Table ofContents

 

 

 

**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 September 30,  2009**                                                                                                                                                      |
| ** **                                                                                                                                                                                                       | ** ** | ** **                                                                                                    |
| **or**                                                                                                                                                                                                           |
| ** **                                                                                                                                                                                                       | ** ** | ** **                                                                                                    |
| **o**                                                                                                                                                                                                            | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
| ** **                                                                                                                                                                                                       | ** ** | ** **                                                                                                    |
| **For the transition period from                 to               ** |

 

**Commissionfile number: 001-33437**

 

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**KKR FINANCIAL HOLDINGS LLC**

(Exact name of registrant asspecified in its charter)

 

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

 

Registrant’s telephonenumber, including area code: **(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 has submittedelectronically and posted on its corporate Web site, if any, every InteractiveData File required to be submitted and posted pursuant to Rule 405 ofRegulation S-T (§232.405 of this chapter) during the preceding 12 months (orfor such shorter period that the registrant was required to submit and postsuch files). Yes o  No o

 

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.(Check one):

 
| Large accelerated filer o                |   | Accelerated filer x              |
|-----------------------------------------------|--------|----------------------------------|
|                                          |   |                             |
| 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 November 2, 2009 was 158,359,757.

 

 

 

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Table ofContents

 

**TABLE OF CONTENTS**

 
| **PART I.FINANCIAL INFORMATION** | ** **                                                                                  |
|---------------------------------------|---------------------------------------------------------------------------------------------|
| Item 1.                               | Financial Statements                                                                        | 3 |
| Item 2.                               | Management’s Discussion  and Analysis of Financial Condition and Results of Operations | 33 |
| Item 3.                               | Quantitative and  Qualitative Disclosures about Market Risk                                 | 57 |
| Item 4.                               | Controls and Procedures                                                                     | 57 |
| **Part II.OTHER INFORMATION**    | ** **                                                                                  |
| Item 1.                               | Legal Proceedings                                                                           | 57 |
| Item 1A.                              | Risk Factors                                                                                | 58 |
| Item 2.                               | Unregistered Sales of Equity  Securities and Use of Proceeds                                | 58 |
| Item 3.                               | Defaults Upon Senior  Securities                                                            | 58 |
| Item 4.                               | Submission of Matters to a  Vote of Security Holders                                        | 58 |
| Item 5.                               | Other Information                                                                           | 58 |
| Item 6.                               | Exhibits                                                                                    | 58 |

 

2

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Table of Contents

 

**PART I.   FINANCIALINFORMATION**

 

**Item 1.Financial Statements**

 

**KKR Financial Holdings LLC and Subsidiaries**

**CondensedConsolidated Balance Sheets**

**(Unaudited)**

**(Amounts in thousands, except share information)**

 
| ** **                                                                                                                                                                                      | ** ** | **September 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                      |       |                         |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                       |       | $                            | 125,862    |                        | $          | 41,430 |   |
| Restricted cash and cash equivalents                                                                                                                                                            |       | 188,151                      |       | 1,233,585                   |       |
| Securities available-for-sale, $736,823 and  $553,441 pledged as collateral as of September 30, 2009 and  December 31, 2008, respectively                                        |       | 736,823                      |       | 555,965                     |       |
| Corporate loans, net of allowance for loan losses  of $470,224 and $480,775 as of September 30, 2009 and December 31,  2008, respectively                                             |       | 6,221,005                    |       | 7,246,797                   |       |
| Residential mortgage-backed securities, at  estimated fair value, $70,256 and $102,814 pledged as collateral as of  September 30, 2009 and December 31, 2008, respectively       |       | 70,256                       |       | 102,814                     |       |
| Residential mortgage loans, at estimated fair  value                                                                                                                                            |       | 2,274,585                    |       | 2,620,021                   |       |
| Corporate loans held for sale                                                                                                                                                                   |       | 504,093                      |       | 324,649                     |       |
| Private equity investments, at estimated fair  value                                                                                                                                            |       | 76,310                       |       | 5,287                       |       |
| Derivative assets                                                                                                                                                                               |       | 23,163                       |       | 73,869                      |       |
| Interest and principal receivable                                                                                                                                                               |       | 60,811                       |       | 116,788                     |       |
| Reverse repurchase agreements                                                                                                                                                                   |       | 80,344                       |       | 88,252                      |       |
| Other assets                                                                                                                                                                                    |       | 98,062                       |       | 105,625                     |       |
| **Total assets**                                                                                                                                                                                |       | $                            | 10,459,465 |                        | $          | 12,515,082 |   |
| **Liabilities**                                                                                                                                                                                 |       |                         |       |                        |       |
| Collateralized loan obligation senior secured  notes                                                                                                                                            |       | $                            | 5,706,882  |                        | $          | 7,487,611 |   |
| Collateralized loan obligation junior secured  notes to affiliates                                                                                                                              |       | 547,421                      |       | 655,313                     |       |
| Senior secured credit facility                                                                                                                                                                  |       | 187,500                      |       | 275,633                     |       |
| Convertible senior notes                                                                                                                                                                        |       | 275,800                      |       | 291,500                     |       |
| Junior subordinated notes                                                                                                                                                                       |       | 283,671                      |       | 288,671                     |       |
| Residential mortgage-backed securities issued, at  estimated fair value                                                                                                                         |       | 2,165,423                    |       | 2,462,882                   |       |
| Accounts payable, accrued expenses and other  liabilities                                                                                                                                       |       | 7,209                        |       | 60,124                      |       |
| Accrued interest payable                                                                                                                                                                        |       | 23,840                       |       | 61,119                      |       |
| Accrued interest payable to affiliates                                                                                                                                                          |       | 2,981                        |       | 3,987                       |       |
| Related party payable                                                                                                                                                                           |       | 12,893                       |       | 2,876                       |       |
| Securities sold, not yet purchased                                                                                                                                                              |       | 78,633                       |       | 90,809                      |       |
| Derivative liabilities                                                                                                                                                                          |       | 57,091                       |       | 171,212                     |       |
| **Total liabilities**                                                                                                                                                                           |       | 9,349,344                    |       | 11,851,737                  |       |
| **Shareholders’ Equity**                                                                                                                                                                   |       |                         |       |                        |       |
| Preferred shares, no par value, 50,000,000 shares  authorized and none issued and outstanding at September 30, 2009  and December 31, 2008                                       |       | —                       |       | —                      |       |
| Common shares, no par value, 500,000,000 shares  authorized, and 158,359,757 and 150,881,500 shares issued and outstanding at  September 30, 2009 and December 31, 2008, respectively |       | —                       |       | —                      |       |
| Paid-in-capital                                                                                                                                                                                 |       | 2,562,262                    |       | 2,550,849                   |       |
| Accumulated other comprehensive income (loss)                                                                                                                                                   |       | 91,761                       |       | (268,782                    | )          |
| Accumulated deficit                                                                                                                                                                             |       | (1,543,902                   | )          | (1,618,722                  | )          |
| **Total shareholders’ equity**                                                                                                                                                             |       | 1,110,121                    |       | 663,345                     |       |
| **Total liabilities and  shareholders’ equity**                                                                                                                                            |       | $                            | 10,459,465 |                        | $          | 12,515,082 |   |

 

See notes to condensedconsolidated financial statements.

 

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Table of Contents

 

**KKRFinancial Holdings LLC and Subsidiaries**

**CondensedConsolidated Statements of Operations**

**(Unaudited)(Amounts in thousands, except per share information)**

** **
| ** **                                                                                                                                                                                           | ** ** | **For the three  months ended  September 30,  2009** | ** ** | **For the three  months ended  September 30,  2008** | ** ** | **For the nine  months ended  September 30,  2009** | ** ** | **For the nine  months ended  September 30,  2008** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| **Net investment income:**                                                                                                                                                                           | ** ** | ** **                                                               | ** ** | ** **                                                               | ** ** | ** **                                                              | ** ** | ** **                                                              | ** ** |
| Securities interest income                                                                                                                                                                           |       | $                                                                        | 21,701     |                                                                     | $          | 34,507                                                                  |       | $                                                                       | 73,805     |   | $ | 109,104 |   |
| Loan interest income                                                                                                                                                                                 |       | 113,460                                                                  |       | 187,756                                                                  |       | 364,583                                                                 |       | 588,843                                                                 |       |
| Dividend income                                                                                                                                                                                      |       | 26                                                                       |       | 358                                                                      |       | 313                                                                     |       | 2,266                                                                   |       |
| Other interest income                                                                                                                                                                                |       | 49                                                                       |       | 4,431                                                                    |       | 511                                                                     |       | 20,505                                                                  |       |
| Total investment income                                                                                                                                                                              |       | 135,236                                                                  |       | 227,052                                                                  |       | 439,212                                                                 |       | 720,718                                                                 |       |
| Interest expense                                                                                                                                                                                     |       | (57,340                                                                  | )          | (118,105                                                                 | )          | (219,625                                                                | )          | (400,207                                                                | )          |
| Interest expense to affiliates                                                                                                                                                                       |       | (5,171                                                                   | )          | (18,794                                                                  | )          | (16,355                                                                 | )          | (66,319                                                                 | )          |
| Provision for loan losses                                                                                                                                                                            |       | —                                                                   |       | —                                                                   |       | (39,795                                                                 | )          | (10,000                                                                 | )          |
| Net investment income                                                                                                                                                                                |       | 72,725                                                                   |       | 90,153                                                                   |       | 163,437                                                                 |       | 244,192                                                                 |       |
| **Other income (loss):**                                                                                                                                                                             | ** ** | ** **                                                               | ** ** | ** **                                                               | ** ** | ** **                                                              | ** ** | ** **                                                              | ** ** |
| Net realized and unrealized gain (loss) on  derivatives and foreign exchange                                                                                                                    |       | 19,930                                                                   |       | (15,534                                                                  | )          | 58,831                                                                  |       | (68,468                                                                 | )          |
| Net realized and unrealized gain (loss) on  investments                                                                                                                                              |       | 21,181                                                                   |       | (28,278                                                                  | )          | (85,576                                                                 | )          | (59,254                                                                 | )          |
| Net realized and unrealized (loss) gain on  residential mortgage-backed securities, residential mortgage loans, and  residential mortgage-backed securities issued, carried at estimated fair  value |       | (17,681                                                                  | )          | 121                                                                      |       | (44,545                                                                 | )          | (14,651                                                                 | )          |
| Net realized and unrealized (loss) gain on  securities sold, not yet purchased                                                                                                                       |       | (996                                                                     | )          | 14,242                                                                   |       | 2,920                                                                   |       | 22,892                                                                  |       |
| Net (loss) gain on restructuring and extinguishment  of debt                                                                                                                                         |       | (10,627                                                                  | )          | 3,056                                                                    |       | 30,836                                                                  |       | 20,281                                                                  |       |
| Other income                                                                                                                                                                                         |       | 1,239                                                                    |       | 2,470                                                                    |       | 4,150                                                                   |       | 7,939                                                                   |       |
| Total other income (loss)                                                                                                                                                                            |       | 13,046                                                                   |       | (23,923                                                                  | )          | (33,384                                                                 | )          | (91,261                                                                 | )          |
| **Non-investment expenses:**                                                                                                                                                                         | ** ** | ** **                                                               | ** ** | ** **                                                               | ** ** | ** **                                                              | ** ** | ** **                                                              | ** ** |
| Related party management compensation                                                                                                                                                                |       | 14,616                                                                   |       | 9,811                                                                    |       | 36,132                                                                  |       | 29,357                                                                  |       |
| General, administrative and directors expenses                                                                                                                                                       |       | 1,539                                                                    |       | 3,820                                                                    |       | 6,917                                                                   |       | 14,094                                                                  |       |
| Professional services                                                                                                                                                                                |       | 441                                                                      |       | 1,335                                                                    |       | 5,916                                                                   |       | 4,263                                                                   |       |
| Loan servicing                                                                                                                                                                                       |       | 1,925                                                                    |       | 2,274                                                                    |       | 6,117                                                                   |       | 7,234                                                                   |       |
| Total non-investment expenses                                                                                                                                                                        |       | 18,521                                                                   |       | 17,240                                                                   |       | 55,082                                                                  |       | 54,948                                                                  |       |
| Income from continuing operations before income tax  expense                                                                                                                                         |       | 67,250                                                                   |       | 48,990                                                                   |       | 74,971                                                                  |       | 97,983                                                                  |       |
| Income tax expense                                                                                                                                                                                   |       | (63                                                                      | )          | —                                                                   |       | (151                                                                    | )          | (116                                                                    | )          |
| Income from continuing operations                                                                                                                                                                    |       | 67,187                                                                   |       | 48,990                                                                   |       | 74,820                                                                  |       | 97,867                                                                  |       |
| Income from discontinued operations                                                                                                                                                                  |       | —                                                                   |       | —                                                                   |       | —                                                                  |       | 2,668                                                                   |       |
| Net income                                                                                                                                                                                           |       | $                                                                        | 67,187     |                                                                     | $          | 48,990                                                                  |       | $                                                                       | 74,820     |   | $ | 100,535 |   |
|                                                                                                                                                                                                 |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Net income per common share:                                                                                                                                                                         |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Basic                                                                                                                                                                                                |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Income per share from continuing operations                                                                                                                                                          |       | $                                                                        | 0.42       |                                                                     | $          | 0.32                                                                    |       | $                                                                       | 0.49       |   | $ | 0.71 |   |
| Income per share from discontinued operations                                                                                                                                                        |       | $                                                                        | —     |                                                                     | $          | —                                                                  |       | $                                                                       | —     |   | $ | 0.02 |   |
| Net income per share                                                                                                                                                                                 |       | $                                                                        | 0.42       |                                                                     | $          | 0.32                                                                    |       | $                                                                       | 0.49       |   | $ | 0.73 |   |
| Diluted                                                                                                                                                                                              |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Income per share from continuing operations                                                                                                                                                          |       | $                                                                        | 0.42       |                                                                     | $          | 0.32                                                                    |       | $                                                                       | 0.49       |   | $ | 0.71 |   |
| Income per share from discontinued operations                                                                                                                                                        |       | $                                                                        | —     |                                                                     | $          | —                                                                  |       | $                                                                       | —     |   | $ | 0.02 |   |
| Net income per share                                                                                                                                                                                 |       | $                                                                        | 0.42       |                                                                     | $          | 0.32                                                                    |       | $                                                                       | 0.49       |   | $ | 0.73 |   |
|                                                                                                                                                                                                 |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Weighted-average number of common shares  outstanding:                                                                                                                                               |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Basic                                                                                                                                                                                                |       | 156,997                                                                  |       | 149,612                                                                  |       | 152,664                                                                 |       | 136,777                                                                 |       |
| Diluted                                                                                                                                                                                              |       | 156,997                                                                  |       | 149,612                                                                  |       | 152,664                                                                 |       | 136,777                                                                 |       |

 

See notes to condensedconsolidated financial statements.

 

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Table of Contents

 

**KKRFinancial Holdings LLC and Subsidiaries**

**CondensedConsolidated Statement of Changes in Shareholders’ Equity**

**(Unaudited)(Amounts in thousands)**

** **
| ** **                                                            | ** ** | **Common  Shares** | ** ** | **Paid-In  Capital** | ** ** | **Accumulated Other  Comprehensive  (Loss) Income** | ** ** | **Accumulated  Deficit** | ** ** | **Comprehensive  Income** | ** ** | **Total  Shareholders’  Equity** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------|------------|----------------------|------------|----------------------------------------------------------|------------|--------------------------|------------|---------------------------|------------|---------------------------------------|------------|
| **Balance at January 1, 2009**                                   |       | 150,881            |       | $                    | 2,550,849  |                                                     | $          | (268,782                 | )          | $                         | (1,618,722 | )                                     |       |   | $ | 663,345 |   |
| Net income                                                            |       | —             |       | —               |       | —                                                   |       | 74,820                   |       | $                         | 74,820     |                                  | 74,820     |   |
| Net change in unrealized loss on cash flow hedges                     |       | —             |       | —               |       | 24,569                                                   |       | —                   |       | 24,569                    |       | 24,569                                |       |
| Net change in unrealized loss on securities  available-for-sale       |       | —             |       | —               |       | 335,974                                                  |       | —                   |       | 335,974                   |       | 335,974                               |       |
| Comprehensive income                                                  |       |               |       |                 |       |                                                     |       |                     |       | $                         | 435,363    |                                  |       |   |
| Issuance of common shares                                             |       | 7,479              |       | 8,808                |       | —                                                   |       | —                   |       |                      |       | 8,808                                 |       |
| Share-based compensation expense related to  restricted common shares |       | —             |       | 2,605                |       | —                                                   |       | —                   |       |                      |       | 2,605                                 |       |
| **Balance at September 30,  2009**                               |       | 158,360            |       | $                    | 2,562,262  |                                                     | $          | 91,761                   |       | $                         | (1,543,902 | )                                     |       |   | $ | 1,110,121 |   |

 

See notes tocondensed consolidated financial statements.

 

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**KKR Financial Holdings LLC and Subsidiaries**

**Condensed****ConsolidatedStatements of Cash Flows**

**(Unaudited)(Amounts in thousands)**

 
| ** **                                                                                                                                               | ** ** | **For the nine months  ended September 30, 2009** | ** ** | **For the nine months  ended September 30, 2008** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| **Cash flows from operating  activities:**                                                                                                               |       |                                                   |       |                                                   |       |
| Net income                                                                                                                                               |       | $                                                      | 74,820     |                                                   | $          | 100,535 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities:                                                                       |       |                                                   |       |                                                   |       |
| Net realized and unrealized (gain) loss on  derivatives, foreign exchange, and securities sold, not yet purchased                                   |       | (61,751                                                | )          | 45,576                                                 |       |
| Gain on restructuring and extinguishment of debt                                                                                                         |       | (59,635                                                | )          | (20,281                                                | )          |
| Write-off of debt issuance costs                                                                                                                         |       | 4,611                                                  |       | 1,224                                                  |       |
| Lower of cost or estimated fair value adjustment on  corporate loans held for sale                                                                       |       | 38,898                                                 |       | 2,353                                                  |       |
| Provision for loan losses                                                                                                                                |       | 39,795                                                 |       | 10,000                                                 |       |
| Impairment on securities available-for-sale                                                                                                              |       | 40,013                                                 |       | 20,254                                                 |       |
| Share-based compensation                                                                                                                                 |       | 2,605                                                  |       | 959                                                    |       |
| Net realized and unrealized loss (gain) on  residential mortgage-backed securities, residential mortgage loans, and  liabilities at estimated fair value |       | 44,545                                                 |       | (7,568                                                 | )          |
| Net realized and unrealized (gain) loss on  investments                                                                                                  |       | 6,665                                                  |       | 39,735                                                 |       |
| Depreciation and net amortization                                                                                                                        |       | (38,731                                                | )          | (26,043                                                | )          |
| Changes in assets and liabilities:                                                                                                                       |       |                                                   |       |                                                   |       |
| Interest receivable                                                                                                                                      |       | 50,057                                                 |       | 32,617                                                 |       |
| Other assets                                                                                                                                             |       | (11,911                                                | )          | (11,897                                                | )          |
| Related party payable                                                                                                                                    |       | 10,017                                                 |       | (4,623                                                 | )          |
| Accounts payable, accrued expenses and other  liabilities                                                                                                |       | (47,847                                                | )          | (27,953                                                | )          |
| Accrued interest payable                                                                                                                                 |       | (37,278                                                | )          | (57,656                                                | )          |
| Accrued interest payable to affiliates                                                                                                                   |       | 18,893                                                 |       | 17,556                                                 |       |
| Net cash provided by operating activities                                                                                                                |       | 73,766                                                 |       | 114,788                                                |       |
| **Cash flows from investing  activities:**                                                                                                               |       |                                                   |       |                                                   |       |
| Principal payments from investments                                                                                                                      |       | 879,235                                                |       | 1,307,765                                              |       |
| Proceeds from sale of investments                                                                                                                        |       | 1,069,201                                              |       | 1,415,574                                              |       |
| Purchases of investments                                                                                                                                 |       | (685,456                                               | )          | (1,818,037                                             | )          |
| Net proceeds, purchases, and settlements of  derivatives                                                                                                 |       | 20,530                                                 |       | (52,811                                                | )          |
| Net change in reverse repurchase agreements                                                                                                              |       | 7,908                                                  |       | 42,195                                                 |       |
| Net reductions to restricted cash and cash  equivalents                                                                                                  |       | 1,045,434                                              |       | 212,359                                                |       |
| Net cash provided by investing activities                                                                                                                |       | 2,336,852                                              |       | 1,107,045                                              |       |
| **Cash flows from financing  activities:**                                                                                                               |       |                                                   |       |                                                   |       |
| Net change in repurchase agreements, senior secured  credit facility, and secured demand loan                                                            |       | (88,133                                                | )          | (2,620,935                                             | )          |
| Net change in asset-backed secured liquidity notes                                                                                                       |       | —                                                 |       | (136,596                                               | )          |
| Repayment of residential mortgage-backed securities  issued                                                                                              |       | (442,984                                               | )          | (531,601                                               | )          |
| Repayment of collateralized loan obligation senior  secured notes                                                                                        |       | (1,788,694                                             | )          | —                                                 |       |
| Issuance of collateralized loan obligation senior  secured notes                                                                                         |       | —                                                 |       | 1,600,000                                              |       |
| Net change in subordinated notes to affiliates                                                                                                           |       | —                                                 |       | (43,880                                                | )          |
| Net change in junior subordinated notes                                                                                                                  |       | (1,238                                                 | )          | (20,956                                                | )          |
| Net proceeds from common share offering                                                                                                                  |       | —                                                 |       | 383,519                                                |       |
| Distributions on common shares                                                                                                                           |       | —                                                 |       | (178,310                                               | )          |
| Other capitalized costs                                                                                                                                  |       | (5,137                                                 | )          | (628                                                   | )          |
| Net cash used in financing activities                                                                                                                    |       | (2,326,186                                             | )          | (1,549,387                                             | )          |
| **Net increase (decrease) in cash  and cash equivalents**                                                                                                |       | 84,432                                                 |       | (327,554                                               | )          |
| **Cash and cash equivalents at  beginning of period**                                                                                                    |       | 41,430                                                 |       | 524,080                                                |       |
| **Cash and cash equivalents at  end of period**                                                                                                          |       | $                                                      | 125,862    |                                                   | $          | 196,526 |   |
| **Supplemental cash flow  information:**                                                                                                                 |       |                                                   |       |                                                   |       |
| Cash paid for interest                                                                                                                                   |       | $                                                      | 247,029    |                                                   | $          | 547,266 |   |
| Cash paid for income taxes                                                                                                                               |       | $                                                      | 373        |                                                   | $          | 100 |   |
| **Non-cash investing and  financing activities:**                                                                                                        |       |                                                   |       |                                                   |       |
| Conversion from corporate loans to corporate debt  securities                                                                                            |       | $                                                      | —     |                                                   | $          | 331,725 |   |
| Distributions of securities to the asset-backed  secured liquidity noteholders                                                                           |       | $                                                      | —     |                                                   | $          | 3,623,049 |   |
| Conversion of corporate loan to private equity  investment                                                                                               |       | $                                                      | 48,467     |                                                   | $          | — |   |
| Exchange of convertible senior notes to equity                                                                                                           |       | $                                                      | 8,808      |                                                   | $          | — |   |
| Exchange of CLO 2009-1 subordinated notes to  affiliate for 20% interest in CLO 2009-1 assets                                                            |       | $                                                      | 90,429     |                                                   |       | — |   |

 

See notes to condensed consolidated financial statements.

 

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**KKR Financial Holdings LLC and Subsidiaries**

 

**Notes to Condensed Consolidated Financial Statements****(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 below investment grade corporatedebt, including senior secured and unsecured loans, mezzanine loans, high yieldcorporate bonds, distressed and stressed debt securities, marketable equitysecurities, private equity investments and credit default and total rate of returnswaps. The corporate loans the Company invests in are generally referred to assyndicated bank loans, or leveraged loans, and are purchased via assignment orparticipation in either the primary or secondary market. The majority of theCompany’s corporate debt investments are held in collateralized loan obligation(“CLO”) transactions that the Company uses as long term financing for theseinvestments. The Company’s CLO transactions are structured as on-balance sheetsecuritizations of corporate loans and high yield debt securities. The seniorsecured notes issued by the CLO transactions are generally owned by third partyinvestors who are unaffiliated with the Company and the Company owns the majority of thesubordinated notes in the CLO transactions.

 

The Company closelymonitors its liquidity position and believes it has sufficient liquidity andaccess to liquidity to meet its financial obligations for at least the next 12months. The Company believes that it is in compliance with the covenants containedin its borrowing agreements.

 

KKR Financial Advisors LLC (the “Manager”), awholly owned subsidiary of Kohlberg Kravis Roberts & Co. (FixedIncome) LLC, manages the Company pursuant to a management agreement (the “ManagementAgreement”). Kohlberg Kravis Roberts & Co. (FixedIncome) LLC is a wholly-owned subsidiary of Kohlberg Kravis Roberts &Co. L.P. (“KKR”).

 

**Note 2. Summary of Significant AccountingPolicies**

 

**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. Certain prior period amountshave been reclassified to conform to the current period’s presentation.

 

These condensed consolidated financial statements should be read inconjunction with the consolidated financial statements and notes theretoincluded in the Company’s Annual Report on Form 10-K for the year ended December 31,2008. The Company’s results for any interim period are not necessarilyindicative of results for a full year or any other interim period. In theopinion of management, all normal recurring adjustments have been included fora fair statement of this interim financial information.

 

**Subsequent Events**

 

The Companyevaluated subsequent events through the date the financial statements wereissued on November 5, 2009.

 

**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**

 

TheCompany consolidates all non-variable interest entities in which it holds agreater than 50 percent voting interest. The Company also consolidates allvariable interest entities (“VIEs”) for which it is considered to be theprimary beneficiary pursuant to the Financial Accounting Standards Board (“FASB”)Accounting Standards Codification (“ASC,” or collectively the “Codification”)810, *Consolidation*(“FASB ASC 810”). Ingeneral, an enterprise is required to consolidate a VIE when the enterpriseholds a variable interest in the VIE and is deemed to be the primarybeneficiary of the VIE. An enterprise is the primary beneficiary if it absorbsa majority of the VIE’s expected losses, receives a majority of the VIE’sexpected residual returns, or both.

 

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KKR Financial CLO 2005-1, Ltd. (“CLO2005-1”), KKR Financial CLO 2005-2, Ltd. (“CLO 2005-2”), KKR FinancialCLO 2006-1, Ltd. (“CLO 2006-1”), KKR FinancialCLO 2007-1, Ltd. (“CLO 2007-1”), KKR Financial CLO2007-A, Ltd. (“CLO 2007-A”) and KKR Financial CLO 2009-1, Ltd. (“CLO2009-1”), are entities established to complete secured financing transactions.These entities are VIEs and are not considered to be qualifying special-purposeentities (“QSPE”) as defined by FASB ASC 860, *Transfers and Servicing*(“FASBASC 860”). The Company has determined it is the primary beneficiary of theseentities and has included the accounts of these entities in these condensedconsolidated financial statements. Additionally, the Company is the primarybeneficiary of six residential mortgage loan securitization trusts that are notconsidered to be QSPEs and the Company has therefore included the accounts ofthese entities in these condensed consolidated financial statements.

 

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

 

**Fair Value of Financial Instruments**

 

As defined in FASB ASC 820, *Fair Value Measurementsand Disclosures* (“FASB ASC 820”), fair value is the price that wouldbe received 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 condensed consolidated balancesheets are categorized based upon the level of judgment associated with theinputs used to measure their value. Hierarchical levels which are directlyrelated to the amount of subjectivity associated with the inputs to fairvaluations 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, certain corporate loans heldfor sale, certain private equity investments, certain securities sold, not yetpurchased and certain financial instruments classified as derivatives where thefair value is based on observable market inputs.

 

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 consideration offactors specific to the asset.

 

Generally, assets and liabilities carried at fair value and included inthis category are certain corporate debt securities, certain corporate loansheld for sale, certain private equity investments, residential mortgage-backedsecurities, residential mortgage loans, real estate owned (“REO”), residentialmortgage-backed securities issued and certain derivatives.

 

Duringthe second quarter of 2009, the Company adopted FASB ASC 820-10-65. This topicprovides additional guidance on determining fair value when the volume andlevel of activity for the asset or liability have significantly decreased whencompared with normal market activity for the asset or liability (or similarassets or liabilities). A significant decrease in the volume and level ofactivity for the asset or liability is an indication that transactions orquoted prices may not be determinative of fair value because in such marketconditions there may be increased instances of transactions that are notorderly. In those circumstances, further analysis of transactions or quotedprices is needed, and a significant adjustment to the transactions or quotedprices may be necessary to estimate fair value. The adoption did not have a material impact on the Company’scondensed consolidated financial statements.

 

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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 onmodels or inputs 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.

 

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 willing 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.

 

Depending on the relative liquidity in the markets for certain assets,the Company may transfer assets to level 3 if it determines thatobservable quoted prices, obtained directly or indirectly, are not available.The valuation techniques used for the assets and liabilities that are valuedusing level 3 of the fair value hierarchy are described below.

 

*Residential Mortgage-Backed Securities, Residential MortgageLoans, and Residential Mortgage-Backed Securities Issued:*  Residential mortgage-backed securities,residential mortgage loans, and residential mortgage-backed securities issuedare initially valued at transaction price and are subsequently valued usingindustry recognized models (including Intex and Bloomberg) and data for similarinstruments (e.g., nationally recognized pricing services or brokerquotes). The most significant inputs to the valuation of these instruments aredefault and loss expectations and market credit spreads.

 

*Corporate Debt Securities:*  Corporate debt securities are initiallyvalued at transaction price and are subsequently valued using market data forsimilar instruments (e.g., recent transactions or broker quotes),comparisons to benchmark derivative indices or valuation models. Valuationmodels are based on discounted cash flow techniques, for which the key inputsare the amount and timing of expected future cash flows, market yields for suchinstruments and recovery assumptions. Inputs are generally determined based onrelative value analyses, which incorporate similar instruments from similarissuers.

 

*Over-the-counter (“OTC”) Derivative Contracts:*  OTC derivative contracts include forward,swap and option contracts related to interest rates, foreign currencies, creditstanding of reference entities, and equity prices. The fair value of OTCderivative products can be modeled using a series of techniques, includingclosed-form analytic formulae, such as the Black-Scholes option-pricing model,and simulation models or a combination thereof. Many pricing models do notentail material subjectivity because the methodologies employed do notnecessitate significant judgment, and the pricing inputs are observed fromactively quoted markets, as is the case for generic interest rate swap andoption 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.

On the condensed consolidated statement of cash flows, net additions orreductions to restricted cash and cash equivalents are classified as aninvesting activity as restricted cash and cash equivalents reflect the receiptsfrom collections or sales of investments, as well as payments made to acquireinvestments held by third parties.

 

**Residential Mortgage-Backed Securities**

 

TheCompany carries its residential mortgage-backed securities at estimated fairvalue with unrealized gains and losses reported in income. The Companyelected the fair value option for its residential mortgage investments for thepurpose of enhancing the transparency of its financial condition as fair valueis consistent with how the Company manages the risks of its residentialmortgage investments.

 

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**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, on estimatesprovided by independent pricing sources or dealers who make markets in suchsecurities, or internal valuation models when external sources of fair valueare not available. Upon the sale of a security, the realized net gain or lossis computed on a weighted-average cost basis. Purchases and sales of securitiesare recorded on the trade date.

 

TheCompany monitors its available-for-sale securities portfolio for impairments. Aloss is recognized when it is determined that a decline in the estimated fairvalue of a security below its amortized cost is other-than-temporary. TheCompany considers many factors in determining whether the impairment of asecurity is deemed to be other-than-temporary, including, but not limited to,the length of time the security has had a decline in estimated fair value belowits amortized cost and the severity of the decline, the amount of theunrealized loss, recent events specific to the issuer or industry, externalcredit ratings and recent changes in such ratings. In addition, for debt securities,the Company considers its intent to sell the debt security, the Company’sestimation of whether or not it expects to recover the debt security’s entireamortized cost if it intends to hold the debt security, and whether it is morelikely than not that the Company will be required to sell the debt securitybefore its anticipated recovery. For equity securities, the Company alsoconsiders its intent and ability to hold the equity security for a period oftime sufficient for a recovery in value.

 

The amount of the loss that is recognized when it is determined that adecline in the estimated fair value of a security below its amortized cost isother-than-temporary is dependent on certain factors. If the security is anequity security or if the security is a debt security that the Company intendsto sell or estimates that it is more likely than not that the Company will berequired to sell before recovery of its amortized cost, then the impairmentamount recognized in earnings is the entire difference between the estimatedfair value of the security and its amortized cost. For debt securities that theCompany does not intend to sell or estimates that it is not more likely thannot to be required to sell before recovery, the impairment is separated intothe estimated amount relating to credit loss and the estimated amount relatingto all other factors. Only the estimated credit loss amount is recognized inearnings, with the remainder of the loss amount recognized in othercomprehensive income (loss).

 

During the second quarter of 2009, the Companyadopted FASB ASC 320-10-65 which amends the other-than-temporary impairmentguidance for debt securities to make the guidance more operational and toimprove the presentation and disclosure of other-than-temporary impairments ondebt and equity securities in the financial statements. The adoption of did nothave a material impact on the Company’s condensed consolidated financialstatements.

 

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.

 

**Private Equity Investments**

 

Private equity investments are accounted for under either the costmethod or at fair value if the fair value option of accounting has beenelected. The Company evaluates its investments accounted for under the costmethod on a quarterly basis for possible other-than-temporary impairment. TheCompany reduces the carrying value of the investment and recognizes a loss whenthe Company considers a decline in estimated fair value below the cost basis ofthe security to be other-than-temporary. Private equity investments recorded atcost are included in other assets on the condensed consolidated balance sheets.Private equity investments carried at fair value are presented separately onthe condensed consolidated balance sheets, with unrealized gains and lossesreported in net realized and unrealized gains and losses on investments.

 

**Securities Sold, Not Yet Purchased**

 

Securities sold, not yet purchased consist of equity and debtsecurities that the Company has sold short. In order to facilitate a shortsale, the Company borrows the securities from another party and delivers thesecurities to the buyer. The Company will be required to “cover” its short salein the future through the purchase of the security in the market at theprevailing market price and deliver it to the counterparty from which itborrowed. The Company is exposed to a loss to the extent that the securityprice increases during the time from when the Company borrowed the security towhen the Company purchases it in the market to cover the short sale.

 

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**Corporate Loans**

 

The Company purchases participations and assignments in corporate loansin the primary and secondary market. Loans are held for investment and theCompany initially records loans at their purchase prices. The Companysubsequently accounts for loans based on their outstanding principal plus orminus unaccreted purchase discounts and unamortized purchase premiums. Incertain instances, where the credit fundamentals underlying a particular loanhave materially changed in such a manner that the Company’s expected return maydecrease, the Company may elect to sell a loan held for investment. Interestincome on loans includes interest at stated coupon rates adjusted for accretionof purchase discounts and the amortization of purchase premiums. Unamortizedpremiums and unaccreted discounts are recognized in interest income over thecontractual life, adjusted for actual prepayments, of the loans using theeffective interest method.

 

A loan is generally placed on non-accrual status at such time as: (i) managementbelieves that scheduled debt service payments may not be paid whencontractually due; (ii) the loan becomes 90 days delinquent; (iii) managementdetermines the borrower is incapable of, or has ceased efforts toward, curingthe cause of the impairment; or (iv) the net realizable value of theunderlying collateral securing the loan decreases below the Company’s carryingvalue of such loan. As such, loans placed on non-accrual status may or may notbe contractually past due at the time of such determination. While onnon-accrual status, previously recognized accrued interest is reversed if it isdetermined that such amounts are not collectible and interest income isrecognized using the cost-recovery method, cash-basis method or somecombination of the two methods. An impaired loan may be left on accrual statusduring the period the Company is pursuing repayment of the loan. A loan isplaced back on accrual status when the ultimate collectability of the principaland interest is not in doubt.

 

**Residential Mortgage Loans**

 

TheCompany carries its residential mortgage loans at estimated fair value withunrealized gains and losses reported in income. The Company elected thefair value option for its residential mortgage investments for the purpose ofenhancing the transparency of its financial condition as fair value isconsistent with how the Company manages the risks of its residential mortgageinvestments.

 

**Corporate Loans Held for Sale**

 

Corporate loans held for sale consist of loans that the Company hasdetermined to no longer hold for investment. Corporate loans held for sale arestated at lower of cost or estimated fair value.

 

**Allowance for Loan Losses**

 

TheCompany’s allowance for loan losses represents its estimate of probable creditlosses inherent in its corporate loan portfolio held for investment as of thebalance sheet date. Estimating the Company’s allowance for loan losses involvesa high degree of management judgment and is based upon a comprehensive reviewof the Company’s loan portfolio that is performed on a quarterly basis. TheCompany’s allowance for loan losses consists of two components, an allocatedcomponent and an unallocated component. The allocated component of theallowance for loan losses pertains to specific loans that the Company hasdetermined are impaired. The Company determines a loan is impaired whenmanagement estimates that it is probable that the Company will be unable tocollect all amounts due according to the contractual terms of the loanagreement. On a quarterly basis, the Company performs a comprehensive review ofits entire loan portfolio and identifies certain loans that it has determinedare impaired. Once a loan is identified as being impaired, the Company placesthe loan on non-accrual status, unless the loan is already on non-accrualstatus, and records a reserve that reflects management’s best estimate of theloss that the Company expects to recognize from the loan. Generally, theexpected loss is estimated as being the difference between the Company’scurrent cost basis of the loan, including accrued interest receivable, and theloans’ estimated fair value.

 

Theunallocated component of the Company’s allowance for loan losses reflects itsestimate of probable losses in the loan portfolio as of the balance sheet datewhere the specific loan that the loan loss relates to is indeterminable. TheCompany estimates the unallocated component of the allowance for loan lossesthrough a comprehensive review of its loan portfolio and identifies certainloans that demonstrate possible indicators of impairment. This assessmentexcludes all loans that are determined to be impaired and as a result, anallocated reserve has been recorded. Such indicators include, but are notlimited to, the current and/or forecasted financial performance and liquidityprofile of the issuer, specific industry or economic conditions that may impactthe issuer, and the observable trading price of the loan if available. Loans thatdemonstrate possible indicators of impairment are aggregated on a watch listfor monitoring and are sub-divided for categorization based on the seniority ofthe loan in the issuer’s capital structure, whether the loan is secured orunsecured, and the nature of the collateral securing the loan, for purposes ofapplying possible default and loss severity ranges based on the nature of theissuer and the specific loan. The Company applies a range of default and lossseverity estimates in order to estimate a range of loss outcomes upon which tobase its estimate of probable losses that results in the determination of theunallocated component of the Company’s allowance for loan losses.

 

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**Leasehold Improvements and Equipment**

 

Leasehold improvements and equipment are carried at cost lessdepreciation and amortization and are reviewed for impairment whenever eventsor changes in circumstances indicate that the carrying amount of the assetsmight not be recoverable. Equipment is depreciated using the straight-linemethod over 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, residential mortgage-backed securities and securitiesavailable-for-sale, primarily through the use of secured borrowings in the formof securitization transactions structured as secured financings and other securedand unsecured borrowings. The Company recognizes interest expense on allborrowings on an accrual basis.

 

**Residential Mortgage-Backed Securities Issued**

 

TheCompany carries its residential mortgage-backed securities issued at estimatedfair value with unrealized gains and losses reported in income. The Companyelected the fair value option for its residential mortgage-backed securitiesissued for the purpose of enhancing the transparency of its financial conditionas fair value is consistent with how the Company manages the risks of itsresidential mortgage portfolio.

 

**Trust Preferred Securities**

 

Trusts formed by the Company for the sole purpose of issuing trustpreferred securities are not consolidated by the Company as the Company hasdetermined that it is not the primary beneficiary of such trusts as defined byFASB ASC 810. The Company’s investment in the common securities of such trustsis included in other assets on the Company’s condensed consolidated financialstatements.

 

**Derivative Financial Instruments**

 

The Company recognizes all derivatives on the condensed consolidatedbalance sheet at estimated fair value. On the date the Company enters into aderivative contract, the Company designates and documents each derivativecontract as one of the following at the time the contract is executed: (i) ahedge of a recognized asset or liability (“fair value” hedge); (ii) ahedge of a forecasted transaction or of the variability of cash flows to bereceived or paid related to a recognized asset or liability (“cash flow”hedge); (iii) a hedge of a net investment in a foreign operation; or (iv) aderivative instrument not designated as a hedging instrument (“free-standingderivative”). For a fair value hedge, the Company records changes in theestimated fair value of the derivative and, to the extent that it is effective,changes in the fair value of the hedged asset or liability attributable to thehedged risk, in the current period earnings in the same financial statementcategory as the hedged item. For a cash flow hedge, the Company records changesin the estimated fair value of the derivative to the extent that it iseffective in other comprehensive (loss) income. The Company subsequentlyreclassifies these changes in estimated fair value to net income in the sameperiod(s) that the hedged transaction affects earnings in the samefinancial statement category as the hedged item. For free-standing derivatives,the Company reports changes in the fair values in current period non-netinvestment 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, the Company also formally assesses whether the derivative itdesignated in each hedging relationship is expected to be and has been highlyeffective in offsetting changes in estimated fair values or cash flows of thehedged item using either the dollar offset or the regression analysis method.If the Company determines that a derivative is not highly effective as a hedge,it discontinues hedge accounting.

 

**Foreign Currency**

 

The Company makes investments in non-United States dollar denominatedsecurities and loans. As a result, the Company is subject to the risk offluctuation in the exchange rate between the United States dollar and theforeign currency in which it makes an investment. In order to reduce the currencyrisk, the Company may hedge the applicable foreign currency. All investmentsdenominated in a foreign currency are converted to the United States dollarusing prevailing exchange rates on the balance sheet date. Income, expenses,gains and losses on investments denominated in a foreign currency are convertedto the United States dollar using the prevailing exchange rates on the dateswhen they are recorded. Foreign exchange gains and losses are recorded in thecondensed consolidated statements of operations.

 

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**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 16 to these condensed consolidated financialstatements for the specific terms of the computation and payment of theincentive fee. The base management fee and the incentive fee are accrued andexpensed during the period for which they are earned by the Manager.

 

**Share-Based Compensation**

 

The Company accounts for share-based compensation issued to itsdirectors and to the Manager using a fair value based methodology.Compensationcost related to restricted commonshares issued to the Company’sdirectors is measured at its estimated fair value atthe grant date, and isamortized and expensed over thevesting period on astraight-line basis. Compensation cost relatedto restricted common sharesand commonshare options issued to the Manager is initially measured at estimated fairvalue at the grant date, and is remeasured on subsequent dates to the extenttheawards are unvested. The Company has elected to use the graded vestingattribution method to amortize compensation expense for the restricted commonshares and common share options granted to the Manager.

 

**Income Taxes**

 

The Company intends to continue to operate in order to qualify as apartnership, and not as an association or publicly traded partnership that istaxable as a corporation, for United States federal income tax purposes.Therefore, the Company is not subject to United States federal income tax atthe entity level, but is subject to limited state income taxes. Holders of theCompany’s shares will be required to take into account their allocable share ofeach item of the Company’s income, gain, loss, deduction, and credit for thetaxable year of the Company ending within or with their taxable year.

 

KKR TRS Holdings, Ltd. (“TRS Ltd.”), KKR Financial Holdings, Ltd. (“KFHLtd.”), and KFN PEI VII, LLC (“PEI VII”) are taxable as corporations for UnitedStates federal income tax purposes and thus are not consolidated with theCompany for United States federal income tax 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 PEI VII, adomestic taxable corporate subsidiary, because PEI VII is taxed as a regularcorporation under the Internal Revenue Code of 1986, as amended (the “Code”).Deferred income tax assets and liabilities are computed based on temporarydifferences between the GAAP consolidated financial statements and the UnitedStates federal income tax basis of assets and liabilities as of eachconsolidated balance sheet date. CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO2007-1, CLO 2007-A and CLO 2009-1 are foreign subsidiaries of the Company thatelected to be treated as disregarded entities or partnerships for United Statesfederal income tax purposes. These subsidiaries were established to facilitatesecuritization transactions, structured as secured financing transactions. TRSLtd. and KFH Ltd. are foreign corporate subsidiaries that were formed to makecertain foreign and domestic investments from time to time. TRS Ltd. and KFHLtd. are organized as exempted companies incorporated with limited liabilityunder the laws of the Cayman Islands, and are generally exempt from UnitedStates federal 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 the Company’s calculationof its taxable income allocable to shareholders.

 

**Earnings Per Share**

 

Effective January 1, 2009, the Company calculates EPS using thetwo-class method which is an earnings allocation formula that determines EPSfor common shares and participating securities. Unvested share-based paymentawards that contain non-forfeitable rights to dividends or dividend equivalents(whether paid or unpaid) are participating securities and shall be included inthe computation of EPS using the two-class method. Accordingly, all earnings(distributed and undistributed) are allocated to common shares andparticipating securities based on their respective rights to receive dividends.

 

The Company presents both basic and diluted earnings (loss) per commonshare in its condensed consolidated financial statements and footnotes thereto.Basic earnings (loss) per common share (“Basic EPS”) excludes dilution and iscomputed by dividing net income or loss by the weighted-average number ofcommon shares, including vested restricted common shares, outstanding for theperiod. Diluted earnings (loss) per share (“Diluted EPS”) reflects thepotential dilution of common share options and unvested restricted commonshares using the treasury method, as well as the potential dilution ofconvertible senior notes using the if-converted method, if they are notanti-dilutive. See Note 3 to these condensed consolidated financial statementsfor earnings (loss) per common share computations.

 

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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.

 

**Recent Accounting Pronouncements**

 

In January 2009, the FASB issued FASB ASC 325-40-65 whicheliminates the requirement that a holder’s best estimate of cash flows be basedupon those that “a market participant” would use. Instead, it requires that another-than-temporary impairment be recognized as a realized loss when it is “probable”there has been an adverse change in the holder’s estimated cash flows from thecash flows previously projected. The topic also reiterates and emphasizes therelated guidance and disclosure requirements in accordance with the FASB ASC320,*Investments-Debt and Equity Securities*.The standard is effective for all periods ending after December 15, 2008and retroactive application is not permitted. The Company has taken this topicinto consideration when evaluating its investments for other-than-temporaryimpairment.

 

On June 12, 2009,the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 166,*Accounting for Transfers of Financial Assets, anamendment of FASB Statement No. 140, Accounting for Transfers andServicing of Financial Assets and Extinguishments of Liabilities*(“SFASNo. 140”) (collectively “SFAS No. 166”). The most significantamendments that SFAS No. 166 makes consist of the removal of the conceptof a qualifying special-purpose entity (“QSPE”) from FASB ASC 860 and theelimination of the exception for QSPE from the consolidation guidance of FASBASC 810. The disclosures required by this standard are to provide greatertransparency about transfers of financial assets and an entity’s continuinginvolvement in transferred financial assets. SFAS No. 166 willsignificantly affect existing securitizations that use QSPEs, as well as futuresecuritizations. SFAS No. 166 is effective January 1, 2010 forcalendar-year reporting entities and earlier application is prohibited. TheCompany is evaluating the impact of adopting SFAS No. 166.

 

Also on June 12,2009, the FASB issued SFAS No. 167, *Amendment to FASBInterpretation No. 46(R) *(“SFAS No. 167”) whichaddresses the effects of elimination of the QSPE concept from FASB ASC 860 andresponds to concerns about the application of certain key provisions of FASBASC 810, including concerns over the transparency of enterprises’ involvementwith VIEs. SFAS No. 167 requires additional disclosures for various areasincluding situations that use significant judgment and assumptions indetermining whether or not to consolidate a VIE as well as the nature of andchanges in the risks associated with a VIE. This standard is effective forcalendar year-end companies beginning on January 1, 2010. The Company isevaluating the impact of adopting SFAS No. 167.

 

In September 2009, the FASB issued AccountingStandards Update (“ASU”) 2009-5 which amends FASB ASC 820 to providefurther guidance on how to measure the fair value of a liability. ASU2009-5 primarily setsforth the types of valuation techniques to be used to value a liability when aquoted price in an active market for the identical liability is not available.In these circumstances, ASU 2009-5 states that a company can apply the quotedprice of an identical or similar liability when traded as an asset, or othervaluation techniques that are consistent with principles of FASB ASC 820. ASU2009-5 is effective beginning the fourth quarter of 2009. The Company does notbelieve the adoption of ASU 2009-5 will have a material impact on its financialstatements.

 

**Note 3. Earnings per Share**

 

Effective January 1, 2009, the Company calculates EPS using thetwo-class method which is an earnings allocation formula that determines EPSfor common shares and participating securities. Unvested share-based paymentawards that contain non-forfeitable rights to dividends or dividend equivalents(whether paid or unpaid) are participating securities and shall be included inthe computation of EPS using the two-class method. Accordingly, all earnings(distributed and undistributed) are allocated to common shares andparticipating securities based on their respective rights to receive dividends.

 

The Company calculates basic net income per common share by dividingnet income for the period by the weighted-average number of shares of itscommon shares outstanding for the period. Diluted net income per common shareis calculated by dividing net income by the weighted-average number of commonshares plus potentially dilutive common shares outstanding during the period.Potentially dilutive common shares include the assumed exercise of outstandingcommon share options and assumed vesting of outstanding restricted commonshares using the treasury stock method, as well as the assumed conversion ofconvertible senior notes using the if-converted method, if they are notanti-dilutive.

 

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The following table presents a reconciliation of basic and diluted netincome per common share, as well as the distributions declared per common sharefor the three and nine months ended September 30, 2009 and 2008 (amountsin thousands, except per share information):

 
| ** **                                                                        | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                        | ** ** | **2009 (1)**                              | ** ** | **2008 (1)**                             | ** ** | **2009 (1)** | ** ** | **2008 (1)** | ** ** |
| Income from continuing operations                                                 |       | $                                         | 67,187     |                                     | $          | 48,990 |   | $ | 74,820 |   | $ | 97,867 |   |
| Less: Dividends and undistributed earnings  allocated to participating securities |       | 574                                       |       | 378                                      |       | 657 |   | 856 |   |
| Income from continuing operations applicable to  common shareholders              |       | 66,613                                    |       | 48,612                                   |       | 74,163 |   | 97,011 |   |
| Income from discontinued operations                                               |       | —                                    |       | —                                   |       | — |   | 2,668 |   |
| Net income applicable to common shareholders                                      |       | $                                         | 66,613     |                                     | $          | 48,612 |   | $ | 74,163 |   | $ | 99,679 |   |
| ** **                                                                        |       |                                      |       |                                     |       |   |   |   |   |
| **Basic:**                                                                        |       |                                      |       |                                     |       |   |   |   |   |
| Basic weighted-average shares outstanding                                         |       | 156,997                                   |       | 149,612                                  |       | 152,664 |   | 136,777 |   |
| Income per share from continuing operations                                       |       | $                                         | 0.42       |                                     | $          | 0.32 |   | $ | 0.49 |   | $ | 0.71 |   |
| Income per share from discontinued operations                                     |       | $                                         | —     |                                     | $          | — |   | $ | — |   | $ | 0.02 |   |
| Net income per share                                                              |       | $                                         | 0.42       |                                     | $          | 0.32 |   | $ | 0.49 |   | $ | 0.73 |   |
| ** **                                                                        |       |                                      |       |                                     |       |   |   |   |   |
| **Diluted:**                                                                      |       |                                      |       |                                     |       |   |   |   |   |
| Basic weighted-average shares outstanding                                         |       | 156,997                                   |       | 149,612                                  |       | 152,664 |   | 136,777 |   |
| Dilutive effect of restricted common shares                                       |       | —                                    |       | —                                   |       | — |   | — |   |
| Diluted weighted-average shares outstanding (2)                                   |       | 156,997                                   |       | 149,612                                  |       | 152,664 |   | 136,777 |   |
| Income per share from continuing operations                                       |       | $                                         | 0.42       |                                     | $          | 0.32 |   | $ | 0.49 |   | $ | 0.71 |   |
| Income per share from discontinued operations                                     |       | $                                         | —     |                                     | $          | — |   | $ | — |   | $ | 0.02 |   |
| Net income per share                                                              |       | $                                         | 0.42       |                                     | $          | 0.32 |   | $ | 0.49 |   | $ | 0.73 |   |
| Distributions declared per common share                                           |       | $                                         | —     |                                     | $          | 0.40 |   | $ | — |   | $ | 1.30 |   |

 

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(1)                                 For the threeand nine months ended September 30, 2008, EPS reflects the retrospectiveadjustments to include unvested share-based payment awards as participatingsecurities. No dividend was declared on common shares for the three and ninemonths ended September 30, 2009.

(2)                             Potentialanti-dilutive common shares excluded from diluted income earnings per share forboth the three and nine months ended September 30, 2009 were 8,896,784related to convertible debt securities and 1,932,279 related to common shareoptions.  Potential anti-dilutive commonshares excluded from diluted income earnings per share for both the three andnine months ended September 30, 2008 were 9,667,430 related to convertibledebt securities and 1,932,279 related to common share options.

 

**Note 4. Private Equity Investments**

 

As of September 30, 2009, the Company had private equityinvestments carried at cost of $17.5 million and two private equity investmentscarried at estimated fair value of $76.3 million. As of December 31, 2008,the Company had private equity investments at cost of $17.5 million and privateequity investments at estimated fair value of $5.3 million. During the secondquarter of 2009, the Company’s term loan investments related to one issuer weremodified and exchanged for equity in a transaction which qualified as atroubled debt restructuring. This transaction resulted in a charge-off to theallowance for loan loss of $41.4 million (see Note 6 to these condensedconsolidated financial statements for further discussion). At the time ofrestructuring, the Company elected to carry this investment at estimated fairvalue, with unrealized gains and losses reported in income.

 

For the three and nine months ended September 30, 2009, theCompany had net realized and unrealized gains of $22.3 million and $22.6million, respectively, on private equity investments carried at estimated fairvalue. There was no net realized and unrealized gain or loss for the three andnine months ended September 30, 2008.

 

Note 10 to these condensed consolidated financial statements describesthe Company’s borrowings under which the Company has pledged private equityinvestments for borrowings. The following table summarizes the carrying valueof private equity investments pledged as collateral under secured financingtransactions as of September 30, 2009 and December 31, 2008 (amountsin thousands):

 
| ** **                                                                                                            | ** ** | **As of  September 30, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|-----------------------------------|------------|
| Pledged as collateral for borrowings under senior  secured credit facility                                            |       | $                                  | 35,898     |                              | $          | — |   |
| Pledged as collateral for collateralized loan  obligation senior secured notes and junior secured notes to affiliates |       | 57,917                             |       | 5,287                             |       |
| Total                                                                                                                 |       | $                                  | 93,815     |                              | $          | 5,287 |   |

 

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

 

The following table summarizes the Company’s securities classified asavailable-for-sale as of September 30, 2009, which are carried at estimatedfair value (amounts in thousands):

 
| **Description**            | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
|----------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|---------------------------|------------|
| Corporate debt securities  |       | $                   | 592,571    |                         | $          | 168,370                       |       | $                         | (25,312    | ) | $ | 735,629 |   |
| Common and preferred stock |       | 713                 |       | 481                          |       | —                        |       | 1,194                     |       |
| Total                      |       | $                   | 593,284    |                         | $          | 168,851                       |       | $                         | (25,312    | ) | $ | 736,823 |   |

 

The following table shows the grossunrealized 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 September 30, 2009(amounts in thousands):

 
| ** **                | ** ** | **Less Than 12 months**   | ** ** | **12 Months or More**  | ** ** | **Total**                 | ** ** |
|---------------------------|------------|---------------------------|------------|------------------------|------------|---------------------------|------------|
| **Description**           | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| Corporate debt securities |       | $                         | —     |                   | $          | —                    |       | $ | 278,399 |   | $ | (25,312 | ) | $ | 278,399 |   | $ | (25,312 | ) |
|                           |            |                           |            |                        |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The unrealized losses in the table above are considered to be temporaryimpairments due to market factors and are not reflective of creditdeterioration.  The Company considersmany factors when evaluating whether an impairment is other-than-temporary. Forcorporate debt securities included in the table above, the Company does notintend to sell them and does not believe that it is more likely than not thatthe Company will be required to sell any of its corporate debt securities priorto recovery. In addition, based on the analyses performed by the Company oneach of its corporate debt securities, it believes that it will be able torecover the entire amortized cost amount of the corporate debt securitiesincluded in the table above.

 

During the three and nine months endedSeptember 30, 2009, the Company recognized a loss totaling nil and $40.0million, respectively, for corporate debt securities that it determined to beother-than-temporarily impaired based on the criteria above. The Companyintends to sell these securities and as a result, the entire amount is recordedthrough earnings in net realized and unrealized (loss) gain on investments inthe condensed consolidated statements of operations.

 

As of September 30, 2009 and December 31,2008, the Company held one corporate debt security that was in default with atotal fair value of $5.9 million and $3.2 million, respectively. This corporatedebt security was determined to be other-than-temporarily impaired as ofSeptember 30, 2009 and December 31, 2008.

 

The following table summarizes the Company’ssecurities classified as available-for-sale as of December 31, 2008, which arecarried at estimated fair value (amounts in thousands):

 
| **Description**            | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
|----------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|---------------------------|------------|
| Corporate debt securities  |       | $                   | 742,474    |                         | $          | 3,676                         |       | $                         | (192,709   | ) | $ | 553,441 |   |
| Common and preferred stock |       | 3,126               |       | —                       |       | (602                          | )          | 2,524                     |       |
| Total                      |       | $                   | 745,600    |                         | $          | 3,676                         |       | $                         | (193,311   | ) | $ | 555,965 |   |

 

The following table shows the grossunrealized 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, 2008 (amountsin thousands):

 
| ** **                 | ** ** | **Less Than 12 months**   | ** ** | **12 Months or More**  | ** ** | **Total**                 | ** ** |
|----------------------------|------------|---------------------------|------------|------------------------|------------|---------------------------|------------|
| **Description**            | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| Corporate debt securities  |       | $                         | 396,279    |                   | $          | (119,849                  | )          | $ | 121,080 |   | $ | (72,860 | ) | $ | 517,359 |   | $ | (192,709 | ) |
| Common and preferred stock |       | 2,499                     |       | (256                   | )          | 25                        |       | (346 | ) | 2,524 |   | (602 | ) |
| Total                      |       | $                         | 398,778    |                   | $          | (120,105                  | )          | $ | 121,105 |   | $ | (73,206 | ) | $ | 519,883 |   | $ | (193,311 | ) |

 

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The table above excludes $460.4 million ofunrealized losses for securities that it determined to beother-than-temporarily impaired. These securities were determined to beother-than-temporarily impaired either due to management’s determination thatrecovery in value is no longer likely or because the Company has decided tosell the respective security in response to specific credit concerns regardingthe issuer. The charges relating to the impairment of these securities wererecognized in net realized and unrealized (loss) gain on investments in thecondensed consolidated statements of operations.

 

During the three and nine months endedSeptember 30, 2009, the Company had gross realized gains from the sales ofsecurities available-for-sale of nil and $10.0 million, respectively, and grossrealized losses from the sales of securities available-for-sale of $2.0 millionand $9.4 million, respectively. During the three and nine months endedSeptember 30, 2008, the Company had gross realized gains from the sale ofsecurities available-for-sale of $0.6 million and $5.2 million, respectively,and gross realized losses from the sales of securities available-for-sale of$7.7 million and $22.4 million, respectively.

 

Note 10 to these condensed consolidatedfinancial statements describe the Company’s borrowings under which the Companyhas pledged securities available-for-sale for borrowings. The following tablesummarizes the estimated fair value of securities available-for-sale pledged ascollateral as of September 30, 2009 and December 31, 2008 (amounts inthousands):

 
| ** **                                                                                                            | ** ** | **As of  September 30, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|------------------------------|------------|
| Pledged as collateral for borrowings under  senior secured credit facility                                            |       | $                             | 88,768     |                         | $          | 93,764 |   |
| Pledged as collateral for collateralized  loan obligation senior secured notes and junior secured notes to affiliates |       | 648,055                       |       | 459,677                      |       |
| Total                                                                                                                 |       | $                             | 736,823    |                         | $          | 533,441 |   |

** **

**Note 6. Corporate Loans and Allowance forLoan Losses**

 

The following table summarizes the Company’scorporate loans as of September 30, 2009 and December 31, 2008 (amounts inthousands):

 
| ** **                     | ** ** | **September  30, 2009** | ** ** | **December  31, 2008**    | ** ** |
|--------------------------------|------------|-------------------------|------------|---------------------------|------------|
| ** **                     | ** ** | **Principal**           | ** ** | **Unamortized  Discount** | ** ** | **Lower of  Cost  or Fair Value  Adjustment** | ** ** | **Net  Carrying  Value** | ** ** | **Principal** | ** ** | **Unamortized  Discount** | ** ** | **Lower of  Cost  or Fair Value  Adjustment** | ** ** | **Net  Carrying  Value** | ** ** |
| Corporate  loans(1)            |       | $                       | 7,111,936  |                      | $          | (420,707 | ) | $ | — |   | $ | 6,691,229 |   | $ | 7,983,449 |   | $ | (255,877 | ) | $ | — |   | $ | 7,727,572 |   |
| Corporate  loans held for sale |       | 547,079                 |       | (13,525                   | )          | (29,461 | ) | 504,093 |   | 472,669 |   | (10,751 | ) | (137,269 | ) | 324,649 |   |
| Total  corporate loans         |       | $                       | 7,659,015  |                      | $          | (434,232 | ) | $ | (29,461 | ) | $ | 7,195,322 |   | $ | 8,456,118 |   | $ | (266,628 | ) | $ | (137,269 | ) | $ | 8,052,221 |   |

 

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(1)                                 Grossof allowance for loan losses of $470.2 million and $480.8 million as ofSeptember 30, 2009 and December 31, 2008, respectively. Principal amount is netof charge-offs and other adjustments totaling $5.9 million.

 

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The following table summarizes the changes inthe allowance for loan losses for the Company’s corporate loan portfolio duringthe three and nine months ended September 30, 2009 and 2008 (amounts inthousands):

 
| ** **                     | ** ** | **For the three  months ended  September 30,  2009** | ** ** | **For the three  months ended  September 30,  2008** | ** ** | **For the nine  months ended  September 30,  2009** | ** ** | **For the nine  months ended  September 30,  2008** | ** ** |
|--------------------------------|------------|------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|
| Balance at beginning of period |       | $                                                    | 473,202    |                                                 | $          | 35,000                                              |       | $                                                   | 480,775    |   | $ | 25,000 |   |
| Provision for loan losses      |       | —                                               |       | —                                               |       | 39,795                                              |       | 10,000                                              |       |
| Charge-offs                    |       | (2,978                                               | )          | —                                               |       | (50,346                                             | )          | —                                              |       |
| Balance at end of period       |       | $                                                    | 470,224    |                                                 | $          | 35,000                                              |       | $                                                   | 470,224    |   | $ | 35,000 |   |

 

As of September 30, 2009 and December 31,2008, the Company had an allowance for loan loss of $470.2 million and $480.8million, respectively. As described in Note 2 to these condensed consolidatedfinancial statements, the allowance for loan losses represents the Company’sestimate of probable credit losses inherent in its loan portfolio as of thebalance sheet date. The Company’s allowance for loan losses consists of twocomponents, an allocated component and an unallocated component. The allocatedcomponent of the allowance for loan losses consists of individual loans thatare impaired. The unallocated component of the allowance for loan lossesrepresents the Company’s estimate of losses inherent, but not identified, inits portfolio as of the balance sheet date.

 

As of September 30, 2009, the allocated component of the allowance forloan losses totaled $430.8 million and relates to investments in loans issuedby thirteen issuers with an aggregate par amount of $902.0 million and anaggregate amortized cost amount of $701.6 million. As of December 31, 2008, theallocated component of the allowance for loan losses totaled $320.6 million andrelates to investments in loans issued by eleven issuers with an aggregate paramount of $828.2 million and an aggregate amortized cost amount of $715.4million. The unallocated component of the allowance for loan losses totaled $39.4million and $160.2 million as of September 30, 2009 and December 31, 2008,respectively. The Company recorded charge-offs during the three months endedSeptember 30, 2009 totaling $3.0 million related to loans transferred to loansheld for sale. During the nine months ended September 30, 2009, the Companyrecorded charge-offs totaling $50.4 million comprised of the $3.0 millionabove, $6.0 million related to a loan sold during the second quarter of 2009,and $41.4 million related to a loan exchanged for equity and which qualified asa troubled debt restructuring (see Note 4 to these condensed consolidatedfinancial statements for further details). There were no charge-offs during thethree and nine months ended September 30, 2008.

 

As of September 30, 2009 and December 31,2008, the Company had loans on non-accrual status with total amortized costs of$730.2 million and $358.0 million, respectively.  The average recorded investment in theimpaired loans during the three and nine months ended September 30, 2009 was$717.3 million and $544.2 million, respectively, and during the three and ninemonths ended September 30, 2008 average recorded investment in the impairedloans was nil. The amount of interest income recognized using the cash-basismethod during the time within the period that the loans were impaired was $8.2million and $15.0 million for the three and nine months ended September 30,2009, respectively, and nil for the three and nine months ended September 30,2008.

 

As of September 30, 2009, the Company heldloans that were in default with a total amortized cost of $743.6 million fromten issuers. As of December 31, 2008, the Company held loans that were indefault with a total amortized cost of $312.7 million from three issuers. Themajority of corporate loans in default during 2009 and 2008 were included inthe loans for which the allocated component of the Company’s allowance forlosses was related to as of September 30, 2009 and December 31, 2008,respectively.

 

Note 10 to these condensed consolidatedfinancial statements describes the Company’s borrowings under which the Companyhas pledged loans for borrowings. The following table summarizes the carryingvalue of corporate loans pledged as collateral as of September 30, 2009 andDecember 31, 2008 (amounts in thousands):

 
| ** **                                                                                                            | ** ** | **As of  September 30, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|------------------------------|------------|
| Pledged as collateral for borrowings under  senior secured credit facility                                            |       | $                             | 548,519    |                         | $          | 182,899 |   |
| Pledged as collateral for collateralized  loan obligation senior secured notes and junior secured notes to affiliates |       | 6,646,803                     |       | 7,816,154                    |       |
| Total                                                                                                                 |       | $                             | 7,195,322  |                         | $          | 7,999,053 |   |

 

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**Note 7. Residential Mortgage-BackedSecurities**

 

As of September 30, 2009 and December 31,2008, residential mortgage-backed securities (“RMBS”) totaled $70.3 million and$102.8 million, respectively.

 

Note 10 to these condensed consolidatedfinancial statements describes the Company’s borrowings under which the Companyhas pledged RMBS. The following table summarizes the estimated fair value ofRMBS pledged as collateral as of September 30, 2009 and December 31, 2008(amounts in thousands):

 
| ** **                                                                                                            | ** ** | **As of  September 30, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|------------------------------|------------|
| Pledged as collateral for borrowings under  senior secured credit facility                                            |       | $                             | 64,577     |                         | $          | 96,651 |   |
| Pledged as collateral for collateralized  loan obligation senior secured notes and junior secured notes to affiliates |       | 5,679                         |       | 6,163                        |       |
| Total                                                                                                                 |       | $                             | 70,256     |                         | $          | 102,814 |   |

 

**Note 8. Residential Mortgage Loans**

 

The following table summarizes the Company’sresidential mortgage loans as of September 30, 2009 and December 31, 2008(amounts in thousands):

 
| ** **                                              | ** ** | **As of  September 30, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|---------------------------------------------------------|------------|-------------------------------|------------|------------------------------|------------|
| Residential mortgage loans, at estimated  fair value(1) |       | $                             | 2,274,585  |                         | $          | 2,620,021 |   |
|                                                         |            |                               |            |                              |            |  |  |

 

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| (1) |   | Excludes REO as a result of foreclosure on delinquent loans of $12.8  million and $10.8 million as of September 30, 2009 and December 31, 2008,  respectively. Loans are transferred to REO at the lower of cost or fair  value. REO is recorded within other assets on the Company’s condensed  consolidated balance sheets. |
|-----|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

Note 10 to these condensed consolidatedfinancial statements describes the Company’s borrowings under which the Companyhas pledged residential mortgage loans. The following table summarizes theestimated fair value of residential mortgage loans pledged as collateral as ofSeptember 30, 2009 and December 31, 2008 (amounts in thousands):

 
| ** **                                                                 | ** ** | **As of  September 30, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------------|------------|------------------------------|------------|
| Pledged as collateral for borrowings under  senior secured credit facility |       | $                             | 121,965    |                         | $          | 167,933 |   |
| Pledged as collateral for residential  mortgage-backed securities issued   |       | 2,152,620                     |       | 2,452,088                    |       |
|                                                                       |       | $                             | 2,274,585  |                         | $          | 2,620,021 |   |

 

The following is a reconciliation of carryingamounts of residential mortgage loans for the periods ended September 30, 2009and December 31, 2008 (amounts in thousands):

 
| ** **                                                            | ** ** | **2009** | ** ** | **2008** | ** ** |
|-----------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Beginning balance                                                     |       | $        | 2,620,021  |     | $          | 3,921,323 |   |
| Principal payments                                                    |       | (453,962 | )          | (666,900 | )          |
| Transfers out of (in to) REO                                          |       | (2,010   | )          | (3,594   | )          |
| Net change in unrealized and realized  gain/loss and premium/discount |       | 110,536  |       | (630,808 | )          |
| Ending balance                                                        |       | $        | 2,274,585  |     | $          | 2,620,021 |   |

 

As of September 30, 2009, thirty of theresidential mortgage loans owned by the Company with an outstanding balance of$12.8 million (not included in the table above) were REO as a result offoreclosure on delinquent loans. As of December 31, 2008, thirty-three of theresidential mortgage loans owned by the Company with an outstanding balance of$10.8 million (not included in the table above) were REO as a result offoreclosure on delinquent loans.

 

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The following table summarizes thedelinquency statistics of the residential mortgage loans, excluding REOs, as ofSeptember 30, 2009 and December 31, 2008 (dollar amounts in thousands):

 
| ** **                  | ** ** | **September 30, 2009**    | ** ** | **December 31, 2008** | ** ** |
|-----------------------------|------------|---------------------------|------------|-----------------------|------------|
| **Delinquency Status** | ** ** | **Number  of Loans** | ** ** | **Principal  Amount** | ** ** | **Number  of Loans** | ** ** | **Principal  Amount** | ** ** |
| 30 to 59 days               |       | 77                        |       | $                     | 29,205     |   | 93 |   | $ | 37,282 |   |
| 60 to 89 days               |       | 39                        |       | 15,407                |       | 41 |   | 15,654 |   |
| 90 days or more             |       | 111                       |       | 47,034                |       | 76 |   | 29,803 |   |
| In foreclosure              |       | 135                       |       | 54,776                |       | 67 |   | 22,841 |   |
| Total                       |       | 362                       |       | $                     | 146,422    |   | 277 |   | $ | 105,580 |   |

 

As of September 30, 2009 and December 31,2008, the loss exposure or uncollected principal amount related to theCompany’s delinquent residential mortgage loans in the table above exceededtheir fair value by $18.2 million and $4.0 million, respectively.

 

**Note 9. Residential Mortgage-BackedSecurities Issued**

 

Residential mortgage-backed securities issued(“RMBS Issued”) consists of the senior tranches of six residential mortgageloan securitization trusts that the Company consolidates under GAAP (see Note 2to these condensed consolidated financial statements) and for which the Companyreports the debt issued by these trusts that it does not hold on its condensedconsolidated balance sheets. The following table summarizes the Company’s RMBSIssued as of September 30, 2009 and December 31, 2008 (amounts in thousands):

 
| ** **                                     | ** ** | **September 30, 2009** | ** ** | **December 31, 2008**      | ** ** |
|------------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| **Description**                                | ** ** | **Outstanding**        | ** ** | **Estimated  Fair  Value** | ** ** | **Outstanding** | ** ** | **Estimated  Fair  Value** | ** ** |
| Residential mortgage-backed securities  issued |       | $                      | 2,711,990  |                       | $          | 2,165,423 |   | $ | 3,154,974 |   | $ | 2,462,882 |   |
|                                                |            |                        |            |                            |            |  |  |  |  |  |  |  |  |

 

The Company carries RMBS Issued at estimatedfair value with changes in estimated fair value reflected in net income. As ofSeptember 30, 2009 and December 31, 2008, the weighted average coupon of theRMBS Issued was 2.7% and 3.4%, respectively, and the weighted average years tomaturity were 26.0 years and 26.8 years as of September 30, 2009 and December31, 2008, respectively.

** **

**Note 10. Borrowings**

 

Certain information with respect to theCompany’s borrowings as of September 30, 2009 is summarized in the followingtable (dollar amounts in thousands):

 
| ** **                                        | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted  Average  Borrowing  Rate** | ** ** | **Weighted  Average  Remaining  Maturity  (in days)** | ** ** | **Fair Value of  Collateral(1)** | ** ** |
|---------------------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|-------------------------------------------------------|------------|----------------------------------|------------|
| Senior secured credit facility(2)                 |       | $                           | 187,500    |                                   | 4.25       | %                                                     | 771        |                             | $          | 789,473 |   |
| CLO 2005-1 senior secured notes                   |       | 832,473                     |       | 0.83                                   |       | 2,765                                                 |       | 869,723                          |       |
| CLO 2005-2 senior secured notes                   |       | 800,300                     |       | 0.70                                   |       | 2,979                                                 |       | 857,820                          |       |
| CLO 2006-1 senior secured notes                   |       | 683,265                     |       | 0.76                                   |       | 3,251                                                 |       | 846,621                          |       |
| CLO 2007-1 senior secured notes                   |       | 2,216,180                   |       | 0.98                                   |       | 4,245                                                 |       | 2,284,074                        |       |
| CLO 2007-1 junior secured notes to  affiliates(3) |       | 448,349                     |       | —                                 |       | 4,245                                                 |       | 460,404                          |       |
| CLO 2007-A senior secured notes                   |       | 1,174,664                   |       | 1.38                                   |       | 2,937                                                 |       | 1,192,676                        |       |
| CLO 2007-A junior secured notes to  affiliates(4) |       | 99,072                      |       | —                                 |       | 2,937                                                 |       | 100,592                          |       |
| Convertible senior notes                          |       | 275,800                     |       | 7.00                                   |       | 1,019                                                 |       | —                           |       |
| Junior subordinated notes                         |       | 283,671                     |       | 5.51                                   |       | 9,839                                                 |       | —                           |       |
| Total                                             |       | $                           | 7,001,274  |                                   |       |                                                  |       |                             | $          | 7,401,383 |   |

 

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(1)                                 Collateralfor borrowings consists of RMBS, securities available-for-sale, private equityinvestments and corporate and residential mortgage loans.

 

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(2)                                 Calculatedweighted average remaining maturity based on the amended maturity date ofNovember 10, 2011.

 

(3)                                 CLO2007-1 junior secured notes to affiliates consist of (x) $261.7 million ofmezzanine notes with a weighted average borrowing rate of 5.39% and(y) $186.6 million of subordinated notes that do not have acontractual coupon rate, but instead receive a pro rata amount of the net distributionsfrom CLO 2007-1.

 

(4)                                 CLO2007-A junior secured notes to affiliates consist of(x) $84.0 million of mezzanine notes with a weighted averageborrowing rate of 6.69% and (y) $15.1 million of subordinated notesthat do not have a contractual coupon rate, but instead receive a pro rataamount of the net distributions from CLO 2007-A.

 

*CLO2009-1*

 

OnMarch 31, 2009, the Company completed the restructuring of WayzataFunding LLC (“Wayzata”), itsmarket value CLO transaction. As a result of the restructuring, substantiallyall of Wayzata’s assets were transferred to CLO 2009-1, a newly formed specialpurpose company, which issued $560.8 million aggregate principal amount ofsenior notes due April 2017 and $154.3 million aggregate principal amountof subordinated notes due April 2017 to the existing Wayzata note holdersin exchange for cancellation of the Wayzata notes, due November 2012,previously held by each of them. CLO 2009-1 was structured as a cash flowtransaction and does not contain the market value provisions contained inWayzata. The portfolio manager of the CLO is an affiliate of the Manager. Thenotes issued by CLO 2009-1 are secured by the same collateral that secured theWayzata facility, consisting primarily of senior secured leveraged loans. Aswas the case with Wayzata, the Company and an affiliate of the Managercurrently own all of the subordinated notes issued by the CLO. The subordinatednotes entitle the Company to receive a pro rata**portion of all excess cash flows from the portfolio after all seniorobligations of CLO 2009-1 have been paid in full or otherwise satisfied,including all outstanding principal of the senior notes and interest thereonaccruing at a rate of 3-month LIBOR plus 4.25%.

 

The restructuring of Wayzata and the formation of CLO 2009-1 outlinedabove qualified as a troubled debt restructuring under FASB ASC 470-60. Priorto the restructuring on March 31, 2009, an affiliate of the Manager heldan aggregate par amount of $125.0 million of subordinated notes issued by Wayzata(the “Wayzata Subordinated Notes”). In connection with the restructuring, theWayzata Subordinated Notes were exchanged for $30.9 million par amount ofjunior notes issued by CLO 2009-1 (the “CLO 2009-1 Junior Notes”). The portionof the CLO 2009-1 Junior Notes held by the affiliate of the Manager was carriedat $90.4 million which represented the total future cash payments that theaffiliate of the Manager could receive from the CLO 2009-1 Junior Notes. Theexchange by the affiliate of the Manager of Wayzata Subordinated Notes for CLO2009-1 Junior Notes was treated as a modification of terms of the WayzataSubordinated Notes. Accordingly, the Company recognized a gain on debtrestructuring totaling $34.6 million, or $0.23 per diluted common share, whichreflected the difference between the Company’s carrying amount of interest inthe Wayzata Subordinated Notes held by the affiliate of the Manager, or $125.0million, and the carrying value of the portion of the CLO 2009-1 Junior Notesheld by the same affiliate of the Manager, or $90.4 million. The WayzataSubordinated Notes were included in collateralized loan obligation juniorsecured notes to affiliates on the condensed consolidated balance sheets as ofDecember 31, 2008.

 

During the second quarter of 2009, theproceeds from the sale of certain CLO 2009-1 assets were used to pay down$516.4 million of CLO 2009-1 senior secured notes. On July 24, 2009,the Company retired the remaining outstanding balance of senior notes issued byCLO 2009-1 totaling $44.4 million. Prior to the retirement of the seniornotes, an affiliate of the Company held a 20% interest in the subordinatednotes issued by CLO 2009-1 as described above. As part of the deleveraging ofCLO 2009-1, the subordinated notes in CLO 2009-1 held by the Company’saffiliate were retired in exchange for the affiliate’s proportionate interestin the assets held by CLO 2009-1.

 

The retirement of the senior notes issued by CLO 2009-1 included thepayment of a $28.8 million placement fee to the senior note holders that waspaid from the cash held by CLO 2009-1. The placement fee was structured to bepaid by CLO 2009-1 on a quarterly basis over the life of the transaction andthe $28.8 million amount reflects the present value of the future quarterly feepayments. As the Company consolidates CLO 2009-1, this fee was recognized as anexpense during the third quarter of 2009 and was partially offset by a $14.4million net gain recognized from the retirement of the subordinated notesissued by CLO 2009-1 to an affiliate. The net loss from the CLO 2009-1deleveraging was recorded in (loss) gain on restructuring and extinguishment ofdebt on the condensed consolidated statements of operations.

 

*CLONotes*

 

The indentures governing the Company’s CLOtransactions include numerous compliance tests, the majority of which relate tothe CLO’s portfolio profile. In the event that a portfolio profile test is notmet, the indenture places restrictions on the ability of the CLO’s manager toreinvest available principal proceeds generated by the collateral in the CLOsuntil the specific test has been cured. In addition to the portfolio profiletests, the indentures for the CLO transactions include over-collateralizationtests (“OC Tests”) which set the ratio of the collateral value of the assets inthe CLO to the tranches of debt for which the test is being measured, as well 

 

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as interest coverage tests. If a CLO is not in compliance with an OCTest or an interest coverage test, cash flows normally payable to the holdersof junior classes of notes will be used by the CLO to amortize the most seniorclass of notes until such point as the OC test is brought back into compliance.Due to the failure of OC Tests during the third quarter of 2009, CLO 2007-1senior secured notes were paid down by $27.3 million and CLO 2007-A seniorsecured notes were paid down by $16.2 million. During the nine monthsended September 30, 2009, CLO 2005-2 senior secured notes were paid down by$9.0 million, CLO 2006-1 senior secured notes were paid down by$32.1 million, CLO 2007-1 senior secured notes were paid down by$108.6 million and CLO 2007-A senior secured notes were paid down by $38.9million.

 

Due to the failure of OC Tests during 2008,CLO 2006-1 senior secured notes were paid down by $12.1 million and CLO2007-1 senior secured notes were paid down by $53.6 million.

* *

On July 10, 2009, the Company surrendered for cancellation,without consideration, approximately $298.4 million in aggregate of mezzaninenotes and junior notes (“Surrendered Notes”) issued to the Company by CLO2005-1, CLO 2005-2 and CLO 2006-1. The Surrendered Notes were promptly cancelledupon receipt by the trustee of each transaction and the related debt wasextinguished by the issuers thereof. The Company consolidates its CLOsubsidiaries and therefore, does not expect this transaction to have an impacton its consolidated financial statements. Similarly, as CLO 2005-1, CLO 2005-2and CLO 2006-1 are treated as disregarded entities for tax purposes, thistransaction is not expected to have any tax implications for the Company or itsshareholders.

 

*Senior Secured Credit Facility*

 

On August 5, 2009, the Company entered intoan agreement with its lenders to amend the terms of its senior secured creditfacility. Among other things, the amendment provides that: (i) the size of thefacility be reduced to $200.0 million from $300.0 million, (ii) the lendingcommitments of the lenders to this facility be modified to provide forquarterly amortization of $12.5 million per quarter until the size of thefacility has been reduced to $150 million on June 30, 2010, (iii) the interestrate applicable to borrowings under the facility be increased from LIBOR plus300 basis points to LIBOR plus 400 basis points, (iv) the adjusted tangible networth covenant be reduced to $700.0 million from $1.0 billion, (v) the maturitydate of the borrowings under the facility be extended to November 10, 2011, and(vi) certain events of default under the Credit Agreement be added. Theamendment also provides that the Company can (i) pay a yearly distribution toits shareholders in an amount equal to no greater than 50% of its taxableincome for such year and (ii) use up to $50 million of its unrestricted cash torepurchase its convertible notes due July 2012 and/or its outstanding trustpreferred securities. In conjunction with this amendment, the Company paid thelenders of the credit facility fees totaling $4.5 million.

 

*Standby Revolving Credit Facility*

 

On November 10, 2008, the Company entered into an agreement for atwo year $100.0 million standby unsecured revolving credit agreement with itsManager and Kohlberg Kravis Roberts & Co. (Fixed Income) LLC, theparent of its Manager. The borrowing facility matures in December 2010 andbears interest at a rate equal to LIBOR for an interest period of 1, 2 or 3months (at the Company’s option) plus 15.00% per annum. Under the terms of theagreement, the Company can elect to capitalize a portion of accrued interest onany loan under the agreement by adding up to 80% of the interest due andpayable at a particular time in respect of such loan to the outstandingprincipal amount of the loan. The Company has the right to prepay loans underthe agreement in whole or in part at any time. No borrowings were outstandingunder this facility as of September 30, 2009.

 

*ConvertibleDebt*

 

During June 2009, the Company completed two transactions toexchange a total of $15.7 million par value of convertible notes for 7.2million of the Company’s common shares. These transactions resulted in the Company recording a gain of $6.9million, or approximately $0.05 per diluted common share, which was partiallyoffset by a write-off of $0.1 million of unamortized debt issuance costs and$0.4 million of other associated costs during the second quarter of 2009.

 

On May 9, 2008, the FASB issued FASB ASC470-20-65. The topic clarifies the accounting for convertible debt instrumentswhich may be settled in cash and in particular, specifies that issuers of suchinstruments should separately account for the liability and equity componentsin a manner that will reflect the entity’s nonconvertible debt borrowing ratewhen interest cost is recognized in subsequent periods. The Company hasassessed this topic in relation to its convertible senior notes and determinedthat it does not have a material impact on its condensed consolidated financialstatements for the periods presented.

 

*JuniorSubordinated Notes*

 

During the third quarter of 2009, the Companyrepurchased $5.0 million of junior subordinated notes, which resulted in a gainon extinguishment of $3.8 million, partially offset by a $0.1 million write-offof unamortized debt issuance costs.

 

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Certain information with respect to theCompany’s borrowings as of December 31, 2008 is summarized in thefollowing table (dollar amounts in thousands):

 
| ** **                                        | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted  Average  Borrowing  Rate** | ** ** | **Weighted  Average  Remaining  Maturity  (in days)** | ** ** | **Fair Value of  Collateral(1)** | ** ** |
|---------------------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|-------------------------------------------------------|------------|----------------------------------|------------|
| Senior secured credit facility                    |       | $                           | 275,633    |                                   | 3.44       | %                                                     | 699        |                             | $          | 441,812 |   |
| CLO 2005-1 senior secured notes                   |       | 832,025                     |       | 3.84                                   |       | 3,038                                                 |       | 631,937                          |       |
| CLO 2005-2 senior secured notes                   |       | 808,701                     |       | 2.48                                   |       | 3,252                                                 |       | 647,092                          |       |
| CLO 2006-1 senior secured notes                   |       | 715,394                     |       | 2.52                                   |       | 3,524                                                 |       | 623,003                          |       |
| CLO 2007-1 senior secured notes                   |       | 2,318,191                   |       | 2.68                                   |       | 4,518                                                 |       | 1,511,707                        |       |
| CLO 2007-1 junior secured notes to  affiliates(2) |       | 436,185                     |       | —                                 |       | 4,518                                                 |       | 277,357                          |       |
| CLO 2007-A senior secured notes                   |       | 1,213,300                   |       | 5.62                                   |       | 3,210                                                 |       | 867,666                          |       |
| CLO 2007-A junior secured notes to  affiliates(3) |       | 94,128                      |       | —                                 |       | 3,210                                                 |       | 67,314                           |       |
| Wayzata senior secured notes                      |       | 1,600,000                   |       | 2.95                                   |       | 1,415                                                 |       | 766,024                          |       |
| Convertible senior notes                          |       | 291,500                     |       | 7.00                                   |       | 1,292                                                 |       | —                           |       |
| Junior subordinated notes                         |       | 288,671                     |       | 6.84                                   |       | 10,118                                                |       | —                           |       |
| Subordinated notes to affiliates(4)               |       | 125,000                     |       | —                                 |       | 1,415                                                 |       | 59,846                           |       |
| Total                                             |       | $                           | 8,998,728  |                                   |       |                                                  |       |                             | $          | 5,893,758 |   |

 

----

| (1)    |   | Collateral for borrowings consists of RMBS, securities  available-for-sale, and corporate and residential mortgage loans.                                                                                                                                                                                                                       |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| (2)    |   | CLO 2007-1 junior secured notes to affiliates consist of  (x) $249.6 million of mezzanine notes with a weighted average  borrowing rate of 7.03% and (y) $186.6 million of subordinated  notes that do not have a contractual coupon rate, but instead receive a pro  rata amount of the net distributions from CLO 2007-1. |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| (3)    |   | CLO 2007-A junior secured notes to affiliates consist of  (x) $79.0 million of mezzanine notes with a weighted average  borrowing rate of 10.90% and (y) $15.1 million of subordinated  notes that do not have a contractual coupon rate, but instead receive a pro  rata amount of the net distributions from CLO 2007-A.  |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| (4)    |   | Subordinated notes do not have a contractual coupon rate, but instead  receive a pro rata amount of the net distributions from Wayzata. Note that  the $125.0 million outstanding is included in collateralized loan obligation  junior secured notes to affiliates on the condensed consolidated balance  sheets.                              |

 

**Note 11.Securities Sold, Not Yet Purchased**

 

Securities sold, not yet purchased consist ofequity and debt securities that the Company has sold short. As ofSeptember 30, 2009, the Company had securities sold, not yet purchasedwith an amortized cost of $75.3 million and an accumulated net unrealized lossof $3.3 million. As of December 31, 2008, the Company had securities sold,not yet purchased with an amortized cost basis of $97.3 million and anaccumulated net unrealized gain of $6.5 million.

 

For the three and nine months endedSeptember 30, 2009, the Company had net realized and unrealized (losses)gains on short security sales of $(1.0) million and $2.9 million, respectively,compared to net realized and unrealized gains on short security sales of$14.2 million and $22.9 million, for the three and nine months endedSeptember 30, 2008, respectively.

 

**Note 12. Derivative FinancialInstruments**

 

The Company enters into derivativetransactions in order to hedge its interest rate risk exposure to the effectsof interest rate changes. Additionally, the Company enters into derivativetransactions in the course of its investing. The counterparties to theCompany’s derivative agreements are major financial institutions with which theCompany and its affiliates may also have other financial relationships. In theevent 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 interest rate derivatives consistingof swaps to hedge a portion of the interest rate risk associated with itsborrowings under CLO senior secured notes. The Company designates thesefinancial instruments as cash flow hedges. The Company also uses interest rateswaps to hedge all or a portion of the interest rate risk associated withcertain fixed interest rate investments. The Company designates these financialinstruments as fair value hedges.

 

**Free-Standing Derivatives**

 

Free-standing derivatives are derivativesthat the Company has entered into in conjunction with its investment and riskmanagement activities, but for which the Company has not designated thederivative contract as a hedging instrument for accounting purposes. Suchderivative contracts may include credit default swaps (“CDS”), foreign exchangecontracts, and interest rate derivatives. Free-standing derivatives alsoinclude investment financing arrangements (total rate of return swaps) wherebythe Company receives the sum of all interest, fees and any positive change infair value amounts from a reference asset with a specified notional amount andpays interest on such notional amount plus any negative change in fair valueamounts from such reference asset.

 

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The table below summarizes the aggregatenotional amount and estimated net fair value of the derivative instruments asof September 30, 2009 and December 31, 2008 (amounts in thousands):

 
| ** **                                     | ** ** | **As of September 30, 2009** | ** ** | **As of December 31, 2008** | ** ** |
|------------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **                                     | ** ** | **Notional**                      | ** ** | **Estimated  Fair Value**        | ** ** | **Notional** | ** ** | **Estimated  Fair Value** | ** ** |
| **Cash  Flow Hedges:**                         |       |                              |       |                             |       |   |   |   |   |
| Interest rate swaps                            |       | $                                 | 383,333    |                             | $          | (53,869 | ) | $ | 383,333 |   | $ | (77,668 | ) |
| **Fair  Value Hedges:**                        |       |                              |       |                             |       |   |   |   |   |
| Interest rate swaps                            |       | —                            |       | —                           |       | 32,000 |   | (2,915 | ) |
| **Free-Standing  Derivatives:**                |       |                              |       |                             |       |   |   |   |   |
| Interest rate swaps                            |       | 97,259                            |       | 277                              |       | 106,074 |   | 274 |   |
| Credit default swaps—protection sold      |       | 51,000                            |       | (773                             | )          | 53,500 |   | (9,782 | ) |
| Credit default swaps—protection purchased |       | —                            |       | —                           |       | 222,650 |   | 69,972 |   |
| Total rate of return swaps                     |       | 120,234                           |       | 20,437                           |       | 207,524 |   | (77,224 | ) |
| Total                                          |       | $                                 | 651,826    |                             | $          | (33,928 | ) | $ | 1,005,081 |   | $ | (97,343 | ) |

 

A CDS is acontract in which the contract buyer pays, in the case of a short position, orreceives, in the case of long position, a periodic premium until the contract expires or acredit event occurs. In return for this premium, the contract seller receives apayment from or makes a payment to the buyer if there is a credit default orother specified credit event with respect to the issuer (also known as thereferenced entity) of the underlying credit instrument referenced in the CDS. Typical credit events include bankruptcy,dissolution or insolvency of the referenced entity, failure to pay andrestructuring of the obligations of the referenced entity.

* *

As of September 30, 2009 and December 31, 2008, the Company had anotional amount of approximately nil and $222.7 million, respectively, ofcredit protection purchased. As ofSeptember 30, 2009 and December 31, 2008, the Company had soldprotection with a notional amount of approximately $51.0 million and $53.5million, respectively. The Company sells protection to replicate fixed incomesecurities and to complement the spot market when cash securities of thereferenced entity of a particular maturity are not available or when thederivative alternative is less expensive compared to other purchasingalternatives.

 

For the three and ninemonths ended September 30, 2009, the Company recognized realized gains on itsCDS of nil and $59.0 million, respectively. Realized losses of nil and$1.0 million were recognized for the same periods in 2009, respectively. Forthe three and nine months ended September 30, 2008, the Company recognizedrealized gains on its CDS of nil and $3.3 million, respectively. Realizedlosses of $0.7 million and $1.2 million were recognized for the same periods in2008, respectively.

 

For all hedges where hedge accounting isbeing applied, effectiveness testing and other procedures to ensure the ongoingvalidity of the hedges are performed at least monthly. During the three andnine months ended September 30, 2009 and 2008, the Company recognized animmaterial amount of ineffectiveness in income on the condensed consolidatedstatements of operations from its cash flow and fair value hedges.

 

**Note 13. Accumulated Other ComprehensiveIncome (Loss)**

 

The components of accumulated othercomprehensive income (loss), were as follows (amounts in thousands):

 
| ** **                                                      | ** ** | **As of  September 30, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|-----------------------------------------------------------------|------------|------------------------------------|------------|-----------------------------------|------------|
| Net unrealized gains (losses) on  available-for-sale securities |       | $                                  | 143,539    |                              | $          | (192,435 | ) |
| Net unrealized losses on cash flow hedges                       |       | (51,778                            | )          | (76,347                           | )          |
| Accumulated other comprehensive income  (loss)                  |       | $                                  | 91,761     |                              | $          | (268,782 | ) |

 

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

 
| ** **                                                      | ** ** | **Three months  ended  September 30, 2009** | ** ** | **Three months  ended  September 30, 2008** | ** ** | **Nine months  ended  September 30, 2009** | ** ** | **Nine months  ended  September 30, 2008** | ** ** |
|-----------------------------------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Unrealized gains (losses) on securities  available-for-sale:    |       |                                                       |       |                                                       |       |                                                      |       |                                                      |       |
| Unrealized holding gains (losses) arising  during period        |       | $                                                          | 146,406    |                                                       | $          | (188,065                                                  | )          | $                                                         | 312,076    |   | $ | (254,042 | ) |
| Reclassification adjustments for losses  realized in net income |       | 1,972                                                      |       | 17,667                                                     |       | 23,898                                                    |       | 37,464                                                    |       |
| Unrealized gains (losses) on securities  available-for-sale     |       | 148,378                                                    |       | (170,398                                                   | )          | 335,974                                                   |       | (216,578                                                  | )          |
| Unrealized (losses) gains on cash flow  hedges                  |       | (7,422                                                     | )          | (4,940                                                     | )          | 24,569                                                    |       | (4,101                                                    | )          |
| Other comprehensive income (loss)                               |       | $                                                          | 140,956    |                                                       | $          | (175,338                                                  | )          | $                                                         | 360,543    |   | $ | (220,679 | ) |

 

**Note 14. Commitments and Contingencies**

** **

***Commitments***

 

As part of its strategy of investing in corporate loans, the Companycommits to purchase interests in primary market loan syndications, whichobligate the Company to acquire a predetermined interest in such loans at aspecified price on a to-be-determined settlement date. Consistent with standardindustry practices, once the Company has been informed of the amount of itssyndication allocation in a particular loan by the syndication agent, theCompany bears the risks and benefits of changes in the fair value of thesyndicated loan from that date forward. As of September 30, 2009, theCompany had committed to purchase corporate loans with aggregate commitmentstotaling $101.2 million. In addition, the Company participates in certain contingent financingarrangements, including revolvers and delayed draw facilities, whereby theCompany is committed to provide funding of up to a specific amount at thediscretion of the borrower. As of September 30, 2009, we hadunfunded financing commitments totaling $48.4 million. The Company doesnot expect material losses related to those corporate loans for which itcommitted to purchase and fund.

** **

***Contingencies***

 

On July 10,2009, the Company surrendered for cancellation, without consideration,approximately $64.0 million of mezzanine notes issued to the Company by CLO2005-2, as well as certain other notes issued to the Company by other CLOs asdescribed in Note 10 to these condensed consolidated financial statements. Thesurrendered notes were cancelled by the trustee under the indenture, and theobligations due under such surrendered notes were deemed extinguished.  Holders constituting a majority of thecontrolling class of senior notes of CLO 2005-2 (“Noteholders”) have notifiedthe related trustee of purported defaults under the indenture related to thenote surrender.  The Company does notbelieve based on discussions with counsel that an event of default has occurredand is engaged in discussions with the Noteholders to resolve this matter.  Accordingly, the Company does not believethat this matter will have a material effect on its financial condition.

 

The Company hasbeen named as a party in various legal actions which include the mattersdescribed below. It is inherently difficult to predict the ultimate outcome,particularly in cases in which claimants seek substantial or unspecifieddamages, or where investigations or proceedings are at an early stage and theCompany cannot predict with certainty the loss or range of loss that may beincurred. The Company has denied, or believes it has a meritorious defense andwill deny liability in the significant cases pending against the Companydiscussed below. Based on current discussion and consultation with counsel,management believes that the resolution of these matters will not have amaterial impact on the Company's condensed consolidated financial statements.

 

OnAugust 7, 2008, the members of the Company’s board of directors andcertain of its current and former executive officers and the Companywere named in a putative class action complaint filed by Charter Township ofClinton Police and Fire Retirement System in the United States District Courtfor the Southern District of New York (the “Charter Litigation”). OnMarch 13, 2009, the lead plaintiff filed an Amended Complaint, whichdeleted as defendants the members of the Company’s board of directors and namedas individual defendants only the Company’s former chief executive officerSaturnino S. Fanlo, the Company’s former chief operating officer David A.Netjes, and the Company’s current chief financial officer Jeffrey B. Van Horn(the “Individual Defendants,” and, together with the Company,“Defendants”). The Amended Complaint alleges that the Company’sApril 2, 2007 registration statement and prospectus and the financialstatements incorporated therein contained material omissions in violationof Section 11 of the Securities Act of 1933, as amended (the “1933 Act”),regarding the risks and potential losses associated with theCompany’s real estate-related assets, the Company’s ability to finance itsreal estate-related assets, and the adequacy of the Company’s lossreserves for its real estate-related assets (the “alleged Section 11violation”). The Amended Complaint further alleges that, pursuant toSection 15 of the 1933 Act, the Individual Defendants have legalresponsibility for the alleged Section 11 violation.  OnApril 27, 2009, Defendants filed a motion to dismiss the Amended Complaintfor failure to state a claim under the 1933 Act.

 

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On August 15, 2008,the members of the Company’s board of directors and its executive officers (the“Kostecka Individual Defendants”) were named in a shareholder derivative actionbrought by Raymond W. Kostecka, a purported shareholder, in the Superior Courtof California, County of San Francisco (the “California Derivative Action”).The Company was named as a nominal defendant. The complaint in the CaliforniaDerivative Action asserts claims against the Kostecka Individual Defendants forbreaches of fiduciary duty, abuse of control, gross mismanagement, waste ofcorporate assets, and unjust enrichment in connection with the conduct at issuein the Charter Litigation, including the filing of the April 2, 2007Registration Statement with alleged material misstatements and omissions. Byorder dated January 8, 2009, the Court approved the parties’ stipulationto stay the proceedings in the California Derivative Action until the CharterLitigation is dismissed on the pleadings or the Company files an answer to theCharter Litigation.

 

On March 23, 2009, the members of the Company’s board of directorsand certain of its executive officers (the “Haley Individual Defendants”) werenamed in a shareholder derivative action brought by Paul B. Haley, a purportedshareholder, in the United States District Court for the Southern District ofNew York (the “New York Derivative Action”). The Company was named as a nominaldefendant. The complaint in the New York Derivative Action asserts claimsagainst the Haley Individual Defendants for breaches of fiduciary duty,breaches of the duty of full disclosure, and for contribution in connectionwith the conduct at issue in the Charter Litigation, including the filing ofthe April 2, 2007 registration statement with alleged materialmisstatements and omissions. By order dated June 18, 2009, the Courtapproved the parties’ stipulation to stay the proceedings in the New YorkDerivative Action until the Charter Litigation is dismissed on the pleadings orthe Company files an answer to the Charter Litigation.

 

**Note 15. Share Options and Restricted Shares**

 

On May 4, 2007, the Company adopted an amended and restated shareincentive plan (the “2007 Share Incentive Plan”) that provides for the grant ofqualified incentive common share options that meet the requirements of Section 422of the Code, non-qualified common share options, share appreciation rights,restricted common shares and other share-based awards. The CompensationCommittee of the board of directors administers the plan. Share options andother share-based awards may be granted to the Manager, directors, officers andany key employees of the Manager and to any other individual or entity performingservices for the Company.

 

The exercise price for any share option granted under the 2007 ShareIncentive Plan may not be less than 100% of the fair market value of the commonshares at the time the common share option is granted. Each option to acquire acommon share must terminate no more than ten years from the date it is granted.As of September 30, 2009, the 2007 Share Incentive Plan authorizes a totalof 8,464,625 shares that may be used to satisfy awards under the 2007 ShareIncentive Plan. On August 12, 2009, the Compensation Committee of theBoard of Directors granted 220,519 restricted common shares to the Company’sdirectors pursuant to the 2007 Share Incentive Plan.

 

The following table summarizes restricted common share transactions:

 
| ** **                                         | ** ** | **Manager** | ** ** | **Directors** | ** ** | **Total** | ** ** |
|----------------------------------------------------|------------|-------------|------------|---------------|------------|-----------|------------|
| **Unvested shares as of  January 1, 2009**    |       | 1,097,000   |       | 66,282        |       | 1,163,282 |       |
| Issued                                             |       | —      |       | 220,519       |       | 220,519   |       |
| Vested                                             |       | —      |       | (31,183       | )          | (31,183   | )          |
| Cancelled                                          |       | —      |       | —        |       | —    |       |
| Forfeited                                          |       | —      |       | —        |       | —    |       |
| **Unvested shares as of  September 30, 2009** |       | 1,097,000   |       | 255,618       |       | 1,352,618 |       |

 

The Company is required to value any unvested restricted common sharesgranted to the Manager at the current market price. The Company valued theunvested restricted common shares granted to the Manager at $4.62 and $6.36 pershare at September 30, 2009 and September 30, 2008, respectively.There were $3.1 million and $6.2 million of total unrecognizedcompensation costs related to unvested restricted common shares granted as of September 30,2009 and 2008, respectively. These costs are expected to be recognized overthree years from the date of grant.

 

The following table summarizes common share option transactions:

 
|                                           |   | **Number of  Options** | ** ** | **Weighted-Average  Exercise Price** | ** ** |
|------------------------------------------------|--------|------------------------|------------|--------------------------------------|------------|
| **Outstanding as of  January 1, 2009**    |   | 1,932,279              |       | $                                    | 20.00      |   |
| Granted                                        |   | —                 |       | —                               |       |
| Exercised                                      |   | —                 |       | —                               |       |
| Forfeited                                      |   | —                 |       | —                               |       |
| **Outstanding as of  September 30, 2009** |   | 1,932,279              |       | $                                    | 20.00      |   |

 

 

 

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As of September 30, 2009 and December 31, 2008, 1,932,279common share options were exercisable. As of September 30, 2009, thecommon share options were fully vested and expire in August 2014. For thethree and nine months ended September 30, 2009 and 2008, the components ofshare-based compensation expense are as follows (amounts in thousands):

 
| ** **                                     | ** ** | **For the three  months ended  September 30, 2009** | ** ** | **For the three  months ended  September 30, 2008** | ** ** | **For the nine  months ended  September 30, 2009** | ** ** | **For the nine  months ended  September 30, 2008** | ** ** |
|------------------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| Restricted shares granted to Manager           |       | $                                                                            | 2,260      |                                                                         | $          | (195                                                                        | )          | $                                                                           | 2,225      |   | $ | 462 |   |
| Restricted shares granted to certain directors |       | 104                                                                          |       | 142                                                                          |       | 380                                                                         |       | 497                                                                         |       |
| Total share-based compensation expense         |       | $                                                                            | 2,364      |                                                                         | $          | (53                                                                         | )          | $                                                                           | 2,605      |   | $ | 959 |   |

 

**Note 16. Management Agreement and Related PartyTransactions**

 

The Manager manages the Company’s day-to-day operations, subject to thedirection and oversight of the Company’s board of directors. The ManagementAgreement expires on December 31 of each year, but is automaticallyrenewed for a one-year term each December 31 unless terminated upon theaffirmative vote of at least two-thirds of the Company’s independent directors,or by a vote of the holders of a majority of the Company’s outstanding commonshares, based upon (1) unsatisfactory performance by the Manager that ismaterially detrimental to the Company or (2) a determination that themanagement fee payable by the Manager is not fair, subject to the Manager’sright to prevent such a termination under this clause (2) byaccepting a mutually acceptable reduction of management fees. The Manager mustbe provided 180 days prior notice of any such termination and will be paida termination fee equal to four times the sum of the average annual basemanagement fee and the average annual incentive fee for the two 12-monthperiods immediately preceding the date of termination, calculated as of the endof the most recently completed fiscal quarter prior to the date of termination.

 

The Management Agreement contains certain provisions requiring theCompany to indemnify the Manager with respect to all losses or damages arisingfrom acts not constituting bad faith, willful misconduct, or gross negligence.The Company has evaluated the impact of these guarantees on its condensed consolidatedfinancial statements and determined that they are not material.

 

For the three and nine months ended September 30, 2009, theCompany incurred $3.7 million and $11.0 million, respectively, in basemanagement fees. In addition, the Company recognized share-basedcompensation expense related to common share options and restricted commonshares granted to the Manager of $2.3 million and $2.2 million, respectively,for the three and nine months ended September 30, 2009 (see Note 15 tothese condensed consolidated financial statements). For the three and ninemonths ended September 30, 2008, the Company incurred $8.7 million and$25.1 million, respectively, in base management fees. In addition, the Companyrecognized share-based compensation expense related to common share options andrestricted common shares granted to the Manager of $(0.2) million and $0.5million, respectively, for the three and nine months ended September 30,2008 (see Note 15 to these condensed consolidated financial statements). Effective January 1,2009, the Manager has agreed to defer 50% of the monthly base managementfee payable by the Company for the period from January 1, 2009 through November 30,2009. The aggregate amount of fees otherwise payable during the deferral periodwill be payable to the Manager upon the earlier of (x) December 15,2009 and (y) the date of any termination of the Management Agreementpursuant to either Section 13(a) or Section 15(b) thereof.  As of September 30, 2009, the Companyhad $6.1 million base management fee payable to the Manager. Base managementfees incurred and share-based compensation expense relating to common shareoptions and restricted common shares granted to the Manager are included inrelated party management compensation on the condensed consolidated statementsof operations. Expenses incurred by the Manager and reimbursed by the Companyare reflected in the respective condensed consolidated statements ofoperations, non-investment expense category based on the nature of the expense.

 

The Manager is waiving base management fees related to the$230.4 million common share offering and $270.0 million common sharerights offering that occurred during the third quarter of 2007 until such timeas the Company’s common share closing price on the NYSE is $20.00 or more forfive consecutive trading days. Accordingly, the Manager permanently waivedapproximately $2.2 million of base management fees during each of the threemonths ended September 30, 2009 and 2008, and $6.6 million during each ofthe nine months ended September 30, 2009 and 2008.

 

For the three and nine months ended September 30, 2009, $4.5million of incentive fees were earned and payable to the Manager. The Manageragreed to defer the $4.5 million incentive fee to December 15, 2009. Noincentive fees were earned or paid to the Manager during the three and ninemonths ended September 30, 2008. 

 

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An affiliate of the Manager has entered into separate managementagreements with the respective investment vehicles for CLO 2005-1,CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and CLO2009-1 and is entitled to receive fees for the services performed as collateralmanager.  Previously, the collateralmanager had waived the fees it earned for providing management services for theCompany’s CLOs. Beginning April 15, 2007, the collateral manager ceasedwaiving fees for CLO 2005-1 and beginning January 1, 2009, thecollateral manager ceased waiving fees for CLO 2005-2, CLO 2006-1,CLO 2007-1, CLO 2007-A and Wayzata (restructured and replaced withCLO 2009-1 on March 31, 2009). As described above in Note 10 to thesecondensed consolidated financial statements, the Company surrendered forcancellation the Surrendered Notes issued by CLO 2005-1, CLO 2005-2 and CLO2006-1. As a result, beginning in July 2009, the collateral managerreinstated waiving the CLO management fees for CLO 2005-2 and CLO 2006-1. Foreach of the three and nine months ended September 30, 2009, the collateralmanager waived $2.6 million for CLO 2005-2 and CLO 2006-1. In addition, due tothe deleveraging of CLO 2009-1 completed in July 2009 whereby all thesenior notes were retired, the collateral manager is no longer entitled toreceive management fees from CLO 2009-1.

 

In addition, beginning January 1, 2009, the Manager permanentlywaived reimbursable general and administrative expenses allocable to theCompany in an amount equal to the incremental CLO management fees received bythe Manager. For the three and nine months ended September 30, 2009, theManager permanently waived reimbursement of $2.4 million and $7.7 million,respectively, in allocable general and administrative expenses. For the threeand nine months ended September 30, 2008, the Company reimbursed theManager $2.5 million and $7.6 million, respectively, for allocable general,administrative and other expenses.

 

The Company has invested in corporate loans, debt securities and otherinvestments of entities that are affiliates of KKR. As of September 30,2009, the aggregate par amount of these affiliated investments totaled$2.9 billion, or approximately 35% of the total investment portfolio, andconsisted of 21 issuers. The total $2.9 billion in affiliated investmentswere primarily comprised of $2.3 billion of corporate loans,$522.6 million of corporate debt securities available-for-sale and$62.7 million notional amount of total rate of return swaps referenced tocorporate loans issued by affiliates of KKR (included in derivative assets andliabilities on the condensed consolidated balance sheet). As of December 31,2008, the aggregate par amount of these affiliated investments totaled$3.3 billion, or approximately 35% of the total investment portfolio, andconsisted of 23 issuers. The total $3.3 billion in investments werecomprised of $2.6 billion of corporate loans, $587.3 million ofcorporate debt securities available for sale, and $92.4 million notionalamount of total rate of return swaps referenced to corporate loans issued byaffiliates of KKR (included in derivative assets and liabilities on thecondensed consolidated balance sheet).

 

**Note 17. Fair Value of Financial Instruments**

 

**Fair Value of Financial Instruments**

 

During the second quarter of 2009, the Company adopted FASB ASC 825-10-65 which requiresdisclosures about fair value of financial instruments for interim reportingperiods as well as in annual financial statements. The fair value of certaininstruments including securities available-for-sale, loans, derivatives, andloan commitments is based on quoted market prices or estimates provided byindependent pricing sources. The fair value of cash and cash equivalents,interest receivable, senior secured credit facility and interest payable,approximates cost as of September 30, 2009 and December 31, 2008, dueto the short-term nature of these instruments.

 

The table below discloses the carrying value and the estimated fairvalue of the Company’s financial instruments as of September 30, 2009(amounts in thousands):

 
| ** **                                                         | ** ** | **Carrying  Amount** | ** ** | **Estimated Fair  Value** | ** ** |
|--------------------------------------------------------------------|------------|----------------------|------------|---------------------------|------------|
| Financial Assets:                                                  |       |                 |       |                      |       |
| Cash, restricted cash, and cash equivalents                        |       | $                    | 314,013    |                      | $          | 314,013 |   |
| Securities available-for-sale                                      |       | 736,823              |       | 736,823                   |       |
| Corporate loans, net of allowance for loan losses  of $470,224     |       | 6,221,005            |       | 5,869,862                 |       |
| Residential mortgage-backed securities                             |       | 70,256               |       | 70,256                    |       |
| Residential mortgage loans                                         |       | 2,274,585            |       | 2,274,585                 |       |
| Corporate loans held for sale                                      |       | 504,093              |       | 504,093                   |       |
| Private equity investments, at estimated fair  value               |       | 76,310               |       | 76,310                    |       |
| Reverse repurchase agreements                                      |       | 80,344               |       | 80,344                    |       |
| Interest and principal receivable                                  |       | 60,811               |       | 60,811                    |       |
| Derivative assets                                                  |       | 23,163               |       | 23,163                    |       |
| Private equity investments, at cost                                |       | 17,505               |       | 22,074                    |       |
|                                                               |       |                 |       |                      |       |
| Financial Liabilities:                                             |       |                 |       |                      |       |
| Collateralized loan obligation senior secured  notes               |       | $                    | 5,706,882  |                      | $          | 4,476,213 |   |
| Collateralized loan obligation junior secured  notes to affiliates |       | 547,421              |       | 197,861                   |       |
| Senior secured credit facility                                     |       | 187,500              |       | 187,500                   |       |
| Convertible senior notes                                           |       | 275,800              |       | 239,946                   |       |
| Junior subordinated notes                                          |       | 283,671              |       | 218,427                   |       |
| Residential mortgage-backed securities issued                      |       | 2,165,423            |       | 2,165,423                 |       |
| Accounts payable, accrued expenses and other  liabilities          |       | 7,209                |       | 7,209                     |       |
| Accrued interest payable                                           |       | 23,840               |       | 23,840                    |       |
| Accrued interest payable to affiliates                             |       | 2,981                |       | 2,981                     |       |
| Related party payable                                              |       | 12,893               |       | 12,893                    |       |
| Securities sold, not yet purchased                                 |       | 78,633               |       | 78,633                    |       |
| Derivative liabilities                                             |       | 57,091               |       | 57,091                    |       |

 

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The table below discloses the carrying value and the estimated fairvalue of the Company’s financial instruments as of December 31, 2008(amounts in thousands):

 
| ** **                                                         | ** ** | **Carrying  Amount** | ** ** | **Estimated Fair  Value** | ** ** |
|--------------------------------------------------------------------|------------|----------------------|------------|---------------------------|------------|
| Financial  Assets:                                                 |       |                 |       |                      |       |
| Cash,  restricted cash, and cash equivalents                       |       | $                    | 1,275,015  |                      | $          | 1,275,015 |   |
| Securities  available-for-sale                                     |       | 555,965              |       | 555,965                   |       |
| Corporate  loans, net of allowance for loan losses of $480,775     |       | 7,246,797            |       | 4,772,934                 |       |
| Residential  mortgage-backed securities                            |       | 102,814              |       | 102,814                   |       |
| Residential  mortgage loans                                        |       | 2,620,021            |       | 2,620,021                 |       |
| Corporate  loans held for sale                                     |       | 324,649              |       | 324,649                   |       |
| Private  equity investments, at estimated fair value               |       | 5,287                |       | 5,287                     |       |
| Reverse  repurchase agreements                                     |       | 88,252               |       | 88,252                    |       |
| Interest  and principal receivable                                 |       | 116,788              |       | 116,788                   |       |
| Derivative  assets                                                 |       | 73,869               |       | 73,869                    |       |
| Private  equity investments, at cost                               |       | 17,505               |       | 17,505                    |       |
|                                                               |       |                 |       |                      |       |
| Financial  Liabilities:                                            |       |                 |       |                      |       |
| Collateralized  loan obligation senior secured notes               |       | $                    | 7,487,611  |                      | $          | 4,936,286 |   |
| Collateralized  loan obligation junior secured notes to affiliates |       | 655,313              |       | 194,589                   |       |
| Senior  secured credit facility                                    |       | 275,633              |       | 275,633                   |       |
| Convertible  senior notes                                          |       | 291,500              |       | 84,000                    |       |
| Junior  subordinated notes                                         |       | 288,671              |       | 51,300                    |       |
| Residential  mortgage-backed securities issued                     |       | 2,462,882            |       | 2,462,882                 |       |
| Accounts  payable, accrued expenses and other liabilities          |       | 60,124               |       | 60,124                    |       |
| Accrued  interest payable                                          |       | 61,119               |       | 61,119                    |       |
| Accrued  interest payable to affiliates                            |       | 3,987                |       | 3,987                     |       |
| Related  party payable                                             |       | 2,876                |       | 2,876                     |       |
| Securities  sold, not yet purchased                                |       | 90,809               |       | 90,809                    |       |
| Derivative  liabilities                                            |       | 171,212              |       | 171,212                   |       |

 

**Fair Value Measurements**

 

Thefollowing table presents information about the Company’s assets and liabilities(including derivatives that are presented net) measured at fair value on arecurring basis as of September 30, 2009, 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  September 30, 2009** | ** ** |
|------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|-------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                           | ** ** | ** **                                                                 | ** ** | ** **                                               | ** ** | ** **                                            | ** ** | ** **                                 | ** ** |
| **Assets:**                                          | ** ** | ** **                                                                 | ** ** | ** **                                               | ** ** | ** **                                            | ** ** | ** **                                 | ** ** |
| Securities available-for-sale                        |       | $                                                                          | 1,194      |                                                     | $          | 661,462                                               |       | $                                          | 74,167     |   | $ | 736,823 |   |
| Residential mortgage-backed securities               |       | —                                                                     |       | —                                                   |       | 70,256                                                |       | 70,256                                     |       |
| Residential mortgage loans                           |       | —                                                                     |       | —                                                   |       | 2,274,585                                             |       | 2,274,585                                  |       |
| Private equity investments, at estimated fair  value |       | —                                                                     |       | 72,700                                                   |       | 3,610                                                 |       | 76,310                                     |       |
| Total                                                |       | $                                                                          | 1,194      |                                                     | $          | 734,162                                               |       | $                                          | 2,422,618  |   | $ | 3,157,974 |   |
| ** **                                           | ** ** | ** **                                                                 | ** ** | ** **                                               | ** ** | ** **                                            | ** ** | ** **                                 | ** ** |
| **Liabilities:**                                     | ** ** | ** **                                                                 | ** ** | ** **                                               | ** ** | ** **                                            | ** ** | ** **                                 | ** ** |
| Derivatives, net                                     |       | $                                                                          | —     |                                                     | $          | (54,642                                               | )          | $                                          | 20,714     |   | $ | (33,928 | ) |
| Residential mortgage-backed securities issued        |       | —                                                                     |       | —                                                   |       | (2,165,423                                            | )          | (2,165,423                                 | )          |
| Securities sold, not yet purchased                   |       | —                                                                     |       | (78,633                                                  | )          | —                                                |       | (78,633                                    | )          |
| Total                                                |       | $                                                                          | —     |                                                     | $          | (133,275                                              | )          | $                                          | (2,144,709 | ) | $ | (2,277,984 | ) |

 

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The following table presents information about the Company’s assetsmeasured at fair value on a non-recurring basis as of September 30, 2009,and indicates the fair value hierarchy of the valuation techniques utilized bythe Company to determine such fair value (amounts in thousands). There were noliabilities measured at fair value on a non-recurring basis:

 
| ** **          | ** ** | **Quoted Prices in  Active Markets  for Identical Assets  (Level 1)** | ** ** | **Significant Other  Observable Inputs  (Level 2)** | ** ** | **Significant  Unobservable Inputs  (Level 3)** | ** ** | **Balance as of  September 30, 2009** | ** ** |
|---------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|------------------------------------------------------|------------|--------------------------------------------|------------|
| Loans held for sale |       | $                                                                          | —     |                                                     | $          | 503,788                                              |       | $                                          | 305        |   | $ | 504,093 |   |
| REO                 |       | —                                                                     |       | —                                                   |       | 12,803                                               |       | 12,803                                     |       |
| Total               |       | $                                                                          | —     |                                                     | $          | 503,788                                              |       | $                                          | 13,108     |   | $ | 516,896 |   |

 

The majority of loans held for sale were classified as level 2 giventhat the assets were valued using quoted prices and other observable inputs inan active market. There was a single loan held for sale classified as level 3given that the valuation required management’s judgment.

 

Thefollowing table presents information about the Company’s assets and liabilities(including derivatives that are presented net) measured at fair value on arecurring basis as of December 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  December 31, 2008** | ** ** |
|-----------------------------------------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                          |       |                                                                       |       |                                                     |       |                                                 |       |                                      |       |
| **Assets:**                                         |       |                                                                       |       |                                                     |       |                                                 |       |                                      |       |
| Securities available-for-sale                       |       | $                                                                          | 2,524      |                                                     | $          | 464,332                                              |       | $                                         | 89,109     |   | $ | 555,965 |   |
| Residential mortgage-backed securities              |       | —                                                                     |       | —                                                   |       | 102,814                                              |       | 102,814                                   |       |
| Residential mortgage loans                          |       | —                                                                     |       | —                                                   |       | 2,620,021                                            |       | 2,620,021                                 |       |
| Private equity investments, at estimated fair value |       | —                                                                     |       | —                                                   |       | 5,287                                                |       | 5,287                                     |       |
| Total                                               |       | $                                                                          | 2,524      |                                                     | $          | 464,332                                              |       | $                                         | 2,817,231  |   | $ | 3,284,087 |   |
| ** **                                          |       |                                                                       |       |                                                     |       |                                                 |       |                                      |       |
| **Liabilities:**                                    |       |                                                                       |       |                                                     |       |                                                 |       |                                      |       |
| Derivatives, net                                    |       | $                                                                          | —     |                                                     | $          | (20,393                                              | )          | $                                         | (76,950    | ) | $ | (97,343 | ) |
| Residential mortgage-backed securities issued       |       | —                                                                     |       | —                                                   |       | (2,462,882                                           | )          | (2,462,882                                | )          |
| Securities sold, not yet purchased                  |       | (2,220                                                                     | )          | (88,589                                                  | )          | —                                               |       | (90,809                                   | )          |
| Total                                               |       | $                                                                          | (2,220     | )                                                        | $          | (108,982                                             | )          | $                                         | (2,539,832 | ) | $ | (2,651,034 | ) |

 

During2008, the Company began valuing its residential mortgage-backed securities,residential mortgage loans and residential mortgage-backed securities issuedusing level 3 inputs. Previously, the Company had valued these financialinstruments based on broker quotes that the Company classified as level 2inputs; however, due in large part to the widespread dislocation in theresidential mortgage market, the Company was no longer able to obtain level 2inputs.

 

The following table presents information about the Company’s assetsmeasured at fair value on a non-recurring basis as of December 31, 2008,and indicates the fair value hierarchy of the valuation techniques utilized bythe Company to determine such fair value (amounts in thousands). There were noliabilities measured at fair value on a non-recurring basis:

 
| ** **          | ** ** | **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, 2008** | ** ** |
|---------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------|------------|
| Loans held for sale |       | $                                                                          | —     |                                                     | $          | 219,199                                              |       | $                                         | 105,450    |   | $ | 324,649 |   |
| REO                 |       | —                                                                     |       | —                                                   |       | 10,794                                               |       | 10,794                                    |       |
| Total               |       | $                                                                          | —     |                                                     | $          | 219,199                                              |       | $                                         | 116,244    |   | $ | 335,443 |   |

 

Loans held for sale of $105.5 million were transferred intolevel 3 as of December 31, 2008 given that they were valued based onthe estimated sale price. REO of $10.8 million were transferred intolevel 3 as of December 31, 2008 as there was little market activityfor these assets and the valuation of REOs required management’s judgment.

 

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The following table presents additional information about assets,including derivatives that are measured at fair value on a recurring basis forwhich the Company has utilized level 3 inputs to determine fair value, forthe three months ended September 30, 2009 (amounts in thousands):

 
| ** **                                                                                                                                                                                     | ** ** | **Fair Value Measurements Using Significant Unobservable Inputs  (Level 3)** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                     | ** ** | **Securities  Available-  For-Sale**                                                                            | ** ** | **Residential  Mortgage-  Backed  Securities** | ** ** | **Residential  Mortgage  Loans** | ** ** | **Private Equity  Investments,  at estimated  fair value** | ** ** | **Derivatives,  net** | ** ** | **Residential  Mortgage-  Backed  Securities  Issued** | ** ** |
| Beginning balance as of July 1, 2009                                                                                                                                                      |       | $                                                                                                               | 89,998     |   | $ | 76,572 |   | $ | 2,218,319 |   | $ | 5,549 |   | $ | 6,087 |   | $ | (2,080,592 | ) |
| Total gains or losses (realized and unrealized):                                                                                                                                               |       |                                                                                                            |       |   |   |   |   |   |   |   |   |   |   |
| Included in earnings                                                                                                                                                                           |       | (520                                                                                                            | )          | 597 |   | 239,114 |   | (1,939 | ) | 17,276 |   | (258,576 | ) |
| Included in other comprehensive income                                                                                                                                                         |       | 12,969                                                                                                          |       | — |   | — |   | — |   | — |   | — |   |
| Net transfers in and/or out of level 3                                                                                                                                                    |       | —                                                                                                          |       | — |   | (2,988 | ) | — |   | — |   | — |   |
| Purchases, sales, other settlements and issuances,  net                                                                                                                                        |       | (28,280                                                                                                         | )          | (6,913 | ) | (179,860 | ) | — |   | (2,649 | ) | 173,745 |   |
| Ending balance as of September 30, 2009                                                                                                                                                   |       | $                                                                                                               | 74,167     |   | $ | 70,256 |   | $ | 2,274,585 |   | $ | 3,610 |   | $ | 20,714 |   | $ | (2,165,423 | ) |
| 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) |       | $                                                                                                               | —     |   | $ | 845 |   | $ | 241,346 |   | $ | (1,939 | ) | $ | 11,221 |   | $ | (258,130 | ) |

 

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(1)                                 Amounts areincluded in net realized and unrealized gain (loss) on investments, netrealized and unrealized gain (loss) on derivatives and foreign exchange or netrealized and unrealized (loss) gain on residential mortgage-backed securities,residential mortgage loans, and residential mortgage-backed securities issued,carried at estimated fair value in the condensed consolidated statements ofoperations.

 

The following table presents additional information about assets, includingderivatives that are measured at fair value on a recurring basis for which theCompany has utilized level 3 inputs to determine fair value, for the ninemonths ended September 30, 2009 (amounts in thousands):

 
| ** **                                                                                                                                                                                     | ** ** | **Fair Value Measurements Using Significant Unobservable Inputs  (Level 3)** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                     | ** ** | **Securities  Available-  For-Sale**                                                                            | ** ** | **Residential  Mortgage-  Backed  Securities** | ** ** | **Residential  Mortgage  Loans** | ** ** | **Private  Equity  Investments,  at estimated  fair value** | ** ** | **Derivatives,  net** | ** ** | **Residential  Mortgage-  Backed  Securities  Issued** | ** ** |
| Beginning balance as of January 1, 2009                                                                                                                                                   |       | $                                                                                                               | 89,109     |   | $ | 102,814 |   | $ | 2,620,021 |   | $ | 5,287 |   | $ | (76,950 | ) | $ | (2,462,882 | ) |
| Total gains or losses (realized and unrealized):                                                                                                                                               |       |                                                                                                            |       |   |   |   |   |   |   |   |   |   |   |
| Included in earnings                                                                                                                                                                           |       | (6,676                                                                                                          | )          | (8,718 | ) | 110,536 |   | (1,677 | ) | 42,556 |   | (145,525 | ) |
| Included in other comprehensive income                                                                                                                                                         |       | 28,798                                                                                                          |       | — |   | — |   | — |   | — |   | — |   |
| Net transfers in and/or out of level 3                                                                                                                                                    |       | —                                                                                                          |       | — |   | (2,010 | ) | — |   | — |   | — |   |
| Purchases, sales, other settlements and issuances,  net                                                                                                                                        |       | (37,064                                                                                                         | )          | (23,840 | ) | (453,962 | ) | — |   | 55,108 |   | 442,984 |   |
| Ending balance as of September 30, 2009                                                                                                                                                   |       | $                                                                                                               | 74,167     |   | $ | 70,256 |   | $ | 2,274,585 |   | $ | 3,610 |   | $ | 20,714 |   | $ | (2,165,423 | ) |
| 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) |       | $                                                                                                               | —     |   | $ | (6,713 | ) | $ | 119,801 |   | $ | (1,677 | ) | $ | 55,106 |   | $ | (144,215 | ) |

 

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(1)                                  Amounts areincluded in net realized and unrealized gain (loss) on investments, netrealized and unrealized gain (loss) on derivatives and foreign exchange or netrealized and unrealized (loss) gain on residential mortgage-backed securities,residential mortgage loans, and residential mortgage-backed securities issued,carried at estimated fair value in the condensed consolidated statements ofoperations.

 

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Thefollowing table presents additional information about assets, includingderivatives, that are measured at fair value on a recurring basis for which theCompany has utilized level 3 inputs to determine fair value, for the threemonths ended September 30, 2008 (amounts in thousands):

 
| ** **                                                                                                                                                                                     | ** ** | **Fair Value Measurements Using Significant Unobservable Inputs  (Level 3)** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                     | ** ** | **Securities  Available-  For-Sale**                                                                            | ** ** | **Residential  Mortgage-  Backed  Securities** | ** ** | **Residential  Mortgage  Loans** | ** ** | **Derivatives,  net** | ** ** | **Residential  Mortgage-  Backed  Securities  Issued** | ** ** |
| Beginning balance as of July 1, 2008                                                                                                                                                      |       | $                                                                                                               | 45,343     |   | $ | 115,652 |   | $ | 3,394,996 |   | $ | 3,471 |   | $ | (3,204,392 | ) |
| Total gains or losses (realized and unrealized):                                                                                                                                               |       |                                                                                                            |       |   |   |   |   |   |   |   |   |
| Included in earnings                                                                                                                                                                           |       | —                                                                                                          |       | 1,621 |   | (168,058 | ) | (16,625 | ) | 168,059 |   |
| Included in other comprehensive loss                                                                                                                                                           |       | (1,532                                                                                                          | )          | — |   | — |   | — |   | — |   |
| Net transfers in and/or out of level 3                                                                                                                                                    |       | 73,959                                                                                                          |       | — |   | (1,938 | ) | (39,067 | ) | — |   |
| Purchases, sales, other settlements and issuances,  net                                                                                                                                        |       | (327                                                                                                            | )          | (4,293 | ) | (170,244 | ) | (675 | ) | 168,101 |   |
| Ending balance as of September 30, 2008                                                                                                                                                   |       | $                                                                                                               | 117,443    |   | $ | 112,980 |   | $ | 3,054,756 |   | $ | (52,896 | ) | $ | (2,868,232 | ) |
| 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(1) |       | $                                                                                                               | —     |   | $ | 1,055 |   | $ | (167,404 | ) | $ | (16,625 | ) | $ | 168,059 |   |

 

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| (1) |   | Amounts are included in net realized and unrealized  gain (loss) on derivatives and foreign exchange or net  realized and unrealized (loss) gain on residential mortgage-backed  securities, residential mortgage loans, and residential mortgage-backed  securities issued, carried at estimated fair value in the condensed consolidated  statements of operations. |
|-----|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

Thefollowing table presents additional information about assets, includingderivatives, that are measured at fair value on a recurring basis for which theCompany has utilized level 3 inputs to determine fair value, for the ninemonths ended September 30, 2008 (amounts in thousands):

 
| ** **                                                                                                                                                                                     | ** ** | **Fair Value Measurements Using Significant Unobservable Inputs  (Level 3)** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                     | ** ** | **Securities  Available-  For-Sale**                                                                            | ** ** | **Residential  Mortgage-  Backed  Securities** | ** ** | **Residential  Mortgage  Loans** | ** ** | **Derivatives,  net** | ** ** | **Residential  Mortgage-  Backed  Securities  Issued** | ** ** |
| Beginning balance as of January 1, 2008                                                                                                                                                   |       | $                                                                                                               | 99,498     |   | $ | — |   | $ | — |   | $ | 802 |   | $ | — |   |
| Total gains or losses (realized and unrealized):                                                                                                                                               |       |                                                                                                            |       |   |   |   |   |   |   |   |   |
| Included in earnings                                                                                                                                                                           |       | —                                                                                                          |       | (5,515 | ) | (307,122 | ) | (16,158 | ) | 315,311 |   |
| Included in other comprehensive loss                                                                                                                                                           |       | (5,622                                                                                                          | )          | — |   | — |   | — |   | — |   |
| Net transfers in and/or out of level 3                                                                                                                                                    |       | 41,234                                                                                                          |       | 131,688 |   | 3,917,666 |   | (36,256 | ) | (3,169,353 | ) |
| Purchases, sales, other settlements and issuances,  net                                                                                                                                        |       | (17,667                                                                                                         | )          | (13,193 | ) | (555,788 | ) | (1,284 | ) | (14,190 | ) |
| Ending balance as of September 30, 2008                                                                                                                                                   |       | $                                                                                                               | 117,443    |   | $ | 112,980 |   | $ | 3,054,756 |   | $ | (52,896 | ) | $ | (2,868,232 | ) |
| 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(1) |       | $                                                                                                               | —     |   | $ | (8,195 | ) | $ | (318,679 | ) | $ | (16,158 | ) | $ | 315,311 |   |

 

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| (1) |   | Amounts are included in net realized and unrealized  gain (loss) on derivatives and foreign exchange or net  realized and unrealized (loss) gain on residential mortgage-backed  securities, residential mortgage loans, and residential mortgage-backed  securities issued, carried at estimated fair value in the condensed  consolidated statements of operations. |
|-----|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

**Note 18. Subsequent Events**

 

On November 5, 2009, theCompany’s board of directors agreed to terminate the two year $100.0 millionstandby unsecured revolving credit facility, entered into on November 10, 2008with the Company’s Manager and Kohlberg Kravis Roberts & Co. (Fixed Income)LLC.

 

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**Item 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS**

 

*Except where otherwise expressly stated or thecontext suggests otherwise, the terms “we,” “us” and “our” refer to KKRFinancial Holdings LLC and its subsidiaries.*

 

**Executive Overview**

 

Weare a specialty finance company that uses leverage with the objective ofgenerating competitive risk-adjusted returns. We invest in financial assetsconsisting primarily of below investment grade corporate debt, including seniorsecured and unsecured loans, mezzanine loans, high yield corporate bonds,distressed and stressed debt securities, marketable equity securities, privateequity investments and credit default and total rate of return swaps. Themajority of our investments are in senior secured loans of large capitalizationcompanies. The corporate loans we invest in are generally referred to assyndicated bank loans, or leveraged loans, and are purchased via assignment orparticipation in either the primary or secondary market. The majority of ourcorporate debt investments are held in collateralized loan obligation (“CLO”)transactions that are structured as on-balance sheet securitizations and areused as long term financing for these investments. The senior secured notesissued by the CLO transactions are generally owned by unaffiliated third partyinvestors and we own the majority of the subordinated notes in the CLOtransactions. Our CLO transactions consist of five cash flow CLO transactions,KKR Financial CLO 2005-1, Ltd. (“CLO2005-1”), KKR Financial CLO 2005-2, Ltd. (“CLO 2005-2”), KKR Financial CLO2006-1, Ltd. (“CLO 2006-1”), KKR Financial CLO 2007-1, Ltd. (“CLO 2007-1”) andKKR Financial CLO 2007-A, Ltd. (“CLO 2007-A” and, togetherwith CLO 2005-1, CLO 2005-2, CLO 2006-1, and CLO 2007-1, the “Cash Flow CLOs”).

 

In addition to our Cash Flow CLOs, a portion of our assets werepreviously held in Wayzata Funding LLC (“Wayzata”), a market value CLOtransaction. On March 31,2009, we completed the restructuring of Wayzata and replaced it with KKR FinancialCLO 2009-1, Ltd. (“CLO 2009-1”). As a result of the restructuring, substantially allof Wayzata’s assets were transferred to CLO 2009-1, a newly formed specialpurpose company, which issued $560.8 million aggregate principal amount ofsenior notes due April 2017 and $154.3 million aggregate principal amountof subordinated notes due April 2017 to the existing Wayzata note holdersin exchange for cancellation of the Wayzata notes, due November 2012,previously held by each of them. CLO 2009-1 was structured as a cash flowtransaction and does not contain the market value provisions contained inWayzata. The portfolio manager of CLO 2009-1 was an affiliate of KKR FinancialAdvisors LLC (our “Manager”). The notes issued by CLO 2009-1 were secured by thesame collateral that secured the Wayzata notes, consisting primarily of seniorsecured leveraged loans. As was the case with Wayzata, at the time of therestructuring, we and an affiliate of our Manager owned all of the subordinatednotes issued by CLO 2009-1.

 

During the second quarter of 2009, we sold approximately $423.1 millionof investments that were held in CLO 2009-1 in order to generate proceeds toretire the senior notes outstanding. These sales resulted in us recording aloss during the second quarter of $27.2 million. During June 2009, we paiddown the senior notes issued by CLO 2009-1 by $516.4 million and on July 24,2009, we retired the remaining balance of $44.4 million of outstanding seniornotes. Prior to theretirement of the senior notes, an affiliate of ours held a 20% interest in thesubordinated notes issued by CLO 2009-1. As part of the deleveraging of CLO2009-1, the subordinated notes in CLO 2009-1 held by our affiliate were retiredin exchange for our affiliate’s proportionate interest in the assets held byCLO 2009-1. As a result of the deleveraging transaction and thedistribution of assets to our affiliate, we now hold 100% of the residualassets of CLO 2009-1.

 

As described above, we own a majority of the subordinated notes issuedby the Cash Flow CLOs and therefore have historically received a majority ofour cash flows from our investments in these entities. The indentures governingthe Cash Flow CLOs include numerous compliance tests, the majority of whichrelate to the CLO’s portfolio profile. In addition to the portfolio profiletests, the indentures for the Cash Flow CLOs include over-collateralizationtests (“OC Tests”) which set the ratio of the collateral value of the assets inthe CLO to the tranches of debt for which the test is being measured, as wellas interest coverage tests. If a CLO is not in compliance with an OC Test or aninterest coverage test, cash flows normally payable to the holders of juniorclasses of notes will be used by the CLO to amortize the most senior class ofnotes until such point as the OC Test is brought back into compliance. Duringthe third quarter of 2009, certain of our Cash Flow CLOs failed certain oftheir respective OC Tests. Accordingly, the cash flows we would generallyexpect to receive from our investments in the mezzanine and subordinated notesissued by the Cash Flow CLOs were used to amortize the most senior class ofnotes. During the three and nine months ended September 30, 2009, thesenior notes issued by our Cash Flow CLOs were reduced by $43.5 million and$188.6 million, respectively, due to amortization of the senior note balancesas a result of non-compliance with certain OC Tests in certain of our CLOs.

 

OnJuly 10, 2009, we surrendered for cancellation, without consideration,$298.4 million in aggregate mezzanine and junior notes (“Surrendered Notes”)issued to us by CLO 2005-1, CLO 2005-2 and CLO 2006-1. The Surrendered Noteswere promptly cancelled upon receipt by the trustee of each transaction and therelated debt was extinguished by the issuers thereof. As a result of thesetransactions, we were in compliance with the OC Tests for these three CLOs,which enabled the mezzanine and subordinated note holders, including us, toresume receiving cash flows from these CLOs. These CLO transactions areconsolidated by us under accounting principles generally accepted in the UnitedStates of America (“GAAP”) and thus, did not have any impact on our condensedconsolidated financial statements. Similarly, as CLO 2005-1, CLO 2005-2 and CLO2006-1 are treated as disregarded entities for tax purposes, this transactiondid not have any tax implications for us or our shareholders.

 

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On August 5, 2009, we entered into an agreement with our lendersto amend the terms of our senior secured credit facility. Among other things,the amendment provides that: (i) the size of the facility be reduced to$200.0 million from $300.0 million, (ii) the lending commitments of thelenders to this facility be modified to provide for quarterly amortization of$12.5 million per quarter until the size of the facility has been reduced to$150 million on June 30, 2010, (iii) the interest rate applicable toborrowings under the facility be increased from LIBOR plus 300 basis points toLIBOR plus 400 basis points, (iv) the adjusted tangible net worth covenantbe reduced to $700.0 million from $1.0 billion, (v) the maturity date ofthe borrowings under the facility be extended to November 10, 2011, and (vi) certainevents of default under the Credit Agreement be added. The amendment alsoprovides that the we can (i) pay a yearly distribution to our shareholdersin an amount equal to no greater than 50% of our taxable income for such yearand (ii) use up to $50 million of our unrestricted cash to repurchase ourconvertible notes due July 2012 and/or our outstanding trust preferredsecurities. In conjunction with this amendment, we paid the lenders to ourcredit facility fees totaling $4.5 million.

 

 

***Non-Cash “Phantom” Taxable Income***

 

We intend to continue to operate so that we qualify, for United Statesfederal income tax purposes, as a partnership and not as an association or apublicly traded partnership taxable as a corporation. Holders of our shares aresubject to United States federal income taxation and, in some cases, state,local and foreign income taxation, on their allocable share of our taxableincome, regardless of whether or when they receive cash distributions. Inaddition, certain of our investments, including investments in foreigncorporate subsidiaries, CLO issuers, including those treated as partnerships ordisregarded entities for United States federal income tax purposes, and debtsecurities, may produce taxable income without corresponding distributions ofcash to us or may produce taxable income prior to or following the receipt ofcash relating to such income. Consequently, in some taxable years, holders ofour shares may recognize taxable income in excess of our cash distributions.Furthermore, if we did not pay cash distributions with respect to a taxableyear, holders of our shares may still have a tax liability attributable totheir allocation of taxable income from us during such year.

 

***Investment Portfolio***

 

*Overview*

 

As discussed above, the majority of our investments are held throughCLO transactions that are managed by an affiliate of our Manager and for whichwe own the majority, and in some cases all, of the economic interests in thetransaction through the subordinated notes in the transaction. On an unconsolidatedbasis, our investment portfolio primarily consists of the following as of September 30,2009: (i) mezzanine and subordinated tranches of CLO transactions with anaggregate par amount of $1.0 billion; (ii) corporate loans with anaggregate par amount of $766.8 million and an estimated fair value of$473.7 million; (iii) corporate debt securities with an aggregate paramount of $100.8 million and an estimated fair value of $87.6 million; (iv) residentialmortgage-backed securities (“RMBS”) with a par amount of $284.1 millionand estimated fair value of $186.5 million; (v) private equityinvestments with an aggregate cost amount of $29.8 million and an estimatedfair value of $40.5 million; (vi) marketable equity securities with anaggregate estimated fair value of $1.2 million. In addition, we hold otherinvestments including loan investments financed under total rate of returnswaps that are accounted for as derivative transactions, credit default swaps,shorts on equity and debt instruments, and interest rate swaps.

 

As our condensed consolidated financial statements in this QuarterlyReport on Form 10-Q are presented to reflect the consolidation of the CLOswe hold investments in, the information contained in this Management’sDiscussion and Analysis of Financial Condition and Results of Operationsreflects the CLOs on a consolidated basis consistent with the disclosures inour condensed consolidated financial statements.

 

*CorporateDebt Investments*

 

Our investments in corporate debt primarily consist of investments inbelow investment grade corporate loans, often referred to as syndicated bankloans or leveraged loans, and corporate debt securities. As of September 30,2009, our corporate debt investments, excluding investments held through totalrate of return swaps, had an aggregate par balance of $8.5 billion, anaggregate net amortized cost of $7.8 billion and an aggregate estimatedfair value of $7.1 billion. Included in these amounts is $7.7 billion paramount or $6.5 billion estimated fair value of investments held in our CashFlow CLOs which have aggregate senior secured notes outstanding totaling $5.7billion and an aggregate of $547.4 million of mezzanine and subordinated notesoutstanding that are held by an affiliate of our Manager. In addition to theinvestments, our Cash Flow CLOs had an aggregate principal cash balancetotaling $66.8 million as of September 30, 2009.

 

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*RMBSInvestments*

 

Our residential mortgage investment portfolio consists of investmentsin RMBS with an estimated fair value of $192.2 million as of September 30,2009. Of the $192.2 million of RMBS investments we hold, $121.9 millionare in six residential mortgage-backed securitization trusts that weconsolidate under GAAP as we hold the majority of the risk of loss on thesetransactions. This results in us reflecting the financial position and resultsof these trusts in our condensed consolidated financial statements.Consolidation of these six entities does not impact our net assets or netincome; however, it does result in us showing the condensed consolidated assets,liabilities, income and expenses on our condensed consolidated financialstatements. On our condensed consolidated balance sheet as of September 30,2009, the $192.2 million of RMBS is computed as our investments in RMBS of$70.3 million, plus $121.9 million, which represents the differencebetween residential mortgage loans of $2.3 billion less residentialmortgage-backed securities issued of $2.2 billion plus $12.8 millionof real estate owned (“REO”) that is included in other assets on our condensedconsolidated balance sheet.

 

**Critical Accounting Policies**

 

Our condensed consolidated financial statements are prepared bymanagement in conformity with GAAP. Our significant accounting policies arefundamental to understanding our financial condition and results of operationsbecause some of these policies require that we make significant estimates andassumptions that may affect the value of our assets or liabilities andfinancial results. We believe that certain of our policies are critical becausethey require us to make difficult, subjective, and complex judgments aboutmatters that are inherently uncertain. We have reviewed these criticalaccounting policies with our board of directors and our audit committee.

 

***Fair Value of Financial Instruments***

 

As defined in FASB ASC 820, *Fair Value Measurementsand Disclosures* (“FASB ASC 820”), fair value is the price that wouldbe received 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 condensed consolidatedbalance sheets are categorized based upon the level of judgment associated withthe inputs used to measure their value. Hierarchical levels which are directlyrelated to the amount of subjectivity associated with the inputs to fairvaluations 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, certain corporate loans heldfor sale, certain private equity investments, certain securities sold, not yetpurchased and certain financial instruments classified as derivatives where thefair value is based on observable market inputs.

 

Level 3: Inputs are unobservable inputs for the asset or liability,and include situations where there is little, if any, market activity for theasset or liability. In certain cases, the inputs used to measure fair value mayfall into different levels of the fair value hierarchy. In such cases, thelevel in the fair value hierarchy within which the fair value measurement inits entirety falls has been determined based on the lowest level input that issignificant to the fair value measurement in its entirety. Our assessment ofthe significance of a particular input to the fair value measurement in itsentirety requires judgment and the consideration of factors specific to theasset.

 

Generally, assets and liabilities carried at fair value and included inthis category are certain corporate debt securities, certain corporate loansheld for sale, certain private equity investments, residential mortgage-backedsecurities, residential mortgage loans, REO, residential mortgage-backedsecurities issued and certain derivatives.

 

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Duringthe second quarter of 2009, we adopted FASB ASC 820-10-65. This topic providesadditional guidance on determining fair value when the volume and level ofactivity for the asset or liability have significantly decreased when comparedwith normal market activity for the asset or liability (or similar assets orliabilities). A significant decrease in the volume and level of activity forthe asset or liability is an indication that transactions or quoted prices maynot be determinative of fair value because in such market conditions there maybe increased instances of transactions that are not orderly. In thosecircumstances, further analysis of transactions or quoted prices is needed, anda significant adjustment to the transactions or quoted prices may be necessaryto estimate fair value. The adoptiondid not have a material impact on our condensed consolidated financialstatements.

 

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 onmodels or inputs that are less observable or unobservable in the market, thedetermination of fair value requires more judgment. Accordingly, the degree ofjudgment exercised by us in determining fair value is greatest for instrumentscategorized in level 3. In certain cases, the inputs used to measure fairvalue may fall into different levels of the fair value hierarchy. In suchcases, for disclosure purposes, the level in the fair value hierarchy withinwhich the fair value measurement in its entirety falls is determined based onthe lowest level input that is significant to the fair value measurement in itsentirety.

 

Many financial assets and liabilities have bid and ask prices that canbe observed in the marketplace. Bid prices reflect the highest price that weand others are willing to pay for an asset. Ask prices represent the lowestprice that we and others are willing to accept for an asset. For financial assetsand liabilities whose inputs are based on bid-ask prices, we do not requirethat fair value always be a predetermined point in the bid-ask range. Ourpolicy is to allow for mid-market pricing and adjusting to the point within thebid-ask range that meets our best estimate of fair value.

 

Depending on the relative liquidity in the markets for certain assets,we may transfer assets to level 3 if we determine that observable quotedprices, obtained directly or indirectly, are not available. The valuation techniquesused for the assets and liabilities that are valued using level 3 of thefair value hierarchy are described below.

 

*Residential Mortgage-Backed Securities, ResidentialMortgage Loans, and Residential Mortgage-Backed Securities Issued:*  Residential mortgage-backed securities,residential mortgage loans, and residential mortgage-backed securities issuedare initially valued at transaction price and are subsequently valued usingindustry recognized models (including Intex and Bloomberg) and data for similarinstruments (e.g., nationally recognized pricing services or brokerquotes). The most significant inputs to the valuation of these instruments aredefault and loss expectations and market credit spreads.

 

*Corporate Debt Securities:*  Corporate debt securities are initiallyvalued at transaction price and are subsequently valued using market data forsimilar instruments (e.g., recent transactions or broker quotes),comparisons to benchmark derivative indices or valuation models. Valuationmodels are based on discounted cash flow techniques, for which the key inputsare the amount and timing of expected future cash flows, market yields for suchinstruments and recovery assumptions. Inputs are generally determined based onrelative value analyses, which incorporate similar instruments from similarissuers.

 

*Over-the-counter (“OTC”) Derivative Contracts:*  OTC derivative contracts include forward,swap and option contracts related to interest rates, foreign currencies, creditstanding of reference entities, and equity prices. The fair value of OTCderivative products can be modeled using a series of techniques, includingclosed-form analytic formulae, such as the Black-Scholes option-pricing model,and simulation models or a combination thereof. Many pricing models do notentail material subjectivity because the methodologies employed do notnecessitate significant judgment, and the pricing inputs are observed fromactively quoted markets, as is the case for generic interest rate swap andoption contracts.

 

***Share-Based Compensation***

 

We account for share-based compensation issued to members of our boardof directors and our Manager using a fair value based methodology. We do nothave any employees, although we believe that members of our board of directorsare deemed to be employees for purposes of interpreting and applying accountingprinciples 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 ourManager using the graded vesting attribution method.

 

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Because we remeasure the amount of compensation costs associated withthe unvested restricted common shares and unvested common share options that weissued to our Manager as of each reporting period, our share-based compensationexpense reported in our condensed consolidated financial statements will changebased on the estimated fair value of our common shares and this may result inearnings volatility. For the three and nine months ended September 30,2009, share-based compensation was $2.4 million and $2.6 million, respectively.As of September 30, 2009, substantially all of the non-vested restrictedcommon shares issued are subject to remeasurement. As of September 30,2009, a $1 increase in the price of our common shares would have increased ourfuture share-based compensation expense by approximately $1.1 million andthis future share-based compensation expense would be recognized over theremaining vesting periods of our outstanding restricted common shares andcommon share options. As of September 30, 2009, the common share optionswere fully exercised and expire in August 2014. As of September 30,2009, future unamortized share-based compensation totaled $3.1 million, ofwhich $0.6 million, $2.1 million, and $0.4 million will be recognizedin 2009, 2010, and beyond, respectively.

 

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

 

We recognize all derivatives on our condensed consolidated balancesheets at estimated fair value. On the date we enter into a derivativecontract, we designate and document each derivative contract as one of thefollowing at the time the contract is executed: (i) a hedge of arecognized asset or liability (“fair value” hedge); (ii) a hedge of aforecasted transaction or of the variability of cash flows to be received orpaid related to a recognized asset or liability (“cash flow” hedge); (iii) ahedge of a net investment in a foreign operation; or (iv) a derivativeinstrument not designated as a hedging instrument (“free-standing derivative”).For a fair value hedge, we record changes in the estimated fair value of thederivative and, to the extent that it is effective, changes in the fair valueof the hedged asset or liability attributable to the hedged risk, in thecurrent period earnings in the same financial statement category as the hedgeditem. For a cash flow hedge, we record changes in the estimated fair value ofthe derivative to the extent that it is effective in other comprehensiveincome. We subsequently reclassify these changes in estimated fair value to netincome in the same period(s) that the hedged transaction affects earnings in thesame financial statement category as the hedged item. For free-standingderivatives, we report changes in the fair values in current periodnon-interest income.

 

We formally document at inception our hedge relationships, includingidentification of the hedging instruments and the hedged items, our riskmanagement objectives, strategy for undertaking the hedge transaction and ourevaluation of effectiveness of our hedged transactions. Periodically, we alsoformally assess whether the derivative designated in each hedging relationshipis expected to be and has been highly effective in offsetting changes inestimated fair values or cash flows of the hedged item using either the dollaroffset or the regression analysis method. If we determine that a derivative isnot highly effective as a hedge, we discontinue hedge accounting.

 

We are not required to account for our derivative contracts using hedgeaccounting as described above. If we decide not to designate the derivativecontracts as hedges or if we fail to fulfill the criteria necessary to qualifyfor hedge accounting, then the changes in the estimated fair values of ourderivative contracts would affect periodic earnings immediately potentiallyresulting in the increased volatility of our earnings. The qualificationrequirements for hedge accounting are complex and as a result, we mustevaluate, designate, and thoroughly document each hedge transaction atinception and perform ineffectiveness analysis and prepare relateddocumentation at inception and on a recurring basis thereafter. As of September 30,2009, the estimated fair value of our net derivative liabilities totaled$33.9 million.

 

***Impairments***

 

Wemonitor our available-for-sale securities portfolio for impairments. A loss isrecognized when it is determined that a decline in the estimated fair value ofa security below its amortized cost is other-than-temporary. We consider manyfactors in determining whether the impairment of a security is deemed to beother-than-temporary, including, but not limited to, the length of time thesecurity has had a decline in estimated fair value below its amortized cost andthe severity of the decline, the amount of the unrealized loss, recent eventsspecific to the issuer or industry, external credit ratings and recent changesin such ratings.  In addition, for debtsecurities we consider our intent to sell the debt security, our estimation ofwhether or not we expect to recover the debt security’s entire amortized costif we intend to hold the debt security, and whether it is more likely than notthat we will be required to sell the debt security before its anticipatedrecovery. For equity securities, we also consider our intent and ability tohold the equity security for a period of time sufficient for a recovery in value.

 

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Theamount of the loss that is recognized when it is determined that a decline inthe estimated fair value of a security below its amortized cost isother-than-temporary is dependent on certain factors.  If the security is an equity security or ifthe security is a debt security that we intend to sell or estimate that it ismore likely than not that we will be required to sell before recovery of itsamortized cost, then the impairment amount recognized in earnings is the entiredifference between the estimated fair value of the security and its amortizedcost. For debt securities that we do not intend to sell or estimate that we arenot more likely than not to be required to sell before recovery, the impairmentis separated into the estimated amount relating to credit loss and theestimated amount relating to all other factors. Only the estimated credit loss amountis recognized in earnings, with the remainder of the loss amount recognized inother comprehensive income.

 

This process involves a considerable amount of subjective judgment byour management. As of September 30, 2009, we had aggregate unrealized losseson our securities classified as available-for-sale of approximately$25.3 million, which if not recovered may result in the recognition offuture losses. During the three and nine months ended September 30, 2009,we recorded charges for impairments of securities that we determined to beother-than-temporary totaling nil and $40.0 million, respectively.

 

During the second quarter of 2009, we adopted FASBASC 320-10-65, which amends the other-than-temporary impairment guidance fordebt securities. We determined that the adoption did not have a material impacton our condensed consolidated financial statements.

 

***Allowance for Loan Losses***

 

Ourallowance for loan losses represents our estimate of probable credit lossesinherent in our corporate loan portfolio held for investment as of the balancesheet date.  Estimating our allowance forloan losses involves a high degree of management judgment and is based upon acomprehensive review of our loan portfolio that is performed on a quarterlybasis. Our allowance for loan losses consists of two components, an allocatedcomponent and an unallocated component. The allocated component of ourallowance for loan losses pertains to specific loans that we have determinedare impaired. We determine a loan is impaired when we estimate that it isprobable that we will be unable to collect all amounts due according to thecontractual terms of the loan agreement. On a quarterly basis we perform acomprehensive review of our entire loan portfolio and identify certain loans thatwe have determined are impaired. Once a loan is identified as being impaired weplace the loan on non-accrual status, unless the loan is already on non-accrualstatus, and record a reserve that reflects our best estimate of the loss thatwe expect to recognize from the loan. Generally, the expected loss is estimatedas being the difference between our current cost basis of the loan, includingaccrued interest receivable, and the loans’ estimated fair value.

 

Theunallocated component of our allowance for loan losses reflects our estimate ofprobable losses in our loan portfolio as of the balance sheet date where thespecific loan that the loan loss relates to is indeterminable. We estimate theunallocated component of our allowance for loan losses through a comprehensivereview of our loan portfolio and identify certain loans that demonstratepossible indicators of impairment. This assessment excludes all loans that aredetermined to be impaired and as a result, an allocated reserve has beenrecorded as described in the preceding paragraph. Such indicators include, butare not limited to, the current and/or forecasted financial performance andliquidity profile of the issuer, specific industry or economic conditions thatmay impact the issuer, and the observable trading price of the loan ifavailable. Loans that demonstrate possible indicators of impairment areaggregated on a watch list for monitoring and are sub-divided forcategorization based on the seniority of the loan in the issuer’s capitalstructure, whether the loan is secured or unsecured, and the nature of thecollateral securing the loan, for purposes of applying possible default andloss severity ranges based on the nature of the issuer and the specific loan.We apply a range of default and loss severity estimates in order to estimate arange of loss outcomes upon which to base our estimate of probable losses thatresults in the determination of the unallocated component of our allowance forloan losses. As of September 30, 2009, the range of outcomes used toestimate the probability of default was between 5% and 40% and the range ofloss severity assumptions for loans that may default was between 20% and 75%.The estimates and assumptions we use to estimate our allowance for loan lossesare based on our estimated range of outcomes that are determined from industryinformation providing both historical and forecasted empirical performance ofthe type of corporate loans that we invest in, as well as from our ownestimates based on the nature of our corporate loan portfolio. These estimatesand assumptions are susceptible to change due to our corporate loan portfolioperformance as well as industry performance of the corporate loan asset classand general economic conditions. Changes in the assumptions and estimates usedto estimate our allowance for loan losses could have a material impact on ourfinancial condition and results of operations.

 

As of September 30, 2009, our allowance for loan losses totaled$470.2 million.

 

**Recent Accounting Pronouncements**

 

In January 2009, the FASB issued FASB ASC 325-40-65 whicheliminates the requirement that a holder’s best estimate of cash flows be basedupon those that “a market participant” would use. Instead, it requires that another-than-temporary impairment be recognized as a realized loss when it is “probable”there has been an adverse change in the holder’s estimated cash flows from thecash flows previously projected. The topic also reiterates and emphasizes therelated guidance and disclosure requirements in accordance with FASB ASC 320, *Investments-Debt and Equity Securities*. The standard is effective for allperiods ending after December 15, 2008 and retroactive application is notpermitted. We have taken this topic into consideration when evaluating our investmentsfor other-than-temporary impairment.

 

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On June 12, 2009,the FASB issued SFAS No. 166, *Accounting for Transfersof Financial Assets, an amendment of FASB Statement No. 140, Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities*(“SFAS No. 140”) (collectively “SFAS No. 166”).The most significant amendments that SFAS No. 166 makes consist of theremoval of the concept of a qualifying special-purpose entity (“QSPE”) fromFASB ASC 860, *Transfers and Servicing*(“FASBASC 860”), and the elimination of the exception for QSPE from FASB ASC 810, *Consolidation*(“FASB ASC 810”). The disclosures required bythis standard are to provide greater transparency about transfers of financialassets and an entity’s continuing involvement in transferred financial assets.SFAS No. 166 will significantly affect existing securitizations that useQSPEs, as well as future securitizations. SFAS No. 166 is effective January 1,2010 for calendar-year reporting entities and earlier application isprohibited. We are evaluating the impact of adopting SFAS No. 166.

 

Also on June 12,2009, the FASB issued SFAS No. 167, *Amendment to FASBInterpretation No. 46(R) *(“SFAS No. 167”) whichaddresses the effects of elimination the QSPE concept from the FASB ASC 860 andresponds to concerns about the application of certain key provisions of FASBASC 810, including concerns over the transparency of enterprises’ involvementwith VIEs. SFAS No. 167 requires additional disclosures for various areasincluding situations that use significant judgment and assumptions indetermining whether or not to consolidate a VIE as well as the nature of andchanges in the risks associated with a VIE. This standard is effective forcalendar year-end companies beginning on January 1, 2010. We areevaluating the impact of adopting SFAS No. 167.

 

In September 2009, the FASB issued AccountingStandards Update (“ASU”) 2009-5 which amends FASB ASC 820 to providefurther guidance on how to measure the fair value of a liability. ASU2009-5 primarily setsforth the types of valuation techniques to be used to value a liability when aquoted price in an active market for the identical liability isnot available. In these circumstances, ASU 2009-5 states that a companycan apply the quoted price of an identical or similar liability when traded asan asset, or other valuation techniques that are consistent with principles ofFASB ASC 820. ASU 2009-5 is effective beginning the fourth quarter of 2009. Wedo not believe the adoption of ASU 2009-5 will have a material impact on ourfinancial statements.

 

**Results of Operations**

 

*Summary*

 

Our net income for the three and nine months ended September 30,2009 totaled $67.2 million (or $0.42 per diluted common share) and $74.8million (or $0.49 per diluted common share), respectively, as compared to netincome of $49.0 million (or $0.32 per diluted common share) and $100.5million (or $0.73 per diluted common share), respectively, for the three andnine months ended September 30, 2008. Income from continuing operationsfor the three and nine months ended September 30, 2009 totaled $67.2million (or $0.42 per diluted common share) and $74.8 million (or $0.49 perdiluted common share), respectively, as compared to income from continuingoperations of $49.0 million (or $0.32 per diluted common share) and $97.9million (or $0.71 per diluted common share), respectively, for the three andnine months ended September 30, 2008. The increase in income fromcontinuing operations of $18.2 million from the three months ended September 30,2008 to 2009 was primarily a result of realized and unrealized gains onderivatives and foreign exchange, and investments, as compared to realized andunrealized losses in 2008. These gains were partially offset by a decline innet investment income, loss on restructuring and extinguishment of debt, andrealized and unrealized losses on our residential mortgage portfolio. Thedecrease in income from continuing operations of $23.1 million from the ninemonths ended September 30, 2008 to 2009 was attributable to significantlylower net investment income resulting from a smaller investment portfolio and alower yield from our investment portfolio due to the continued decline ininterest rates over the past year, most notably LIBOR, partially mitigated byrealized and unrealized gains on derivatives and foreign exchange in 2009.

 

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*NetInvestment Income*

 

The following table presents the components of our net investmentincome for the three and nine months ended September 30, 2009 and 2008:

 

**Comparative Net Investment Income Components**

**(Amounts inthousands)**

 
| ** **                                                 | ** ** | **For the three  months ended  September 30, 2009** | ** ** | **For the three  months ended  September 30, 2008** | ** ** | **For the nine  months ended  September 30, 2009** | ** ** | **For the nine  months ended  September 30, 2008** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| Investment Income:                                         |       |                                                                         |       |                                                                         |       |                                                                        |       |                                                                        |       |
| Corporate loans and securities interest income             |       | $                                                                            | 92,549     |                                                                         | $          | 165,878                                                                     |       | $                                                                           | 295,133    |   | $ | 529,068 |   |
| Residential mortgage loans and securities interest  income |       | 25,369                                                                       |       | 41,871                                                                       |       | 96,213                                                                      |       | 134,718                                                                     |       |
| Other interest income                                      |       | 49                                                                           |       | 4,431                                                                        |       | 511                                                                         |       | 20,505                                                                      |       |
| Dividend income                                            |       | 26                                                                           |       | 358                                                                          |       | 313                                                                         |       | 2,266                                                                       |       |
| Net discount accretion                                     |       | 17,243                                                                       |       | 14,514                                                                       |       | 47,042                                                                      |       | 34,161                                                                      |       |
| Total investment income                                    |       | 135,236                                                                      |       | 227,052                                                                      |       | 439,212                                                                     |       | 720,718                                                                     |       |
| Interest Expense:                                          |       |                                                                         |       |                                                                         |       |                                                                        |       |                                                                        |       |
| Repurchase agreements                                      |       | —                                                                       |       | 970                                                                          |       | —                                                                      |       | 34,407                                                                      |       |
| Collateralized loan obligation senior secured  notes       |       | 19,247                                                                       |       | 68,246                                                                       |       | 98,872                                                                      |       | 214,653                                                                     |       |
| Senior secured credit facility                             |       | 5,164                                                                        |       | 3,496                                                                        |       | 13,022                                                                      |       | 9,269                                                                       |       |
| Secured demand loan                                        |       | —                                                                       |       | —                                                                       |       | —                                                                      |       | 348                                                                         |       |
| Convertible senior notes                                   |       | 4,969                                                                        |       | 5,440                                                                        |       | 15,474                                                                      |       | 16,450                                                                      |       |
| Junior subordinated notes                                  |       | 4,092                                                                        |       | 4,941                                                                        |       | 12,709                                                                      |       | 17,045                                                                      |       |
| Residential mortgage-backed securities issued              |       | 18,940                                                                       |       | 31,506                                                                       |       | 66,043                                                                      |       | 99,938                                                                      |       |
| Other interest expense                                     |       | 1,013                                                                        |       | 1,665                                                                        |       | 3,260                                                                       |       | 2,687                                                                       |       |
| Interest rate swap                                         |       | 3,915                                                                        |       | 1,841                                                                        |       | 10,245                                                                      |       | 5,410                                                                       |       |
| Total interest expense                                     |       | 57,340                                                                       |       | 118,105                                                                      |       | 219,625                                                                     |       | 400,207                                                                     |       |
| Interest expense to affiliates                             |       | 5,171                                                                        |       | 18,794                                                                       |       | 16,355                                                                      |       | 66,319                                                                      |       |
| Provision for loan losses                                  |       | —                                                                       |       | —                                                                       |       | 39,795                                                                      |       | 10,000                                                                      |       |
| Net investment income                                      |       | $                                                                            | 72,725     |                                                                         | $          | 90,153                                                                      |       | $                                                                           | 163,437    |   | $ | 244,192 |   |

 

The decrease in net investment income from the three and nine monthsended September 30, 2008 to 2009 was attributable to a smaller investmentportfolio and a lower yield from our investment portfolio due to the continueddecline in interest rates over the past year, most notably LIBOR, partiallyoffset by a decline in interest expense related to pay downs of ourcollateralized loan obligation senior secured notes during 2009.

 

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*Other Income (Loss)*

 

The following table presents the components of other income (loss) forthe three and nine months ended September 30, 2009 and 2008:

 

**Comparative Other Income (Loss) Components**

**(Amounts inthousands)**

 
| ** **                                                                                                                                                                             | ** ** | **For the three  months ended  September 30, 2009** | ** ** | **For the three  months ended  September 30, 2008** | ** ** | **For the nine  months ended  September 30, 2009** | ** ** | **For the nine  months ended  September 30, 2008** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| Net realized and unrealized gain (loss) on  derivatives and foreign exchange:                                                                                                          |       |                                                                         |       |                                                                         |       |                                                                        |       |                                                                        |       |
| Interest rate swaps                                                                                                                                                                    |       | $                                                                            | (3,347     | )                                                                            | $          | (706                                                                        | )          | $                                                                           | (2,780     | ) | $ | 2,820 |   |
| Credit default swaps                                                                                                                                                                   |       | 3,928                                                                        |       | 9,543                                                                        |       | 16,836                                                                      |       | 19,877                                                                      |       |
| Total rate of return swaps                                                                                                                                                             |       | 18,061                                                                       |       | (20,019                                                                      | )          | 42,774                                                                      |       | (86,464                                                                     | )          |
| Common stock warrants                                                                                                                                                                  |       | —                                                                       |       | (15                                                                          | )          | —                                                                      |       | (722                                                                        | )          |
| Foreign exchange(1)                                                                                                                                                                    |       | 1,288                                                                        |       | (4,337                                                                       | )          | 2,001                                                                       |       | (3,979                                                                      | )          |
| Total net realized and unrealized gain (loss) on  derivatives and foreign exchange                                                                                                     |       | 19,930                                                                       |       | (15,534                                                                      | )          | 58,831                                                                      |       | (68,468                                                                     | )          |
| Net realized loss on residential mortgage-backed  securities and residential mortgage loans, carried at estimated fair value                                                           |       | (1,742                                                                       | )          | (1,589                                                                       | )          | (13,418                                                                     | )          | (3,088                                                                      | )          |
| Net unrealized (loss) gain on residential  mortgage-backed securities, residential mortgage loans, and residential  mortgage-backed securities issued, carried at estimated fair value |       | (15,939                                                                      | )          | 1,710                                                                        |       | (31,127                                                                     | )          | (11,563                                                                     | )          |
| Net realized and unrealized gain (loss) on  investments(2)                                                                                                                             |       | 21,181                                                                       |       | (17,712                                                                      | )          | (45,563                                                                     | )          | (39,000                                                                     | )          |
| Net realized and unrealized (loss) gain on  securities sold, not yet purchased                                                                                                         |       | (996                                                                         | )          | 14,242                                                                       |       | 2,920                                                                       |       | 22,892                                                                      |       |
| Impairment of securities available for sale                                                                                                                                            |       | —                                                                       |       | (10,566                                                                      | )          | (40,013                                                                     | )          | (20,254                                                                     | )          |
| Net (loss) gain on restructuring and  extinguishment of debt                                                                                                                           |       | (10,627                                                                      | )          | 3,056                                                                        |       | 30,836                                                                      |       | 20,281                                                                      |       |
| Other income                                                                                                                                                                           |       | 1,239                                                                        |       | 2,470                                                                        |       | 4,150                                                                       |       | 7,939                                                                       |       |
| Total other income (loss)                                                                                                                                                              |       | $                                                                            | 13,046     |                                                                         | $          | (23,923                                                                     | )          | $                                                                           | (33,384    | ) | $ | (91,261 | ) |

 

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| (1) | Includes  foreign exchange contracts and foreign exchange gain or loss.                                                                                                              |
|-----|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Includes  lower of cost or estimated fair value adjustment to corporate loans held for  sale and unrealized gain (loss) on private equity investments held at  estimated fair value. |

 

As presented in the tableabove, other income totaled $13.0 million for the three months ended September 30,2009 and other loss totaled $33.4 million for the nine months ended September 30,2009, as compared to other loss of $23.9 million and $91.3 million for thethree and nine months ended September 30, 2008, respectively. Total otherincome for the three months ended September 30, 2009 primarily consistedof net realized and unrealized gains on derivatives and foreign exchangetotaling $19.9 million and net realized and unrealized gains on investmentstotaling $21.2 million, partially offset by a $10.6 million net loss onrestructuring and extinguishment of debt, and $17.7 million of net realized andunrealized losses onresidential mortgage-backed securities, residential mortgage loans andresidential mortgage-backed securities issued. The $10.6 million net loss onrestructuring and extinguishment of debt represents the payment of a $28.8million placement fee to the senior note holders of CLO 2009-1, partiallyoffset by a $14.4 million net gain recognized from the retirement of the CLO2009-1 subordinated notes and a $3.8 million gain on the repurchase of $5.0million of junior subordinated notes in the third quarter of 2009. See“Liquidity and Capital Resources” for further discussion regarding CLO 2009-1. Total otherloss for the nine months ended September 30, 2009 primarily consisted ofnet realized and unrealized losses on investments totaling $45.6 million, a loss from other-than-temporaryimpairments on securities available-for-sale totaling $40.0 million, and net realized and unrealized losses onresidential mortgage-backed securities, residential mortgage loans andresidential mortgage-backed securities issued totaling $44.5 million. Theselosses were partially offset by net realized and unrealizedgains on derivatives and foreign exchange totaling $58.8 million and a netgain on restructuring and extinguishment of debt totaling $30.8 million.

 

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*Non-InvestmentExpenses*

 

The following table presents the components of non-investment expensesfor the three and nine months ended September 30, 2009 and 2008:

 

**Comparative Non-Investment Expense Components**

**(Amounts inthousands)**

 
| ** **                             | ** ** | **For the three  months ended  September 30, 2009** | ** ** | **For the three  months ended  September 30, 2008** | ** ** | **For the nine  months ended  September 30, 2009** | ** ** | **For the nine  months ended  September 30, 2008** | ** ** |
|----------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| Related party management compensation: |       |                                                                         |       |                                                                         |       |                                                                        |       |                                                                        |       |
| Base management fees                   |       | $                                                                            | 3,720      |                                                                         | $          | 8,729                                                                       |       | $                                                                           | 10,998     |   | $ | 25,089 |   |
| Incentive fees                         |       | 4,472                                                                        |       | —                                                                       |       | 4,472                                                                       |       | —                                                                      |       |
| Share-based compensation               |       | 2,260                                                                        |       | (195                                                                         | )          | 2,225                                                                       |       | 462                                                                         |       |
| CLO management fees                    |       | 4,164                                                                        |       | 1,277                                                                        |       | 18,437                                                                      |       | 3,806                                                                       |       |
| Related party management compensation  |       | 14,616                                                                       |       | 9,811                                                                        |       | 36,132                                                                      |       | 29,357                                                                      |       |
| Professional services                  |       | 441                                                                          |       | 1,335                                                                        |       | 5,916                                                                       |       | 4,263                                                                       |       |
| Loan servicing                         |       | 1,925                                                                        |       | 2,274                                                                        |       | 6,117                                                                       |       | 7,234                                                                       |       |
| Insurance                              |       | 636                                                                          |       | 302                                                                          |       | 1,242                                                                       |       | 621                                                                         |       |
| Directors expenses                     |       | 710                                                                          |       | 208                                                                          |       | 1,402                                                                       |       | 924                                                                         |       |
| General and administrative             |       | 193                                                                          |       | 3,310                                                                        |       | 4,273                                                                       |       | 12,549                                                                      |       |
| Total non-investment expenses          |       | $                                                                            | 18,521     |                                                                         | $          | 17,240                                                                      |       | $                                                                           | 55,082     |   | $ | 54,948 |   |

 

As presented in the table above, our non-investment expenses increasedby approximately $1.3 million from the three months ended September 30,2008 to 2009 and $0.1 million from the nine months ended September 30,2008 to 2009. The significant components of non-investment expense aredescribed below.

 

Management compensation to related parties consists of base managementfees payable to our Manager pursuant to the Management Agreement, incentivefees, collateral management fees, and share-based compensation related torestricted common shares and common share options granted to our Manager.

 

The base management fee payable was calculated in accordance with theManagement Agreement and is based on an annual rate of 1.75% times our “equity”as defined in the Management Agreement. Base management fee decreased by $5.0million and $14.1 million from the three and nine months ended September 30,2008 to 2009, respectively, due to the significant decline in “equity” from the$1.1 billion loss we reported for the year ended December 31, 2008. Effective January 1,2009, our Manager agreed to defer 50% of the monthly base management feepayable by us for the period from January 1, 2009 through November 30,2009. The aggregate amount of fees otherwise payable during the deferral periodwill be payable to our Manager upon the earlier of (x) December 15,2009 and (y) the date of any termination of the Management Agreementpursuant to either Section 13(a) or Section 15(b) thereof.

 

Our Manager is also entitled to a quarterly incentive fee provided thatour quarterly “net income,” as defined in the Management Agreement, before theincentive fee exceeds a defined return hurdle. Incentive fees of $4.5 millionwere earned by our Manager during the three and nine months ended September 30,2009 and nil during the three and nine months ended September 30, 2008.Our Manager agreed to defer the $4.5 million incentive fee to December 15, 2009.

 

An affiliate of our Manager has entered into separate managementagreements with the respective investment vehicles CLO 2005-1, CLO 2005-2, CLO2006-1, CLO 2007-1, CLO 2007-A and CLO 2009-1 and is entitled to receive feesfor the services performed as collateral manager. Beginning April 15,2007, the collateral manager ceased waiving fees for CLO 2005-1 andbeginning January 1, 2009, the collateral manager ceased waiving fees forCLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and Wayzata(restructured and replaced with CLO 2009-1 on March 31, 2009). However, asa result of the cancellation of Surrendered Notes in July 2009, thecollateral manager reinstated waiving management fees for CLO 2005-2 and CLO2006-1. For each of the three and nine months ended September 30, 2009,the collateral manager waived $2.6 million for CLO 2005-2 and CLO 2006-1. Inaddition, due to the deleveraging of CLO 2009-1 completed in July 2009whereby all the senior notes were retired, the collateral manager is no longerentitled to receive fees for CLO 2009-1. Accordingly, CLO management feesincreased $2.9 million from the three months ended September 30, 2008 to2009 to account for the fees related to CLO 2007-1 and CLO 2007-A, and $14.6 millionfrom the nine months ended September 30, 2008 to 2009 to account for thefees related to all six CLOs for either the full or partial nine month period.

 

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In addition, beginning January 1, 2009, our Manager permanentlywaived reimbursable general and administrative expenses allocable to us in anamount equal to the incremental CLO management fees received by our Manager.For the three and nine months ended September 30, 2009, our Managerpermanently waived reimbursement of $2.4 million and $7.7 million,respectively, in allocable general and administrative expenses. For the threeand nine months ended September 30, 2008, we reimbursed our Manager $2.5million and $7.6 million, respectively, for expenses.

 

General and administrative expenses include expenses incurred by ourManager on our behalf that are reimbursable to our Manager pursuant to theManagement Agreement. Professional services expenses consist of legal,accounting and other professional services. Directors’ expenses representshare-based compensation, as well as expenses and reimbursables due to theboard of directors for their services. Professional fees decreased $0.9 millionfrom the three months ended September 30, 2008 to 2009. In contrast,professional fees increased $1.7 million from the nine months ended September 30,2008 to 2009 primarily due to expenses associated with the replacement ofWayzata with CLO 2009-1 on March 31, 2009. The decrease in general andadministrative expenses of $3.1 million and $8.3 million from the threeand nine months ended September 30, 2008 to 2009, respectively, waslargely attributable to the rebated CLO management fees reducing the generaland administrative expenses otherwise reimbursable to our Manager.

 

*Income Tax Provision*

 

We intend to continue to operate so that we qualify as a partnership,and not as an association or publicly traded partnership that is taxable as acorporation, for United States federal income tax purposes. Therefore, wegenerally are not subject to United States federal income tax at the entitylevel, but are subject to limited state income taxes. Holders of our shares arerequired to take into account their allocable share of each item of our income,gain, loss, deduction and credit for our taxable year end ending within or withtheir taxable year.

 

KKR TRS Holdings, Ltd. (“TRS Ltd.”), KKR FinancialHoldings, Ltd. (“KFH Ltd.”), and KFN PEI VII, LLC (“PEI VII”)are not consolidated with us for United States federal income tax purposes. Forfinancial reporting purposes, current and deferred taxes are provided for onthe portion of earnings recognized by us with respect to our interest in PEIVII, a domestic taxable corporate subsidiary, because PEI VII is taxed as aregular corporation under the Code. Deferred income tax assets and liabilitiesare computed based on temporary differences between the GAAP consolidatedfinancial statements and the United States federal income tax basis of assetsand liabilities as of each consolidated balance sheet date. CLO 2005-1, CLO2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and CLO 2009-1 are our foreignsubsidiaries that elected to be treated as disregarded entities or partnershipsfor United States federal income tax purposes. Those subsidiaries wereestablished to facilitate securitization transactions, structured as securedfinancing transactions. TRS Ltd. and KFH Ltd. are our foreign subsidiariesand are taxed as corporations for United States federal income tax purposes.These entities were formed to make certain foreign and domestic investmentsfrom time to time. TRS Ltd. and KFH Ltd. are organized as exemptedcompanies incorporated with limited liability under the laws of the CaymanIslands, and are generally exempt from United States federal and state incometax at the corporate entity level because they restrict their activities in theUnited States to trading in stock and securities for their own account. Theygenerally will not be subject to corporate income tax in our financialstatements on their earnings, and no provisions for income taxes for thequarter ended September 30, 2009 were recorded; however, we are generallyrequired to include their current taxable income in our calculation of taxableincome allocable to shareholders.

 

We own both REIT and domestic taxable corporate subsidiaries, none ofwhich are expected to incur a 2009 federal or state tax liability.

 

**Investment Portfolio**

 

***Corporate Investment PortfolioSummary***

 

Our corporate investment portfolio primarily consists of investments incorporate loans and debt securities. Our corporate loans primarily consist ofsenior secured, second lien and mezzanine loans. The corporate loans we investin are generally below investment grade and are floating rate indexed to eitherone-month or three-month LIBOR. Our investments in corporate debt securitiesprimarily consist of investments in below investment grade corporate bonds thatare senior secured, senior unsecured and subordinated. We evaluate and monitorthe asset quality of our investment portfolio by performing detailed creditreviews and by monitoring key credit statistics and trends. The key creditstatistics and trends we monitor to evaluate the quality of our investmentsinclude credit ratings of both our investments and the issuer, financialperformance of the issuer including earnings trends, free cash flows of theissuer, debt service coverage ratios of the issuer, financial leverage of theissuer, and industry trends that have or may impact the issuer’s current orfuture financial performance and debt service ability.

 

*CorporateLoans*

 

Our corporate loan portfolio totaled approximately $7.2 billion as of September 30,2009 and $8.1 billion as of December 31, 2008. Our corporate loanportfolio consists of debt obligations of corporations, partnerships and otherentities in the form of senior secured loans, second lien loans and mezzanineloans.

 

The following table summarizes our corporate loans portfolio stratifiedby type as of September 30, 2009 and December 31, 2008:

 

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**Corporate Loans**

**(Amounts inthousands)**

 
| ** **     | ** ** | **September 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|----------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **     | ** ** | **Carrying  Value (1)**      | ** ** | **Amortized  Cost**         | ** ** | **Estimated  Fair  Value** | ** ** | **Carrying  Value(1)** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair  Value** | ** ** |
| Senior secured |       | $                            | 6,356,334  |                        | $          | 6,356,334 |   | $ | 5,716,199 |   | $ | 7,147,665 |   | $ | 7,147,665 |   | $ | 4,627,121 |   |
| Second lien    |       | 632,288                      |       | 632,288                     |       | 517,691 |   | 655,371 |   | 655,371 |   | 361,196 |   |
| Mezzanine      |       | 206,700                      |       | 206,700                     |       | 140,065 |   | 249,185 |   | 249,185 |   | 109,266 |   |
| Total          |       | $                            | 7,195,322  |                        | $          | 7,195,322 |   | $ | 6,373,955 |   | $ | 8,052,221 |   | $ | 8,052,221 |   | $ | 5,097,583 |   |

 

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| (1) |   | Total  carrying value is gross of allowance for loan losses of $470.2 million and  $480.8 million as of September 30, 2009 and December 31, 2008,  respectively, and includes loans held for sale of $504.1 million and  $324.6 million as of September 30, 2009 and December 31, 2008,  respectively. |
|-----|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

As of September 30, 2009, $7.1 billion, or 98.1%, of ourcorporate loan portfolio was floating rate and $0.1 billion, or 1.9%, wasfixed rate. As of December 31, 2008, $7.9 billion, or 98.6%, of ourcorporate loan portfolio was floating rate and $0.1 billion, or 1.4%, wasfixed rate. Fixed and floating percentages were calculated based on theportfolio mix as a percentage of estimated fair value.

 

All of our floating rate corporate loans have index reset frequenciesof twelve months or less with the majority being quarterly. Theweighted-average coupon on our floating rate corporate loans was 3.7% and 4.6%as of September 30, 2009 and December 31, 2008, respectively, and theweighted-average coupon spread to LIBOR of our floating rate corporate loanportfolio was 3.0% and 2.9% as of September 30, 2009 and December 31,2008, respectively. The rates above were calculated assuming that non-accrualloans were accruing interest as of the stated periods. The weighted-averageyears to maturity of our floating rate corporate loans was 4.5 years and 5.1years as of September 30, 2009 and December 31, 2008, respectively.

 

As of September 30, 2009, our fixed rate corporate loans had aweighted-average coupon of 13.1% and weighted-average years to maturity of5.5 years, as compared to 13.7% and weighted-average years to maturity of6.4 years as of December 31, 2008.

 

Loans placed on non-accrual status may or may not be contractually pastdue at the time of such determination. When placed on non-accrual status,previously recognized accrued interest is reversed and charged against currentincome. While on non-accrual status, interest income is recognized using thecost-recovery method, cash-basis method or some combination of the two methods.A loan is placed back on accrual status when the ultimate collectability of theprincipal and interest is not in doubt.

 

As of September 30, 2009 and December 31, 2008, we had $730.2million and $358.0 million of loans on non-accrual status, respectively.The average recorded investment in the impaired loans during the three and ninemonths ended September 30, 2009 was $717.3 million and $544.2 million,respectively. As of September 30, 2008, there were no corporate loanbalances placed on non-accrual status. The amount of interest income recognizedusing the cash-basis method during the time within the period that the loanswere impaired was $8.2 million and $12.4 million for the three and nine monthsended September 30, 2009, respectively, and nil for the three and ninemonths ended September 30, 2008.

 

As of September 30, 2009, we held loans that were in default witha total amortized cost of $743.6 million from ten issuers. During the yearended December 31, 2008, we held investments that were in default with atotal amortized cost of $312.7 million from three issuers. The majority ofcorporate loans in default during 2009 and 2008 were included in theinvestments for which the allocated component of our allowance for losses wasrelated to as of September 30, 2009 and December 31, 2008,respectively.

 

The following table summarizes the changes in the allowance for loanlosses for our corporate loan portfolio during the three and nine months ended September 30,2009 and 2008 (amounts in thousands):

 
| ** **                     | ** ** | **For the three  months ended  September 30, 2009** | ** ** | **For the three  months ended  September 30, 2008** | ** ** | **For the nine  months ended  September 30, 2009** | ** ** | **For the nine  months ended  September 30, 2008** | ** ** |
|--------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------------------------------|------------|
| Balance at beginning of period |       | $                                                        | 473,202    |                                                     | $          | 35,000                                                  |       | $                                                       | 480,775    |   | $ | 25,000 |   |
| Provision for loan losses      |       | —                                                   |       | —                                                   |       | 39,795                                                  |       | 10,000                                                  |       |
| Charge-offs                    |       | (2,978                                                   | )          | —                                                   |       | (50,346                                                 | )          | —                                                  |       |
| Balance at end of period       |       | $                                                        | 470,224    |                                                     | $          | 35,000                                                  |       | $                                                       | 470,224    |   | $ | 35,000 |   |

 

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Asof September 30, 2009 and December 31, 2008, we had an allowance forloan loss of $470.2 million and $480.8 million, respectively. As describedunder Critical Accounting Policies, our allowance for loan losses representsour estimate of probable credit losses inherent in our corporate loan portfolioheld for investment as of the balance sheet date. Estimating our allowance forloan losses involves a high degree of management judgment and is based upon acomprehensive review of our loan portfolio that is performed on a quarterlybasis. Our allowance for loan losses consists of two components, an allocatedcomponent and an unallocated component. The allocated component of ourallowance for loan losses pertains to specific loans that we have determinedare impaired. We determine a loan is impaired when we estimate that it isprobable that we will be unable to collect all amounts due according to thecontractual terms of the loan agreement. On a quarterly basis we perform acomprehensive review of our entire loan portfolio and identify certain loansthat we have determined are impaired. Once a loan is identified as beingimpaired we place the loan on non-accrual status, unless the loan is already onnon-accrual status, and record a reserve that reflects our best estimate of theloss that we expect to recognize from the loan. Generally, the expected loss isestimated as being the difference between our current cost basis of the loan,including accrued interest receivable, and the loans’ estimated fair value.

 

Theunallocated component of our allowance for loan losses reflects our estimate ofprobable losses in our loan portfolio as of the balance sheet date where thespecific loan that the loan loss relates to is indeterminable. We estimate theunallocated component of our allowance for loan losses through a comprehensivereview of our loan portfolio and identify certain loans that demonstratepossible indicators of impairment. This assessment excludes all loans that aredetermined to be impaired and as a result, an allocated reserve has beenrecorded as described in the preceding paragraph. Such indicators include, butare not limited to, the current and/or forecasted financial performance andliquidity profile of the issuer, specific industry or economic conditions thatmay impact the issuer, and the observable trading price of the loan ifavailable. Loans that demonstrate possible indicators of impairment areaggregated on a watch list for monitoring and are sub-divided forcategorization based on the seniority of the loan in the issuer’s capitalstructure, whether the loan is secured or unsecured, and the nature of thecollateral securing the loan, for purposes of applying possible default andloss severity ranges based on the nature of the issuer and the specific loan.We apply a range of default and loss severity estimates in order to estimate arange of loss outcomes upon which to base our estimate of probable losses thatresults in the determination of the unallocated component of our allowance forloan losses.

 

As of September 30, 2009, the allocated component of the allowancefor loan losses totaled $430.8 million and relates to investments in loansissued by thirteen issuers with an aggregate par amount of $902.0 millionand an aggregate amortized cost amount of $701.6 million. As of December 31,2008, the allocated component of the allowance for loan losses totaled $320.6million and relates to investments in loans issued by eleven issuers with anaggregate par amount of $828.2 million and an aggregate amortized costamount of $715.4 million. The amount recorded to the allocated component ofour allowance for loan losses reflects significant deterioration in the creditperformance of these issuers as demonstrated by default, bankruptcy or amaterial deterioration of the issuer such that default or restructuring isconsidered likely to occur.

 

Theunallocated component of the allowance for loan losses totaled $39.4 millionand $160.2 million as of September 30, 2009 and December 31,2008, respectively. The decline in the unallocated component of our allowancefor loan losses from December 31, 2008 to September 30, 2009 isattributable to the migration of the unallocated component to the allocatedcomponent of the allowance for loan losses since year end.

 

Asof September 30, 2009, no additional provision for loan losses wasrequired based on our review of the allocated and unallocated components of theallowance for loan losses.

 

Werecorded charge-offs during the three months ended September 30, 2009totaling $3.0 million related to loans transferred to loans held for sale.During the nine months ended September 30, 2009, we recorded charge-offstotaling $50.4 million comprised of the $3.0 million above, $6.0 millionrelated to a loan sold during the second quarter of 2009 and $41.4 millionrelated to a loan exchanged for equity and which qualified as a troubled debtrestructuring. At the time of restructuring, we elected the option to carrythis investment at estimated fair value in accordance with FASB ASC 825, *Financial Instruments*, with unrealized gains and lossesreported in income. There were no charge-offs during the three and nine monthsended September 30, 2008.

 

We recorded no additional charge to earnings during the quarter ended September 30,2009 for the lower of cost or estimated fair value adjustment for corporateloans held for sale which had an estimated fair value of $504.1 million asof September 30, 2009. We recorded a $2.4 million charge to earningsduring the quarter ended September 30, 2008 for the lower of cost orestimated fair value adjustment for loans held for sale which had an estimatedfair value of $28.2 million as of September 30, 2008.

 

The following table summarizes the par value of our corporate loanportfolio stratified by Moody’s Investors Service, Inc. (“Moody’s”) andStandard & Poor’s Ratings Services (“Standard & Poor’s”)ratings category as of September 30, 2009 and December 31, 2008:

 

**Corporate Loans**

**(Amounts inthousands)**

 
| **Ratings Category**        | ** ** | **As of  September 30, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|-----------------------------|------------|------------------------------------|------------|-----------------------------------|------------|
| Aaa/AAA                     |       | $                                  | —     |                              | $          | — |   |
| Aa1/AA+ through Aa3/AA-     |       | —                             |       | —                            |       |
| A1/A+ through A3/A-         |       | —                             |       | —                            |       |
| Baa1/BBB+ through Baa3/BBB- |       | 41,067                             |       | —                            |       |
| Ba1/BB+ through Ba3/BB-     |       | 1,498,974                          |       | 2,885,285                         |       |
| B1/B+ through B3/B-         |       | 4,933,381                          |       | 4,580,280                         |       |
| Caa1/CCC+ and lower         |       | 1,095,862                          |       | 957,104                           |       |
| Non-rated                   |       | 95,594                             |       | 33,449                            |       |
| Total                       |       | $                                  | 7,664,878  |                              | $          | 8,456,118 |   |

 

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*CorporateDebt Securities*

 

Ourcorporate debt securities portfolio totaled $735.6 million and$553.4 million as of September 30, 2009 and December 31, 2008,respectively. Our corporate debt securities portfolio consists of debtobligations of corporations, partnerships and other entities in the form ofsenior secured, senior unsecured and subordinated bonds.

 

Thefollowing table summarizes our corporate debt securities portfolio stratifiedby type as of September 30, 2009 and December 31, 2008:

 

**Corporate Debt Securities**

**(Amounts in thousands)**

 
| ** **       | ** ** | **September 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **       | ** ** | **Carrying  Value**          | ** ** | **Amortized  Cost**         | ** ** | **Estimated  Fair  Value** | ** ** | **Carrying  Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair  Value** | ** ** |
| Senior secured   |       | $                            | 87,300     |                        | $          | 44,182 |   | $ | 87,300 |   | $ | 57,641 |   | $ | 75,127 |   | $ | 57,641 |   |
| Senior unsecured |       | 423,478                      |       | 346,701                     |       | 423,478 |   | 400,357 |   | 503,897 |   | 400,357 |   |
| Subordinated     |       | 224,851                      |       | 201,688                     |       | 224,851 |   | 95,443 |   | 163,450 |   | 95,443 |   |
| Total            |       | $                            | 735,629    |                        | $          | 592,571 |   | $ | 735,629 |   | $ | 553,441 |   | $ | 742,474 |   | $ | 553,441 |   |

 

Asof September 30, 2009, $580.3 million, or 78.9%, of our corporate debtsecurities portfolio was fixed rate and $155.4 million, or 21.1%, wasfloating rate. As of December 31, 2008, $494.6 million, or 89.4%, of ourcorporate debt securities portfolio was fixed rate and $58.8 million, or 10.6%,was floating rate.

 

Asof September 30, 2009, our fixed rate corporate debt securities had aweighted-average coupon of 10.1% and weighted-average years to maturity of6.4 years, as compared to 10.3% and 6.8 years, as of December 31,2008. All of our floating rate corporate debt securities have index resetfrequencies of less than twelve months. The weighted-average coupon on ourfloating rate corporate debt securities was 3.5% and 7.0% as of September 30,2009 and December 31, 2008, respectively, and the weighted-average couponspread to LIBOR of our floating rate corporate debt securities was 3.1% and3.6% as of September 30, 2009 and December 31, 2008, respectively.The weighted-average years to maturity of our floating rate corporate debtsecurities was 4.5 years as of both September 30, 2009 and December 31,2008.

 

Duringthe three and nine months ended September 30, 2009, we recorded impairmentlosses totaling nil million and $40.0 million, respectively, for corporatedebt and equity securities that we determined to be other-than-temporarilyimpaired. These securities were determined to be other-than-temporarily impairedeither due to our determination that recovery in value is no longer likely orbecause we decided to sell the respective security in response to specificcredit concerns regarding the issuer. For the three and nine months ended September 30,2008, we recorded impairment losses totaling $10.6 million and$20.3 million, respectively, for corporate debt and equity securities thatwe determined to be other-than-temporarily impaired.

 

As of September 30, 2009 and December 31, 2008, we held onecorporate debt security that was in default with a total fair value of$5.9 million and $3.2 million, respectively. This corporate debt securitywas determined to be other-than-temporarily impaired as of September 30,2009 and December 31, 2008.

 

The following table summarizes the par value of our corporate debtsecurities portfolio stratified by Moody’s and Standard & Poor’sratings category as of September 30, 2009 and December 31, 2008:

 

**Corporate Debt Securities**

**(Amounts inthousands)**

 
| **Ratings Category**        | ** ** | **As of  September 30, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|-----------------------------|------------|------------------------------------|------------|-----------------------------------|------------|
| Aaa/AAA                     |       | $                                  | —     |                              | $          | — |   |
| Aa1/AA+ through Aa3/AA-     |       | —                             |       | —                            |       |
| A1/A+ through A3/A-         |       | 36,000                             |       | 37,500                            |       |
| Baa1/BBB+ through Baa3/BBB- |       | —                             |       | —                            |       |
| Ba1/BB+ through Ba3/BB-     |       | 27,381                             |       | 32,000                            |       |
| B1/B+ through B3/B-         |       | 221,935                            |       | 408,856                           |       |
| Caa1/CCC+ and lower         |       | 583,394                            |       | 734,303                           |       |
| Non-Rated                   |       | 6,816                              |       | 6,816                             |       |
| Total                       |       | $                                  | 875,526    |                              | $          | 1,219,475 |   |

 

***Residential Mortgage InvestmentsSummary***

 

Our residential mortgage investment portfolio consists of investmentsin RMBS with an estimated fair value of $192.2 million as of September 30,2009. The $192.2 million of RMBS is comprised of $95.7 million ofRMBS that are rated investment grade or higher and $96.5 million of RMBSthat are rated below investment grade. Of the $192.2 million of RMBSinvestments we hold, $121.9 million are in six residential mortgage-backedsecuritization trusts that are not structured as qualifying special-purposeentities. Accordingly, as we own the first loss securities in these trusts, weare deemed to be the primary beneficiary of these entities and as such,consolidate these trusts in accordance with GAAP. This results in us reflectingthe financial position and results of these 

 

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trustsin our condensed consolidated financial statements. Consolidation of these sixentities does not impact our net assets or net income; however, it does resultin us showing the condensed consolidated assets, liabilities, revenues andexpenses on our condensed consolidated financial statements. On our condensedconsolidated balance sheet as of September 30, 2009, the $192.2 million ofRMBS is computed as our investments in RMBS of $70.3 million, plus$121.9 million, which represents the difference between residentialmortgage loans of $2.3 billion less residential mortgage-backed securitiesissued of $2.2 billion plus $12.8 million of REO that is included in otherassets on our condensed consolidated balance sheet. The $192.2 million ofRMBS as of September 30, 2009 represents a decrease of 29.0% from$270.7 million as of December 31, 2008.

 

As our condensed consolidated financial statements included in thisquarterly report are presented to reflect the consolidation of theaforementioned residential mortgage securitization trusts, the informationcontained in this Management’s Discussion and Analysis of Financial Conditionand Results of Operations reflects our residential mortgage portfolio presentedon a consolidated basis consistent with the disclosures in our condensedconsolidated financial statements.

 

The table below summarizes the carrying value, amortized cost, andestimated fair value of our residential mortgage investment portfolio as of September 30,2009 and December 31, 2008. Carrying value is the value that investmentsare recorded on our condensed consolidated balance sheets and is estimated fairvalue for residential mortgage-backed securities and residential mortgageloans. Estimated fair values set forth in the tables below are based on dealerquotes, nationally recognized pricing services and/or management’s judgmentwhen relevant observable inputs do not exist.

 

**Residential Mortgage Investment Portfolio**

**(Dollaramounts in thousands)**

 
| ** **                             | ** ** | **September 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|----------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                             | ** ** | **Carrying  Value**         | ** ** | **Amortized  Cost**        | ** ** | **Estimated  Fair Value** | ** ** | **Carrying  Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| Residential Mortgage Loans(1)          |       | $                           | 2,274,585  |                       | $          | 2,905,776 |   | $ | 2,274,585 |   | $ | 2,620,021 |   | $ | 3,371,014 |   | $ | 2,620,021 |   |
| Residential Mortgage-Backed Securities |       | 70,256                      |       | 100,004                    |       | 70,256 |   | 102,814 |   | 125,849 |   | 102,814 |   |
| Total                                  |       | $                           | 2,344,841  |                       | $          | 3,005,780 |   | $ | 2,344,841 |   | $ | 2,722,835 |   | $ | 3,496,863 |   | $ | 2,722,835 |   |

 

----

| (1) |   | Excludes  REO as a result of foreclosure on delinquent loans of $12.8 million and $10.8  million as of September 30, 2009 and December 31, 2008,  respectively. |
|-----|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

As of September 30, 2009, thirty of our residential mortgage loanswith an outstanding balance of $12.8 million were REO as a result offoreclosure on delinquent loans. As of December 31, 2008, thirty-three ofour residential mortgage loans owned by us with an outstanding balance of$10.8 million were REO as a result of foreclosure on delinquent loans.

 

The following table summarizes the delinquency statistics of ourresidential mortgage loans, excluding REOs, as of September 30, 2009 and December 31,2008 (dollar amounts in thousands):

 
| ** **             | ** ** | **September 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|------------------------|------------|-----------------------------|------------|----------------------------|------------|
| **Delinquency Status** | ** ** | **Number  of Loans**        | ** ** | **Principal  Amount**      | ** ** | **Number  of Loans** | ** ** | **Principal  Amount** | ** ** |
| 30 to 59 days     |       | 77                          |       | $                          | 29,205     |   | 93 |   | $ | 37,282 |   |
| 60 to 89 days     |       | 39                          |       | 15,407                     |       | 41 |   | 15,654 |   |
| 90 days or more   |       | 111                         |       | 47,034                     |       | 76 |   | 29,803 |   |
| In foreclosure         |       | 135                         |       | 54,776                     |       | 67 |   | 22,841 |   |
| Total                  |       | 362                         |       | $                          | 146,422    |   | 277 |   | $ | 105,580 |   |

 

**Portfolio Purchases**

 

We purchased $0.3 billion and $0.9 billion par amount ofinvestments during the three months and nine months ended September 30,2009, respectively, as compared to $0.5 billion and $1.8 billion for the threeand nine months ended September 30, 2008, respectively.

 

The table below summarizes our investment portfolio purchases for theperiods indicated and includes the par amount of the securities and loans thatwere purchased:

 

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**Investment Portfolio Purchases**

**(Dollaramounts in thousands)**

 
| ** **                         | ** ** | **Three months ended  September 30, 2009** | ** ** | **Three months ended  September 30, 2008** | ** ** | **Nine months ended  September 30, 2009** | ** ** | **Nine months ended  September 30, 2008** | ** ** |
|------------------------------------|------------|----------------------------------------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                         | ** ** | **Par Amount**                                            | ** ** | **%**                                                          | ** ** | **Par Amount**                                           | ** ** | **%**                                                         | ** ** | **Par Amount** | ** ** | **%** | ** ** | **Par Amount** | ** ** | **%** | ** ** |
| Securities:                        |       |                                                           |       |                                                           |       |                                                          |       |                                                          |       |   |   |   |   |   |   |   |   |
| Corporate Debt Securities          |       | $                                                              | 52,052     |                                                           | 20.1       | %                                                             | $          | 50,000                                                        |       | 10.5 | % | $ | 94,615 |   | 10.2 | % | $ | 176,747 |   | 9.9 | % |
| Marketable Equity Securities       |       | —                                                         |       | —                                                         |       | —                                                        |       | —                                                        |       | — |   | — |   | 6,496 |   | 0.4 |   |
| Total Securities Principal Balance |       | 52,052                                                         |       | 20.1                                                           |       | 50,000                                                        |       | 10.5                                                          |       | 94,615 |   | 10.2 |   | 183,243 |   | 10.3 |   |
| Loans:                             |       |                                                           |       |                                                           |       |                                                          |       |                                                          |       |   |   |   |   |   |   |   |   |
| Corporate Loans                    |       | 206,873                                                        |       | 79.9                                                           |       | 426,320                                                       |       | 89.5                                                          |       | 831,091 |   | 89.8 |   | 1,597,573 |   | 89.7 |   |
| Grand Total Principal Balance      |       | $                                                              | 258,925    |                                                           | 100.0      | %                                                             | $          | 476,320                                                       |       | 100.0 | % | $ | 925,706 |   | 100.0 | % | $ | 1,780,816 |   | 100.0 | % |

 

The schedule above excludes purchases of securities sold, not yetpurchased, with a par amount of nil and $136.4 million as of September 30,2009 and 2008, respectively.

 

**Shareholders’ Equity**

 

Our shareholders’ equity at September 30, 2009 and December 31,2008 totaled $1.1 billion and $663.3 million, respectively. Included in ourshareholders’ equity as of September 30, 2009 and December 31, 2008is accumulated other comprehensive income (loss) totaling $91.8 million and$(268.8) million, respectively.

 

Our average shareholders’ equity and return on average shareholders’equity for the three and nine months ended September 30, 2009 were$1.0 billion and 26.5% and $841.8 million and 11.9%, respectively.  Our average shareholders’ equity and returnon average shareholders’ equity and for the three and nine months ended September 30,2008, were $1.8 billion and 10.7% and $1.8 billion and 7.6%, respectively.Return on average shareholders’ equity is defined as net income divided byweighted average shareholders’ equity.

 

Our book value per share as of September 30, 2009 and December 31,2008 was $7.01 and $4.40, respectively, and is computed based on 158,359,757and 150,881,500 shares issued and outstanding as September 30, 2009 and December 31,2008, respectively.

 

**Liquidity and Capital Resources**

 

We actively manage our liquidity position with theobjective of preserving our ability to fund our operations and fulfill ourcommitments on a timely and cost-effective basis. To achieve this objective, wecompleted several initiatives in the past three months as described below. Asof September 30, 2009, we had unrestricted cash and cash equivalentstotaling $125.9 million.

 

The majority of our investments are held in Cash Flow CLOs (CLO 2005-1,CLO 2005-2, CLO 2006-1, CLO 2007-1 and CLO 2007-A). Accordingly, the majorityof our cash flows have historically been received from our investments in themezzanine and subordinated notes of our Cash Flow CLOs. Current market economicconditions have had a material adverse impact on our cash flows and liquidity.During the quarter ended September 30, 2009, certain of our Cash Flow CLOswere out of compliance with certain compliance tests (specifically, OC Tests)outlined in their respective indentures and as a result, the cash flows wewould generally expect to receive from our Cash Flow CLO holdings was paid tothe senior note holders of the Cash Flow CLOs that were out of compliance withtheir respective OC Tests. Based on current market conditions, most notably thecredit ratings of certain investments held in our Cash Flow CLOs and theirrelated market values, we expect that certain of our Cash Flow CLOs will be outof compliance with their respective OC Tests during the remainder of 2009 andas a result, we expect that the cash flows that we would generally expect toreceive will be used to reduce the principal balances of the senior notesissued by certain of our Cash Flow CLOs.

 

OnJuly 10, 2009, we undertook certain actions with respect to CLO 2005-1,CLO 2005-2 and CLO 2006-1 that are expected to have a positive cash flow impactfor us. Specifically, we surrendered for cancellation, without consideration,$298.4 million in aggregate of mezzanine notes and junior notes issued to us bythese three CLO transactions. The Surrendered Notes were promptly cancelledupon receipt by the trustee of each transaction and the related debt wasextinguished by the issuers thereof. As a result of the transaction, the OCTests for these three CLOs were brought into compliance, enabling the mezzanineand subordinated note holders, including us, to resume receiving cash flowsfrom these transactions during the period when the OC Tests remain incompliance.

 

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In addition to our Cash Flow CLOs, a portion of our assets werepreviously held in Wayzata, a market value CLO transaction. On March 31, 2009, we completed therestructuring of Wayzata and replaced it with CLO 2009-1. As a result of therestructuring, substantially all of Wayzata’s assets were transferred to CLO2009-1, a newly formed special purpose company, which issued $560.8 millionaggregate principal amount of senior notes due April 2017 and $154.3million aggregate principal amount of subordinated notes due April 2017 tothe existing Wayzata note holders in exchange for cancellation of the Wayzatanotes, due November 2012, previously held by each of them. CLO 2009-1 wasstructured as a cash flow transaction and does not contain the market valueprovisions contained in Wayzata. The portfolio manager of CLO 2009-1 was anaffiliate of our Manager. The notes issued by CLO 2009-1 were secured by thesame collateral that secured the Wayzata notes, consisting primarily of seniorsecured leveraged loans. As was the case with Wayzata, at the time of therestructuring, we and an affiliate of our Manager owned all of the subordinatednotes issued by CLO 2009-1.

 

During June 2009, we paid down the senior notes issued by CLO2009-1 by $516.4 million and on July 24, 2009, we retired the remainingbalance of $44.4 million of outstanding senior notes. Prior to the retirement of the seniornotes, an affiliate of ours held a 20% interest in the subordinated notesissued by CLO 2009-1. As part of the deleveraging of CLO 2009-1, thesubordinated notes in CLO 2009-1 held by our affiliate were retired in exchangefor a 20% interest in each of CLO 2009-1’s assets which remained following thedeleveraging. As a result of the deleveraging transaction and thedistribution of assets to our affiliate, we now hold 100% of the residualassets of CLO 2009-1.

 

We closely monitor ourliquidity position and believe we have sufficient liquidity and access toliquidity to meet our financial obligations for at least the next 12 months.

 

**Sources of Funds**

 

*Cash FlowCLO Transactions*

 

As of September 30, 2009, we had five CLO transactionsoutstanding, CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1and CLO 2007-A. An affiliate of our Manager owns a 37% interest in the juniornotes of both CLO 2007-1 and CLO 2007-A. The aggregate carrying amount ofthe junior notes in CLO 2007-1 and CLO 2007-A held by the affiliate of ourManager is $547.4 million as of September 30, 2009, which isreflected as collateralized loan obligation junior secured notes to affiliateson our condensed consolidated balance sheet. In accordance with GAAP, weconsolidate each of these CLO transactions. We utilize CLOs to fund our investmentsin corporate loans and corporate debt securities. The indentures governing ourCash Flow CLOs include numerous compliance tests, the majority of which relateto the CLO’s portfolio profile. In the event that a portfolio profile test isnot met, the indenture places restrictions on the ability of the CLO’s managerto reinvest available principal proceeds generated by the collateral in theCLOs until the specific test has been cured. In addition to the portfolioprofile tests, the indentures for the CLO transactions include OC Tests whichset the ratio of the collateral value of the assets in the CLO to the tranchesof debt for which the test is being measured, as well as interest coveragetests. For purposes of the calculation, collateral value is the par value ofthe assets unless an asset is in default, is a discounted obligation, or is aCCC-rated asset in excess of the percentage of CCC-rated asset limit specifiedfor each CLO transaction.

 

If an asset is in default, the indenture for each Cash Flow CLOtransaction defines the value used to determine the collateral value, whichvalue is generally the lower of market value of the asset or the recovery valueproscribed for the asset based on its type and rating by Standard &Poor’s or Moody’s.

 

A discount obligation is an asset with a purchase price of less than aparticular percentage of par. The discount obligation amounts are specified ineach Cash Flow CLO transaction and are generally set at a purchase price ofless than 80% of par for corporate loans and 75% of par for corporate debtsecurities.

 

The indenture for each Cash Flow CLO transaction specifies aCCC-threshold for the percentage of total assets in the CLO that can be ratedCCC. All assets in excess of the CCC threshold specified for the respective CLOare included in the OC Tests at market value and not par.

 

Defaults of assets in Cash Flow CLOs, ratings downgrade of assets inCash Flow CLOs to CCC, price declines of CCC assets in excess of the proscribedCCC threshold amount, and price declines in assets classified as discountobligations may reduce the OC ratio such that a Cash Flow CLO is not incompliance. If a Cash Flow CLO is not in compliance with an OC Test, cash flowsnormally payable to the holders of junior classes of notes will be used by theCLO to amortize the most senior class of notes until such point as the OC Testis brought back into compliance. Declines in asset prices, particularly in thecorporate loan and high yield securities asset classes during the fourthquarter of 2008, have been of a historic magnitude and have therefore increasedthe risk of failing the OC Tests on all CLO transactions. Accordingly, weexpect that one or more of our CLO transactions will be out of compliance withthe OC Tests for periods of time. While being out of compliance with an OC Testwould not impact our investment portfolio or results of operations, it wouldimpact our unrestricted cash flows available for operations, new investmentsand dividend distributions. As of the date we filed this Quarterly Report on Form 10-Q,we believe that we are or will be failing one or more of the OC Tests forcertain of our Cash Flow CLO transactions.

 

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The following table summarizes several of the material tests andmetrics for each of our Cash Flow CLOs. This information is based on the September 2009 monthlyreports which are prepared by the independent third-party trustee for each CashFlow CLO transaction:

 

·                  Investments: The par valueof the investments in each CLO plus principal cash in the CLO.

 

·                  Senior interest coverage (“IC”)ratio minimum: Minimum required ratio of interest income earned on investmentsto interest expense on the senior debt issued by the CLO per the respective CLO’sindenture.

 

·                  Actual senior IC ratio: Theratio is interest income earned on the investments divided by interest expenseon the senior debt issued by the CLO.

 

·                  CCC amount: The par amountof assets rated CCC or below (excluding defaults, if any).

 

·                  CCC threshold percentage:Maximum amount of assets in portfolio that are rated CCC without being subjectto being valued at fair value for purposes of the OC Tests.

 

·                  Senior OC Test minimum:Minimum senior OC requirement per the respective CLO’s indenture.

 

·                  Actual senior OC Test:Actual senior OC amount as of the report date.

 

·                  Actual cushion / (excess):Dollar amount that OC test is being passed, cushion, or failed (excess).

 

·                  Subordinated OC Testminimum: Minimum subordinated OC requirement per the respective CLO’sindenture.

 

·                  Actual subordinated OC Test:Actual subordinated OC amount as of the report date.

 

·                  Subordinated cushion /(excess): Dollar amount that the OC Test is being passed, cushion, or failed(excess).

 
| **(dollar amounts in thousands)** | ** ** | **CLO 2005-1** | ** ** | **CLO 2005-2** | ** ** | **CLO 2006-1** | ** ** | **CLO 2007-1** | ** ** | **CLO 2007-A** | ** ** |
|-----------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| Investments                       |       | $              | 1,053,339  |           | $          | 998,792        |       | $              | 1,023,013  |           | $          | 3,485,182 |   | $ | 1,541,049 |   |
| Senior IC ratio minimum           |       | 115.0          | %          | 125.0          | %          | 115.0          | %          | 115.0          | %          | 120.0          | %          |
| Actual senior IC ratio            |       | 575.9          | %          | 567.0          | %          | 392.4          | %          | 471.1          | %          | 357.4          | %          |
| CCC amount                        |       | $              | 65,840     |           | $          | 92,810         |       | $              | 160,639    |           | $          | 759,050 |   | $ | 316,496 |   |
| CCC percentage of portfolio       |       | 6.3            | %          | 9.3            | %          | 15.7           | %          | 21.8           | %          | 20.5           | %          |
| CCC threshold percentage          |       | 5.0            | %          | 7.5            | %          | 7.5            | %          | 7.5            | %          | 7.5            | %          |
| Senior OC Test minimum            |       | 119.4          | %          | 123.0          | %          | 143.1          | %          | 159.1          | %          | 119.7          | %          |
| Actual senior OC Test             |       | 127.1          | %          | 128.8          | %          | 151.0          | %          | 153.2          | %          | 122.2          | %          |
| Cushion / (Excess)                |       | $              | 59,598     |           | $          | 43,316         |       | $              | 48,159     |           | $          | (112,511 | ) | $ | 28,136 |   |
| Subordinated OC Test minimum      |       | 106.2          | %          | 106.9          | %          | 114.0          | %          | 120.1          | %          | 109.9          | %          |
| Actual OC Test                    |       | 108.7          | %          | 114.4          | %          | 128.9          | %          | 107.6          | %          | 105.4          | %          |
| Cushion / (Excess)                |       | $              | 22,510     |           | $          | 62,439         |       | $              | 106,177    |           | $          | (338,482 | ) | $ | (58,077 | ) |

 

As reflected in the table above, each of our cash flow CLO transactionsis in compliance with its respective IC ratio tests based on the September 2009 monthlyreports for the respective CLOs. Based on the September 2009 monthlyreports, CLO 2005-1, CLO 2005-2, CLO 2006-1, and CLO 2007-A are in compliancewith their respective senior OC Tests and CLO 2005-1, CLO 2005-2, and CLO2006-1 are in compliance with their respective subordinated OC Tests.

 

*SeniorSecured Credit Facility*

 

On August 5, 2009, we entered into an agreement with our lendersto amend the terms of our senior secured credit facility. Among other things,the amendment provides that: (i) the size of the facility be reduced to$200.0 million from $300.0 million, (ii) the lending commitments of thelenders to this facility be modified to provide for quarterly amortization of$12.5 million per quarter until the size of the facility has been reduced to$150 million on June 30, 2010, (iii) the interest rate applicable toborrowings under the 

 

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facilitybe increased from LIBOR plus 300 basis points to LIBOR plus 400 basis points, (iv) theadjusted tangible net worth covenant be reduced to $700.0 million from $1.0billion, (v) the maturity date of the borrowings under the facility beextended to November 10, 2011, and (vi) certain events of defaultunder the Credit Agreement be added. The amendment also provides that the wecan (i) pay a yearly distribution to our shareholders in an amount equalto no greater than 50% of our taxable income for such year and (ii) use upto $50 million of our unrestricted cash to repurchase our convertible notes dueJuly 2012 and/or our outstanding trust preferred securities. Inconjunction with this amendment, we paid the lenders to our credit facilityfees totaling $4.5 million.

 

As of September 30, 2009, we had borrowings outstanding under theFacility totaling $187.5 million.

 

*StandbyRevolving Credit Facility*

 

On November 10, 2008, we entered into an agreement for a two-year$100.0 million standby unsecured revolving credit agreement (the “StandbyAgreement”) with our Manager and Kohlberg Kravis Roberts & Co.(Fixed Income) LLC, the parent of our Manager. The borrowing facilitymatures in December 2010 and bears interest at a rate equal to LIBOR foran interest period of 1, 2 or 3 months (at our option) plus 15.00% perannum. Under the terms of the agreement, we can elect to capitalize a portionof accrued interest on any loan under the agreement by adding up to 80% of theinterest due and payable at a particular time in respect of such loan to theoutstanding principal amount of the loan. We have the right to prepay loansunder the Standby Agreement in whole or in part at any time. The StandbyAgreement includes covenants, representations, warranties, indemnities andevents of default that are customary for facilities of this type. 

 

No borrowings were outstanding under the Standby Agreement as of September 30,2009.

 

On November 5, 2009, our board of directors agreed to terminatethe Standby Agreement.

 

*ConvertibleDebt*

 

DuringJune 2009, we completed two transactions to exchange a total of $15.7million par value of convertible notes for 7.2 million of our commonshares. As a result of these transactions, we recorded a gain of $6.9 million,or approximately $0.05 per diluted common share, which was partially offset bya write-off of $0.1 million of unamortized debt issuance costs and $0.4 millionof other associated costs.

 

Asof September 30, 2009, we had $275.8 million of convertible debtoutstanding.

 

*JuniorSubordinated Notes*

 

InAugust 2009, we repurchased $5.0 million of junior subordinated notes,which resulted in a gain on extinguishment of debt of $3.8 million, partiallyoffset by a $0.1 million write-off of unamortized debt issuance costs.

 

Asof September 30, 2009, we had junior subordinated notes outstandingtotaling $283.7 million.

 

*Off-Balance Sheet Commitments*

 

As of September 30, 2009, we had committed to purchase corporateloans with aggregate commitments totaling $101.2 million. In addition, weparticipate in certain financing arrangements, including revolvers and delayeddraw facilities, whereby we are committed to provide funding at the discretionof the borrower up to a specific predetermined amount. As of September 30,2009, we had unfunded financing commitments totaling $48.4 million. We donot expect material losses related to the corporate loans for which we committo purchase and fund.

 

**Partnership Tax Matters**

 

***Non-Cash “Phantom” Taxable Income***

 

We intend to continue to operate so that we qualify, for United Statesfederal income tax purposes, as a partnership and not as an association or apublicly traded partnership taxable as a corporation. Holders of our shares aresubject to United States federal income taxation and, in some cases, state,local and foreign income taxation, on their allocable share of our taxableincome, regardless of whether or when they receive cash distributions. Inaddition, certain of our investments, including investments in foreigncorporate subsidiaries, CLO issuers, including those treated as partnerships ordisregarded entities for United States federal income tax purposes, and debtsecurities, may produce taxable income without corresponding distributions ofcash to us or may produce taxable income prior to or following the receipt ofcash relating to such income. Consequently, in some taxable years, holders ofour shares may recognize taxable income in excess of our cash distributions.Furthermore, if we did not pay cash distributions with respect to a taxableyear, holders of our shares may still have a tax liability attributable totheir allocation of taxable income from us during such year.

 

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***Qualifying Income Exception***

 

We intend to continue to operate so that we qualify as a partnership,and not as an association or a publicly traded partnership taxable as acorporation, for United States federal income tax purposes. In general, if apartnership is “publicly traded” (as defined in the Code), it will be treatedas a corporation for United States federal income purposes. A publicly tradedpartnership will, however, be taxed as a partnership, and not as a corporation,for United States federal income tax purposes, so long as it is not required toregister under the Investment Company Act and at least 90% of its gross incomefor each taxable year constitutes “qualifying income” within the meaning of Section 7704(d) ofthe Code. We refer to this exception as the “qualifying income exception.”Qualifying income generally includes rents, dividends, interest (to the extentsuch interest is neither derived from the “conduct of a financial or insurancebusiness” nor based, directly or indirectly, upon “income or profits” of anyperson), and capital gains from the sale or other disposition of stocks, bondsand real property. Qualifying income also includes other income derived fromthe business of investing in, among other things, stocks and securities.

 

If we fail to satisfy the “qualifyingincome exception” described above, items of income, gain, loss, deduction andcredit would not pass through to holders of our shares and such holders wouldbe treated for United States federal (and certain state and local) income taxpurposes as shareholders in a corporation. In such case, we would be requiredto pay income tax at regular corporate rates on all of our income. In addition,we would likely be liable for state and local income and/or franchise taxes onall of our income. Distributions to holders of our shares would constituteordinary dividend income taxable to such holders to the extent of our earningsand profits, and these distributions would not be deductible by us. If we weretaxable as a corporation, it could result in a material reduction in cash flowand after-tax return for holders of our shares and thus could result in asubstantial reduction in the value of our shares and any other securities wemay issue.

 

**Our 1940 Act Status**

 

We are organized as a holding company that conducts its operationsprimarily through majority-owned subsidiaries and we intend to continue toconduct our operations so that we are not required to register as an investmentcompany under the Investment Company Act of 1940, as amended (the “1940 Act”). Section 3(a)(1)(C) ofthe 1940 Act defines an investment company as any issuer that is engaged orproposes to engage in the business of investing, reinvesting, owning, holdingor trading in securities and owns or proposes to acquire “investment securities”(within the meaning of the 1940 Act) having a value exceeding 40% of the valueof the issuer’s total assets (exclusive of U.S. government securities and cashitems) on an unconsolidated basis (the “40% test”). Excluded from the term “investmentsecurities” are, among others, securities issued by majority-owned subsidiariesunless the subsidiary is an investment company or relies on the exceptions fromthe definition of an investment company provided by Section 3(c)(1) orSection 3(c)(7) of the 1940 Act (a “fund”). The 1940 Act defines a “majority-ownedsubsidiary” of a person as any company 50% or more of the outstanding votingsecurities (*i.e.*, thosesecurities presently entitling the holder thereof to vote for the election ofdirectors of the company) of which are owned by that person, or by anothercompany that is, itself, a majority-owned subsidiary of that person. We areresponsible for determining whether any of our subsidiaries is majority-owned.We treat subsidiaries in which we own at least 50% of the outstanding votingsecurities, including those that issue collateralized loan obligations or “CLOs”,as majority-owned for purposes of the 40% test.

 

We monitor our holdings regularly to confirm our continued compliancewith the 40% test. Some of our subsidiaries may rely solely on Section 3(c)(1) orSection 3(c)(7) of the 1940 Act. In order for us to satisfy the 40%test, securities issued to us by those subsidiaries or any of our subsidiariesthat are not majority-owned, together with any other “investment securities”that we may own, may not have a combined value in excess of 40% of the value ofour total assets on an unconsolidated basis and exclusive of U.S. governmentsecurities and cash items. However, most of our subsidiaries rely on exceptionsprovided by provisions of, and rules and regulations promulgated under,the 1940 Act (other than Section 3(c)(1) or Section 3(c)(7) ofthe 1940 Act) to avoid being defined and regulated as an investment company. Inorder to conform to these exceptions, our subsidiaries may be limited withrespect to the assets in which each of them can invest and/or the types ofsecurities each of them may issue. We must, therefore, monitor each subsidiary’scompliance with its applicable exception and our freedom of action, and that ofour subsidiaries, may be limited as a result. For example, our subsidiariesthat issue CLOs generally rely on Rule 3a-7 under the 1940 Act, while KKRFinancial Holdings II, LLC, or “KFH II,” our subsidiary that is taxed as a realestate investment trust or “REIT,” for United States federal income taxpurposes, generally relies on Section 3(c)(5)(C) of the 1940 Act.Each of these exceptions requires, among other things that the subsidiary (i) notissue redeemable securities and (ii) engage in the business of holdingcertain types of assets, consistent with the terms of the exception. We do nottreat our interests in majority-owned subsidiaries that rely on Section 3(c)(5)(C) of,or Rule 3a-7 under, the 1940 Act as investment securities when calculatingour 40% test.

 

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We sometimes refer to our subsidiaries that rely on Rule 3a-7under the 1940 Act as “CLO subsidiaries.” Rule 3a-7 under the 1940 Act isavailable to certain structured financing vehicles that are engaged in thebusiness of holding financial assets that, by their terms, convert into cashwithin a finite time period and that issue fixed income securities entitlingholders to receive payments that depend primarily on the cash flows from theseassets, provided that, among other things, the structured finance vehicle doesnot engage in certain portfolio management practices resembling those employedby mutual funds. Accordingly, each of these CLO subsidiaries is subject to anindenture (or similar transaction documents) that contains specific guidelinesand restrictions limiting the discretion of the CLO subsidiary and itscollateral manager. In particular, these guidelines and restrictions prohibitthe CLO subsidiary from acquiring and disposing of assets primarily for thepurpose of recognizing gains or decreasing losses resulting from market valuechanges. Thus, a CLO subsidiary cannot acquire or dispose of assets primarilyto enhance returns to the owner of the equity in the CLO subsidiary; however,subject to this limitation, sales and purchases of assets may be made so longas doing so does not violate guidelines contained in the CLO subsidiary’srelevant transaction documents. A CLO subsidiary generally can, for example,sell an asset if the collateral manager believes that its credit quality hasdeclined since its acquisition or that the credit profile of the obligor willdeteriorate and the proceeds of permitted dispositions may be reinvested inadditional collateral, subject to fulfilling the requirements set forth in Rule 3a-7under the 1940 Act and the CLO subsidiary’s relevant transaction documents. Asa result of these restrictions, our CLO subsidiaries may suffer losses on theirassets and we may suffer losses on our investments in those CLO subsidiaries.

 

We sometimes refer to KFH II, our subsidiary that relies on Section 3(c)(5)(C) ofthe 1940 Act, as our “REIT subsidiary.” Section 3(c)(5)(C) of the1940 Act is available to companies that are primarily engaged in the businessof purchasing or otherwise acquiring mortgages and other liens on and interestsin real estate. While the Securities and Exchange Commission (“SEC”) has notpromulgated rules to address precisely what is required for a company tobe considered to be “primarily engaged in the business of purchasing orotherwise acquiring mortgages and other liens on and interests in real estate,”the SEC’s Division of Investment Management, or the “Division,” has taken theposition, through a series of no-action and interpretive letters, that acompany may rely on Section 3(c)(5)(C) of the 1940 Act if, amongother things, at least 55% of the company’s assets consist of mortgage loansand other assets that are considered the functional equivalent of mortgageloans (collectively, “qualifying real estate assets”), and at least 25% of thecompany’s assets consist of real estate-related assets (reduced by the excessof the company’s qualifying real estate assets over the required 55%), leavingno more than 20% of the company’s assets to be invested in miscellaneousassets. The Division has also provided guidance as to the types of assets thatcan be considered qualifying real estate assets. Because the Division’sinterpretive letters are not binding except as they relate to the companies towhom they are addressed, if the Division were to change its position as to,among other things, what assets might constitute qualifying real estate assetsour REIT subsidiary might be required to change its investment strategy tocomply with the changed position. We cannot predict whether such a change wouldbe adverse.

 

Based on current guidance, our REIT subsidiary classifies investmentsin mortgage loans as qualifying real estate assets, as long as the loans are “fullysecured” by an interest in real estate on which we retain the right to foreclose.That is, if the loan-to-value ratio of the loan is equal to or less than 100%,then the mortgage loan is considered to be a qualifying real estate asset.Mortgage loans with loan-to-value ratios in excess of 100% are considered to beonly real estate-related assets. Our REIT subsidiary considers agency wholepool certificates to be qualifying real estate assets. Examples of agenciesthat issue whole pool certificates are the Federal National MortgageAssociation, the Federal Home Loan Mortgage Corporation and the GovernmentNational Mortgage Association. An agency whole pool certificate is acertificate issued or guaranteed as to principal and interest by the U.S.government or by a federally chartered entity, that represents the entirebeneficial interest in the underlying pool of mortgage loans. By contrast, anagency certificate that represents less than the entire beneficial interest inthe underlying mortgage loans is not considered to be a qualifying real estateasset, but is considered to be a real estate-related asset.

 

Most non-agency mortgage-backed securities do not constitute qualifyingreal estate assets, because they represent less than the entire beneficialinterest in the related pool of mortgage loans; however, based on Division guidancewhere our REIT subsidiary’s investment in non-agency mortgage- backedsecurities is the “functional equivalent” of owning the underlying mortgageloans, our REIT subsidiary may treat those securities as qualifying real estateassets. Moreover, investments in mortgage-backed securities that do notconstitute qualifying real estate assets will be classified as real estate-related assets. Therefore, based upon the specific terms and circumstancesrelated to each non-agency mortgage-backed security that our REIT subsidiaryowns, our REIT subsidiary will make a determination of whether that securityshould be classified as a qualifying real estate asset or as a real estate-related asset; and there may be instances where a security is recharacterizedfrom being a qualifying real estate asset to a real estate-related asset, orconversely, from being a real estate-related asset to being a qualifying realestate asset based upon the acquisition or disposition or redemption of relatedclasses of securities from the same securitization trust. If our REITsubsidiary acquires securities that, collectively, receive all of the principaland interest paid on the related pool of underlying mortgage loans (less fees,such as servicing and trustee fees, and expenses of the securitization), andthat subsidiary has foreclosure rights with respect to those mortgage loans,then our REIT subsidiary will consider those securities, collectively, to bequalifying real estate assets. If another entity acquires any of the securitiesthat are expected to receive cash flow from the underlying mortgage loans, thenour REIT subsidiary will consider whether it has appropriate foreclosure rightswith respect to the underlying loans and whether its investment is a first lossposition in deciding whether these securities should be classified asqualifying real estate assets. If our REIT subsidiary owns more than one 

 

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subordinateclass, then, to determine the classification of subordinate classes other thanthe first loss class, our REIT subsidiary will consider whether such classesare contiguous with the first loss class (with no other classes absorbinglosses after the first loss class and before any other subordinate classes thatour REIT subsidiary owns), whether our REIT subsidiary owns the entire amountof each such class and whether our REIT subsidiary would continue to haveappropriate foreclosure rights in connection with each such class if the moresubordinate classes were no longer outstanding. If the answers to any of thesequestions is no, then our REIT subsidiary would expect not to classify thatparticular class, or classes senior to that class, as qualifying real estateassets.

 

As noted above, if the combined values of the investment securitiesissued by our subsidiaries that must rely on Section 3(c)(1) or Section 3(c)(7) ofthe 1940 Act, together with any other investment securities we may own, exceeds40% of the value of our total assets (exclusive of U.S. government securitiesand cash items) on an unconsolidated basis, we may be deemed to be aninvestment company. If we fail to maintain an exception, exemption or otherexclusion from the 1940 Act, we could, among other things, be required either (i) tochange substantially the manner in which we conduct our operations to avoidbeing subject to the 1940 Act or (ii) to register as an investmentcompany. Either of these would likely have a material adverse effect on us, ourability to service our indebtedness and to make distributions on our shares,and on the market price of our shares and any other securities we may issue. Ifwe were required to register as an investment company under the 1940 Act, wewould become subject to substantial regulation with respect to our capitalstructure (including our ability to use leverage), management, operations,transactions with certain affiliated persons (within the meaning of the 1940Act), portfolio composition (including restrictions with respect todiversification and industry concentration) and other matters. Additionally,our Manager would have the right to terminate our management agreement.Moreover, if we were required to register as an investment company, we would nolonger be eligible to be treated as a partnership for United States federalincome tax purposes. Instead, we would be classified as a corporation for taxpurposes and would be able to avoid corporate taxation only to the extent thatwe were able to elect and qualify as a regulated investment company (“RIC”)under applicable tax rules. Because our eligibility for RIC status would dependon our investments and sources of income at the time that we were required toregister as an investment company, there can be no assurance that we would beable to qualify as a RIC. If we were to lose partnership status and fail toqualify as a RIC, we would be taxed as a regular corporation. See “PartnershipTax Matters—*Qualifying Income Exception*.”

 

We have not requested approval or guidance from the SEC or its staffwith respect to our 1940 Act determinations, including, in particular: ourtreatment of any subsidiary as majority-owned; the compliance of any subsidiarywith Section 3(c)(5)(C) of, or Rule 3a-7 under, the 1940 Act,including any subsidiary’s determinations with respect to the consistency ofits assets or operations with the requirements thereof; or whether ourinvestments in one or more subsidiaries constitute investment securities forpurposes of the 40% test. If the SEC were to disagree with our treatment of oneor more subsidiaries as being excepted from the 1940 Act pursuant to Rule 3a-7or Section 3(c)(5)(C), or with our determination that one or more of ourother investments do not constitute investment securities for purposes of the40% test, we and/or one or more of our subsidiaries would need to adjust ourinvestment strategies or investments in order for us to continue to pass the40% test or register as an investment company, which could have a materialadverse effect on us. Moreover, we may be required to adjust our investmentstrategy and investments if the SEC or its staff provides more specific ordifferent guidance regarding the application of relevant provisions of, and rules under,the 1940 Act. Such guidance could provide additional flexibility, or it couldfurther inhibit our ability, or the ability of a subsidiary, to pursue a choseninvestment strategy, which could have a material adverse effect on us.

 

**Quantitative and Qualitative Disclosures About MarketRisk**

 

*CurrencyRisks*

 

From time to time, we may make investments that are denominated in aforeign currency through which we may be subject to foreign currency exchangerisk.

 

*LiquidityRisk*

 

Liquidity risk is defined as the risk that we will be unable to fulfillour obligations on a timely basis, continuously borrow funds in the market on acost-effective basis to fund actual or proposed commitments, or liquidateassets when needed at a reasonable price.

 

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A material event that impacts capital markets participants may impairour ability to access additional liquidity. If our cash resources are at anytime insufficient to satisfy our liquidity requirements, we may have to sellassets or issue debt or additional equity securities.

 

Our ability to meet our long-term liquidity and capital resourcerequirements may be subject to our ability to obtain additional debt financingand equity capital. We may increase our capital resources through offerings ofequity securities (possibly including common shares and one or more classes ofpreferred shares), 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.

 

We have established a formal liquidity contingency plan which providesguidelines for liquidity management. We determine our current liquidityposition and forecast liquidity based on anticipated changes in the balancesheet. We also stress test our liquidity position under several differentstress scenarios. A stress test aims at capturing the impact of extreme (butrare) market rate changes on the market value of equity and net interestincome. This scenario is applied on a daily basis to our balance sheet and theresulting loss in cash is evaluated. Besides providing a measure of thepotential loss under the extreme scenario, this technique enables us toidentify the nature of the changes in market risk factors to which it is themost sensitive, allowing us to take appropriate action to address those riskfactors. A decrease in the fair value of our investments held through totalrate of return swaps would result in us posting additional collateral.Conversely, an increase in the fair value of these swaps would result in usreceiving a portion of the previously posted collateral.

 

The table below summarizes the potential impact on our liquidityposition under different stress scenarios as applied to our investments heldthrough total rate of return swap agreements (amounts in thousands):

 
| ** **                 | ** ** | **Impact on liquidity due to (decrease) increase in fair value of investments** | ** ** |
|----------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                 | ** ** | **-10.0%**                                                                                                                             | ** ** | **-7.5%** | ** ** | **-5.0%** | ** ** | **-2.5%** | ** ** | **0.0%** | ** ** | **2.5%** | ** ** | **5.0%** | ** ** | **7.5%** | ** ** | **10.0%** | ** ** |
| Total rate of return swaps |       | $                                                                                                                                      | (7,651     | ) | $ | (5,739 | ) | $ | (3,826 | ) | $ | (1,913 | ) | $ | — |   | $ | 1,913 |   | $ | 3,826 |   | $ | 5,739 |   | $ | 7,651 |   |
|                            |            |                                                                                                                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As discussed above in “Liquidity and Capital Resources,” current marketconditions have had a material adverse impact on our cash flows from CLOs as aresult of our CLOs being out of compliance with their OC Tests. However, basedon our current liquidity and access to liquidity, we believe that we are ableto meet our obligations for at least the next 12 months. As of September 30,2009, we had unencumbered cash and cash equivalents totaling$125.9 million.

 

*CreditSpread Exposure*

 

Our investments are subject to spread risk. Our investments in floatingrate loans and securities are valued based on a market credit spread over LIBORand for which the value is affected by changes in the market credit spreadsover LIBOR. Our investments in fixed rate loans and securities are valued basedon a market credit spread over the rate payable on fixed rate United StatesTreasuries of like maturity. Increased credit spreads, or credit spreadwidening, will have an adverse impact on the value of our investments whiledecreased credit spreads, or credit spread tightening, will have a positiveimpact on the value of our investments.

 

*DerivativeRisk*

 

Derivative transactions, including engaging in swaps and foreigncurrency transactions, are subject to certain risks. There is no guarantee thata company can eliminate its exposure under an outstanding swap agreement byentering into an offsetting swap agreement with the same or another party.Also, there is a possibility of default of the other party to the transactionor illiquidity of the derivative instrument. Furthermore, the ability tosuccessfully use derivative transactions depends on the ability to predictmarket movements which cannot be guaranteed. As such, participation inderivative instruments may result in greater losses as we would have to sell orpurchase an investment at inopportune times for prices other than currentmarket prices or may force us to hold an asset we might otherwise have sold. Inaddition, as certain derivative instruments are unregulated, they are difficultto value and are therefore susceptible to liquidity and credit risks.

 

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Collateral posting requirements are individually negotiated betweencounterparties and there is no regulatory requirement concerning the amount ofcollateral that a counterparty must post to secure its obligations undercertain derivative instruments. Because they are unregulated, there is norequirement that parties to a contract be informed in advance when a creditdefault swap is sold. As a result, investors may have difficulty identifyingthe party responsible for payment of their claims. If a counterparty’s creditbecomes significantly impaired, multiple requests for collateral posting in ashort period of time could increase the risk that we may not receive adequatecollateral. Amounts paid by us as premiums and cash or other assets held inmargin accounts with respect to derivative instruments are not available forinvestment purposes.

 

*CounterpartyRisk*

 

We have credit risks that are generally related to the counterpartieswith which we do business. If a counterparty becomes bankrupt, or otherwise failsto perform its obligations under a derivative contract due to financialdifficulties, we may experience significant delays in obtaining any recoveryunder the derivative contract in a bankruptcy or other reorganizationproceeding. These risks of non-performance may differ from risks associatedwith exchange-traded transactions which are typically backed by guarantees andhave daily marks-to-market and settlement positions. Transactions entered intodirectly between parties do not benefit from such protections and thus, aresubject to counterparty default. It may be the case where any cash orcollateral we pledged to the counterparty may be unrecoverable and we may beforced to unwind our derivative agreements at a loss. We may obtain only alimited recovery or may obtain no recovery in such circumstances, therebyreducing liquidity and earnings.

 

*ManagementEstimates*

 

The preparation of our financial statements requires management to makeestimates and assumptions that affect the amounts reported in our condensedconsolidated financial statements and accompanying notes. Significantestimates, assumptions and judgments are applied in situations including thedetermination of our allowance for loan losses and the valuation of certaininvestments. We revise our estimates when appropriate. However, actual resultscould materially differ from management’s estimates.

 

*InterestRate Risk*

 

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

 

We are exposed to basis risk between our investments and ourborrowings. Interest rates on our floating rate investments and our variablerate borrowings do not reset on the same day or with the same frequency and, asa result, we are exposed to basis risk with respect to index reset frequency.Our floating rate investments may reprice on indices that are different thanthe indices that are used to price our variable rate borrowings and, as aresult, we are exposed to basis risk with respect to repricing index. The basisrisks noted above, in addition to other forms of basis risk that exist betweenour investments and borrowings, may be material and could negatively impactfuture net interest margins.

 

Interest rate risk impacts our interest income, interest expense,prepayments, and the fair value of our investments, interest rate derivatives,and liabilities. We manage our interest rate risk using various techniquesranging from the purchase of floating rate investments to the use of interestrate derivatives. We generally fund our variable rate investments with variablerate borrowings with similar interest rate reset frequencies.

 

The following table summarizes the estimated net fair value of ourderivative instruments held at September 30, 2009 and December 31,2008 (amounts in thousands):

 

**Derivative Fair Value**

 
| ** **                                      | ** ** | **As of  September 30, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|-------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | **Notional**                                 | ** ** | **Estimated  Fair Value**              | ** ** | **Notional** | ** ** | **Estimated  Fair Value** | ** ** |
| **Cash Flow Hedges:**                           |       |                                         |       |                                        |       |   |   |   |   |
| Interest rate swaps                             |       | $                                            | 383,333    |                                        | $          | (53,869 | ) | $ | 383,333 |   | $ | (77,668 | ) |
| **Fair Value Hedges:**                          |       |                                         |       |                                        |       |   |   |   |   |
| Interest rate swaps                             |       | —                                       |       | —                                      |       | 32,000 |   | (2,915 | ) |
| **Free-Standing Derivatives:**                  |       |                                         |       |                                        |       |   |   |   |   |
| Interest rate swaps                             |       | 97,259                                       |       | 277                                         |       | 106,074 |   | 274 |   |
| Credit default swaps—protection sold       |       | 51,000                                       |       | (773                                        | )          | 53,500 |   | (9,782 | ) |
| Credit default swaps— protection purchased |       | —                                       |       | —                                      |       | 222,650 |   | 69,972 |   |
| Total rate of return swaps                      |       | 120,234                                      |       | 20,437                                      |       | 207,524 |   | (77,224 | ) |
| Total                                           |       | $                                            | 651,826    |                                        | $          | (33,928 | ) | $ | 1,005,081 |   | $ | (97,343 | ) |

 

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**Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

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

 

**Item 4. 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 September 30, 2009. Based on their evaluation, the Company’sprincipal executive and principal financial officer concluded that the Company’sdisclosure controls and procedures as of September 30, 2009 were designedand were 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 three and nine months ending September 30,2009, that has materially affected, or is reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

 

**PART II.OTHER INFORMATION**

 

**Item 1. LegalProceedings**

 

We have been named as a party in various legal actions which includethe matters described below. We have denied, or believe we have a meritoriousdefense and will deny liability in the significant cases pending against usdiscussed below. Based on current discussion and consultation with counsel, webelieve that the resolution of these matters will not have a material impact onour financial condition or cash flow.

 

On August 7, 2008,the members of our board of directors and certain of our current andformer executive officers and we were named in a putative class actioncomplaint filed by Charter Township of Clinton Police and Fire RetirementSystem in the United States District Court for the Southern District of NewYork (the “Charter Litigation”). On March 13, 2009, the leadplaintiff filed an Amended Complaint, which deleted as defendants the membersof our board of directors and named as individual defendants only our formerchief executive officer Saturnino S. Fanlo, our former chief operating officerDavid A. Netjes, and our current chief financial officer Jeffrey B. Van Horn(the “Individual Defendants,” and, together with the Company, “Defendants”). The AmendedComplaint alleges that our April 2, 2007 registration statement andprospectus and the financial statements incorporated therein containedmaterial omissions in violation of Section 11 of the Securities Actof 1933, as amended (the “1933 Act”), regarding the risks andpotential losses associated with our real estate-related assets, ourability to finance our real estate-related assets, and the adequacy of ourloss reserves for our real estate-related assets (the “alleged Section 11violation”). The Amended Complaint further alleges that, pursuant to Section 15of the 1933 Act, the Individual Defendants have legal responsibilityfor the alleged Section 11 violation.  On April 27, 2009,Defendants filed a motion to dismiss the Amended Complaint for failure to statea claim under the 1933 Act.

 

On August 15, 2008,the members of our board of directors and our executive officers (the “KosteckaIndividual Defendants”) were named in a shareholder derivative action broughtby Raymond W. Kostecka, a purported shareholder, in the Superior Court ofCalifornia, County of San Francisco (the “California Derivative Action”). Weare named as a nominal defendant. The complaint in the California DerivativeAction asserts claims against the Kostecka Individual Defendants for breachesof fiduciary duty, abuse of control, gross mismanagement, waste of corporateassets, and unjust enrichment in connection with the conduct at issue in theCharter Litigation, including the filing of the April 2, 2007 RegistrationStatement with alleged material misstatements and omissions. By order dated January 8,2009, the Court approved the parties’ stipulation to stay the proceedings inthe California Derivative Action until the Charter Litigation is dismissed onthe pleadings or we file an answer to the Charter Litigation.

 

On March 23, 2009, the members of our board of directors andcertain of our executive officers (the “Haley Individual Defendants”) werenamed in a shareholder derivative action brought by Paul B. Haley, a purportedshareholder, in the United States District Court for the Southern District of NewYork (the “New York Derivative Action”). We are named as a nominal defendant.The complaint in the New York Derivative Action asserts claims against theHaley Individual Defendants for breaches of fiduciary duty, breaches of theduty of full disclosure, and for contribution in connection with the conduct atissue in the Charter Litigation, including the filing of the April 2, 2007registration statement with alleged material misstatements and omissions. Byorder dated June 18, 2009, the Court approved the parties’ stipulation tostay the proceedings in the New York Derivative Action until the CharterLitigation is dismissed on the pleadings or we file an answer to the CharterLitigation.

 

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**Item 1A. Risk Factors**

 

Therehave been no material changes in our risk factors from those disclosed in ourAnnual Report on Form 10-K for the year ended December 31, 2008.

 

**Item 2 *.*Unregistered Sales of Equity Securities andUse of Proceeds**

 

None.

 

**Item 3. DefaultsUpon Senior Securities**

 

None.

 

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

 

None.

 

**Item 5. OtherInformation**

 

None.

 

**Item 6. Exhibits**

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

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, KKR FinancialHoldings LLC has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
| ** **                | ** ** | KKR Financial Holdings LLC                                            |
|---------------------------|------------|-----------------------------------------------------------------------|
| ** **                | ** ** | ** **                                                            |
| **Signature**             | ** ** | **Title**                                                             |
|                      |       |                                                                  |
|                      |       |                                                                  |
| /s/ WILLIAM C.  SONNEBORN |       | Chief Executive Officer  (Principal Executive Officer)                |
| **William  C. Sonneborn** |       |                                                                  |
|                      |       |                                                                  |
|                      |       |                                                                  |
| /s/ JEFFREY B. VAN HORN   |       | Chief Financial Officer  (Principal Financial and Accounting Officer) |
| **Jeffrey  B. Van Horn**  |       |                                                                  |

 

Date: November 5, 2009

 

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