estimate fair value adjustment on loans held for saleof $71.9 million as of March 31, 2008. We had no loans held for sale as ofDecember 31, 2007.

 

The followingtable summarizes the par value of our corporate loan portfolio stratified byMoody’s and Standard & Poor’s ratings category as of March 31,2008 and December 31, 2007:

 

**Corporate Loans**

**(Amounts in thousands)**

 
| **Ratings Category**        | ** ** | **As of  March 31, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|----------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                          |       | $                                        | —     |                                        | $          | — |   |
| Aa1/AA+ through Aa3/AA–     |       | —                                   |       | —                                      |       |
| A1/A+ through A3/A–         |       | —                                   |       | —                                      |       |
| Baa1/BBB+ through Baa3/BBB– |       | 5,713                                    |       | 10,353                                      |       |
| Ba1/BB+ through Ba3/BB–     |       | 4,607,655                                |       | 4,595,862                                   |       |
| B1/B+ through B3/B–         |       | 4,031,135                                |       | 3,391,638                                   |       |
| Caa1/CCC+ and lower              |       | 535,730                                  |       | 405,584                                     |       |
| Non-rated                        |       | —                                   |       | 362,731                                     |       |
| Total                            |       | $                                        | 9,180,233  |                                        | $          | 8,766,168 |   |

 

*Corporate Debt Securities*

 

Our corporatedebt securities portfolio totaled $1.1 billion as of March 31, 2008 and$1.3 billion as of December 31, 2007. Our corporate debt securitiesportfolio consists of debt obligations of corporations, partnerships and otherentities in the form of senior secured, senior secured and subordinatednotes.  As of March 31, 2008, $0.9billion, or 85.5%, of our corporate debt securities portfolio was fixed rateand $0.2 billion, or 14.5%, was floating rate. As of December 31, 2007, $1.1 billion, or 84.7% of our corporatedebt securities portfolio was fixed rate and $0.2 billion, or 15.3%, wasfloating rate.

 

As of March 31,2008, our fixed rate corporate debt securities had a weighted-average coupon of10.43% and a weighted-average years to maturity of 7.3 years, as compared to10.42% and 7.5 years, respectively, as of December 31, 2007.

 

All of our floatingrate corporate debt securities have index reset frequencies of less than twelvemonths.  The weighted-average coupon onour floating rate corporate debt securities was 7.61% and 8.39% as of March 31,2008 and December 31, 2007, respectively, and the weighted-average spreadto LIBOR of our floating rate corporate debt securities was 3.21% and 3.28% asof March 31, 2008 and December 31, 2007, respectively. Theweighted-average years to maturity of our floating rate corporate debtsecurities was 5.5 years and 5.4 years as of March 31, 2008 and December 31,2007, respectively.

 

We evaluateand monitor the asset quality of our investment portfolio by performingdetailed credit reviews and by monitoring key credit statistics and trends. Thekey credit statistics and trends we monitor to evaluate the quality of ourinvestments include credit ratings of both our investments and the issuer,financial performance of the issuer including 

 

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earnings trends, free cashflows of the issuer, debt service coverage ratios of the issuer, financialleverage of the issuer, and industry trends that have or may impact the issuer’scurrent or future financial performance and debt service ability. As of March 31,2008, none of our investments corporate debt securities were delinquent onprincipal or interest payments and none of the investments were in defaultstatus.

 

The followingtable summarizes the par value of our corporate debt securities portfoliostratified by Moody’s Investors Service, Inc. (“Moody’s”) and Standard &Poor’s Ratings Services (“Standard & Poor’s”) ratings category as of March 31,2008 and December 31, 2007:

 

**Corporate Debt Securities**

**(Amounts in thousands)**

 
| **Ratings Category**        | ** ** | **As of March 31, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|----------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                          |       | $                                            | —     |                                        | $          | — |   |
| Aa1/AA+ through Aa3/AA–     |       | —                                       |       | —                                      |       |
| A1/A+ through A3/A–         |       | —                                       |       | —                                      |       |
| Baa1/BBB+ through Baa3/BBB– |       | —                                       |       | —                                      |       |
| Ba1/BB+ through Ba3/BB–     |       | 206,500                                      |       | 236,553                                     |       |
| B1/B+ through B3/B–         |       | 411,281                                      |       | 431,478                                     |       |
| Caa1/CCC+ and lower              |       | 669,250                                      |       | 772,315                                     |       |
| Non-Rated                        |       | 7,143                                        |       | 30,000                                      |       |
| Total                            |       | $                                            | 1,294,174  |                                        | $          | 1,470,346 |   |

 

**Portfolio Purchases**

 

We purchased$0.7 billion and $0.3 billion par amount of investments during thethree months ended March 31, 2008 and 2007, respectively.

 

The tablebelow summarizes our investment portfolio purchases for the periods indicatedand includes the par amount of the securities and loans that were purchased:

 

**Investment Portfolio Purchases**

**(Dollar amounts in thousands)**

 
| ** **                         | ** ** | **Three months ended  March 31, 2008** | ** ** | **Three months ended  March 31, 2007** | ** ** |
|------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                         | ** ** | **Par Amount**                                        | ** ** | **%**                                                      | ** ** | **Par Amount** | ** ** | **%** | ** ** |
| Securities:                        |       |                                                       |       |                                                       |       |   |   |   |   |
| Corporate Debt Securities          |       | $                                                          | 43,000     |                                                       | 5.8        | % | $ | 34,000 |   | 9.8 | % |
| Marketable Equity Securities       |       | 1,527                                                      |       | 0.2                                                        |       | 17,728 |   | 5.1 |   |
| Non-Marketable Equity Securities   |       | —                                                     |       | —                                                     |       | 7,500 |   | 2.2 |   |
| Total Securities Principal Balance |       | 44,527                                                     |       | 6.0                                                        |       | 59,228 |   | 17.1 |   |
| Loans:                             |       |                                                       |       |                                                       |       |   |   |   |   |
| Corporate Loans                    |       | 694,573                                                    |       | 94.0                                                       |       | 287,687 |   | 82.9 |   |
| Grand Total Principal Balance      |       | $                                                          | 739,100    |                                                       | 100.0      | % | $ | 346,915 |   | 100.0 | % |

 

The scheduleabove excludes equity securities sold, not yet purchased, with a cost of $34.4million as of March 31, 2008. There were no equity securities sold, notyet purchased as of March 31, 2007.

 

**Discontinued Operations**

 

Summarizedfinancial information for discontinued operations is as follows (amounts inthousands):

 
| ** **                             | ** ** | **As of  March 31, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|----------------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Assets of discontinued operations      |       | $                                        | 3,770,536  |                                        | $          | 7,129,106 |   |
| Liabilities of discontinued operations |       | $                                        | 3,519,354  |                                        | $          | 7,012,284 |   |

 

Income fromdiscontinued operations is as follows (amounts in thousands):

 
| ** **                          | ** ** | **Three months ended  March 31, 2008** | ** ** | **Three months ended  March 31, 2007** | ** ** |
|-------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| Income from discontinued operations |       | $                                                          | 5,203      |                                                       | $          | 16,195 |   |
|                                     |            |                                                            |            |                                                            |            |  |  |

 

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**Shareholders’ Equity**

 

Ourshareholders’ equity at March 31, 2008 and December 31, 2007 totaled$1.5 billion and $1.6 billion, respectively. Included in our shareholders’equity as of March 31, 2008 and December 31, 2007, was accumulatedother comprehensive loss totaling $250.4 million and $157.2 million,respectively.

 

Our averageshareholders’ equity and return on average shareholders’ equity for the threemonths ended March 31, 2008 were $1.6 billion and 3.6%, respectively,compared to $1.7 billion and 11.4%, respectively, for the three months ended March 31,2007. Return on average shareholders’ equity is defined as net income dividedby weighted average shareholders’ equity. Our book value per share as of March 31,2008 and December 31, 2007 was $12.96 and $14.27, respectively, and iscomputed based on 116,343,151 and 115,248,990 shares issued and outstanding as ofMarch 31, 2008 and December 31, 2007, respectively.

 

On May 1,2008, our board of directors declared a cash distribution for the quarter endedMarch 31, 2008 on our common shares of $0.40 per share. The distribution ispayable on May 30, 2008 to shareholders of record as of the close of businesson May 15, 2008.

 

**Liquidity and Capital Resources**

 

We manage ourliquidity with the intention of maintaining the continuing ability to fund ouroperations and fulfill our commitments on a timely and cost-effective basis.Based on changes in our working capital, for any given period the cash flowsprovided by operating activities may be less than the cumulative distributionspaid on our shares for such period and such shortfall, if any, may be fundedthrough the issuance of unsecured indebtedness or through the borrowing ofadditional amounts through the pledging of certain of our assets. Our board ofdirectors considers available liquidity when declaring distributions toshareholders. As of March 31, 2008, we had unrestricted cash and cashequivalents totaling $210.7 million.

 

We believethat our liquidity level and access to additional financing is in excess ofthat necessary to sufficiently enable us to meet our anticipated liquidityrequirements including, but not limited to, funding our purchases ofinvestments, required cash payments and additional collateral under ourborrowings and our derivative transactions, required periodic cash paymentsrelated to our derivative transactions, payment of fees and expenses related toour Management Agreement, payment of general corporate expenses and generalcorporate capital expenditures, distributions to our shareholders andimplementing our long-term business strategy, although there can be noassurance in this regard. As of March 31, 2008, we owed our Manager$4.9 million for the payment of management fees, collateral managementfees and reimbursable expenses pursuant to the Management Agreement.

 

Our ability tomeet our long-term liquidity and capital resource requirements may be subjectto our ability to obtain additional debt financing and equity capital. We mayincrease our capital resources through offerings of equity securities (possiblyincluding common shares and one or more classes of preferred shares), commercialpaper, medium-term notes, securitization transactions structured as securedfinancings, and senior or subordinated notes. If we are unable to renew,replace or expand our sources of financing on acceptable terms, it may have anadverse effect on our business and results of operations and our ability tomake distributions to shareholders. Upon liquidation, holders of our debtsecurities and lenders with respect to other borrowings will receive, and anyholders of preferred shares that we may issue in the future may receive, adistribution of our available assets prior to holders of our common shares. 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.

 

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**Sources of Funds**

 

*Common Share Offering*

 

On April 8, 2008, wecompleted a public offering of 34.5 million common shares at a price of$11.85 per common share. Net proceeds from the transaction before expenses totaled$384.3 million, which we will use for general corporate purposes.

 

*Repurchase Agreements*

 

As of March 31,2008, we had $2.4 billion outstanding on repurchase facilities with sixcounterparties with a weighted average effective rate of 3.24% and a weightedaverage remaining term to maturity of 60 days. Because we borrow underrepurchase agreements based on the estimated fair value of our pledgedinvestments, and because changes in interest rates can negatively impact thevaluation of our pledged investments, our ongoing ability to borrow under ourrepurchase facilities may be limited and our lenders may initiate margin callsin the event interest rates change or the value of our pledged securitiesdecline as a result of adverse changes in interest rates or credit spreads.

 

*Secured Credit Facility*

 

On December 14,2007, we amended our Second Amended and Restated Credit Agreement, dated May 4,2007, with Bank of America, N.A., as Administrative Agent and the lenderparties thereto, and the REIT Subsidiary, KKR TRS Holdings, Inc. (“TRS Inc.”),TRS Ltd., KFH II, KFH III, KKR Financial Holdings, Inc. and KKRFinancial Holdings, Ltd. The amendment decreased the size of the creditfacility from $800.0 million to $500.0 million. Outstandingborrowings under the credit facility bear interest at either (a) aninterest rate per annum equal to the LIBOR rate for the applicable interestperiod plus 0.825% for borrowings under tranche A of the facility and 1.075%for borrowings under tranche B of the facility or (b) an alternatebase rate per annum equal to the greater of (i) the prime rate in effecton such day and (ii) the federal funds rate in effect on such day plus0.50%. In addition, pursuant to this amendment our financial covenants wereamended to now require that we:

 

·                  maintain adjusted consolidatedtangible net worth of at least $1.437 billion plus an amount equal to 85%of the net proceeds, subject to certain exceptions, from the issuance of equityinterests (as defined in the amendment) subsequent to September 30, 2007;

 

·                  not permit our adjusted net incomefrom continuing operations (as defined in the amendment) to be less than $1.00for any quarter; and

 

·                  not exceed a leverage ratio (asdefined in the amendment) of 4.75 to 1.0, computed on a basis thatgenerally excludes debt of discontinued operations.

 

*Capital Utilization and Leverage*

 

As of March 31,2008 and December 31, 2007, we had shareholders’ equity totaling $1.5billion and $1.6 billion, respectively and our leverage was 6.6 times and6.1 times equity, respectively.

 

*Off-Balance Sheet Commitments*

 

As of March 31,2008, we had committed to purchase corporate loans with aggregate commitmentstotaling $13.7 million. In a typical loan syndication, there is a delaybetween the time we are informed of our allocable portion of such loan and theactual funding of such loan.

 

We participatein certain financing arrangements, including revolvers and delayed drawfacilities, whereby we are committed to provide funding at the discretion ofthe borrower up to a specific predetermined amount. As of March 31, 2008,we had unfunded financing commitments totaling $135.1 million.

 

**REIT Matters**

 

As of March 31,2008, we believe that the REIT Subsidiary and KFH II qualified as REITsunder the provisions of the Code. The Code requires, among other things, thatat the end of each calendar quarter at least 75% of a REIT’s total assets mustbe “real estate assets” as defined in the Code. The Code also requires thateach year at least 75% of a REIT’s gross income come from real estate sourcesand at least 95% of a REIT’s gross income come from real estate sources andcertain other passive sources itemized in the Code, such as dividends andinterest. As of March 31, 2008, we believe that the REIT Subsidiary and KFH IIwere in compliance with 

 

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such requirements. As of March 31,2008, we also believe that the REIT Subsidiary and KFH II met all of theREIT requirements regarding the ownership of their common stock and shares,respectively, and the distribution of their taxable income. However, thesections of the Code and the corresponding U.S. Treasury Regulations thatrelate to qualification and taxation as a REIT are highly technical andcomplex, and each REIT subsidiary’s qualification and taxation as a REITdepends upon its ability to meet various qualification tests imposed under theCode (such as those described above), including through its actual annualoperating results, asset composition, distribution levels and diversity of shareownership. Accordingly, no assurance can be given that the REIT Subsidiary and KFH IIhave been organized and have operated, or will continue to be organized andoperated, in a manner so as to qualify or remain qualified as REITs.

 

To maintain theirstatus as REITs for federal income tax purposes, the REIT Subsidiary andKFH II are required to distribute at least 90% of their REIT taxableincome for each year. In addition, for each taxable year, to avoid certainfederal excise taxes, the REIT Subsidiary and KFH II are required todeclare and pay dividends amounting to certain designated percentages of theirtaxable income by the end of such taxable year. For the periods covered by ourcalendar year 2008 and 2007 federal tax return, we believe that the REIT Subsidiaryand KFH II met all of the distribution requirements of a REIT.

 

**Exemption from Regulation under theInvestment Company Act**

 

We intend toconduct our operations so that we are not required to register as an investmentcompany under the Investment Company Act. Section 3(a)(l)(C) of theInvestment Company Act defines as an investment company any issuer that isengaged or proposes to engage in the business of investing, reinvesting,owning, holding or trading in securities and owns or proposes to acquireinvestment securities having a value exceeding 40% of the value of the issuer’stotal assets (exclusive of U.S. government securities and cash items) on anunconsolidated basis. Excluded from the term “investment securities,” amongother things, are securities issued by majority-owned subsidiaries that are notthemselves investment companies and are not relying on the exception from thedefinition of an investment company set forth in Section 3(c)(l) or Section 3(c)(7) ofthe Investment Company Act.

 

After theRestructuring Transaction, we were organized as a holding company that conductsits businesses primarily through majority-owned subsidiaries. As a result, thesecurities issued to us by our subsidiaries that are excepted from thedefinition of an “investment company” by Section 3(c)(l) or 3(c)(7) ofthe Investment Company Act, together with any other “investment securities” wemay own, may not have a combined value in excess of 40% of the value of ourtotal assets on an unconsolidated basis. The determination of whether an entityis a majority-owned subsidiary of ours is made by us. The Investment CompanyAct defines a majority-owned subsidiary of a person as a company 50% or more ofthe outstanding voting securities of which are owned by such person, or byanother company which is a majority-owned subsidiary of such person. TheInvestment Company Act further defines voting securities as any securitypresently entitling the owner or holder thereof to vote for the election ofdirectors of a company. We treat companies, including CLO issuers, in which weown at least a majority of the outstanding voting securities as majority-ownedsubsidiaries for purposes of the 40% test.

 

Oursubsidiaries that issue CLOs generally will rely on Rule 3a-7, an exemptionfrom the Investment Company Act provided for certain structured financingvehicles. Accordingly, each of our CLO subsidiaries that rely on Rule 3a-7is subject to specific guidelines and restrictions, including a prohibition onthe CLO issuers from acquiring and disposing of assets primarily for thepurposes of recognizing gains or decreasing losses resulting from market valuechanges. Certain sales and purchases of assets may be made so long as the CLOsdo not violate our guidelines and are not based primarily on the changes inmarket value. We can, however, sell assets without limitation if we believe thecredit profile of the obligor will deteriorate. The proceeds of permitteddispositions may be reinvested in collateral that is consistent with the creditprofile of the CLO under specific and predetermined guidelines.

 

In addition,the combined value of the investment securities issued by our subsidiaries thatare excepted by Section 3(c)(1) or 3(c)(7) of the InvestmentCompany Act, together with any other investment securities we may own, may notexceed 40% of the value of our total assets on an unconsolidated basis. Thisrequirement limits the types of businesses in which we may engage through thesesubsidiaries.

 

To the extentthat the SEC provides more specific or different guidance regarding theapplication of Rule 3a-7 of the Investment Company Act, we may be requiredto adjust our investment strategy accordingly. Any additional guidance from theSEC could provide additional flexibility to us, or it could further inhibit ourability to pursue the investment strategy we have chosen, which could have amaterial adverse effect on our operations.

 

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**Quantitative and Qualitative DisclosuresAbout Market Risk**

 

*Currency Risks*

 

From time totime, we may make investments that are denominated in a foreign currencythrough which we may be subject to foreign currency exchange risk.

 

*Liquidity Risk*

 

Liquidity riskis defined as the risk that we will be unable to fulfill our obligations on atimely basis, continuously borrow funds in the market on a cost-effective basisto fund actual or proposed commitments, or liquidate assets when needed at areasonable price.

 

A materialevent that impacts capital markets participants may impair our ability toaccess additional liquidity. If our cash resources are at any time insufficientto satisfy our liquidity requirements, we may have to sell assets or issue debtor additional equity securities.

 

Our ability tomeet our long-term liquidity and capital resource requirements may be subjectto our ability to obtain additional debt financing and equity capital. We mayincrease our capital resources through offerings of equity securities (possiblyincluding common shares and one or more classes of preferred shares),commercial paper, medium-term notes, securitization transactions structured assecured financings, and senior or subordinated notes. If we are unable torenew, replace or expand our sources of financing on acceptable terms, it mayhave an adverse effect on our business and results of operations and ourability to make distributions to shareholders. Upon liquidation, holders of ourdebt securities and lenders with respect to other borrowings will receive, andany holders of preferred shares that we may issue in the future may receive, adistribution of our available assets prior to holders of our common shares. 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.

 

We haveestablished a formal liquidity contingency plan which provides guidelines forliquidity management. We determine our current liquidity position and forecastliquidity based on anticipated changes in the balance sheet. We also stresstest our liquidity position under several different stress scenarios. A stresstest aims at capturing the impact of extreme (but rare) market rate changes onthe market value of equity and net interest income. This scenario is applied ona daily basis to our balance sheet and the resulting loss in cash is evaluated.Besides providing a measure of the potential loss under the extreme scenario,this technique enables us to identify the nature of the changes in market riskfactors to which it is the most sensitive, allowing us to take appropriateaction to address those risk factors.

 

*Credit Spread Exposure*

 

Ourinvestments are subject to spread risk. Our investments in floating rate loansand securities are valued based on a market credit spread over LIBOR and arevalued affected similarly by changes in LIBOR spreads. Our investments in fixedrate loans and securities are valued based on a market credit spread over therate payable on fixed rate U.S. Treasuries of like maturity. Increased creditspreads, or credit spread widening, will have an adverse impact on the value ofour investments while decreased credit spreads, or credit spread tightening,will have a positive impact on the value of our investments.

 

*Interest Rate Risk*

 

Interest raterisk is defined as the sensitivity of our current and future earnings tointerest rate volatility, variability of spread relationships, the differencein repricing 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 are exposedto basis risk between our investments and our borrowings. Interest rates on ourfloating rate investments and our variable rate borrowings do not reset on thesame day or with the same frequency and, as a result, we are exposed to basisrisk with respect to index reset frequency. Our floating rate investments mayreprice on indices that are different than the indices that are used to priceour variable rate borrowings and, as a result, we are exposed to basis riskwith 

 

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respect to repricing index. Thebasis risks noted above, in addition to other forms of basis risk that existbetween our investments and borrowings, may be material and could negativelyimpact future net interest margins.

 

Interest raterisk impacts our interest income, interest expense, prepayments, and the fairvalue of our investments, interest rate derivatives, and liabilities. Duringperiods of increasing interest rates we are biased to purchase investments thatare floating rate and we have had that bias since our inception. We manage ourinterest rate risk using various techniques ranging from the purchase offloating rate investments to the use of interest rate derivatives. We generallyfund our variable rate investments with variable rate borrowings with similarinterest rate reset frequencies. We generally fund our fixed rate and ourhybrid investments with short-term variable rate borrowings and we may useinterest rate derivatives to hedge the variability of the cash flows associatedwith our existing or forecasted variable rate borrowings.

 

The followingtable summarizes the estimated net fair value of our derivative instrumentsheld at March 31, 2008 and December 31, 2007 (amounts in thousands):

 

**Derivative Fair Value**

 
| ** **                      | ** ** | **As of  March 31, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|---------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **Notional**                             | ** ** | **Fair Value**                         | ** ** | **Notional** | ** ** | **Fair Value** | ** ** |
| **Cash Flow Hedges:**           |       |                                     |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | $                                        | 383,333    |                                        | $          | (38,225 | ) | $ | 383,333 |   | $ | (19,018 | ) |
| **Fair Value Hedges:**          |       |                                     |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | 32,000                                   |       | (2,844                                      | )          | 32,000 |   | (1,212 | ) |
| **Free-Standing Derivatives:**  |       |                                     |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | 73,091                                   |       | 938                                         |       | 112,500 |   | 1,950 |   |
| Credit default swaps—long  |       | 66,000                                   |       | (2,762                                      | )          | 66,000 |   | (1,154 | ) |
| Credit default swaps—short |       | 196,820                                  |       | 25,090                                      |       | 268,000 |   | 12,613 |   |
| Total rate of return swaps      |       | 511,515                                  |       | (87,028                                     | )          | 442,204 |   | (21,998 | ) |
| Foreign exchange contracts      |       | 6,656                                    |       | 10                                          |       | 6,656 |   | 3 |   |
| Common stock warrants           |       | —                                   |       | 111                                         |       | — |   | 799 |   |
| Total                           |       | $                                        | 1,269,415  |                                        | $          | (104,710 | ) | $ | 1,310,693 |   | $ | (28,017 | ) |

** **

**Item 3.**                          Quantitative and Qualitative Disclosures AboutMarket Risk

** **

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

 

**Item 4.**                          Controls and Procedures

** **

TheCompany’s management evaluated, with the participation of the Company’sprincipal executive and principal financial officer, the effectiveness of theCompany’s disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) as of March 31, 2008. Based on their evaluation, the Company’sprincipal executive and principal financial officer concluded that the Company’sdisclosure controls and procedures as of March 31, 2008 were designed andwere functioning effectively to provide reasonable assurance that theinformation required to be disclosed by the Company in reports filed under theExchange Act is (i) recorded, processed, summarized, and reported withinthe time periods specified in the SEC’s rules and forms, and (ii) accumulatedand communicated to management, including the principal executive and principalfinancial officers, as appropriate, to allow timely decisions regardingdisclosure.

 

Therehas been no change in the Company’s internal control over financial reporting(as defined in Rules 13a-15(f) and 15d-15(f) under the ExchangeAct) that occurred during the Company’s three months ending March 31,2008, that has materially affected, or is reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

 

45

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**PART II. OTHER INFORMATION**

 

**Item 1.**                          *Legal Proceedings*

 

None.

 

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

** **

There have been no material changes in our risk factors from thosedisclosed in our Annual Report on Form 10-K for the year ended December 31,2007.

 

**Item 2 *.******                       Unregistered Sales of Equity Securities and Useof Proceeds***

 

None.

 

**Item 3.**                          *Defaults Upon SeniorSecurities*

** **

None.

 

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

** **

None.

 

**Item 5.**                          *Other Information*

** **

None.

 

**Item 6.**                          *Exhibits*

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

 

46

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**SIGNATURES**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, KKR Financial Holdings LLC has duly causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 
|                         |       | KKR  Financial Holdings LLC                                           |
|-------------------------|------------|-----------------------------------------------------------------------|
|                    |       |                                                                  |
| **Signature**           | ** ** | **Title**                                                             |
| ** **              | ** ** | ** **                                                            |
| /s/ SATURNINO S. FANLO  |       | Chief  Executive Officer (Principal Executive Officer)                |
| **Saturnino S. Fanlo**  | ** ** | ** **                                                            |
| ** **              | ** ** | ** **                                                            |
| /s/ JEFFREY B. VAN HORN |       | Chief  Financial Officer (Principal Financial and Accounting Officer) |
| **Jeffrey B. Van Horn** | ** ** | ** **                                                            |
| ** **              | ** ** | ** **                                                            |
| Date:  May 1, 2008 |       |                                                                  |

 

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