**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 June 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**(State or other jurisdiction of  incorporation or organization)                           | ** ** | **11-3801844**(I.R.S. Employer  Identification No.) |
|-------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|
|                                                                                                  |       |                                                |
| **555 California Street, 50th Floor  San Francisco, CA**(Address of principal executive offices) |       | **94104**(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(Do not check if a smaller reporting company) | Smaller reporting company o |

 

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 August 3, 2009 was 158,139,238.

 

 

 

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**TABLE OF CONTENTS**

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

 

2

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| **PART I.** | **FINANCIAL INFORMATION** |
|------------------|---------------------------|

 

**Item 1. Financial Statements**

 

**KKR Financial Holdings LLC and Subsidiaries**

**CondensedConsolidated Balance Sheets**

**(Unaudited)**

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

 
| ** **                                                                                                                                                                                 | ** ** | **June 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                 |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                  |       | $                       | 114,353    |                        | $          | 41,430 |   |
| Restricted cash and cash equivalents                                                                                                                                                       |       | 288,944                 |       | 1,233,585                   |       |
| Securities available-for-sale, $603,979 and $553,441  pledged as collateral as of June 30, 2009 and December 31, 2008,  respectively                                             |       | 604,916                 |       | 555,965                     |       |
| Corporate loans, net of allowance for loan losses  of $473,202 and $480,775 as of June 30, 2009 and December 31, 2008,  respectively                                             |       | 6,646,440               |       | 7,246,797                   |       |
| Residential mortgage-backed securities, at  estimated fair value, $76,572 and $102,814 pledged as collateral as of  June 30, 2009 and December 31, 2008, respectively       |       | 76,572                  |       | 102,814                     |       |
| Residential mortgage loans, at estimated fair  value                                                                                                                                       |       | 2,218,319               |       | 2,620,021                   |       |
| Corporate loans held for sale                                                                                                                                                              |       | 168,547                 |       | 324,649                     |       |
| Private equity investments, at estimated fair  value                                                                                                                                       |       | 54,016                  |       | 5,287                       |       |
| Derivative assets                                                                                                                                                                          |       | 11,562                  |       | 73,869                      |       |
| Interest and principal receivable                                                                                                                                                          |       | 83,395                  |       | 116,788                     |       |
| Reverse repurchase agreements                                                                                                                                                              |       | 80,344                  |       | 88,252                      |       |
| Other assets                                                                                                                                                                               |       | 98,186                  |       | 105,625                     |       |
| **Total assets**                                                                                                                                                                           |       | $                       | 10,445,594 |                        | $          | 12,515,082 |   |
| **Liabilities**                                                                                                                                                                            |       |                    |       |                        |       |
| Collateralized loan obligation senior secured  notes                                                                                                                                       |       | $                       | 5,793,906  |                        | $          | 7,487,611 |   |
| Collateralized loan obligation junior secured  notes to affiliates                                                                                                                         |       | 632,542                 |       | 655,313                     |       |
| Secured revolving credit facility                                                                                                                                                          |       | 256,597                 |       | 275,633                     |       |
| Convertible senior notes                                                                                                                                                                   |       | 275,800                 |       | 291,500                     |       |
| Junior subordinated notes                                                                                                                                                                  |       | 288,671                 |       | 288,671                     |       |
| Residential mortgage-backed securities issued, at  estimated fair value                                                                                                                    |       | 2,080,592               |       | 2,462,882                   |       |
| Accounts payable, accrued expenses and other  liabilities                                                                                                                                  |       | 37,694                  |       | 60,124                      |       |
| Accrued interest payable                                                                                                                                                                   |       | 34,602                  |       | 61,119                      |       |
| Accrued interest payable to affiliates                                                                                                                                                     |       | 3,245                   |       | 3,987                       |       |
| Related party payable                                                                                                                                                                      |       | 5,960                   |       | 2,876                       |       |
| Securities sold, not yet purchased                                                                                                                                                         |       | 77,637                  |       | 90,809                      |       |
| Derivative liabilities                                                                                                                                                                     |       | 58,734                  |       | 171,212                     |       |
| **Total liabilities**                                                                                                                                                                      |       | 9,545,980               |       | 11,851,737                  |       |
| **Shareholders’ Equity**                                                                                                                                                              |       |                    |       |                        |       |
| Preferred shares, no par value, 50,000,000 shares  authorized and none issued and outstanding at June 30, 2009 and  December 31, 2008                                            |       | —                  |       | —                      |       |
| Common shares, no par value, 500,000,000 shares  authorized, and 158,139,238 and 150,881,500 shares issued and outstanding at  June 30, 2009 and December 31, 2008, respectively |       | —                  |       | —                      |       |
| Paid-in-capital                                                                                                                                                                            |       | 2,559,898               |       | 2,550,849                   |       |
| Accumulated other comprehensive loss                                                                                                                                                       |       | (49,195                 | )          | (268,782                    | )          |
| Accumulated deficit                                                                                                                                                                        |       | (1,611,089              | )          | (1,618,722                  | )          |
| **Total shareholders’ equity**                                                                                                                                                        |       | 899,614                 |       | 663,345                     |       |
| **Total liabilities and  shareholders’ equity**                                                                                                                                       |       | $                       | 10,445,594 |                        | $          | 12,515,082 |   |

 

See notes to condensedconsolidated financial statements.

 

3

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**KKRFinancial Holdings LLC and Subsidiaries**

**CondensedConsolidated Statements of Operations**

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

** **
| ** **                                                                                                                                                                                   | ** ** | **For the three  months ended  June 30, 2009** | ** ** | **For the three  months ended  June 30, 2008** | ** ** | **For the six  months ended  June 30, 2009** | ** ** | **For the six  months ended  June 30, 2008** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| **Net investment income:**                                                                                                                                                                   | ** ** | ** **                                                         | ** ** | ** **                                                         | ** ** | ** **                                                       | ** ** | ** **                                                       | ** ** |
| Securities interest income                                                                                                                                                                   |       | $                                                                  | 23,252     |                                                               | $          | 34,788                                                           |       | $                                                                | 52,104     |   | $ | 74,597 |   |
| Loan interest income                                                                                                                                                                         |       | 121,919                                                            |       | 184,550                                                            |       | 251,123                                                          |       | 401,087                                                          |       |
| Dividend income                                                                                                                                                                              |       | 26                                                                 |       | 1,092                                                              |       | 287                                                              |       | 1,908                                                            |       |
| Other interest income                                                                                                                                                                        |       | 106                                                                |       | 4,998                                                              |       | 462                                                              |       | 16,074                                                           |       |
| Total investment income                                                                                                                                                                      |       | 145,303                                                            |       | 225,428                                                            |       | 303,976                                                          |       | 493,666                                                          |       |
| Interest expense                                                                                                                                                                             |       | (72,403                                                            | )          | (128,037                                                           | )          | (162,285                                                         | )          | (282,102                                                         | )          |
| Interest expense to affiliates                                                                                                                                                               |       | (5,379                                                             | )          | (19,707                                                            | )          | (11,184                                                          | )          | (47,525                                                          | )          |
| Provision for loan losses                                                                                                                                                                    |       | (12,808                                                            | )          | (10,000                                                            | )          | (39,795                                                          | )          | (10,000                                                          | )          |
| Net investment income                                                                                                                                                                        |       | 54,713                                                             |       | 67,684                                                             |       | 90,712                                                           |       | 154,039                                                          |       |
| **Other loss:**                                                                                                                                                                              | ** ** | ** **                                                         | ** ** | ** **                                                         | ** ** | ** **                                                       | ** ** | ** **                                                       | ** ** |
| Net realized and unrealized gain (loss) on derivatives  and foreign exchange                                                                                                                 |       | 26,505                                                             |       | (5,918                                                             | )          | 38,901                                                           |       | (52,934                                                          | )          |
| Net realized and unrealized loss on investments                                                                                                                                              |       | (46,553                                                            | )          | (17,217                                                            | )          | (106,757                                                         | )          | (30,976                                                          | )          |
| Net realized and unrealized loss on residential  mortgage-backed securities, residential mortgage loans, and residential  mortgage-backed securities issued, carried at estimated fair value |       | (7,445                                                             | )          | (5,594                                                             | )          | (26,864                                                          | )          | (14,772                                                          | )          |
| Net realized and unrealized gain on securities  sold, not yet purchased                                                                                                                      |       | 2,479                                                              |       | 1,664                                                              |       | 3,916                                                            |       | 8,650                                                            |       |
| Gain on restructuring and extinguishment of debt                                                                                                                                             |       | 6,892                                                              |       | 17,225                                                             |       | 41,463                                                           |       | 17,225                                                           |       |
| Other income                                                                                                                                                                                 |       | 1,578                                                              |       | 513                                                                |       | 2,911                                                            |       | 5,469                                                            |       |
| Total other loss                                                                                                                                                                             |       | (16,544                                                            | )          | (9,327                                                             | )          | (46,430                                                          | )          | (67,338                                                          | )          |
| **Non-investment expenses:**                                                                                                                                                                 | ** ** | ** **                                                         | ** ** | ** **                                                         | ** ** | ** **                                                       | ** ** | ** **                                                       | ** ** |
| Related party management compensation                                                                                                                                                        |       | 10,304                                                             |       | 10,387                                                             |       | 21,516                                                           |       | 19,546                                                           |       |
| General, administrative and directors expenses                                                                                                                                               |       | 2,975                                                              |       | 5,752                                                              |       | 5,378                                                            |       | 10,274                                                           |       |
| Professional services                                                                                                                                                                        |       | 2,090                                                              |       | 1,071                                                              |       | 5,475                                                            |       | 2,928                                                            |       |
| Loan servicing                                                                                                                                                                               |       | 2,056                                                              |       | 2,391                                                              |       | 4,192                                                            |       | 4,960                                                            |       |
| Total non-investment expenses                                                                                                                                                                |       | 17,425                                                             |       | 19,601                                                             |       | 36,561                                                           |       | 37,708                                                           |       |
| Income from continuing operations before income  tax expense                                                                                                                                 |       | 20,744                                                             |       | 38,756                                                             |       | 7,721                                                            |       | 48,993                                                           |       |
| Income tax expense                                                                                                                                                                           |       | (135                                                               | )          | (116                                                               | )          | (88                                                              | )          | (116                                                             | )          |
| Income from continuing operations                                                                                                                                                            |       | 20,609                                                             |       | 38,640                                                             |       | 7,633                                                            |       | 48,877                                                           |       |
| (Loss) income from discontinued operations                                                                                                                                                   |       | —                                                             |       | (1,079                                                             | )          | —                                                           |       | 2,668                                                            |       |
| Net income                                                                                                                                                                                   |       | $                                                                  | 20,609     |                                                               | $          | 37,561                                                           |       | $                                                                | 7,633      |   | $ | 51,545 |   |
|                                                                                                                                                                                         |       |                                                               |       |                                                               |       |                                                             |       |                                                             |       |
| Net income per common share:                                                                                                                                                                 |       |                                                               |       |                                                               |       |                                                             |       |                                                             |       |
| Basic                                                                                                                                                                                        |       |                                                               |       |                                                               |       |                                                             |       |                                                             |       |
| Income per share from continuing operations                                                                                                                                                  |       | $                                                                  | 0.14       |                                                               | $          | 0.25                                                             |       | $                                                                | 0.05       |   | $ | 0.38 |   |
| Income per share from discontinued operations                                                                                                                                                |       | $                                                                  | —     |                                                               | $          | —                                                           |       | $                                                                | —     |   | $ | 0.02 |   |
| Net income per share                                                                                                                                                                         |       | $                                                                  | 0.14       |                                                               | $          | 0.25                                                             |       | $                                                                | 0.05       |   | $ | 0.40 |   |
| Diluted                                                                                                                                                                                      |       |                                                               |       |                                                               |       |                                                             |       |                                                             |       |
| Income per share from continuing operations                                                                                                                                                  |       | $                                                                  | 0.14       |                                                               | $          | 0.25                                                             |       | $                                                                | 0.05       |   | $ | 0.37 |   |
| Income per share from discontinued operations                                                                                                                                                |       | $                                                                  | —     |                                                               | $          | —                                                           |       | $                                                                | —     |   | $ | 0.02 |   |
| Net income per share                                                                                                                                                                         |       | $                                                                  | 0.14       |                                                               | $          | 0.25                                                             |       | $                                                                | 0.05       |   | $ | 0.39 |   |
|                                                                                                                                                                                         |       |                                                               |       |                                                               |       |                                                             |       |                                                             |       |
| Weighted-average number of common shares  outstanding:                                                                                                                                       |       |                                                               |       |                                                               |       |                                                             |       |                                                             |       |
| Basic                                                                                                                                                                                        |       | 151,202                                                            |       | 146,025                                                            |       | 150,462                                                          |       | 130,289                                                          |       |
| Diluted                                                                                                                                                                                      |       | 151,202                                                            |       | 146,025                                                            |       | 150,462                                                          |       | 130,289                                                          |       |

 

See notes to condensedconsolidated financial statements.

 

4

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**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** | ** ** | **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                                                            |       | —             |       | —               |       | —                                          |       | 7,633                    |       | $                         | 7,633      |                                  | 7,633      |   |
| Net change in unrealized loss on cash flow hedges                     |       | —             |       | —               |       | 31,991                                          |       | —                   |       | 31,991                    |       | 31,991                                |       |
| Net change in unrealized loss on securities  available-for-sale       |       | —             |       | —               |       | 187,596                                         |       | —                   |       | 187,596                   |       | 187,596                               |       |
| Comprehensive income                                                  |       |               |       |                 |       |                                            |       |                     |       | $                         | 227,220    |                                  |       |   |
| Issuance of common shares                                             |       | 7,258              |       | 8,808                |       | —                                          |       | —                   |       |                      |       | 8,808                                 |       |
| Share-based compensation expense related to  restricted common shares |       | —             |       | 241                  |       | —                                          |       | —                   |       |                      |       | 241                                   |       |
| **Balance at June 30, 2009**                                     |       | 158,139            |       | $                    | 2,559,898  |                                            | $          | (49,195                  | )          | $                         | (1,611,089 | )                                     |       |   | $ | 899,614 |   |

 

See notes tocondensed consolidated financial statements.

 

5

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**KKR Financial Holdings LLC and Subsidiaries**

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

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

 
| ** **                                                                                                                                               | ** ** | **For the six months  ended June 30, 2009** | ** ** | **For the six months  ended June 30, 2008** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| **Cash flows from operating activities:**                                                                                                                |       |                                             |       |                                             |       |
| Net  income                                                                                                                                              |       | $                                                | 7,633      |                                             | $          | 51,545 |   |
| 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                                       |       | (42,817                                          | )          | 44,284                                           |       |
| Gain on restructuring and extinguishment of debt                                                                                                         |       | (41,463                                          | )          | (17,225                                          | )          |
| Write-off  of debt issuance costs                                                                                                                        |       | 112                                              |       | 1,071                                            |       |
| Lower  of cost or estimated fair value adjustment on corporate loans held for sale                                                                       |       | 39,728                                           |       | 2,637                                            |       |
| Provision  for loan losses                                                                                                                               |       | 39,795                                           |       | 10,000                                           |       |
| Impairment  on securities available-for-sale                                                                                                             |       | 40,013                                           |       | 9,688                                            |       |
| Share-based  compensation                                                                                                                                |       | 241                                              |       | 1,013                                            |       |
| Net realized  and unrealized loss (gain) on residential mortgage-backed securities,  residential mortgage loans, and liabilities at estimated fair value |       | 26,864                                           |       | (4,824                                           | )          |
| Net  realized and unrealized loss on investments                                                                                                         |       | 27,016                                           |       | 20,150                                           |       |
| Depreciation  and net amortization                                                                                                                       |       | (23,753                                          | )          | (14,516                                          | )          |
| Changes  in assets and liabilities:                                                                                                                      |       |                                             |       |                                             |       |
| Interest  and principal receivable                                                                                                                       |       | 39,238                                           |       | 41,049                                           |       |
| Other  assets                                                                                                                                            |       | (11,382                                          | )          | (7,325                                           | )          |
| Related  party payable                                                                                                                                   |       | 3,084                                            |       | (4,255                                           | )          |
| Accounts  payable, accrued expenses and other liabilities                                                                                                |       | (50,670                                          | )          | (43,223                                          | )          |
| Accrued  interest payable                                                                                                                                |       | (20,070                                          | )          | (16,808                                          | )          |
| Accrued  interest payable to affiliates                                                                                                                  |       | 11,058                                           |       | 36,614                                           |       |
| Net  cash provided by operating activities                                                                                                               |       | 44,627                                           |       | 109,875                                          |       |
| **Cash flows from investing activities:**                                                                                                                |       |                                             |       |                                             |       |
| Principal  payments from investments                                                                                                                     |       | 517,202                                          |       | 966,000                                          |       |
| Proceeds  from sale of investments                                                                                                                       |       | 1,001,814                                        |       | 823,721                                          |       |
| Purchases  of investments                                                                                                                                |       | (473,596                                         | )          | (1,337,887                                       | )          |
| Net  proceeds, purchases, and settlements of derivatives                                                                                                 |       | 20,099                                           |       | 18,131                                           |       |
| Net  change in reverse repurchase agreements                                                                                                             |       | 7,908                                            |       | 69,840                                           |       |
| Net  reductions to restricted cash and cash equivalents                                                                                                  |       | 944,641                                          |       | 337,847                                          |       |
| Net  cash provided by investing activities                                                                                                               |       | 2,018,068                                        |       | 877,652                                          |       |
| **Cash flows from financing activities:**                                                                                                                |       |                                             |       |                                             |       |
| Net  change in repurchase agreements, secured revolving credit facility, and  secured demand loan                                                        |       | (19,036                                          | )          | (2,620,935                                       | )          |
| Net  change in asset-backed secured liquidity notes                                                                                                      |       | —                                           |       | (136,596                                         | )          |
| Repayment  of residential mortgage-backed securities issued                                                                                              |       | (269,238                                         | )          | (363,500                                         | )          |
| Repayment  of collateralized loan obligation senior secured notes                                                                                        |       | (1,700,860                                       | )          | —                                           |       |
| Issuance  of collateralized loan obligation senior secured notes                                                                                         |       | —                                           |       | 1,600,000                                        |       |
| Net  change in subordinated notes to affiliates                                                                                                          |       | —                                           |       | (47,880                                          | )          |
| Net  change in junior subordinated notes                                                                                                                 |       | —                                           |       | (18,857                                          | )          |
| Net  proceeds from common share offering                                                                                                                 |       | —                                           |       | 383,631                                          |       |
| Distributions  on common shares                                                                                                                          |       | —                                           |       | (117,958                                         | )          |
| Other  capitalized costs                                                                                                                                 |       | (638                                             | )          | (504                                             | )          |
| Net  cash used in financing activities                                                                                                                   |       | (1,989,772                                       | )          | (1,322,599                                       | )          |
| **Net increase (decrease) in cash and cash  equivalents**                                                                                                |       | 72,923                                           |       | (335,072                                         | )          |
| **Cash and cash equivalents at beginning of period**                                                                                                     |       | 41,430                                           |       | 524,080                                          |       |
| **Cash and cash equivalents at end of period**                                                                                                           |       | $                                                | 114,353    |                                             | $          | 189,008 |   |
| **Supplemental cash flow information:**                                                                                                                  |       |                                             |       |                                             |       |
| Cash  paid for interest                                                                                                                                  |       | $                                                | 183,550    |                                             | $          | 357,894 |   |
| Cash  paid for income taxes                                                                                                                              |       | $                                                | 373        |                                             | $          | 99 |   |
| **Non-cash investing and financing activities:**                                                                                                         |       |                                             |       |                                             |       |
| Net  payable (receivable) for securities purchased                                                                                                       |       | $                                                | 28,238     |                                             | $          | (660 | ) |
| Conversion  from corporate loans to corporate securities                                                                                                 |       | $                                                | —     |                                             | $          | 228,350 |   |
| 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      |                                             | $          | — |   |

 

See notes to condensed consolidated financial statements.

 

6

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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 ofreturn swaps. The corporate loans the Company invests in are generally referredto as syndicated bank loans, or leveraged loans, and are purchased viaassignment or participation in either the primary or secondary market. Themajority of the Company’s corporate debt investments are held in collateralizedloan obligation (“CLO”) transactions that the Company uses as long termfinancing for these investments. The Company’s CLO transactions are structuredas on-balance sheet securitizations of corporate loans and high yield debtsecurities. The senior secured notes issued by the CLO transactions aregenerally owned by third party investors who are unaffiliated with the Company and the Company owns the majority ofthe mezzanine and subordinated 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 covenantscontained in its borrowing agreements.

 

KKR Financial Advisors LLC (the “Manager”), a wholly ownedsubsidiary 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 Companyevaluates subsequent events through the date that the financial statements areissued on August 6, 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.

 

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**Consolidation**

 

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

 

KKR Financial CLO 2005-1, Ltd. (“CLO2005-1”), KKR Financial CLO 2005-2, Ltd. (“CLO 2005-2”), KKRFinancial CLO 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 Statement of Financial Accounting Standards No. 140,*Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities* (“SFAS No. 140”).The Company has determined it is the primary beneficiary of these entities andhas included the accounts of these entities in these condensed consolidatedfinancial statements. Additionally, the Company is the primary beneficiary ofsix residential mortgage loan securitization trusts that are not considered tobe QSPEs under SFAS No. 140 and the Company has therefore included theaccounts of these entities in these condensed consolidated financialstatements.

 

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

 

**Fair Value of Financial Instruments**

 

As defined in SFAS No. 157, *FairValue Measurements* (“SFAS No. 157”), fair value is the pricethat would be received to sell an asset or paid to transfer a liability in anorderly transaction 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, as defined in SFASNo. 157 and directly related to the amount of subjectivity associated withthe inputs to fair valuations of these assets and liabilities, are as follows:

 

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

 

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

 

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

 

Fair value assets and liabilities that are generally included in thiscategory are certain corporate debt securities, 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.

 

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Inthe second quarter of 2009, the Company adopted Financial Accounting StandardsBoard’s Staff Position (“FSP”) FAS 157-4, *Determining Fair ValueWhen the Volume and Level of Activity for the Asset or Liability HaveSignificantly Decreased and Identifying Transactions That Are Not Orderly*(“FSPFAS 157-4”). This FSP provides additional guidance on determining fair valuewhen the volume and level of activity for the asset or liability havesignificantly decreased when compared with normal market activity for the assetor liability (or similar assets or liabilities). A significant decrease in thevolume and level of activity for the asset or liability is an indication thattransactions or quoted prices may not be determinative of fair value because insuch market conditions there may be increased instances of transactions thatare not orderly. In those circumstances, further analysis of transactions orquoted prices is needed, and a significant adjustment to the transactions orquoted prices may be necessary to estimate fair value in accordance with SFAS No. 157.The adoption of FSP FAS 157-4 did nothave a material impact on the Company’s condensed consolidated financialstatements.

 

Ifthere has been a significant decrease in the volume and level of activity forthe asset or liability, a change in valuation technique or the use of multiplevaluation techniques may be appropriate (for example, the use of a marketapproach and a present value technique). When weighting indications of fair value resulting from the use ofmultiple valuation techniques, a reporting entity shall consider thereasonableness of the range of fair value estimates. The objective is todetermine the point within that range that is most representative of fair valueunder current market conditions. A wide range of fair value estimates may be anindication that further analysis is needed.

 

Regardless of the approach taken (i.e. either asingle valuation technique or multiple valuation techniques), even incircumstances where there has been a significant decrease in the volume andlevel of activity for the asset or liability and regardless of the valuationtechnique(s) used, the objective of a fair value measurement remains thesame. Fair value is the price that would be received to sell an asset or paidto transfer a liability in an orderly transaction (that is, not a forcedliquidation or distressed sale) between market participants at the measurementdate under current market conditions. Determining the price at which willingmarket participants would transact at the measurement date under current marketconditions if there has been a significant decrease in the volume and level ofactivity for the asset or liability depends on the facts and circumstances andrequires the use of significant judgment. However, a reporting entity’sintention to hold the asset or liability is not relevant in estimating fairvalue. Fair value is a market-based measurement, not an entity-specificmeasurement

 

The FSP also emphasizes that in identifyingtransactions that are not orderly, an entity cannot assume that the observabletransaction price is not orderly when the volume and level of activity for theasset or liability have significantly declined. Instead, an entity must performan analysis to determine whether the observable price is representative of atransaction that is not orderly. In making this determination, an entity cannotignore information that is available without undue cost and effort; however,the entity is not required to undertake all possible efforts. A reportingentity shall evaluate the circumstances to determine whether the transaction isorderly based on the weight of the evidence.

 

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.Assets and liabilities that are valued using level 3 of the fair valuehierarchy primarily consist of certain corporate debt securities, certainprivate equity investments, certain corporate loans held for sale, residentialmortgage-backed securities, residential mortgage loans, residentialmortgage-backed securities issued and certain over-the-counter (“OTC”)derivative contracts. The valuation techniques used for these are describedbelow.

 

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*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. Valuationsmodels 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 similar issuers.

 

*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.

 

**Residential Mortgage-Backed Securities**

 

The Company carries its residential mortgage-backed securities atestimated fair value, with unrealized gains and losses reported in income.

 

**Securities Available-for-Sale**

 

The Company classifies its investments in securities as available-for-saleas the Company may sell them prior to maturity and does not hold themprincipally for the purpose of selling them in the near term. These investmentsare carried at estimated fair value, with unrealized gains and losses reportedin accumulated other comprehensive income (loss). Estimated fair values arebased on quoted market prices, when available, on estimates provided byindependent pricing sources or dealers who make markets in such securities, orinternal valuation models when external sources of fair value are notavailable. Upon the sale of a security, the realized net gain or loss iscomputed 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 debtsecurities, the Company considers its intent to sell the debt security, theCompany’s estimation of whether or not it expects to recover the debt security’sentire amortized cost if it intends to hold the debt security, and whether itis more likely than not that the Company will be required to sell the debtsecurity before its anticipated recovery. For equity securities, the Companyalso considers its intent and ability to hold the equity security for a periodof time sufficient for a recovery in value.

 

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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 FSP FAS 115-2 and FAS 124-2,*Recognition andPresentation of Other-Than-Temporary Impairments*(“FSP FAS 115-2 andFAS 124-2”), which amends the other-than-temporary impairment guidance for debtsecurities. The adoption of FSP FAS 115-2 and FAS 124-2 did not have a materialimpact on the Company’s condensed consolidated financial statements.

 

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 reviews 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.

 

**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.

 

**Residential Mortgage Loans**

 

The Company carries its residential mortgage loans at estimated fairvalue, with unrealized gains and losses reported in income.

 

**Corporate Loans Held for Sale**

 

Corporate loans held for sale consist of leveraged loans that the Companyhas determined to no longer hold for investment. Corporate loans held for saleare stated at lower of cost or estimated fair value.

 

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**Allowance for Loan Losses**

 

The Company’s allowance for estimated loan losses represents itsestimate of probable credit losses inherent in its corporate loan portfolioheld for investment as of the balance sheet date. When determining the adequacyof the allowance for loan losses, the Company considers historical and industryloss experience, economic conditions and trends, the estimated fair values ofits loans, credit quality trends and other factors that it determines arerelevant. Additions to the allowance for loan losses are charged to currentperiod earnings through the provision for loan losses. The Company’s allowancefor loan losses consists of two components, an allocated component and anunallocated component. Amounts determined to be uncollectible are chargeddirectly to the allowance for loan losses.

 

The allocated component of the Company’s allowance for loan lossesconsists of individual loans that are impaired and for which the estimatedallowance for loan losses is determined in accordance with SFAS No. 114, *Accounting by Creditors for Impairment of a Loan.*The Company considers a loan to be impaired when, based on current informationand events, it believes it is probable that it will be unable to collect allamounts due to it based on the contractual terms of the loan. An impaired loanmay be left on accrual status during the period the Company is pursuingrepayment of the loan; however, the loan is placed on non-accrual status atsuch time as: (i) management believes that scheduled debt service paymentsmay not be paid when contractually due; (ii) the loan becomes 90 daysdelinquent; (iii) management determines the borrower is incapable of, orhas ceased efforts toward, curing the cause of the impairment; or (iv) thenet realizable value of the underlying collateral securing the loan decreasesbelow the Company’s carrying value of such loan. While on non-accrual status,previously recognized accrued interest is reversed if it is determined thatsuch amounts are not collectible and interest income is recognized only uponactual receipt.

 

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

 

**Leasehold Improvements and Equipment**

 

Leasehold improvements and equipment are carried at cost lessdepreciation and amortization and 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 othersecured and unsecured borrowings. The Company recognizes interest expense onall borrowings on an accrual basis.

 

**Residential Mortgage-Backed Securities Issued**

 

The Company carries its residential mortgage-backed securities issuedat estimated fair value, with unrealized gains and losses reported in income.

 

**Trust Preferred Securities**

 

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

 

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**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, as required by SFAS No. 133, *Accounting for Derivative Instruments and Hedging Activities*,as amended and interpreted (“SFAS No. 133”), the Company also formallyassesses whether the derivative it designated in each hedging relationship isexpected to be and has been highly effective in offsetting changes in estimatedfair values or cash flows of the hedged item using either the dollar offset orthe regression analysis method. If the Company determines that a derivative isnot highly effective as a hedge, it discontinues hedge accounting.

 

**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 thecurrency risk, the Company may hedge the applicable foreign currency. Allinvestments denominated in a foreign currency are converted to the UnitedStates dollar using prevailing exchange rates on the balance sheet date.Income, expenses, gains and losses on investments denominated in a foreigncurrency are converted to the United States dollar using the prevailingexchange rates on the dates when they are recorded. Foreign exchange gains andlosses are recorded in the condensed consolidated statements of operations.

 

**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 15 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 and expensedduring 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 the fair value based methodology prescribedby SFAS No. 123(R),*Share-BasedPayment* (“SFAS No. 123(R)”).Compensation cost related torestricted commonshares issued to the Company’s directors ismeasured at its estimated fair value atthe grant date, and isamortized and expensed over thevesting period on a straight-linebasis. 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 pursuant to SFAS No. 123(R) to amortizecompensation expense for the restricted common shares and common share optionsgranted 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.

 

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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, CLO 2007-1,CLO 2007-A and CLO 2009-1 are foreign subsidiaries of the Company that electedto be treated as disregarded entities or partnerships for United States federalincome tax purposes. These subsidiaries were established to facilitatesecuritization transactions, structured as secured financing transactions. TRS Ltd.and KFH Ltd. are foreign corporate subsidiaries that were formed to makecertain foreign and domestic investments from time to time. TRS Ltd. and KFH Ltd.are organized as exempted companies incorporated with limited liability underthe laws of the Cayman Islands, and are generally exempt from United Statesfederal 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**

 

In accordance with SFAS No. 128, *Earningsper Share* (“SFAS No. 128”), the Company presents both basic anddiluted earnings (loss) per common share in its condensed consolidatedfinancial statements and footnotes thereto. Basic earnings (loss) per commonshare (“Basic EPS”) excludes dilution and is computed by dividing net income orloss by the weighted-average number of common shares, including vestedrestricted common shares, outstanding for the period. Diluted earnings (loss)per share (“Diluted EPS”) reflects the potential dilution of common shareoptions and unvested restricted common shares using the treasury method, andthe potential dilution of convertible senior notes using the if-convertedmethod, if they are not anti-dilutive. See Note 3 to these condensedconsolidated financial statements for earnings (loss) per common sharecomputations.

 

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 FSP Emerging Issues Task Force (“EITF”)99-20-1, *Amendments to the ImpairmentGuidance of EITF Issue No. 99-20* (“FSP EITF 99-20-1”). FSP EITF 99-20-1eliminates 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. FSP EITF 99-20-1 also reiterates andemphasizes the related guidance and disclosure requirements in accordance withSFAS No. 115, *Accounting for CertainInvestments in Debt and Equity Securities.* FSP EITF 99-20-1 iseffective for all periods ending after December 15, 2008 and retroactiveapplication is not permitted. The Company has taken this FSP into considerationwhen evaluating its investments for other-than-temporary impairment.

 

On June 12, 2009, theFASB issued SFAS No. 166, *Accounting for Transfersof Financial Assets, an amendment of FASB Statement No. 140, Accounting forTransfers and Servicing of Financial Assets and Extinguishments of Liabilities*(“SFASNo. 140”) (collectively “SFAS No. 166”). The most significant amendments thatSFAS No. 166 makes consist of the removal of the concept of a qualifyingspecial-purpose entity (“QSPE”) from SFAS No. 140, and the elimination of theexception for QSPE from the consolidation guidance of FIN 46R. The disclosuresrequired by this standard are to provide greater transparency about transfersof financial assets and an entity’s continuing involvement in transferredfinancial assets. SFAS No. 166 will significantly affect existingsecuritizations that use QSPEs, as well as future securitizations. SFAS No. 166is effective January 1, 2010 for calendar-year reporting entities and earlierapplication is prohibited. The Company is evaluating the impact ofadopting SFAS No. 166.

 

Also on June 12, 2009,the FASB issued SFAS No. 167, *Amendment to FASBInterpretation No. 46(R)*(“SFAS No. 167”) which addresses theeffects of elimination of the QSPE concept from SFAS No. 140 and responds toconcerns about the application of certain key provisions of FIN 46R includingconcerns over the transparency of enterprises’ involvement with VIEs. SFAS No. 167requires additional disclosures for various areas including situations that usesignificant judgment and assumptions in determining whether or not toconsolidate a VIE as well as the nature of and changes in the risks associatedwith a VIE. This standard is effective for calendar year-end companiesbeginning on January 1, 2010. The Company is evaluating the impact of adoptingSFAS No. 167.

 

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On June 29, 2009,the FASB issued SFAS No. 168, *TheFASBAccounting Standards Codificationand the Hierarchy of Generally Accepted Accounting Principles—a replacement ofFASB Statement No. 162* (“SFAS No. 168”). The FASB AccountingStandards Codification (Codification) will become the single official source ofauthoritative GAAP. The current GAAP hierarchy consists of four levels ofauthoritative accounting and reporting guidance (levels A through D), includingoriginal pronouncements of the FASB, FASB FSPs, EITF abstracts, and otheraccounting literature (“pre-Codification GAAP” or “current GAAP”). TheCodification eliminates this hierarchy and replaces current GAAP (other than rulesand interpretive releases of the SEC) with just two levels of literature:authoritative and nonauthoritative. The Codification will be effective forinterim and annual periods ending on or after September 15, 2009. The Companydoes not believe that the adoption of SFAS No. 168 will have a material impacton its financial statements.

 

**Note 3. Earnings per Share**

 

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.

 

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 six months ended June 30, 2009 and 2008 (amounts inthousands, except per share information):

 
| ** **                                                             | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|------------------------------------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                                             | ** ** | **2009(1)**                     | ** ** | **2008(1)**                   | ** ** | **2009(1)** | ** ** | **2008(1)** | ** ** |
| Income from continuing operations                                      |       | $                               | 20,452     |                          | $          | 38,185 |   | $ | 7,574 |   | $ | 48,172 |   |
| (Loss) income from discontinued operations                             |       | —                          |       | (1,079                        | )          | — |   | 2,668 |   |
| Net income                                                             |       | $                               | 20,452     |                          | $          | 37,106 |   | $ | 7,574 |   | $ | 50,840 |   |
| **Basic:**                                                             |       |                            |       |                          |       |   |   |   |   |
| Basic weighted-average shares outstanding                              |       | 151,202                         |       | 146,025                       |       | 150,462 |   | 130,289 |   |
| Income per share from continuing operations                            |       | $                               | 0.14       |                          | $          | 0.25 |   | $ | 0.05 |   | $ | 0.38 |   |
| Income per share from discontinued operations                          |       | $                               | —     |                          | $          | — |   | $ | — |   | $ | 0.02 |   |
| Net income per share                                                   |       | $                               | 0.14       |                          | $          | 0.25 |   | $ | 0.05 |   | $ | 0.40 |   |
| **Diluted:**                                                           |       |                            |       |                          |       |   |   |   |   |
| Basic weighted-average shares outstanding                              |       | 151,202                         |       | 146,025                       |       | 150,462 |   | 130,289 |   |
| Dilutive effect of restricted common shares using  the treasury method |       | —                          |       | —                        |       | — |   | — |   |
| Diluted weighted-average shares outstanding (2)                        |       | 151,202                         |       | 146,025                       |       | 150,462 |   | 130,289 |   |
| Income per share from continuing operations                            |       | $                               | 0.14       |                          | $          | 0.25 |   | $ | 0.05 |   | $ | 0.37 |   |
| Income per share from discontinued operations                          |       | $                               | —     |                          | $          | — |   | $ | — |   | $ | 0.02 |   |
| Net income per share                                                   |       | $                               | 0.14       |                          | $          | 0.25 |   | $ | 0.05 |   | $ | 0.39 |   |
| Distributions declared per common share                                |       | $                               | —     |                          | $          | 0.40 |   | $ | — |   | $ | 0.90 |   |

 

----

(1)                                  Effective January1, 2009, the Company adopted FSP No. EITF 03-6-1, *DeterminingWhether Instruments Granted in Share-Based Payment Transactions areParticipating Securities*(“FSP No. EITF 03-6-1”). According to thisFSP, unvested share-based payment awards that contain non-forfeitable rights todividends or dividend equivalents (whether paid or unpaid) are participatingsecurities and shall be included in the computation of earnings per sharepursuant to the two-class method.  Nodividend was declared on common shares for the three and six months ended June 30,2009. Prior periods have been adjusted in accordance with FSP No. EITF 03-6-1.

 

(2)                                  Potentialanti-dilutive common shares excluded from diluted income earnings per share forthe three and six months ended June 30, 2009 were 9,293,240 and 9,347,934,respectively, related to convertible debt securities and 1,932,279 related tocommon share options.  Potentialanti-dilutive common shares excluded from diluted income earnings per share forboth the three and six months ended June 30, 2008 were 9,667,430 related toconvertible debt securities and 1,932,279 related to common share options.

 

15

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**Note 4. Private Equity Investments**

 

As of June 30, 2009, the Company had private equity investments carriedat cost of $17.5 million and two private equity investments carried atestimated fair value of $54.0 million. As of December 31, 2008, the Company hadprivate equity investments at cost of $17.5 million and private equityinvestments at estimated fair value of $5.3 million. During the second quarterof 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 in accordance with SFAS No. 159, with unrealized gains and lossesreported in income.

 

As of June 30, 2009 and December 31, 2008, the Company had $41.8 millionand $5.3 million of private equity investments carried at fair value,respectively, pledged as collateral for collateralized loan obligation seniorsecured notes and junior secured notes to affiliates.

 

For both the three and six months ended June 30, 2009, the Company hadnet realized and unrealized gains of $0.3 million on private equity investmentscarried at estimated fair value. There was no net realized and unrealized gainor loss for the three and six months ended June 30, 2008.

 

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

 

Thefollowing table summarizes the Company’s securities classified asavailable-for-sale as of June 30, 2009, which are carried at estimated fairvalue (amounts in thousands):

 
| **Description**            | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
|----------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|---------------------------|------------|
| Corporate debt securities  |       | $                   | 606,568    |                         | $          | 66,783                        |       | $                         | (69,372    | ) | $ | 603,979 |   |
| Common and preferred stock |       | 732                 |       | 205                          |       | —                        |       | 937                       |       |
| Total                      |       | $                   | 607,300    |                         | $          | 66,988                        |       | $                         | (69,372    | ) | $ | 604,916 |   |

 

The following table shows the gross unrealized losses and fair value ofthe Company’s available-for-sale securities, aggregated by length of time thatthe individual securities have been in a continuous unrealized loss position,as of June 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 |       | $                         | 82,358     |                   | $          | (10,323                   | )          | $ | 273,304 |   | $ | (59,049 | ) | $ | 355,662 |   | $ | (69,372 | ) |
|                           |            |                           |            |                        |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Theunrealized losses in the table above are considered to be temporary impairmentsdue to market factors and are not reflective of credit deterioration.  The Company considers many factors whenevaluating whether an impairment is other-than-temporary. For corporate debtsecurities included in the table above, the Company does not intend to sellthem and does not believe that it is more likely than not that the Company willbe required to sell any of its corporate debt securities prior to recovery. Inaddition, based on the analyses performed by the Company on each of itscorporate debt securities, it believes that it will be able to recover theentire amortized cost amount of the corporate debt securities included in thetable above.

 

During the three and six months ended June 30, 2009, the Companyrecognized a loss totaling $6.2 million and $40.0 million, respectively, forcorporate debt securities that it determined to be other-than-temporarilyimpaired based on the criteria above. The Company intends to sell thesesecurities and as a result the entire amount is recorded through earnings innet realized and unrealized (loss) gain on investments in the condensedconsolidated statements of operations.

 

As of June 30, 2009 and December 31, 2008, the Company held onecorporate debt security that was in default with a total fair value of $3.7 millionand $3.2 million, respectively. This corporate debt security was determined tobe other-than-temporarily impaired as of June 30, 2009 and December 31, 2008.

 

16

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The following table summarizes the Company’s securities classified asavailable-for-sale as of December 31, 2008, which are carried at estimated fairvalue (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 gross unrealized losses and fair value ofthe Company’s available-for-sale securities, aggregated by length of time thatthe individual securities have been in a continuous unrealized loss position,as of December 31, 2008 (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 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 | ) |

 

As of December 31, 2008, the Company recognized a loss totaling $460.4 millionfor securities that it determined to be other-than-temporarily impaired, whichare excluded from the table above. 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 six months ended June 30, 2009, the Company hadgross realized gains from the sales of securities available-for-sale of $9.0 millionand $10.0 million, respectively, and gross realized losses from the sales ofsecurities available-for-sale of $1.6 million and $7.4 million, respectively.During the three months and six months ended June 30, 2008, the Company hadgross realized gains from the sale of securities available-for-sale of $2.4million and $4.6 million, respectively, and gross realized losses from thesales of securities available-for-sale of $3.4 million and $14.7 million,respectively.

 

Note 10 to these condensed consolidated financial statements describethe Company’s borrowings under which the Company has pledged securitiesavailable-for-sale for borrowings. The following table summarizes the estimatedfair value of securities available-for-sale pledged as collateral under securedfinancing transactions as of June 30, 2009 (amounts in thousands):

 
| ** **                                                                                                            | ** ** | **Corporate  Securities** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|
| Pledged as collateral for borrowings under secured  revolving credit facility                                         |       | $                         | 66,509     |   |
| Pledged as collateral for collateralized loan  obligation senior secured notes and junior secured notes to affiliates |       | 537,470                   |       |
| Total                                                                                                                 |       | $                         | 603,979    |   |

 

The following table summarizes the estimated fair value of securitiesavailable-for-sale pledged as collateral under secured financing transactionsas of December 31, 2008 (amounts in thousands):

 
| ** **                                                                                                            | ** ** | **Corporate  Securities** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|
| Pledged as collateral for borrowings under secured  revolving credit facility                                         |       | $                         | 93,764     |   |
| Pledged as collateral for collateralized loan  obligation senior secured notes and junior secured notes to affiliates |       | 459,677                   |       |
| Total                                                                                                                 |       | $                         | 553,441    |   |

 

17

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**Note 6. Corporate Loans and Allowance for Loan Losses**

 

The following table summarizes the Company’s corporate loans as of June30, 2009 and December 31, 2008 (amounts in thousands):

 
| ** **                    | ** ** | **June 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)            |       | $                 | 7,533,302  |                      | $          | (413,660 | ) | $ | — |   | $ | 7,119,642 |   | $ | 7,983,449 |   | $ | (255,877 | ) | $ | — |   | $ | 7,727,572 |   |
| Corporate loans held for sale |       | 210,173           |       | (4,065                    | )          | (37,561 | ) | 168,547 |   | 472,669 |   | (10,751 | ) | (137,269 | ) | 324,649 |   |
| Total corporate loans         |       | $                 | 7,743,475  |                      | $          | (417,725 | ) | $ | (37,561 | ) | $ | 7,288,189 |   | $ | 8,456,118 |   | $ | (266,628 | ) | $ | (137,269 | ) | $ | 8,052,221 |   |

 

----

(1)                                  Excludesallowance for loan losses of $473.2 million and $480.8 million as of June 30,2009 and December 31, 2008, respectively.

 

The following table summarizes the changes in the allowance for loanlosses for the Company’s corporate loan portfolio during the three and sixmonths ended June 30, 2009 and 2008 (amounts in thousands):

 
| ** **                     | ** ** | **For the three  months ended  June 30, 2009** | ** ** | **For the three  months ended  June 30, 2008** | ** ** | **For the six  months ended  June 30, 2009** | ** ** | **For the six  months ended  June 30, 2008** | ** ** |
|--------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| Balance at beginning of period |       | $                                              | 507,762    |                                           | $          | 25,000                                       |       | $                                            | 480,775    |   | $ | 25,000 |   |
| Provision for loan losses      |       | 12,808                                         |       | 10,000                                         |       | 39,795                                       |       | 10,000                                       |       |
| Charge-offs                    |       | (47,368                                        | )          | —                                         |       | (47,368                                      | )          | —                                       |       |
| Balance at end of period       |       | $                                              | 473,202    |                                           | $          | 35,000                                       |       | $                                            | 473,202    |   | $ | 35,000 |   |

 

As of June 30, 2009 and December 31, 2008, the Company had an allowancefor loan loss of $473.2 million and $480.8 million, respectively. As describedin Note 2 to these condensed consolidated financial statements, the allowancefor loan losses represents the Company’s estimate of probable credit lossesinherent in its loan portfolio as of the balance sheet date. The Company’sallowance for loan losses consists of two components, an allocated componentand an unallocated component. The allocated component of the allowance for loanlosses consists of individual loans that are impaired. The unallocatedcomponent of the allowance for loan losses represents the Company’s estimate oflosses inherent, but not identified, in its portfolio as of the balance sheetdate.

 

Asof June 30, 2009, the allocated component of the allowance for loan lossestotaled $428.8 million and relates to investments in loans issued by elevenissuers with an aggregate par amount of $891.9 million and an aggregateamortized cost amount of $701.6 million. As of December 31, 2008, the allocatedcomponent of the allowance for loan losses totaled $320.6 million and relatesto investments in loans issued by eleven issuers with an aggregate par amountof $828.2 million and an aggregate amortized cost amount of $715.4 million. Theunallocated component of the allowance for loan losses totaled $44.4 millionand $160.2 million as of June 30, 2009 and December 31, 2008, respectively. TheCompany recorded charge-offs during the three and six months ended June 30,2009 totaling $47.4 million. Of these, $6.0 million related to a loan soldduring the quarter, while $41.4 million related to a loan exchanged for equityand which qualified as a troubled debt restructuring (see Note 4 to these condensedconsolidated financial statements for further details). There were nocharge-offs during the three and six months ended June 30, 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 June 30, 2009 and December 31, 2008, the Company had $704.3million and $358.0 million of loans on non-accrual status, respectively.  The average recorded investment in theimpaired loans during the three and six months ended June 30, 2009 was $738.2million and $531.3 million, respectively, and during the three and six monthsended June 30, 2008 average recorded investment in the impaired loans was nil.The amount of interest income recognized using the cash-basis method during thetime within the period that the loans were impaired was $4.7 million and $6.8million for the three and six months ended June 30, 2009, respectively, and nilfor the three and six months ended June 30, 2008.

 

As of June 30, 2009, the Company held loans that were in default with atotal amortized cost of $727.3 million from nine issuers. During the year endedDecember 31, 2008, the Company 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 the Company’s allowance forlosses was related to as of June 30, 2009 and December 31, 2008, respectively.

 

18

----

 

Note 10 to these condensed consolidated financial statements describesthe Company’s borrowings under which the Company has pledged loans forborrowings. The following table summarizes the carrying value of corporateloans pledged as collateral under secured financing transactions as of June 30,2009 and December 31, 2008 (amounts in thousands):

 
| ** **                                                                                                            | ** ** | **As of  June 30, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|------------------------------|------------|
| Pledged as collateral for borrowings under secured  revolving credit facility                                         |       | $                        | 206,520    |                         | $          | 182,899 |   |
| Pledged as collateral for collateralized loan  obligation senior secured notes and junior secured notes to affiliates |       | 7,029,519                |       | 7,816,154                    |       |
| Total                                                                                                                 |       | $                        | 7,236,039  |                         | $          | 7,999,053 |   |

 

**Note 7. Residential Mortgage-Backed Securities**

 

As of June 30, 2009 and December 31, 2008, residential mortgage-backedsecurities (“RMBS”) totaled $76.6 million and $102.8 million, respectively.

 

Note 10 to these condensed consolidated financial statements describesthe Company’s borrowings under which the Company has pledged RMBS. Thefollowing table summarizes the estimated fair value of RMBS pledged ascollateral under secured financing transactions as of June 30, 2009 and December31, 2008 (amounts in thousands):

 
| ** **                                                                                                            | ** ** | **As of  June 30, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|------------------------------|------------|
| Pledged as collateral for borrowings under secured  revolving credit facility                                         |       | $                        | 70,779     |                         | $          | 96,651 |   |
| Pledged as collateral for collateralized loan  obligation senior secured notes and junior secured notes to affiliates |       | 5,793                    |       | 6,163                        |       |
| Total                                                                                                                 |       | $                        | 76,572     |                         | $          | 102,814 |   |

 

**Note 8. Residential Mortgage Loans**

 

The following table summarizes the Company’s residential mortgage loansas of June 30, 2009 and December 31, 2008 (amounts in thousands):

 
| ** **                                              | ** ** | **As of  June 30, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|---------------------------------------------------------|------------|--------------------------|------------|------------------------------|------------|
| Residential mortgage loans, at estimated fair  value(1) |       | $                        | 2,218,319  |                         | $          | 2,620,021 |   |
|                                                         |            |                          |            |                              |            |  |  |

 

----

(1)          Excludes REO as a result offoreclosure on delinquent loans of $9.8 million and $10.8 million as of June 30,2009 and December 31, 2008, respectively. Loans are transferred to REO at thelower of cost or fair value. REO is recorded within other assets on the Company’scondensed consolidated balance sheets.

 

Note 10 to these condensed consolidated financial statements describesthe Company’s borrowings under which the Company has pledged residentialmortgage loans. The following table summarizes the estimated fair value ofresidential mortgage loans pledged as collateral for a secured revolving creditfacility as of June 30, 2009 and December 31, 2008 (amounts in thousands):

 
| ** **                                                                    | ** ** | **As of  June 30, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|-------------------------------------------------------------------------------|------------|--------------------------|------------|------------------------------|------------|
| Pledged as collateral for borrowings under secured  revolving credit facility |       | $                        | 147,542    |                         | $          | 167,933 |   |
| Pledged as collateral for residential  mortgage-backed securities issued      |       | 2,070,777                |       | 2,452,088                    |       |
|                                                                          |       | $                        | 2,218,319  |                         | $          | 2,620,021 |   |

 

The following is a reconciliation of carrying amounts of residentialmortgage loans for the periods ended June 30, 2009 and December 31, 2008(amounts in thousands):

 
| ** **                              | ** ** | **2009** | ** ** | **2008** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|
| Beginning balance                       |       | $        | 2,620,021  |     | $          | 3,921,323 |   |
| Principal payments                      |       | (274,102 | )          | (666,900 | )          |
| Transfers out of (in to) REO            |       | 978      |       | (3,594   | )          |
| Net unrealized loss/unamortized premium |       | (128,578 | )          | (630,808 | )          |
| Ending balance                          |       | $        | 2,218,319  |     | $          | 2,620,021 |   |

 

19

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As of June 30, 2009, twenty-five of the residential mortgage loansowned by the Company with an outstanding balance of $9.8 million (not includedin the table above) were REO as a result of foreclosure on delinquent loans. Asof December 31, 2008, thirty-three of the residential mortgage loans owned bythe Company with an outstanding balance of $10.8 million (not included in thetable above) were REO as a result of foreclosure on delinquent loans.

 

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

 
| ** **             | ** ** | **June 30, 2009**    | ** ** | **December 31, 2008** | ** ** |
|------------------------|------------|----------------------|------------|-----------------------|------------|
| **Delinquency Status** | ** ** | **Number  of Loans** | ** ** | **Principal  Amount** | ** ** | **Number  of Loans** | ** ** | **Principal  Amount** | ** ** |
| 30 to 59 days          |       | 71                   |       | $                     | 26,766     |   | 93 |   | $ | 37,282 |   |
| 60 to 89 days          |       | 36                   |       | 15,692                |       | 41 |   | 15,654 |   |
| 90 days or more        |       | 116                  |       | 44,770                |       | 76 |   | 29,803 |   |
| In foreclosure         |       | 120                  |       | 48,519                |       | 67 |   | 22,841 |   |
| Total                  |       | 343                  |       | $                     | 135,747    |   | 277 |   | $ | 105,580 |   |

 

As of June 30, 2009 and December 31, 2008, the loss exposure oruncollected principal amount related to the Company’s delinquent residentialmortgage loans in the table above exceeded their fair value by $15.4 millionand $4.0 million, respectively.

 

**Note 9. Residential Mortgage-Backed Securities Issued**

 

Residential mortgage-backed securities issued (“RMBS Issued”) consistsof the senior tranches of six residential mortgage loan securitization truststhat the Company consolidates under GAAP (see Note 2 to these condensedconsolidated financial statements) and for which the Company reports the debtissued by these trusts that it does not hold on its condensed consolidatedbalance sheets. The following table summarizes the Company’s RMBS Issued as of June30, 2009 and December 31, 2008 (amounts in thousands):

 
| ** **                                    | ** ** | **June 30, 2009** | ** ** | **December 31, 2008**      | ** ** |
|-----------------------------------------------|------------|-------------------|------------|----------------------------|------------|
| **Description**                               | ** ** | **Outstanding**   | ** ** | **Estimated  Fair  Value** | ** ** | **Outstanding** | ** ** | **Estimated  Fair  Value** | ** ** |
| Residential mortgage-backed securities issued |       | $                 | 2,885,736  |                       | $          | 2,080,592 |   | $ | 3,154,974 |   | $ | 2,462,882 |   |
|                                               |            |                   |            |                            |            |  |  |  |  |  |  |  |  |

 

The Company carries RMBS Issued at estimated fair value with changes inestimated fair value reflected in net income. As of June 30, 2009 and December 31,2008, the weighted average coupon of the RMBS Issued was 2.9% and 3.4%,respectively, and the weighted average years to maturity were 26.3 years and26.8 years as of June 30, 2009 and December 31, 2008, respectively.

 

**Note 10. Borrowings**

 

Certain information with respect to the Company’s borrowings as of June30, 2009 is summarized in the following table (dollar amounts in thousands):

 
| ** **                                        | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted  Average  Borrowing  Rate** | ** ** | **Weighted  Average  Remaining  Maturity  (in days)** | ** ** | **Fair Value of  Collateral(1)** | ** ** |
|---------------------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|-------------------------------------------------------|------------|----------------------------------|------------|
| Secured revolving credit facility(2)              |       | $                           | 256,597    |                                   | 3.31       | %                                                     | 133        |                             | $          | 386,211 |   |
| CLO 2005-1 senior secured notes                   |       | 832,324                     |       | 1.41                                   |       | 2,857                                                 |       | 795,909                          |       |
| CLO 2005-2 senior secured notes                   |       | 800,095                     |       | 0.98                                   |       | 3,071                                                 |       | 794,928                          |       |
| CLO 2006-1 senior secured notes                   |       | 684,270                     |       | 1.03                                   |       | 3,343                                                 |       | 767,535                          |       |
| CLO 2007-1 senior secured notes                   |       | 2,241,618                   |       | 1.42                                   |       | 4,337                                                 |       | 1,964,280                        |       |
| CLO 2007-1 junior secured notes to affiliates(3)  |       | 444,438                     |       | —                                 |       | 4,337                                                 |       | 388,022                          |       |
| CLO 2007-A senior secured notes                   |       | 1,191,245                   |       | 2.00                                   |       | 3,029                                                 |       | 1,084,347                        |       |
| CLO 2007-A junior secured notes to affiliates(4)  |       | 97,675                      |       | —                                 |       | 3,029                                                 |       | 88,910                           |       |
| CLO 2009-1 senior secured notes                   |       | 44,354                      |       | 4.56                                   |       | 2,855                                                 |       | 109,951                          |       |
| CLO 2009-1 junior secured notes to affiliates (5) |       | 90,429                      |       | —                                 |       | 2,855                                                 |       | 224,168                          |       |
| Convertible senior notes                          |       | 275,800                     |       | 7.00                                   |       | 1,111                                                 |       | —                           |       |
| Junior subordinated notes                         |       | 288,671                     |       | 5.72                                   |       | 9,937                                                 |       | —                           |       |
| Total                                             |       | $                           | 7,247,516  |                                   |       |                                                  |       |                             | $          | 6,604,261 |   |

 

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

 

(2)                                  Calculatedweighted average remaining maturity based on the maturity date of November 10,2009 as $150.0 million of the senior secured revolving credit facility maturesin November 2009 with the remaining maturity in November 2010.

 

20

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(3)           CLO 2007-1junior secured notes to affiliates consist of (x) $257.8 million ofmezzanine notes with a weighted average borrowing rate of 5.81% and(y) $186.6 million of subordinated notes that do not have acontractual coupon rate, but instead receive a pro rata amount of the netdistributions from CLO 2007-1.

 

(4)           CLO 2007-Ajunior secured notes to affiliates consist of (x) $82.6 million ofmezzanine notes with a weighted average borrowing rate of 7.30% and(y) $15.1 million of subordinated notes that do not have acontractual coupon rate, but instead receive a pro rata amount of the netdistributions from CLO 2007-A.

 

(5)           CLO 2009-1junior secured notes do not have a contractual coupon rate, but instead receivea pro rata amount of the net distributions from CLO 2009-1.

 

On March 31, 2009,the Company completed the restructuring of Wayzata Funding LLC (“Wayzata”), its market value CLOtransaction. As a result of the restructuring, substantially all of Wayzata’sassets were transferred to CLO 2009-1, a newly formed special purpose company,which issued $560.8 million aggregate principal amount of senior notes due April 2017and $154.3 million aggregate principal amount of subordinated notes due April 2017to the existing Wayzata note holders in exchange for cancellation of theWayzata notes, due November 2012, previously held by each of them. CLO2009-1 was structured as a cash flow transaction and does not contain themarket value provisions contained in Wayzata. The portfolio manager of the CLOis an affiliate of the Manager. The notes issued by CLO 2009-1 are secured bythe same collateral that secured the Wayzata facility, consisting primarily ofsenior secured leveraged loans. As was the case with Wayzata, the Company andan affiliate of the Manager currently own all of the subordinated notes issuedby the CLO. The subordinated notes entitle the Company to receive a pro rata**portion of all excess cash flows from theportfolio after all senior obligations of CLO 2009-1 have been paid in full orotherwise satisfied, including all outstanding principal of the senior notesand interest thereon accruing at a rate of 3-month LIBOR plus 4.25%.

 

Therestructuring of Wayzata and the formation of CLO 2009-1 outlined abovequalified as a troubled debt restructuring under SFAS No. 15, *Accounting by Debtors and Creditors for Troubled Debt Restructuring*.Prior to the restructuring on March 31, 2009, an affiliate of the Managerheld an aggregate par amount of $125.0 million of subordinated notes issued byWayzata (the “Wayzata Subordinated Notes”). In connection with therestructuring, the Wayzata Subordinated Notes were exchanged for $30.9 millionpar amount of junior notes issued by CLO 2009-1 (the “CLO 2009-1 Junior Notes”).In accordance with GAAP, the portion of the CLO 2009-1 Junior Notes held by theaffiliate of the Manager are carried at $90.4 million which represents thetotal future cash payments that the affiliate of the Manager may receive fromthe CLO 2009-1 Junior Notes. The exchange by the affiliate of the Manager ofWayzata Subordinated Notes for CLO 2009-1 Junior Notes is treated under SFAS No. 15as a modification of terms of the Wayzata Subordinated Notes. Accordingly, theCompany has recognized a gain on debt restructuring totaling $34.6 million, or$0.23 per diluted common share, which reflects the difference between theCompany’s carrying amount of interest in the Wayzata Subordinated Notes held bythe affiliate of the Manager, or $125.0 million, and the carrying value of theportion of the CLO 2009-1 Junior Notes held by the same affiliate of theManager, or $90.4 million. The Wayzata Subordinated Notes and CLO 2009-1 JuniorNotes are included in collateralized loan obligation junior secured notes toaffiliates on the condensed consolidated balance sheets as of June 30,2009 and December 31, 2008.

 

OnMay 9, 2008, the FASB issued FSP APB 14-1, *Accounting for Convertible Debt Instruments That May Be Settled inCash upon Conversion (including Partial Cash Settlement)* (“FSP APB14-1”). FSP APB 14-1 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 FSP 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.

 

21

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DuringJune 2009, the Company completed two transactions to exchange a total of$15.7 million par value of convertible notes for 7.2 million of the Company’scommon shares.  These transactionsresulted in the Company recording a gain of $6.9 million, or approximately$0.05 per diluted common share, which was partially offset by a write-off of$0.1 million of unamortized debt issuance costs and $0.4 million of otherassociated costs.

 

The indentures governing the Company’s CLO transactions includenumerous compliance tests, the majority of which relate to the CLO’s portfolioprofile. In the event that a portfolio profile test is not met, the indentureplaces restrictions on the ability of the CLO’s manager to reinvest availableprincipal proceeds generated by the collateral in the CLOs until the specifictest has been cured. In addition to the portfolio profile tests, the indenturesfor the CLO transactions include over-collateralization tests (“OC Tests”)which set the ratio of the collateral value of the assets in the CLO to thetranches of debt for which the test is being measured, as well as interestcoverage tests. If a CLO is not in compliance with an OC Test or an interestcoverage test, cash flows normally payable to the holders of junior classes ofnotes will be used by the CLO to amortize the most senior class of notes untilsuch point as the OC test is brought back into compliance. Due to the failure ofOC Tests during the second quarter of 2009, CLO 2006-1 senior secured noteswere paid down by $23.2 million, CLO 2007-1 senior secured notes were paiddown by $40.7 million and CLO 2007-A senior secured notes were paid downby $12.9 million. For the first half of 2009, CLO 2005-2 senior secured noteswere paid down by $9.0 million, CLO 2006-1 senior secured notes were paid downby $32.1 million, CLO 2007-1 senior secured notes were paid down by$81.3 million and CLO 2007-A senior secured notes were paid down by $22.7million.

 

Due to the failure of OC Tests during 2008, CLO 2006-1 senior securednotes were paid down by $12.1 million and CLO 2007-1 senior secured noteswere paid down by $53.6 million.

 

During the three months ended June 30, 2009, the proceeds from thesale of certain assets were used to pay down $516.4 million of CLO 2009-1senior secured notes.

 

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

 
| ** **                                       | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted  Average  Borrowing  Rate** | ** ** | **Weighted  Average  Remaining  Maturity  (in days)** | ** ** | **Fair Value of  Collateral(1)** | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|-------------------------------------------------------|------------|----------------------------------|------------|
| Secured revolving 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 |   |

 

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| (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.                               |

 

22

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

 

Securities sold, not yet purchased consist of equity and debtsecurities that the Company has sold short. As of June 30, 2009, theCompany had securities sold, not yet purchased with an amortized cost of $75.3million and an accumulated net unrealized loss of $2.3 million. As of December 31,2008, the Company had securities sold, not yet purchased with an amortized costbasis of $97.3 million and an accumulated net unrealized gain of$6.5 million.

 

For the three and six months ended June 30, 2009, the Company hadnet realized and unrealized gains on short security sales of $2.5 million and$3.9 million, respectively, compared to net realized and unrealized gains onshort security sales of $1.7 million and $8.7 million, for the three andsix months ended June 30, 2008, respectively.

 

**Note 12. Derivative Financial Instruments**

 

The Company enters into derivative transactions in order to hedge itsinterest rate risk exposure to the effects of interest rate changes.Additionally, the Company enters into derivative transactions in the course ofits investing. The counterparties to the Company’s derivative agreements aremajor financial institutions with which the Company and its affiliates may alsohave other financial relationships. In the event of nonperformance by thecounterparties, the Company is potentially exposed to losses. Thecounterparties to the Company’s derivative agreements have investment grade ratingsand, as a result, the Company does not anticipate that any of thecounterparties will fail to fulfill their obligations.

 

**Cash Flow and Fair Value Hedges**

 

The Company uses interest rate derivatives consisting of swaps to hedgea portion of the interest rate risk associated with its borrowings under CLOsenior secured notes. The Company designates these financial instruments ascash flow hedges. The Company also uses interest rate swaps to hedge all or aportion of the interest rate risk associated with certain fixed interest rateinvestments. The Company designates these financial instruments as fair valuehedges.

 

**Free-Standing Derivatives**

 

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

 

Thetable below summarizes the aggregate notional amount and estimated net fairvalue of the derivative instruments as of June 30, 2009 and December 31,2008 (amounts in thousands):

 
| ** **                      | ** ** | **As of  June 30, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|---------------------------------|------------|-------------------------------|------------|-----------------------------------|------------|
| ** **                      | ** ** | **Notional**                  | ** ** | **Estimated  Fair Value**         | ** ** | **Notional** | ** ** | **Estimated  Fair Value** | ** ** |
| **Cash Flow Hedges:**           |       |                          |       |                              |       |   |   |   |   |
| Interest rate swaps             |       | $                             | 383,333    |                              | $          | (46,313 | ) | $ | 383,333 |   | $ | (77,668 | ) |
| **Fair Value Hedges:**          |       |                          |       |                              |       |   |   |   |   |
| Interest rate swaps             |       | 32,000                        |       | (2,654                            | )          | 32,000 |   | (2,915 | ) |
| **Free-Standing Derivatives:**  |       |                          |       |                              |       |   |   |   |   |
| Interest rate swaps             |       | 115,434                       |       | 1,072                             |       | 106,074 |   | 274 |   |
| Credit default swaps—long  |       | 51,000                        |       | (4,292                            | )          | 53,500 |   | (9,782 | ) |
| Credit default swaps—short |       | —                        |       | —                            |       | 222,650 |   | 69,972 |   |
| Total rate of return swaps      |       | 136,132                       |       | 5,015                             |       | 207,524 |   | (77,224 | ) |
| Total                           |       | $                             | 717,899    |                              | $          | (47,172 | ) | $ | 1,005,081 |   | $ | (97,343 | ) |

 

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For all hedges where hedge accounting is being applied, effectivenesstesting and other procedures to ensure the ongoing validity of the hedges areperformed at least monthly. During the three and six months ended June 30,2009 and 2008, the Company recognized an immaterial amount of ineffectivenessin income on the condensed consolidated statements of operations from its cashflow and fair value hedges.

 

**Note 13. Accumulated Other Comprehensive Loss**

 

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

 
| ** **                                              | ** ** | **As of  June 30, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|---------------------------------------------------------|------------|-------------------------------|------------|-----------------------------------|------------|
| Net unrealized losses on available-for-sale  securities |       | $                             | (4,839     | )                                 | $          | (192,435 | ) |
| Net unrealized losses on cash flow hedges               |       | (44,356                       | )          | (76,347                           | )          |
| Accumulated other comprehensive loss                    |       | $                             | (49,195    | )                                 | $          | (268,782 | ) |

 

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

 
| ** **                                                      | ** ** | **Three months  ended  June 30, 2009** | ** ** | **Three months  ended  June 30, 2008** | ** ** | **Six months  ended  June 30, 2009** | ** ** | **Six months  ended  June 30, 2008** | ** ** |
|-----------------------------------------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|
| Unrealized gains (losses) on securities  available-for-sale:    |       |                                                  |       |                                                  |       |                                                |       |                                                |       |
| Unrealized holding gains (losses) arising during  period        |       | $                                                     | 136,724    |                                                  | $          | 18,131                                              |       | $                                                   | 165,670    |   | $ | (65,977 | ) |
| Reclassification adjustments for losses realized  in net income |       | 17,065                                                |       | 10,648                                                |       | 21,926                                              |       | 19,797                                              |       |
| Unrealized gains (losses) on securities  available-for-sale     |       | 153,789                                               |       | 28,779                                                |       | 187,596                                             |       | (46,180                                             | )          |
| Unrealized gains on cash flow hedges                            |       | 22,944                                                |       | 19,076                                                |       | 31,991                                              |       | 839                                                 |       |
| Other comprehensive income (loss)                               |       | $                                                     | 176,733    |                                                  | $          | 47,855                                              |       | $                                                   | 219,587    |   | $ | (45,341 | ) |

 

**Note 14. 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 entityperforming services 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 June 30, 2009, the 2007 Share Incentive Plan authorizes a total of8,464,625 shares that may be used to satisfy awards under the 2007 ShareIncentive Plan. On February 19, 2008, the Compensation Committee of theboard of directors granted the Manager 1,097,000 restricted common shares thatvest on February 19, 2011. On July 2, 2008, the CompensationCommittee of the Board of Directors granted 38,349 restricted common shares tothe Company’s directors 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                                          |       | —      |       | —        |       | —    |       |
| Vested                                          |       | —      |       | —        |       | —    |       |
| Cancelled                                       |       | —      |       | —        |       | —    |       |
| Forfeited                                       |       | —      |       | —        |       | —    |       |
| **Unvested shares as of  June 30, 2009**   |       | 1,097,000   |       | 66,282        |       | 1,163,282 |       |

 

Pursuant to SFAS No. 123(R), the Company is required to value anyunvested restricted common shares granted to the Manager at the current marketprice. The Company valued the unvested restricted common shares granted to theManager at $0.93 and $10.50 per share at June 30, 2009 and June 30,2008, respectively. There were $0.8 million and $10.6 million of totalunrecognized compensation costs related to unvested restricted common sharesgranted as of June 30, 2009 and 2008, respectively. These costs areexpected to be recognized over three years from the date of grant.

 

24

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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 June 30,  2009**   |       | 1,932,279              |       | $                                    | 20.00      |   |

 

As of June 30, 2009 and December 31, 2008, 1,932,279 commonshare options were exercisable. As of June 30, 2009, the common shareoptions were fully vested and expire in August 2014. For the three and sixmonths ended June 30, 2009 and 2008, the components of share-basedcompensation expense are as follows (amounts in thousands):

 
| ** **                                     | ** ** | **For the three  months ended  June 30, 2009** | ** ** | **For the three  months ended  June 30, 2008** | ** ** | **For the six  months ended  June 30, 2009** | ** ** | **For the six  months ended  June 30, 2008** | ** ** |
|------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| Restricted shares granted to Manager           |       | $                                                                       | 105        |                                                                    | $          | 196                                                                   |       | $                                                                     | (35        | ) | $ | 658 |   |
| Restricted shares granted to certain directors |       | 139                                                                     |       | 177                                                                     |       | 276                                                                   |       | 355                                                                   |       |
| Total share-based compensation expense         |       | $                                                                       | 244        |                                                                    | $          | 373                                                                   |       | $                                                                     | 241        |   | $ | 1,013 |   |

 

**Note 15. 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 condensedconsolidated financial statements and determined that they are not material.

 

For the three and six months ended June 30, 2009, the Company incurred$3.7 million and $7.3 million, respectively, in base management fees. In addition, theCompany recognized share-based compensation expense related to common shareoptions and restricted common shares granted to the Manager of $0.1 million andnil, respectively, for the three and six months ended June 30, 2009 (seeNote 14 to these condensed consolidated financial statements). For the threeand six months ended June 30, 2008, the Company incurred $8.9 million and$16.4 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 $0.7million, respectively, for the three and six months ended June 30, 2008(see Note 14 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 June 30, 2009, the Company had$4.2 million base management fee payable to the Manager. Base management feesincurred and share-based compensation expense relating to common share optionsand restricted common shares granted to the Manager are included in relatedparty management compensation on the condensed consolidated statements ofoperations. Expenses incurred by the Manager and reimbursed by the Company arereflected in the respective condensed consolidated statements of operations,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 three monthsended June 30, 2009 and 2008, and $4.4 million during each of the sixmonths ended June 30, 2009 and 2008.

 

No incentive fees were earned or paid to the Manager during the threeand six months ended June 30, 2009 and 2008.

 

25

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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. In addition, beginning January 1,2009, the Manager permanently waived reimbursable general and administrativeexpenses allocable to the Company in an amount equal to the incremental CLOfees received by the Manager. For the three and six months ended June 30,2009, the Manager permanently waived reimbursement of $3.0 million and $5.3million, respectively, in allocable general and administrative expenses. Forthe three and six months ended June 30, 2008, the Company reimbursed theManager $2.6 million and $5.1 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 June 30, 2009,the aggregate par amount of these affiliated investments totaled$3.1 billion, or approximately 35% of the total investment portfolio, andconsisted of 23 issuers. The total $3.1 billion in investments werecomprised of $2.4 billion of corporate loans, $543.0 million of securitiesavailable-for-sale, $48.5 million of private equity investments carried atestimated fair value and $78.4 million notional amount of total rate ofreturn swaps referenced to corporate loans issued by affiliates of KKR(included in derivative assets and liabilities on the condensed consolidatedbalance sheet). As of December 31, 2008, the aggregate par amount of theseaffiliated investments totaled $3.3 billion, or approximately 35% of thetotal investment portfolio, and consisted of 23 issuers. The total$3.3 billion in investments were comprised of $2.6 billion ofcorporate loans, $587.3 million of corporate debt securities available forsale, and $92.4 million notional amount of total rate of return swapsreferenced to corporate loans issued by affiliates of KKR (included inderivative assets and liabilities on the condensed consolidated balance sheet).

 

**Note 16. Fair Value of Financial Instruments**

 

**Fair Value of Financial Instruments**

 

In the second quarter of 2009, the Company adopted FSP FAS 107-1 and APB 28-1, *Interim Disclosures about Fair Value of Financial Instruments*which amends SFAS No. 107, *Disclosures about FairValue of Financial Instruments*, to require disclosures about fairvalue of financial instruments for interim reporting periods as well as inannual financial statements. The fair value of instruments includingsecurities available-for-sale, loans, derivatives, and loan commitments isbased on quoted market prices or estimates provided by independent pricingsources. The fair value of cash and cash equivalents, interest payable, securedrevolving credit facility and interest payable, approximates cost as of June 30,2009 and December 31, 2008, due to the short-term nature of theseinstruments.

 

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

 
| ** **                                                         | ** ** | **Carrying  Amount** | ** ** | **Estimated Fair  Value** | ** ** |
|--------------------------------------------------------------------|------------|----------------------|------------|---------------------------|------------|
| Financial Assets:                                                  |       |                 |       |                      |       |
| Cash, restricted cash, and cash equivalents                        |       | $                    | 403,297    |                      | $          | 403,297 |   |
| Securities available-for-sale                                      |       | 604,916              |       | 604,916                   |       |
| Corporate loans, net of allowance for loan losses  of $473,202     |       | 6,646,440            |       | 5,612,235                 |       |
| Residential mortgage-backed securities                             |       | 76,572               |       | 76,572                    |       |
| Residential mortgage loans                                         |       | 2,218,319            |       | 2,218,319                 |       |
| Corporate loans held for sale                                      |       | 168,547              |       | 168,547                   |       |
| Private equity investments, at estimated fair  value               |       | 54,016               |       | 54,016                    |       |
| Reverse repurchase agreements                                      |       | 80,344               |       | 80,344                    |       |
| Interest and principal receivable                                  |       | 83,395               |       | 83,395                    |       |
| Derivative assets                                                  |       | 11,562               |       | 11,562                    |       |
| Private equity investments, at cost                                |       | 17,505               |       | 14,809                    |       |
|                                                               |       |                 |       |                      |       |
| Financial Liabilities:                                             |       |                 |       |                      |       |
| Collateralized loan obligation senior secured  notes               |       | $                    | 5,793,906  |                      | $          | 3,934,691 |   |
| Collateralized loan obligation junior secured  notes to affiliates |       | 632,542              |       | 237,648                   |       |
| Secured revolving credit facility                                  |       | 256,597              |       | 256,597                   |       |
| Convertible senior notes                                           |       | 275,800              |       | 137,900                   |       |
| Junior subordinated notes                                          |       | 288,671              |       | 114,000                   |       |
| Residential mortgage-backed securities issued                      |       | 2,080,592            |       | 2,080,592                 |       |
| Accounts payable, accrued expenses and other  liabilities          |       | 37,694               |       | 37,694                    |       |
| Accrued interest payable                                           |       | 34,602               |       | 34,602                    |       |
| Accrued interest payable to affiliates                             |       | 3,245                |       | 3,245                     |       |
| Related party payable                                              |       | 5,960                |       | 5,960                     |       |
| Securities sold, not yet purchased                                 |       | 77,637               |       | 77,637                    |       |
| Derivative liabilities                                             |       | 58,734               |       | 58,734                    |       |

 

26

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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                   |       |
| Secured revolving 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 June 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  June 30, 2009** | ** ** |
|------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|-------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                           | ** ** | ** **                                                                 | ** ** | ** **                                               | ** ** | ** **                                            | ** ** | ** **                            | ** ** |
| **Assets:**                                          | ** ** | ** **                                                                 | ** ** | ** **                                               | ** ** | ** **                                            | ** ** | ** **                            | ** ** |
| Securities available-for-sale                        |       | $                                                                          | 937        |                                                     | $          | 513,981                                               |       | $                                     | 89,998     |   | $ | 604,916 |   |
| Residential mortgage-backed securities               |       | —                                                                     |       | —                                                   |       | 76,572                                                |       | 76,572                                |       |
| Residential mortgage loans                           |       | —                                                                     |       | —                                                   |       | 2,218,319                                             |       | 2,218,319                             |       |
| Private equity investments, at estimated fair  value |       | —                                                                     |       | 48,467                                                   |       | 5,549                                                 |       | 54,016                                |       |
| Total                                                |       | $                                                                          | 937        |                                                     | $          | 562,448                                               |       | $                                     | 2,390,438  |   | $ | 2,953,823 |   |
| ** **                                           | ** ** | ** **                                                                 | ** ** | ** **                                               | ** ** | ** **                                            | ** ** | ** **                            | ** ** |
| **Liabilities:**                                     | ** ** | ** **                                                                 | ** ** | ** **                                               | ** ** | ** **                                            | ** ** | ** **                            | ** ** |
| Derivatives, net                                     |       | $                                                                          | —     |                                                     | $          | (53,259                                               | )          | $                                     | 6,087      |   | $ | (47,172 | ) |
| Residential mortgage-backed securities issued        |       | —                                                                     |       | —                                                   |       | (2,080,592                                            | )          | (2,080,592                            | )          |
| Securities sold, not yet purchased                   |       | —                                                                     |       | (77,637                                                  | )          | —                                                |       | (77,637                               | )          |
| Total                                                |       | $                                                                          | —     |                                                     | $          | (130,896                                              | )          | $                                     | (2,074,505 | ) | $ | (2,205,401 | ) |

 

27

----

 

The following table presents information about the Company’s assetsmeasured at fair value on a non-recurring basis as of June 30, 2009, andindicates the fair value hierarchy of the valuation techniques utilized by theCompany 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  June 30, 2009** | ** ** |
|---------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| Loans held for sale |       | $                                                                          | —     |                                                     | $          | 168,547                                              |       | $                                     | —     |   | $ | 168,547 |   |
| REO                 |       | —                                                                     |       | —                                                   |       | 9,815                                                |       | 9,815                                 |       |
| Total               |       | $                                                                          | —     |                                                     | $          | 168,547                                              |       | $                                     | 9,815      |   | $ | 178,362 |   |

 

Loans held for sale were classified as level 2 given that the assetswere valued using quoted prices and other observable inputs in an activemarket.

 

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 | ) |

 

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 |   |

 

28

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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.

 

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 June 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 April 1, 2009                                                                                                                                                     |       | $                                                                                                               | 76,050     |   | $ | 87,883 |   | $ | 2,260,759 |   | $ | 5,287 |   | $ | (2,231 | ) | $ | (2,113,587 | ) |
| Total gains or losses (realized and unrealized):                                                                                                                                               |       |                                                                                                            |       |   |   |   |   |   |   |   |   |   |   |
| Included in earnings                                                                                                                                                                           |       | —                                                                                                          |       | (1,946 | ) | 124,075 |   | 262 |   | 17,852 |   | (130,717 | ) |
| Included in other comprehensive loss                                                                                                                                                           |       | 13,948                                                                                                          |       | — |   | — |   | — |   | — |   | — |   |
| Net transfers in and/or out of level 3                                                                                                                                                    |       | —                                                                                                          |       | — |   | 1,405 |   | — |   | — |   | — |   |
| Purchases, sales, other settlements and issuances,  net                                                                                                                                        |       | —                                                                                                          |       | (9,365 | ) | (167,920 | ) | — |   | (9,534 | ) | 163,712 |   |
| Ending balance as of June 30, 2009                                                                                                                                                        |       | $                                                                                                               | 89,998     |   | $ | 76,572 |   | $ | 2,218,319 |   | $ | 5,549 |   | $ | 6,087 |   | $ | (2,080,592 | ) |
| 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) |       | $                                                                                                               | —     |   | $ | (758 | ) | $ | 126,668 |   | $ | 262 |   | $ | 7,167 |   | $ | (130,086 | ) |

 

----

(1)           Amounts areincluded in net realized and unrealized loss on investments, net realized andunrealized gain (loss) on derivatives and foreign exchange or net realized andunrealized loss on residential mortgage-backed securities, residential mortgageloans, and residential mortgage-backed securities issued, carried at estimatedfair value in the condensed consolidated statements of operations.

 

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 six months ended June 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                                                                                                                                                                           |       | (6,156                                                                                                          | )          | (9,315 | ) | (128,578 | ) | 262 |   | 25,280 |   | 113,051 |   |
| Included in other comprehensive loss                                                                                                                                                           |       | 15,829                                                                                                          |       | — |   | — |   | — |   | — |   | — |   |
| Net transfers in and/or out of level 3                                                                                                                                                    |       | —                                                                                                          |       | — |   | 978 |   | — |   | — |   | — |   |
| Purchases, sales, other settlements and issuances,  net                                                                                                                                        |       | (8,784                                                                                                          | )          | (16,927 | ) | (274,102 | ) | — |   | 57,757 |   | 269,239 |   |
| Ending balance as of June 30, 2009                                                                                                                                                        |       | $                                                                                                               | 89,998     |   | $ | 76,572 |   | $ | 2,218,319 |   | $ | 5,549 |   | $ | 6,087 |   | $ | (2,080,592 | ) |
| 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) |       | $                                                                                                               | —     |   | $ | (7,558 | ) | $ | (121,545 | ) | $ | 262 |   | $ | 43,885 |   | $ | 113,915 |   |

 

----

| (1) |   | Amounts  are included in net realized and unrealized loss on investments, net realized  and unrealized gain (loss) on derivatives and foreign exchange or net  realized and unrealized loss 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. |
|-----|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

29

----

 

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 June 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 April 1, 2008                                                                                                                                                     |       | $                                                                                                               | 78,654     |   | $ | 121,324 |   | $ | 3,605,233 |   | $ | 1,049 |   | $ | (3,410,163 | ) |
| Total gains or losses (realized and unrealized):                                                                                                                                               |       |                                                                                                            |       |   |   |   |   |   |   |   |   |
| Included in earnings                                                                                                                                                                           |       | —                                                                                                          |       | (1,192 | ) | 4,081 |   | (297 | ) | (6,775 | ) |
| Included in other comprehensive loss                                                                                                                                                           |       | (586                                                                                                            | )          | — |   | — |   | — |   | — |   |
| Net transfers in and/or out of level 3                                                                                                                                                    |       | (32,725                                                                                                         | )          | — |   | — |   | 2,811 |   | — |   |
| Purchases, sales, other settlements and issuances,  net                                                                                                                                        |       | —                                                                                                          |       | (4,480 | ) | (214,318 | ) | (92 | ) | 212,546 |   |
| Ending balance as of June 30, 2008                                                                                                                                                        |       | $                                                                                                               | 45,343     |   | $ | 115,652 |   | $ | 3,394,996 |   | $ | 3,471 |   | $ | (3,204,392 | ) |
| 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) |       | $                                                                                                               | —     |   | $ | (2,370 | ) | $ | 4,723 |   | $ | (297 | ) | $ | (7,203 | ) |

 

----

(1)   Amounts are included in net realized andunrealized 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.

 

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 six monthsended June 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                                                                                                                                                                           |       | —                                                                                                          |       | (7,137 | ) | (140,783 | ) | 467 |   | 147,252 |   |
| Included in other comprehensive loss                                                                                                                                                           |       | (4,090                                                                                                          | )          | — |   | — |   | — |   | — |   |
| Net transfers in and/or out of level 3                                                                                                                                                    |       | (32,725                                                                                                         | )          | 131,688 |   | 3,921,323 |   | 2,811 |   | (3,169,353 | ) |
| Purchases, sales, other settlements and issuances,  net                                                                                                                                        |       | (17,340                                                                                                         | )          | (8,899 | ) | (385,544 | ) | (609 | ) | (182,291 | ) |
| Ending balance as of June 30, 2008                                                                                                                                                        |       | $                                                                                                               | 45,343     |   | $ | 115,652 |   | $ | 3,394,996 |   | $ | 3,471 |   | $ | (3,204,392 | ) |
| 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) |       | $                                                                                                               | —     |   | $ | (9,250 | ) | $ | (152,661 | ) | $ | 467 |   | $ | 148,638 |   |

 

----

| (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. |
|-----|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

30

----

 

**Note 17. Subsequent Events**

 

OnJuly 10, 2009, the Company surrendered for cancellation, withoutconsideration, approximately $298.4 million in aggregate of mezzanine notes andjunior notes (“Surrendered Notes”) issued to the Company by CLO 2005-1, CLO2005-2 and CLO 2006-1. The Surrendered Notes were promptly cancelled uponreceipt by the trustee of each transaction and the related debt wasextinguished by the issuers thereof. In accordance with GAAP, the Company consolidatesits CLO subsidiaries and therefore, does not expect this transaction to have animpact on its consolidated financial statements. Similarly, as CLO 2005-1, CLO2005-2 and CLO 2006-1 are treated as disregarded entities for tax purposes,this transaction is not expected to have any tax implications for the Companyor its shareholders.

 

On July 24, 2009, the Company retired the outstanding balance ofsenior notes issued by CLO 2009-1, which totaled $44.4 million as of June 30,2009. Prior to theretirement of the senior notes, an affiliate of the Company held a 20% interestin the subordinated notes issued by CLO 2009-1. 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 a 20% interest in each of CLO 2009-1’sassets which remained following the deleveraging.

 

On August 5, 2009, the Company, TRS Ltd., KFH Ltd., KKR FinancialHoldings II, LLC, KKR Financial Holdings III, LLC, KKR Financial Holdings, Inc.(the “Original Credit Agreement Borrowers”) and CLO 2009-1 (together with theOriginal Credit Agreement Borrowers, the “Amendment Borrowers”) and Bank ofAmerica, N.A. (“BofA”) and Citicorp North America Inc. (“Citicorp”) enteredinto Amendment No. 1 to the Credit Agreement and Security Agreement (the“Credit and Security Agreement Amendment”), amending (i) the Credit Agreementdated as of November 10, 2008 among the Original Credit Agreement Borrowers,BofA, Citicorp, Banc of America Securities LLC and Citigroup Global MarketsInc. (as amended by the Credit and Security Agreement Amendment, the “CreditAgreement”) and (ii) the Security Agreement dated as of November 17, 2008 amongthe Original Credit Agreement Borrowers and BofA (as amended by the Credit andSecurity Agreement Amendment, the “Security Agreement”).

 

Among other things, the Credit and Security Agreement Amendmentprovides that: (i) the size of the facility be reduced to $200.0 million from$300.0 million, (ii) the lending commitments of the lenders under the CreditAgreement be modified to provide for quarterly amortization of $12.5 millionper quarter until the size of the facility has been reduced to $150 million onJune 30, 2010, (iii) the interest rate applicable to borrowings under theCredit Agreement be increased from LIBOR plus 300 basis points to LIBOR plus400 basis points, (iv) the maturity date of the borrowings under the CreditAgreement be extended to November 10, 2011, (v) the tangible net worth covenantbe reduced to $700.0 million from $1.0 billion, (vi) CLO 2009-1 become aBorrower under the Credit Agreement and a party to the Security Agreement andcertain other transaction documents, (vii) certain representations andwarranties and affirmative and negative covenants be modified and added and(viii) certain events of default under the Credit Agreement be added. TheCredit and Security Agreement Amendment also provides that the Company can (i)pay a yearly distribution to its shareholders in an amount equal to no greaterthan 50% of the Company’s taxable income for such year and (ii) use up to $50million of its unrestricted cash to repurchase its outstanding convertiblenotes due July 2012 and/or its outstanding trust preferred securities.

 

In addition, the Amendment Borrowers (i) pledged and delivered certainadditional collateral, including all loans, bonds, instruments, securities andfinancial assets directly or indirectly, legally or beneficially owned by theAmendment Borrowers and (ii) agreed to pay to each lender under the Credit Agreementan arrangement fee equal to 1.0% of each such lender’s commitment under theCredit Agreement and a structuring fee for each such lender in the amount of$1,250,000.

 

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**Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF 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 mezzanine and subordinated notes inthe CLO transactions. Our CLO transactions consist of six cash flow CLOtransactions, KKR Financial CLO 2005-1, Ltd. (“CLO 2005-1”), KKR Financial CLO 2005-2, Ltd. (“CLO 2005-2”), KKRFinancial CLO 2006-1, Ltd. (“CLO 2006-1”), KKR Financial CLO 2007-1, Ltd. (“CLO2007-1”), KKR 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”)and KKR Financial CLO 2009-1, Ltd. (“CLO 2009-1”).

 

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 CLO2009-1. As a result of the restructuring, substantially all of Wayzata’s assetswere transferred to CLO 2009-1, a newly formed special purpose company, whichissued $560.8 million aggregate principal amount of senior notes due April 2017and $154.3 million aggregate principal amount of subordinated notes due April 2017to the existing Wayzata note holders in exchange for cancellation of theWayzata notes, due November 2012, previously held by each of them. CLO2009-1 was structured as a cash flow transaction and does not contain themarket value provisions contained in Wayzata. The portfolio manager of CLO2009-1 is an affiliate of KKR Financial Advisors LLC (our “Manager”). The notes issued by CLO 2009-1 aresecured by the same collateral that secured the Wayzata notes, consistingprimarily of senior secured leveraged loans. As was the case with Wayzata, atthe time of the restructuring, we and an affiliate of our Manager owned all ofthe subordinated notes 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 quarter of $27.2 million. During June 2009, we paid downthe 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 a 20% interest in each of CLO 2009-1’s assets which remainedfollowing the deleveraging.

 

Following the deleveraging transaction and the distribution of assetsto our affiliate, we now hold the residual assets of CLO 2009-1, which consistof approximately $317.4 million par amount of corporate debt investments withan estimated fair value of $242.4 million and approximately $14.9 million ofcash and receivables. As a result of this transaction, we will receive all cashflows generated by the $317.4 million par amount of investments on aprospective basis.

 

As described above, we own a majority of the mezzanine and subordinatednotes issued by the Cash Flow CLOs and therefore have historically received amajority of our cash flows from our investments in these entities. Theindentures governing the Cash Flow CLOs include numerous compliance tests, themajority of which relate to the CLO’s portfolio profile. In addition to theportfolio profile tests, 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 second quarter of 2009, certain of our Cash Flow CLOs failed certain oftheir respective OC Tests as a result of significant asset price declines andrating downgrades of certain investments that occurred during 2008.Accordingly, the cash flows we would generally expect to receive from ourinvestments in the mezzanine and subordinated notes issued by the Cash FlowCLOs were used to amortize the most senior class of notes. During the first sixmonths of 2009 the senior notes issued by our Cash Flow CLOs were reduced by $145.1million due to amortization of the senior note balances as a result ofnon-compliance with certain OC Tests in certain of our CLOs.

 

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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,approximately $298.4 million in aggregate mezzanine and junior notes (“SurrenderedNotes”) issued to us by these three CLO transactions. The Surrendered Noteswere promptly cancelled upon receipt by the trustee of each transaction and therelated debt was extinguished by the issuers thereof. We believe that thistransaction brings the OC Tests for these three CLOs into compliance, enablingthe mezzanine and subordinated note holders, including us, to resume receivingcash flows from these transactions during the period when the OC Tests remainin compliance. As these CLO transactions are consolidated by us underaccounting principles generally accepted in the United States of America (“GAAP”),this transaction is not expected to have any impact on our consolidatedfinancial statements. Similarly, as CLO 2005-1, CLO 2005-2 and CLO 2006-1 aretreated as disregarded entities for tax purposes, this transaction is notexpected to have any tax implications for us or our shareholders.

 

***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 anunconsolidated basis, our investment portfolio primarily consists of thefollowing as of June 30, 2009: (i) mezzanine and subordinatedtranches of CLO transactions, totaling a par amount of $1.4 billion; (ii) corporateloans with an aggregate par amount of $452.7 million and an estimated fairvalue of $147.7 million; (iii) corporate debt securities with anaggregate par amount of $92.8 million and an estimated fair value of $66.5million; (iv) residential mortgage-backed securities (“RMBS”) with a paramount of $300.5 million and estimated fair value of $218.3 million; (v) privateequity investments with an aggregate cost amount of $29.8 million and anestimated fair value of $27.1 million; note that our private equity investmentsare accounted for under either the cost method (cost of $17.5 million) orat fair value if we elected the fair value option of accounting (cost of$12.3 million); (vi) marketable equity securities with an aggregateestimated fair value of $0.9 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 June 30,2009, our corporate debt investments, excluding investments held through totalrate of return swaps, had an aggregate par balance of $8.6 billion, anaggregate net amortized cost of $7.9 billion and an aggregate estimatedfair value of $6.4 billion. Included in these amounts is $7.6 billion paramount or $5.8 billion estimated fair value of investments held in our CashFlow CLOs which have aggregate senior notes outstanding totaling $5.7 billionand an aggregate of $542.1 million of mezzanine and subordinated notesoutstanding that are held by an affiliate of our Manager. In addition to theinvestments held by our Cash Flow CLOs, they had an aggregate principal cashbalance totaling $103.2 million as of June 30, 2009.

 

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As of June 30, 2009, CLO 2009-1 held investments with an aggregatepar balance of $438.8 million and an estimated fair value of $334.1 million.CLO 2009-1 also had an aggregate principal cash balance of $5.1 million, seniornotes outstanding totaling $44.4 million and subordinated notes outstanding toan affiliate of our Manager totaling $90.4 million as of June 30,2009.

 

*RMBSInvestments*

 

Our residential mortgage investment portfolio consists of investmentsin RMBS with an estimated fair value of $224.1 million as of June 30,2009. Of the $224.1 million of RMBS investments we hold,$147.5 million are in six residential mortgage-backed securitizationtrusts that we consolidate under GAAP as we hold the majority of the risk ofloss on these transactions. This results in us reflecting the financialposition and results of these trusts in our condensed consolidated financialstatements. Consolidation of these six entities does not impact our net assetsor net income; however, it does result in us showing the condensed consolidatedassets, liabilities, revenues and expenses on our condensed consolidatedfinancial statements. On our condensed consolidated balance sheet as of June 30,2009, the $224.1 million of RMBS is computed as our investments in RMBS of$76.6 million, plus $147.5 million, which represents the differencebetween residential mortgage loans of $2.2 billion less residentialmortgage-backed securities issued of $2.1 billion plus $9.8 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 are fundamentalto understanding our financial condition and results of operations because someof these policies require that we make significant estimates and assumptionsthat may affect the value of our assets or liabilities and financial results.We believe that certain of our policies are critical because they require us tomake difficult, subjective, and complex judgments about matters that areinherently uncertain. We have reviewed these critical accounting policies withour board of directors and our audit committee.

 

***Fair Value of Financial Instruments***

 

As defined in SFAS No. 157, *FairValue Measurements* (“SFAS No. 157”), fair value is the pricethat would be received to sell an asset or paid to transfer a liability in anorderly transaction 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, as defined in SFASNo. 157 and directly related to the amount of subjectivity associated withthe inputs to fair valuations of these assets and liabilities, are as follows:

 

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

 

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

 

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

 

Fair value assets and liabilities that are generally included in thiscategory are certain corporate debt securities, 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.

 

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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 to measurefair value may fall into different levels of the fair value hierarchy. In suchcases, the level in the fair value hierarchy within which the fair valuemeasurement in its entirety falls has been determined based on the lowest levelinput that is significant to the fair value measurement in its entirety. Ourassessment of the significance of a particular input to the fair valuemeasurement in its entirety requires judgment and the consideration of factorsspecific 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, REO, residential mortgage-backedsecurities issued and certain derivatives.

 

Inthe second quarter of 2009, we adopted Financial Accounting Standards Board’sStaff Position (“FSP”) FAS 157-4, *Determining Fair ValueWhen the Volume and Level of Activity for the Asset or Liability HaveSignificantly Decreased and Identifying Transactions That Are Not Orderly*(“FSPFAS 157-4”). This FSP provides additional guidance on determining fair valuewhen the volume and level of activity for the asset or liability havesignificantly decreased when compared with normal market activity for the assetor liability (or similar assets or liabilities). A significant decrease in thevolume and level of activity for the asset or liability is an indication thattransactions or quoted prices may not be determinative of fair value because insuch market conditions there may be increased instances of transactions thatare not orderly. In those circumstances, further analysis of transactions orquoted prices is needed, and a significant adjustment to the transactions orquoted prices may be necessary to estimate fair value in accordance with SFAS No. 157.We determined that FSP FAS 157-4 didnot have a material impact on our condensed consolidated financial statements.

 

Ifthere has been a significant decrease in the volume and level of activity forthe asset or liability, a change in valuation technique or the use of multiplevaluation techniques may be appropriate (for example, the use of a marketapproach and a present value technique). When weighting indications of fair value resulting from the use ofmultiple valuation techniques, a reporting entity shall consider thereasonableness of the range of fair value estimates. The objective is todetermine the point within that range that is most representative of fair valueunder current market conditions. A wide range of fair value estimates may be anindication that further analysis is needed.

 

Regardless of the approach taken (i.e. either asingle valuation technique or multiple valuation techniques), even incircumstances where there has been a significant decrease in the volume andlevel of activity for the asset or liability and regardless of the valuationtechnique(s) used, the objective of a fair value measurement remains thesame. Fair value is the price that would be received to sell an asset or paidto transfer a liability in an orderly transaction (that is, not a forcedliquidation or distressed sale) between market participants at the measurementdate under current market conditions. Determining the price at which willingmarket participants would transact at the measurement date under current marketconditions if there has been a significant decrease in the volume and level ofactivity for the asset or liability depends on the facts and circumstances andrequires the use of significant judgment. However, a reporting entity’sintention to hold the asset or liability is not relevant in estimating fairvalue. Fair value is a market-based measurement, not an entity-specificmeasurement

 

The FSP also emphasizes that in identifyingtransactions that are not orderly, an entity cannot assume that the observabletransaction price is not orderly when the volume and level of activity for theasset or liability have significantly declined. Instead, an entity must performan analysis to determine whether the observable price is representative of atransaction that is not orderly. In making this determination, an entity cannotignore information that is available without undue cost and effort; however, theentity is not required to undertake all possible efforts. A reporting entityshall evaluate the circumstances to determine whether the transaction isorderly based on the weight of the evidence.

 

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 within whichthe fair value measurement in its entirety falls is determined based on thelowest 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 financialassets and liabilities whose inputs are based on bid-ask prices, we do notrequire that fair value always be a predetermined point in the bid-ask range.Our policy is to allow for mid-market pricing and adjusting to the point withinthe bid-ask range that meets our best estimate of fair value.

 

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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. Assets andliabilities that are valued using level 3 of the fair value hierarchyprimarily consist of certain corporate debt securities, certain private equityinvestments, certain corporate loans held for sale, residential mortgage-backedsecurities, residential mortgage loans, residential mortgage-backed securitiesissued and certain over-the-counter (“OTC”) derivative contracts. The valuationtechniques used for these 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. Valuationsmodels 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.

 

*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 the fair value based methodology inaccordance with SFAS No. 123(R), *Share-basedCompensation* (“SFAS No. 123(R)”). We do not have any employees,although we believe that members of our board of directors are deemed to beemployees for purposes of interpreting and applying accounting principlesrelating to share-based compensation. We record as compensation costs therestricted common shares that we issued to members of our board of directors atestimated fair value as of the grant date and we amortize the cost into expenseover the three-year vesting period using the straight-line method. We recordcompensation costs for restricted common shares and common share options thatwe issued to our Manager at estimated fair value as of the grant date and weremeasure the amount on subsequent reporting dates to the extent the awardshave not vested. Unvested restricted common shares are valued using observablesecondary market prices. Unvested common share options are valued using theBlack-Scholes model and assumptions based on observable market data forcomparable 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 in accordance with SFAS No. 123(R).

 

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 six months ended June 30, 2009,share-based compensation was immaterial. As of June 30, 2009,substantially all of the non-vested restricted common shares issued that aresubject to SFAS No. 123(R) are subject to remeasurement. As of June 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 June 30, 2009, the common share options werefully exercised and expire in August 2014. As of June 30, 2009,future unamortized share-based compensation totaled $0.8 million, of which$0.3 million, $0.5 million, and an immaterial amount will berecognized in 2009, 2010, and beyond, respectively.

 

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***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 a recognizedasset or liability (“fair value” hedge); (ii) a hedge of a forecastedtransaction or of the variability of cash flows to be received or paid relatedto a recognized asset or liability (“cash flow” hedge); (iii) a hedge of anet investment in a foreign operation; or (iv) a derivative instrument notdesignated as a hedging instrument (“free-standing derivative”). For a fairvalue hedge, we record changes in the estimated fair value of the derivativeand, to the extent that it is effective, changes in the fair value of thehedged asset or liability attributable to the hedged risk, in the currentperiod earnings in the same financial statement category as the hedged item.For a cash flow hedge, we record changes in the estimated fair value of thederivative to the extent that it is effective in other comprehensive income. Wesubsequently reclassify these changes in estimated fair value to net income inthe same period(s) that the hedged transaction affects earnings in the samefinancial statement category as the hedged item. For free-standing derivatives,we report changes in the fair values in current period non-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, as requiredby SFAS No. 133, *Accounting forDerivative Instruments and Hedging Activities*, as amended andinterpreted (“SFAS No. 133”), we also formally assesses whether thederivative designated in each hedging relationship is expected to be and hasbeen highly effective in offsetting changes in estimated fair values or cashflows of the hedged item using either the dollar offset or the regressionanalysis method. If we determine that a derivative is not highly effective as ahedge, 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 June 30,2009, the estimated fair value of our net derivative liabilities totaled$47.2 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 alsoconsider our intent and ability to hold the equity security for a period oftime sufficient for a recovery in value.

 

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 lossamount is recognized in earnings, with the remainder of the loss amountrecognized in other comprehensive income.

 

This process involves a considerable amount of subjective judgments byour management. As of June 30, 2009, we had aggregate unrealized losses onour securities classified as available-for-sale of approximately$69.4 million, which if not recovered may result in the recognition offuture losses. During the three and six months ended June 30, 2009, werecorded charges for impairments of securities that we determined to beother-than-temporary totaling $6.2 million and $40.0 million,respectively.

 

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In the second quarter of 2009, we adopted FSP FAS115-2 and FAS 124-2,*Recognition andPresentation of Other-Than-Temporary Impairments*(“FSP FAS 115-2 andFAS 124-2”), which amends the other-than-temporary impairment guidance for debtsecurities. We determined that FSP FAS 115-2 and FAS 124-2 did not have a materialimpact on our condensed consolidated financial statements.

 

***Allowance for Loan Losses***

 

Our allowance for estimated loan losses represents our estimate ofprobable credit losses inherent in our corporate loan portfolio held forinvestment. When determining the adequacy of the allowance for loan losses, weconsider historical and industry loss experience, economic conditions andtrends, the estimated fair values of our loans, credit quality trends and otherfactors that we determine are relevant. This process involves a considerableamount of subjective judgments by our management. Additions to the allowancefor loan losses are charged to current period earnings through the provisionfor loan losses. Amounts determined to be uncollectible are charged directly tothe allowance for loan losses. Our allowance for loan losses consists of twocomponents, an allocated component and an unallocated component.

 

Theallocated component of our allowance for loan losses consists of individualloans that are impaired and for which the estimated allowance for loan lossesis determined in accordance with SFAS No. 114, *Accounting by Creditors for Impairment of a Loan.* Weconsider a loan to be impaired when, based on current information and events,we believe it is probable that we will be unable to collect all amounts due tous based on the contractual terms of the loan. An impaired loan may be left onaccrual status during the period we are pursuing repayment of the loan;however, the loan is placed on non-accrual status at such time as: (i) webelieve that scheduled debt service payments may not be paid when contractuallydue; (ii) the loan becomes 90 days delinquent; (iii) we determine theborrower is incapable of, or has ceased efforts toward, curing the cause of theimpairment; or (iv) the net realizable value of the underlying collateralsecuring the loan decreases below our carrying value of such loan. While onnon-accrual status, previously recognized accrued interest is reversed if it isdetermined that such amounts are not collectible and interest income isrecognized only upon actual receipt.

 

The unallocated component of our allowance for loan losses isdetermined in accordance with SFAS No. 5, *Accountingfor Contingencies*. This component of the allowance for loan lossesrepresents our estimate of losses inherent, but unidentified, in our portfolioas of the balance sheet date. The unallocated component of the allowance forloan losses is estimated based upon a review of the our loan portfolio’s riskcharacteristics, risk grouping of loans in the portfolio based upon estimatedprobability of default and severity of loss based on loan type, andconsideration of general economic conditions and trends.

 

As of June 30, 2009, our allowance for loan losses totaled $473.2 million.

 

**Recent Accounting Pronouncements**

 

In January 2009, the FASB issued FSP EITF 99-20-1, *Amendments to the Impairment Guidance of EITF Issue No. 99-20*(“FSP EITF 99-20-1”). FSP EITF 99-20-1 eliminates the requirementthat a holder’s best estimate of cash flows be based upon those that “a marketparticipant” would use. Instead, it requires that an other-than-temporaryimpairment be recognized as a realized loss when it is “probable” there hasbeen an adverse change in the holder’s estimated cash flows from the cash flowspreviously projected. FSP EITF 99-20-1 also reiterates and emphasizes therelated guidance and disclosure requirements in accordance with SFAS No. 115,*Accounting for Certain Investments in Debtand Equity Securities.* FSP EITF 99-20-1 is effective for allperiods ending after December 15, 2008 and retroactive application is notpermitted. We have taken this FSP into consideration when evaluating ourinvestments for other-than-temporary impairment.

 

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”) fromSFAS No. 140, and the elimination of the exception for QSPE from theconsolidation guidance of FIN 46R. The disclosures required by this standardare to provide greater transparency about transfers of financial assets and anentity’s continuing involvement in transferred financial assets. SFAS No. 166will significantly 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. We are evaluating theimpact 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 SFAS No. 140and responds to concerns about the application of certain key provisions of FIN46R including concerns over the transparency of enterprises’ involvement withVIEs. 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.

 

38

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On June 29, 2009, the FASB issued SFAS No. 168,*The FASB AccountingStandards Codification and theHierarchy of Generally Accepted Accounting Principles—a replacement of FASBStatement No. 162* (“SFAS No. 168”). The FASB AccountingStandards Codification (Codification) will become the single official source ofauthoritative GAAP. The current GAAP hierarchy consists of four levels ofauthoritative accounting and reporting guidance (levels A through D), includingoriginal pronouncements of the FASB, FASB FSPs, EITF abstracts, and otheraccounting literature (“pre-Codification GAAP” or “current GAAP”). TheCodification eliminates this hierarchy and replaces current GAAP (other than rules andinterpretive releases of the SEC) with just two levels of literature:authoritative and nonauthoritative. The Codification will be effective forinterim and annual periods ending on or after September 15, 2009. We donot believe that the adoption of SFAS No. 168 will have a material impacton our financial statements.

 

**Results of Operations**

 

*Summary*

 

Our net income for the three and six months ended June 30, 2009totaled $20.6 million (or $0.14 per diluted common share) and $7.6 million (or$0.05 per diluted common share), respectively, as compared to net income of$37.6 million (or $0.25 per diluted common share) and $51.5 million (or$0.39 per diluted common share), respectively, for the three and six monthsended June 30, 2008. Income from continuing operations for the three andsix months ended June 30, 2009 totaled $20.6 million (or $0.14 per dilutedcommon share) and $7.6 million (or $0.05 per diluted common share),respectively, as compared to income from continuing operations of$38.6 million (or $0.25 per diluted common share) and $48.9 million (or$0.37 per diluted common share), respectively, for the three and six monthsended June 30, 2008. The decrease in income from continuing operations of$18.0 million and $41.2 million from the three and six months ended June 30,2008 to 2009, respectively, is primarily due to an increase in realized andunrealized loss on investments and a decline in net investment income resultingfrom a smaller investment portfolio and lower LIBOR rate. These losses wereslightly offset by net realized and unrealized gains on derivatives and foreignexchange.

 

*Net InvestmentIncome*

 

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

 

**Comparative Net Investment Income Components**

**(Amounts inthousands)**

 
| ** **                                                 | ** ** | **For the three  months ended  June 30, 2009** | ** ** | **For the three  months ended  June 30, 2008** | ** ** | **For the six  months ended  June 30, 2009** | ** ** | **For the six  months ended  June 30, 2008** | ** ** |
|------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| Investment Income:                                         |       |                                                                    |       |                                                                    |       |                                                                  |       |                                                                  |       |
| Corporate loans and securities interest income             |       | $                                                                       | 97,400     |                                                                    | $          | 163,830                                                               |       | $                                                                     | 202,584    |   | $ | 363,190 |   |
| Residential mortgage loans and securities interest  income |       | 31,843                                                                  |       | 44,643                                                                  |       | 70,844                                                                |       | 92,847                                                                |       |
| Other interest income                                      |       | 106                                                                     |       | 4,998                                                                   |       | 462                                                                   |       | 16,074                                                                |       |
| Dividend income                                            |       | 26                                                                      |       | 1,092                                                                   |       | 287                                                                   |       | 1,908                                                                 |       |
| Net discount accretion                                     |       | 15,928                                                                  |       | 10,865                                                                  |       | 29,799                                                                |       | 19,647                                                                |       |
| Total investment income                                    |       | 145,303                                                                 |       | 225,428                                                                 |       | 303,976                                                               |       | 493,666                                                               |       |
| Interest Expense:                                          |       |                                                                    |       |                                                                    |       |                                                                  |       |                                                                  |       |
| Repurchase agreements                                      |       | —                                                                  |       | 4,467                                                                   |       | —                                                                |       | 33,437                                                                |       |
| Collateralized loan obligation senior secured  notes       |       | 33,210                                                                  |       | 71,889                                                                  |       | 79,625                                                                |       | 146,407                                                               |       |
| Secured revolving credit facility                          |       | 3,916                                                                   |       | 3,140                                                                   |       | 7,858                                                                 |       | 5,773                                                                 |       |
| Secured demand loan                                        |       | —                                                                  |       | 25                                                                      |       | —                                                                |       | 348                                                                   |       |
| Convertible senior notes                                   |       | 5,259                                                                   |       | 5,623                                                                   |       | 10,505                                                                |       | 11,010                                                                |       |
| Junior subordinated notes                                  |       | 4,176                                                                   |       | 6,349                                                                   |       | 8,617                                                                 |       | 12,104                                                                |       |
| Residential mortgage-backed securities issued              |       | 21,244                                                                  |       | 34,001                                                                  |       | 47,103                                                                |       | 68,432                                                                |       |
| Other interest expense                                     |       | 1,005                                                                   |       | 272                                                                     |       | 2,247                                                                 |       | 1,022                                                                 |       |
| Interest rate swap                                         |       | 3,593                                                                   |       | 2,271                                                                   |       | 6,330                                                                 |       | 3,569                                                                 |       |
| Total interest expense                                     |       | (72,403                                                                 | )          | (128,037                                                                | )          | (162,285                                                              | )          | (282,102                                                              | )          |
| Interest expense to affiliates                             |       | (5,379                                                                  | )          | (19,707                                                                 | )          | (11,184                                                               | )          | (47,525                                                               | )          |
| Provision for loan losses                                  |       | (12,808                                                                 | )          | (10,000                                                                 | )          | (39,795                                                               | )          | (10,000                                                               | )          |
| Net investment income                                      |       | $                                                                       | 54,713     |                                                                    | $          | 67,684                                                                |       | $                                                                     | 90,712     |   | $ | 154,039 |   |

 

39

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The decrease in net investment income from the three and six monthsended June 30, 2008 to 2009 is primarily attributable to a smallerinvestment portfolio and lower interest rates, partially offset by a decline ininterest expense related to pay downs of our collateralized loan obligationsenior secured notes in 2009.

 

*Other Loss*

 

The following table presents the components of other loss for the threeand six months ended June 30, 2009 and 2008:

 

**Comparative Other Loss Components**

**(Amounts inthousands)**

 
| ** **                                                                                                                                                                      | ** ** | **For the three  months ended  June 30, 2009** | ** ** | **For the three  months ended  June 30, 2008** | ** ** | **For the six  months ended  June 30, 2009** | ** ** | **For the six  months ended  June 30, 2008** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| Net realized and unrealized (loss) gain on  derivatives and foreign exchange:                                                                                                   |       |                                                                    |       |                                                                    |       |                                                                  |       |                                                                  |       |
| Interest rate swaps                                                                                                                                                             |       | $                                                                       | 92         |                                                                    | $          | (268                                                                  | )          | $                                                                     | 567        |   | $ | 3,526 |   |
| Credit default swaps                                                                                                                                                            |       | 4,928                                                                   |       | (2,955                                                                  | )          | 12,908                                                                |       | 10,334                                                                |       |
| Total rate of return swaps                                                                                                                                                      |       | 17,760                                                                  |       | (3,820                                                                  | )          | 24,713                                                                |       | (66,445                                                               | )          |
| Common stock warrants                                                                                                                                                           |       | —                                                                  |       | (20                                                                     | )          | —                                                                |       | (707                                                                  | )          |
| Foreign exchange(1)                                                                                                                                                             |       | 3,725                                                                   |       | 1,145                                                                   |       | 713                                                                   |       | 358                                                                   |       |
| Total realized and unrealized gain (loss) on  derivatives and foreign exchange                                                                                                  |       | 26,505                                                                  |       | (5,918                                                                  | )          | 38,901                                                                |       | (52,934                                                               | )          |
| Net realized loss on residential mortgage-backed  securities and residential mortgage loans, carried at estimated fair value                                                    |       | (3,269                                                                  | )          | (744                                                                    | )          | (11,676                                                               | )          | (1,499                                                                | )          |
| Net unrealized loss on residential mortgage-backed  securities, residential mortgage loans, and residential mortgage-backed  securities issued, carried at estimated fair value |       | (4,176                                                                  | )          | (4,850                                                                  | )          | (15,188                                                               | )          | (13,273                                                               | )          |
| Net realized and unrealized loss on investments(2)                                                                                                                              |       | (40,304                                                                 | )          | (7,529                                                                  | )          | (66,744                                                               | )          | (21,288                                                               | )          |
| Net realized and unrealized gain on securities  sold, not yet purchased                                                                                                         |       | 2,479                                                                   |       | 1,664                                                                   |       | 3,916                                                                 |       | 8,650                                                                 |       |
| Impairment of securities available for sale                                                                                                                                     |       | (6,249                                                                  | )          | (9,688                                                                  | )          | (40,013                                                               | )          | (9,688                                                                | )          |
| Gain on restructuring and extinguishment of debt                                                                                                                                |       | 6,892                                                                   |       | 17,225                                                                  |       | 41,463                                                                |       | 17,225                                                                |       |
| Other income                                                                                                                                                                    |       | 1,578                                                                   |       | 513                                                                     |       | 2,911                                                                 |       | 5,469                                                                 |       |
| Total other loss                                                                                                                                                                |       | $                                                                       | (16,544    | )                                                                       | $          | (9,327                                                                | )          | $                                                                     | (46,430    | ) | $ | (67,338 | ) |

 

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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 loss totaled $16.5 million and $46.4 million for the three and sixmonths ended June 30, 2009, respectively, as compared to other loss of$9.3 million and $67.3 million for the three and six months ended June 30,2008, respectively. Total other loss for the three months ended June 30,2009 primarily consisted of net realized and unrealized losses on investmentstotaling $40.3 million, partially offset by net realized and unrealized gainson derivatives and foreign exchange totaling $26.5 million. Total other lossfor the six months ended June 30, 2009 primarily consisted of net realizedand unrealized losses on investments totaling $66.7 million, net unrealized losses on residentialmortgage-backed securities, residential mortgage loans and residentialmortgage-backed securities issued totaling $15.2 million, and a loss fromother-than-temporary impairments on securities available-for-sale totaling$40.0 million. These losses were partially offset by netrealized and unrealized gains on derivatives and foreign exchange totaling$38.9 million and a gain on restructuring and extinguishment of debttotaling $41.5 million. The gain on restructuring and extinguishment of debtprimarily reflects the reduction of the reported amount of debt held by anaffiliate of our Manager upon the replacement of Wayzata with CLO 2009-1 on March 31,2009.

 

40

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*Non-InvestmentExpenses*

 

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

 

**Comparative Non-Investment Expense Components**

**(Amounts inthousands)**

 
| ** **                             | ** ** | **For the three  months ended  June 30, 2009** | ** ** | **For the three  months ended  June 30, 2008** | ** ** | **For the six  months ended  June 30, 2009** | ** ** | **For the six  months ended  June 30, 2008** | ** ** |
|----------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| Related party management compensation: |       |                                                                    |       |                                                                    |       |                                                                  |       |                                                                  |       |
| Base management fees                   |       | $                                                                       | 3,653      |                                                                    | $          | 8,927                                                                 |       | $                                                                     | 7,278      |   | $ | 16,360 |   |
| Share-based compensation               |       | 105                                                                     |       | 196                                                                     |       | (35                                                                   | )          | 658                                                                   |       |
| CLO management fees                    |       | 6,546                                                                   |       | 1,264                                                                   |       | 14,273                                                                |       | 2,528                                                                 |       |
| Related party management compensation  |       | 10,304                                                                  |       | 10,387                                                                  |       | 21,516                                                                |       | 19,546                                                                |       |
| Professional services                  |       | 2,090                                                                   |       | 1,071                                                                   |       | 5,475                                                                 |       | 2,928                                                                 |       |
| Loan servicing                         |       | 2,056                                                                   |       | 2,391                                                                   |       | 4,192                                                                 |       | 4,960                                                                 |       |
| Insurance                              |       | 303                                                                     |       | 158                                                                     |       | 606                                                                   |       | 319                                                                   |       |
| Directors expenses                     |       | 388                                                                     |       | 315                                                                     |       | 692                                                                   |       | 716                                                                   |       |
| General and administrative             |       | 2,284                                                                   |       | 5,279                                                                   |       | 4,080                                                                 |       | 9,239                                                                 |       |
| Total non-investment expenses          |       | $                                                                       | 17,425     |                                                                    | $          | 19,601                                                                |       | $                                                                     | 36,561     |   | $ | 37,708 |   |

 

As presented in the table above, our non-investment expenses decreasedby approximately $2.2 million from the three months ended June 30, 2008 to2009 and $1.1 million from the six months ended June 30, 2008 to 2009. Thesignificant components of non-investment expense are described 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 $5.3million and $9.1 million, from the three and six months ended June 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, the 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 the Manager upon the earlier of (x) December 15,2009 and (y) the date of any termination of the Management Agreement pursuantto 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 nil wereearned by the Manager during the three and six months ended June 30, 2009and 2008.

 

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.Accordingly, CLO management fees increased $5.3 million and $11.7 million fromthe three and six months ended June 30, 2008 to 2009, respectively. Inaddition, beginning January 1, 2009, our Manager permanently waivedreimbursable general and administrative expenses allocable to us in an amountequal to the incremental CLO fees received by our Manager. For the three andsix months ended June 30, 2009, the Manager permanently waivedreimbursement of $3.0 million and $5.3 million, respectively, in allocablegeneral and administrative expenses. For the three and six months ended June 30,2008, we reimbursed our Manager $2.6 million and $5.1 million, respectively,for expenses.

 

General and administrative expenses consist of expenses incurred by ourManager on our behalf that are reimbursable to our Manager pursuant to the ManagementAgreement. Professional services expenses consist of legal, accounting andother professional services. Directors’ expenses represent share-basedcompensation, as well as expenses and reimbursables due to the board ofdirectors for their services. Professional fees increased by $1.0 million fromthe three months ended June 30, 2008 to 2009 and $2.5 million from the sixmonths ended June 30, 2008 to 2009 primarily due to expenses associatedwith CLO 2009-1. The decrease in general and administrative expenses of$3.0 million and $5.2 million from the three and six months ended June 30,2008 to 2009, respectively, was primarily attributable to the rebated CLO feesreducing the general and administrative expenses otherwise reimbursable to ourManager.

 

41

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*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 foreignsubsidiaries and are taxed as corporations for United States federal income taxpurposes. These entities were formed to make certain foreign and domesticinvestments from time to time. TRS Ltd. and KFH Ltd. are organized asexempted companies incorporated with limited liability under the laws of theCayman Islands, and are generally exempt from United States federal and stateincome tax at the corporate entity level because they restrict their activitiesin the United States to trading in stock and securities for their own account.They generally will not be subject to corporate income tax in our financialstatements on their earnings, and no provisions for income taxes for thequarter ended June 30, 2009 were recorded; however, we are generallyrequired to include their current taxable income in our calculation of taxable incomeallocable 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.

 

The tables below summarize the carrying value, amortized cost andestimated fair value of our corporate investment portfolio as of June 30,2009 and December 31, 2008, stratified by type. Carrying value is thevalue that investments are recorded on our condensed consolidated balancesheets and is estimated fair value for securities, amortized cost for loansheld for investment, and the lower of amortized cost or estimated fair valuefor loans held for sale. Estimated fair values set forth in the tables beloware primarily based on dealer quotes and/or nationally recognized pricingservices.

 

*CorporateLoans*

 

Our corporate loan portfolio totaled approximately $7.3 billion as of June 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 June 30, 2009 and December 31, 2008:

 

**Corporate Loans**

**(Amounts inthousands)**

 
| ** **     | ** ** | **June 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|----------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **     | ** ** | **Carrying  Value (1)** | ** ** | **Amortized  Cost**         | ** ** | **Estimated  Fair  Value** | ** ** | **Carrying  Value(1)** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair  Value** | ** ** |
| Senior secured |       | $                       | 6,459,603  |                        | $          | 6,459,603 |   | $ | 5,259,242 |   | $ | 7,147,665 |   | $ | 7,147,665 |   | $ | 4,627,121 |   |
| Second lien    |       | 597,833                 |       | 597,833                     |       | 401,394 |   | 655,371 |   | 655,371 |   | 361,196 |   |
| Mezzanine      |       | 230,753                 |       | 230,753                     |       | 120,146 |   | 249,185 |   | 249,185 |   | 109,266 |   |
| Total          |       | $                       | 7,288,189  |                        | $          | 7,288,189 |   | $ | 5,780,782 |   | $ | 8,052,221 |   | $ | 8,052,221 |   | $ | 5,097,583 |   |

 

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| (1) | Total  carrying value excludes allowance for loan losses of $473.2 million and  $480.8 million as of June 30, 2009 and December 31, 2008, respectively,  and includes loans held for sale of $168.5 million and $324.6 million as  of June 30, 2009 and December 31, 2008, respectively. |
|-----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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As of June 30, 2009, $7.2 billion, or 98.2%, of our corporateloan portfolio was floating rate and $0.1 billion, or 1.8%, was fixedrate. 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 3.9% and 4.6%as of June 30, 2009 and December 31, 2008, respectively, and theweighted-average coupon spread to LIBOR of our floating rate corporate loanportfolio was 3.1% and 2.9% as of June 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 4.7 years and 5.1 yearsas of June 30, 2009 and December 31, 2008, respectively.

 

As of June 30, 2009, our fixed rate corporate loans had aweighted-average coupon of 13.0% and weighted-average years to maturity of5.7 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 June 30, 2009 and December 31, 2008, we had $704.3million and $358.0 million of loans on non-accrual status, respectively.The average recorded investment in the impaired loans during the three and sixmonths ended June 30, 2009 was $738.2 million and $531.3 million,respectively. As of June 30, 2008, there were no corporate loan balancesplaced on non-accrual status. The amount of interest income recognized usingthe cash-basis method during the time within the period that the loans wereimpaired was $4.7 million and $6.8 million for the three and six months ended June 30,2009, respectively, and nil for the three and six months ended June 30,2008.

 

As of June 30, 2009, we held loans that were in default with atotal amortized cost of $727.3 million from nine issuers. During the year endedDecember 31, 2008, we held investments that were in default with a totalamortized cost of $312.7 million from three issuers. The majority ofcorporate loans in default during 2009 and 2008 were included in the investmentsfor which the allocated component of our allowance for losses was related to asof June 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 six months ended June 30,2009 and 2008 (amounts in thousands):

 
| ** **                     | ** ** | **For the three  months ended  June 30, 2009** | ** ** | **For the three  months ended  June 30, 2008** | ** ** | **For the six  months ended  June 30, 2009** | ** ** | **For the six  months ended  June 30, 2008** | ** ** |
|--------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|---------------------------------------------------|------------|
| Balance at beginning of period |       | $                                                   | 507,762    |                                                | $          | 25,000                                            |       | $                                                 | 480,775    |   | $ | 25,000 |   |
| Provision for loan losses      |       | 12,808                                              |       | 10,000                                              |       | 39,795                                            |       | 10,000                                            |       |
| Charge-offs                    |       | (47,368                                             | )          | —                                              |       | (47,368                                           | )          | —                                            |       |
| Balance at end of period       |       | $                                                   | 473,202    |                                                | $          | 35,000                                            |       | $                                                 | 473,202    |   | $ | 35,000 |   |

 

As of June 30, 2009 and December 31, 2008, we had anallowance for loan loss of $473.2 million and $480.8 million,respectively. As described under Critical Accounting Policies, our allowancefor loan losses represents our estimate of probable credit losses inherent inour loan portfolio as of the balance sheet date. Our allowance for loan lossesconsists of two components, an allocated component and an unallocatedcomponent. The allocated component of our allowance for loan losses consists ofindividual loans that are impaired. The unallocated component of our allowancefor loan losses represents our estimate of losses inherent, but not identified,in our portfolio as of the balance sheet date.

 

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As of June 30, 2009, the allocated component of the allowance forloan losses totaled $428.8 million and relates to investments in loans issuedby eleven issuers with an aggregate par amount of $891.9 million and anaggregate 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 componentof our allowance for loan losses reflects significant deterioration in thecredit performance 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 $44.4 millionand $160.2 million as of June 30, 2009 and December 31, 2008,respectively. The decline in the unallocated component of our allowance forloan losses from December 31, 2008 to June 30, 2009 is attributable to themigration of the unallocated component to the allocated component of theallowance for loan losses since year end. We recorded charge-offs during thethree and six months ended June 30, 2009 totaling $47.4 million. Of these,$6.0 million related to a loan sold during the quarter, while $41.4 millionrelated to a loan exchanged for private equity and which qualified as atroubled debt restructuring. At the time of restructuring, we elected theoption to carry this investment at estimated fair value in accordance with SFASNo. 159, with unrealized gains and losses reported in income. There wereno charge-offs during the three and six months ended June 30, 2008.

 

We recorded a $25.7 million charge to earnings during the quarterended June 30, 2009 for the lower of cost or estimated fair valueadjustment for corporate loans held for sale which had an estimated fair valueof $168.5 million as of June 30, 2009. We recorded a $2.6 millioncharge to earnings during the quarter ended June 30, 2008 for the lower ofcost or estimated fair value adjustment for loans held for sale which had anestimated fair value of $66.7 million as of June 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 June 30, 2009 and December 31, 2008:

 

**Corporate Loans**

**(Amounts inthousands)**

 
| **Ratings Category**        | ** ** | **As of  June 30, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|-----------------------------|------------|-------------------------------|------------|-----------------------------------|------------|
| Aaa/AAA                     |       | $                             | —     |                              | $          | — |   |
| Aa1/AA+ through Aa3/AA-     |       | —                        |       | —                            |       |
| A1/A+ through A3/A-         |       | —                        |       | —                            |       |
| Baa1/BBB+ through Baa3/BBB- |       | 41,173                        |       | —                            |       |
| Ba1/BB+ through Ba3/BB-     |       | 1,577,723                     |       | 2,885,285                         |       |
| B1/B+ through B3/B-         |       | 4,956,391                     |       | 4,580,280                         |       |
| Caa1/CCC+ and lower         |       | 1,078,165                     |       | 957,104                           |       |
| Non-rated                   |       | 90,023                        |       | 33,449                            |       |
| Total                       |       | $                             | 7,743,475  |                              | $          | 8,456,118 |   |

 

*CorporateDebt Securities*

 

Our corporate debt securities portfolio totaled $604.0 million and$553.4 million as of June 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 June 30, 2009 and December 31, 2008:

 

**Corporate Debt Securities**

**(Amounts inthousands)**

 
| ** **       | ** ** | **June 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|------------------|------------|------------------------|------------|----------------------------|------------|
| ** **       | ** ** | **Carrying Value**     | ** ** | **Amortized Cost**         | ** ** | **Estimated Fair  Value** | ** ** | **Carrying Value** | ** ** | **Amortized Cost** | ** ** | **Estimated Fair  Value** | ** ** |
| Senior secured   |       | $                      | 55,134     |                       | $          | 38,220 |   | $ | 55,134 |   | $ | 57,641 |   | $ | 75,127 |   | $ | 57,641 |   |
| Senior unsecured |       | 344,591                |       | 350,172                    |       | 344,591 |   | 400,357 |   | 503,897 |   | 400,357 |   |
| Subordinated     |       | 204,254                |       | 218,176                    |       | 204,254 |   | 95,443 |   | 163,450 |   | 95,443 |   |
| Total            |       | $                      | 603,979    |                       | $          | 606,568 |   | $ | 603,979 |   | $ | 553,441 |   | $ | 742,474 |   | $ | 553,441 |   |

 

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As of June 30, 2009, $497.1 million, or 82.3%, of our corporatedebt securities portfolio was fixed rate and $106.9 million, or 17.7%, 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.

 

As of June 30, 2009, our fixed rate corporate debt securities hada weighted-average coupon of 10.3% and weighted-average years to maturity of7.0 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 4.0% and 7.0% as of June 30,2009 and December 31, 2008, respectively, and the weighted-average couponspread to LIBOR of our floating rate corporate debt securities was 3.2% and3.6% as of June 30, 2009 and December 31, 2008, respectively. Theweighted-average years to maturity of our floating rate corporate debtsecurities was 4.7 years and 4.5 years as of June 30, 2009 and December 31,2008, respectively.

 

During the three and six months ended June 30, 2009, we recordedimpairment losses totaling $6.2 million and $40.0 million, respectively,for corporate debt and equity securities that we determined to beother-than-temporarily impaired. These securities were determined to beother-than-temporarily impaired either due to our determination that recoveryin value is no longer likely or because we decided to sell the respectivesecurity in response to specific credit concerns regarding the issuer. For thethree and six months ended June 30, 2008, we recorded impairment lossestotaling $9.7 million for corporate debt and equity securities that wedetermined to be other-than-temporarily impaired.

 

As of June 30, 2009 and December 31, 2008, we held one corporatedebt security that was in default with a total fair value of $3.7 millionand $3.2 million, respectively. This corporate debt security was determined tobe other-than-temporarily impaired as of June 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 June 30, 2009 and December 31, 2008:

 

**Corporate Debt Securities**

**(Amounts inthousands)**

 
| **Ratings Category**        | ** ** | **As of  June 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-     |       | 32,000                        |       | 32,000                            |       |
| B1/B+ through B3/B-         |       | 265,169                       |       | 408,856                           |       |
| Caa1/CCC+ and lower         |       | 545,368                       |       | 734,303                           |       |
| Non-Rated                   |       | 6,816                         |       | 6,816                             |       |
| Total                       |       | $                             | 885,353    |                              | $          | 1,219,475 |   |

 

***Residential Mortgage InvestmentsSummary***

 

Our residential mortgage investment portfolio consists of investmentsin RMBS with an estimated fair value of $224.1 million as of June 30,2009. The $224.1 million of RMBS is comprised of $105.6 million ofRMBS that are rated investment grade or higher and $118.5 million of RMBSthat are rated below investment grade. Of the $224.1 million of RMBSinvestments we hold, $147.5 million are in six residential mortgage-backedsecuritization trusts that are not structured as qualifying special-purposeentities as defined by SFAS No. 140. Accordingly, as we own the first losssecurities in these trusts, we are deemed to be the primary beneficiary ofthese entities and as such, consolidate these trusts in accordance with GAAP.This results in us reflecting the financial position and results of thesetrusts in our condensed consolidated financial statements. Consolidation ofthese six entities does not impact our net assets or net income; however, itdoes result in us showing the condensed consolidated assets, liabilities,revenues and expenses on our condensed consolidated financial statements. Onour condensed consolidated balance sheet as of June 30, 2009, the $224.1 millionof RMBS is computed as our investments in RMBS of $76.6 million, plus$147.5 million, which represents the difference between residentialmortgage loans of $2.2 billion less residential mortgage-backed securitiesissued of $2.1 billion plus $9.8 million of REO that is included in otherassets on our condensed consolidated balance sheet. The $224.1 million ofRMBS as of June 30, 2009 represents a decrease of 17.2% from$270.7 million as of December 31, 2008.

 

As our condensed consolidated financial statements included in this quarterlyreport are presented to reflect the consolidation of the aforementionedresidential mortgage securitization trusts, the information contained in thisManagement’s Discussion and Analysis of Financial Condition and Results ofOperations reflects our residential mortgage portfolio presented on aconsolidated basis consistent with the disclosures in our condensedconsolidated financial statements.

 

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The table below summarizes the carrying value, amortized cost, andestimated fair value of our residential mortgage investment portfolio as of June 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)**

 
| ** **                             | ** ** | **June 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|----------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                             | ** ** | **Carrying  Value**    | ** ** | **Amortized  Cost**        | ** ** | **Estimated  Fair Value** | ** ** | **Carrying  Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| Residential Mortgage Loans(1)          |       | $                      | 2,218,319  |                       | $          | 3,090,856 |   | $ | 2,218,319 |   | $ | 2,620,021 |   | $ | 3,371,014 |   | $ | 2,620,021 |   |
| Residential Mortgage-Backed Securities |       | 76,572                 |       | 107,165                    |       | 76,572 |   | 102,814 |   | 125,849 |   | 102,814 |   |
| Total                                  |       | $                      | 2,294,891  |                       | $          | 3,198,021 |   | $ | 2,294,891 |   | $ | 2,722,835 |   | $ | 3,496,863 |   | $ | 2,722,835 |   |

 

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| (1) | Excludes  REO as a result of foreclosure on delinquent loans of $9.8 million and $10.8  million as of June 30, 2009 and December 31, 2008, respectively. |
|-----|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

As of June 30, 2009, twenty-five of our residential mortgage loanswith an outstanding balance of $9.8 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 June 30, 2009 and December 31,2008 (dollar amounts in thousands):

 
| ** **             | ** ** | **June 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|------------------------|------------|------------------------|------------|----------------------------|------------|
| **Delinquency Status** | ** ** | **Number  of Loans**   | ** ** | **Principal  Amount**      | ** ** | **Number  of Loans** | ** ** | **Principal  Amount** | ** ** |
| 30 to 59 days     |       | 71                     |       | $                          | 26,766     |   | 93 |   | $ | 37,282 |   |
| 60 to 89 days     |       | 36                     |       | 15,692                     |       | 41 |   | 15,654 |   |
| 90 days or more   |       | 116                    |       | 44,770                     |       | 76 |   | 29,803 |   |
| In foreclosure         |       | 120                    |       | 48,519                     |       | 67 |   | 22,841 |   |
| Total                  |       | 343                    |       | $                          | 135,747    |   | 277 |   | $ | 105,580 |   |

 

**Portfolio Purchases**

 

We purchased $0.4 billion and $0.7 billion par amount ofinvestments during the three months and six months ended June 30, 2009,respectively, as compared to $0.6 billion and $1.3 billion for the three and sixmonths ended June 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:

 

**Investment Portfolio Purchases**

**(Dollaramounts in thousands)**

 
| ** **                         | ** ** | **Three months ended  June 30, 2009** | ** ** | **Three months ended  June 30, 2008** | ** ** | **Six months ended  June 30, 2009** | ** ** | **Six months ended  June 30, 2008** | ** ** |
|------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                         | ** ** | **Par Amount**                                       | ** ** | **%**                                                     | ** ** | **Par Amount**                                     | ** ** | **%**                                                   | ** ** | **Par Amount** | ** ** | **%** | ** ** | **Par Amount** | ** ** | **%** | ** ** |
| Securities:                        |       |                                                      |       |                                                      |       |                                                    |       |                                                    |       |   |   |   |   |   |   |   |   |
| Corporate Debt Securities          |       | $                                                         | 41,000     |                                                      | 11.5       | %                                                       | $          | 83,747                                                  |       | 14.8 | % | $ | 42,563 |   | 6.4 | % | $ | 126,747 |   | 9.7 | % |
| Marketable Equity Securities       |       | —                                                    |       | —                                                    |       | 4,969                                                   |       | 0.9                                                     |       | — |   | — |   | 6,496 |   | 0.5 |   |
| Total Securities Principal Balance |       | 41,000                                                    |       | 11.5                                                      |       | 88,716                                                  |       | 15.7                                                    |       | 42,563 |   | 6.4 |   | 133,243 |   | 10.2 |   |
| Loans:                             |       |                                                      |       |                                                      |       |                                                    |       |                                                    |       |   |   |   |   |   |   |   |   |
| Corporate Loans                    |       | 314,592                                                   |       | 88.5                                                      |       | 476,680                                                 |       | 84.3                                                    |       | 624,218 |   | 93.6 |   | 1,171,253 |   | 89.8 |   |
| Grand Total Principal Balance      |       | $                                                         | 355,592    |                                                      | 100.0      | %                                                       | $          | 565,396                                                 |       | 100.0 | % | $ | 666,781 |   | 100.0 | % | $ | 1,304,496 |   | 100.0 | % |

 

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The schedule above excludes purchases of securities sold, not yetpurchased, with a par amount of nil and $27.2 million as of June 30,2009 and 2008, respectively.

 

**Shareholders’ Equity**

 

Our shareholders’ equity at June 30, 2009 and December 31,2008 totaled $899.6 million and $663.3 million, respectively. Included in ourshareholders’ equity as of June 30, 2009 and December 31, 2008 isaccumulated other comprehensive loss totaling $49.2 million and $268.8 million,respectively.

 

Our average shareholders’ equity and return on average shareholders’equity for the three and six months ended June 30, 2009 were$823.5 million and 10.0% and $757.9 million and 2.0%, respectively.  Our average shareholders’ equity and returnon average shareholders’ equity and for the three and six months ended June 30,2008, were $1.9 billion and 8.0% and $1.7 billion and 6.0%, respectively.Return on average shareholders’ equity is defined as net income divided byweighted average shareholders’ equity.

 

Our book value per share as of June 30, 2009 and December 31,2008 was $5.69 and $4.40, respectively, and is computed based on 158,139,238and 150,881,500 shares issued and outstanding as June 30, 2009 and December 31,2008, respectively.

 

**Liquidity and Capital Resources**

 

We actively manage our liquidity position with the objective ofpreserving our ability to fund our operations and fulfill our commitments on atimely and cost-effective basis. As of June 30, 2009, we had unrestrictedcash and cash equivalents totaling $114.4 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 June 30, 2009, certain of our Cash Flow CLOs wereout 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,approximately $298.4 million in aggregate of mezzanine notes and junior notesissued to us by these three CLO transactions. The Surrendered Notes werepromptly cancelled upon receipt by the trustee of each transaction and therelated debt was extinguished by the issuers thereof. We believe that thistransaction brings the OC Tests for these three CLOs into compliance as of thedate of filing this Quarterly Report on Form 10-Q, enabling the mezzanine andsubordinated note holders, including us, to resume receiving cash flows fromthese transactions during the period when the OC Tests remain in compliance.

 

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 is anaffiliate of our Manager. The notes issued by CLO 2009-1 are 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.

 

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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 thedeleveraging of CLO 2009-1, the subordinated notes in CLO 2009-1 held by ouraffiliate were retired in exchange for a 20% interest in each of CLO 2009-1’sassets which remained following the deleveraging.

 

Following the deleveraging transaction and the distribution of assetsto our affiliate, we now hold the residual assets of CLO 2009-1, which consistof approximately $317.4 million par amount of corporate debt investments withan estimated fair value as of June 30, 2009 of $242.4 million andapproximately $14.9 million of cash and receivables. As a result of thistransaction, we will receive all cash flows generated by the $317.4 million paramount of investments on a prospective basis.

 

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 June 30, 2009, we had six CLO transactions outstanding,CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-Aand CLO 2009-1. An affiliate of our Manager owns a 37% interest in the juniornotes of both CLO 2007-1 and CLO 2007-A, and a 20% interest in thesubordinated notes of CLO 2009-1. The aggregate carrying amount of the juniornotes in CLO 2007-1, CLO 2007-A and CLO 2009-1 held by the affiliate of ourManager is $632.5 million as of June 30, 2009, which is reflected ascollateralized loan obligation junior secured notes to affiliates on ourcondensed consolidated balance sheet. In accordance with GAAP, we consolidateeach of these CLO transactions. We utilize CLOs to fund our investments incorporate 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 for certainof 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 June 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                       |       | $              | 1,047,041  |           | $          | 982,748        |       | $              | 1,005,862  |           | $          | 3,471,652 |   | $ | 1,534,431 |   |
| Senior IC ratio minimum           |       | 115.0          | %          | 125.0          | %          | 115.0          | %          | 115.0          | %          | 120.0          | %          |
| Actual senior IC ratio            |       | 344.8          | %          | 340.9          | %          | 302.2          | %          | 254.6          | %          | 276.5          | %          |
| CCC amount                        |       | $              | 78,599     |           | $          | 89,888         |       | $              | 183,048    |           | $          | 661,687 |   | $ | 279,786 |   |
| CCC percentage of portfolio       |       | 7.5            | %          | 9.2            | %          | 18.2           | %          | 19.1           | %          | 18.2           | %          |
| 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             |       | 124.3          | %          | 127.5          | %          | 140.4          | %          | 146.1          | %          | 119.8          | %          |
| Cushion / (Excess)                |       | $              | 37,954     |           | $          | 33,211         |       | $              | (16,218    | )              | $          | (251,069 | ) | $ | 1,621 |   |
| Subordinated OC Test minimum      |       | 106.2          | %          | 106.9          | %          | 114.0          | %          | 120.1          | %          | 109.9          | %          |
| Actual OC Test                    |       | 104.9          | %          | 105.1          | %          | 104.8          | %          | 103.4          | %          | 103.7          | %          |
| Cushion / (Excess)                |       | $              | (11,816    | )              | $          | (16,038        | )          | $              | (75,015    | )              | $          | (458,072 | ) | $ | (81,805 | ) |

 

As reflected in the table above, each of our cash flow CLO transactionsis in compliance with its respective IC ratio tests based on the June 2009 monthlyreports for the respective CLOs. Based on the June 2009 monthly reports,CLO 2005-1, CLO 2005-2 and CLO 2007-A are in compliance with their respectivesenior OC Tests and none of the CLOs are in compliance with their respectivesubordinated OC Tests.

 

The indenture governing CLO 2009-1 does not contain the portfolio andcoverage tests that apply to the Cash Flow CLOs. This is due to CLO 2009-1having a turbo amortization feature whereby all principal and interest cashflows are paid to the senior note holders prior to the subordinated note holdersreceiving any cash payments.

 

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*SeniorSecured Asset-Based Revolving Credit Facility*

 

On August 5, 2009, we entered into an agreement with our lenders toamend the terms of our senior secured asset-based revolving credit facility.Among other things, the amendment provides that: (i) the size of the facilitybe reduced to $200.0 million from $300.0 million, (ii) the lending commitmentsof the lenders to this facility be modified to provide for quarterlyamortization of $12.5 million per quarter until the size of the facility hasbeen reduced to $150 million on June 30, 2010, (iii) the interest rateapplicable to borrowings under the facility be increased from LIBOR plus 300basis 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 we can (i) pay a yearly distribution to ourshareholders in an amount equal to no greater than 50% of our taxable incomefor such year and (ii) use up to $50 million of our unrestricted cash torepurchase our convertible notes due July 2012 and/or our outstanding trustpreferred securities. In conjunction with this amendment, we paid the lendersto our credit facility fees totaling $4.5 million.

 

As of June 30, 2009 we had borrowings outstanding under theFacility totaling $256.6 million. In conjunction with the amendment to this facility onAugust 5, 2009, we paid down the outstanding balance of borrowings under thisfacility to $200.0 million.

 

*StandbyRevolving Credit Facility*

 

On November 10, 2008, the Borrowers entered into an agreement fora two-year $100.0 million standby unsecured revolving credit agreement(the “Standby Agreement”) 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. The Borrowers have the right toprepay loans under the Standby Agreement in whole or in part at any time. TheStandby Agreement includes covenants, representations, warranties, indemnitiesand events of default that are customary for facilities of this type.

 

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

 

*ConvertibleDebt*

 

During June 2009, wecompleted two transactions to exchange a total of $15.7 million par value ofconvertible notes for 7.2 million of the Company’s common shares. As a resultof these transactions, we recorded a gain of $6.9 million, or approximately$0.05 per diluted common share, which was partially offset by a write-off of$0.1 million of unamortized debt issuance costs and $0.4 million of otherassociated costs.

 

*Off-Balance Sheet Commitments*

 

As of June 30, 2009, we had committed to purchase corporate loanswith aggregate commitments totaling $51.0 million. This amount reflectsunsettled trades as of June 30, 2009.

 

We participate in certain financing arrangements, including revolversand delayed draw facilities, whereby we are committed to provide funding at thediscretion of the borrower up to a specific predetermined amount. As of June 30,2009, we had unfunded financing commitments totaling $47.2 million.

 

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**PartnershipTax 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.

 

***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.

 

Ifwe fail to satisfy the “qualifying income exception” described above, items ofincome, gain, loss, deduction and credit would not pass through to holders ofour shares and such holders would be treated for United States federal (andcertain state and local) income tax purposes as shareholders in a corporation.In such case, we would be required to pay income tax at regular corporate rateson all of our income. In addition, we would likely be liable for state andlocal income and/or franchise taxes on all of our income. Distributions toholders of our shares would constitute ordinary dividend income taxable to suchholders to the extent of our earnings and profits, and these distributionswould not be deductible by us. If we were taxable as a corporation, it couldresult in a material reduction in cash flow and after-tax return for holders ofour shares and thus could result in a substantial reduction in the value of ourshares and any other securities we may 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.

 

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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.

 

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 a companymay rely on Section 3(c)(5)(C) of the 1940 Act if, among otherthings, at least 55% of the company’s assets consist of mortgage loans andother assets that are considered the functional equivalent of mortgage loans(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 toforeclose. That is, if the loan-to-value ratio of the loan is equal to or lessthan 100%, then the mortgage loan is considered to be a qualifying real estateasset. Mortgage loans with loan-to-value ratios in excess of 100% are consideredto be only real estate-related assets. Our REIT subsidiary considers agencywhole pool certificates to be qualifying real estate assets. Examples ofagencies that 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.

 

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Most non-agency mortgage-backed securities do not constitute qualifyingreal estate assets, because they represent less than the entire beneficial interestin 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 be qualifyingreal estate assets. If another entity acquires any of the securities that areexpected to receive cash flow from the underlying mortgage loans, then our REITsubsidiary will consider whether it has appropriate foreclosure rights withrespect 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 onesubordinate class, then, to determine the classification of subordinate classesother than the first loss class, our REIT subsidiary will consider whether suchclasses are contiguous with the first loss class (with no other classesabsorbing losses after the first loss class and before any other subordinateclasses that our REIT subsidiary owns), whether our REIT subsidiary owns theentire amount of each such class and whether our REIT subsidiary would continueto have appropriate foreclosure rights in connection with each such class ifthe more subordinate classes were no longer outstanding. If the answers to anyof these questions is no, then our REIT subsidiary would expect not to classifythat particular class, or classes senior to that class, as qualifying realestate assets.

 

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.

 

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**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.

 

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 applicable thereto,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 |       | $                                                                                                                                      | (7,189     | ) | $ | (5,392 | ) | $ | (3,594 | ) | $ | (1,797 | ) | $ | — |   | $ | 1,797 |   | $ | 3,594 |   | $ | 5,392 |   | $ | 7,189 |   |
|                            |            |                                                                                                                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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 June 30,2009, we had unencumbered cash and cash equivalents totaling$114.4 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.

 

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*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.

 

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 otherwisefails to 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.

 

*InterestRate Risk*

 

Interest rate risk is defined as the sensitivity of our current andfuture earnings to interest rate volatility, variability of spread relationships,the difference in repricing intervals between our assets and liabilities andthe effect that interest rates may have on our cash flows and the prepaymentrates experienced on our investments that have embedded borrower optionality.The objective of interest rate risk management is to achieve earnings, preservecapital and achieve liquidity by minimizing the negative impacts of changinginterest rates, asset and liability mix, and prepayment activity.

 

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.

 

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

 

**Derivative Fair Value**

 
| ** **                      | ** ** | **As of  June 30, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **Notional**                            | ** ** | **Estimated  Fair Value**              | ** ** | **Notional** | ** ** | **Estimated  Fair Value** | ** ** |
| **Cash Flow Hedges:**           |       |                                    |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | $                                       | 383,333    |                                        | $          | (46,313 | ) | $ | 383,333 |   | $ | (77,668 | ) |
| **Fair Value Hedges:**          |       |                                    |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | 32,000                                  |       | (2,654                                      | )          | 32,000 |   | (2,915 | ) |
| **Free-Standing Derivatives:**  |       |                                    |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | 115,434                                 |       | 1,072                                       |       | 106,074 |   | 274 |   |
| Credit default swaps—long  |       | 51,000                                  |       | (4,292                                      | )          | 53,500 |   | (9,782 | ) |
| Credit default swaps—short |       | —                                  |       | —                                      |       | 222,650 |   | 69,972 |   |
| Total rate of return swaps      |       | 136,132                                 |       | 5,015                                       |       | 207,524 |   | (77,224 | ) |
| Total                           |       | $                                       | 717,899    |                                        | $          | (47,172 | ) | $ | 1,005,081 |   | $ | (97,343 | ) |

 

**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 June 30, 2009. Based on their evaluation, the Company’sprincipal executive and principal financial officer concluded that the Company’sdisclosure controls and procedures as of June 30, 2009 were designed andwere functioning effectively to provide reasonable assurance that theinformation required to be disclosed by the Company in reports filed under theExchange Act is (i) recorded, processed, summarized, and reported withinthe time periods specified in the SEC’s rules and forms, and (ii) accumulatedand communicated to management, including the principal executive and principalfinancial officers, as appropriate, to allow timely decisions regardingdisclosure.

 

Therehas been no change in the Company’s internal control over financial reporting(as defined in Rules 13a-15(f) and 15d-15(f) under the ExchangeAct) that occurred during the three and six months ending June 30, 2009,that has materially affected, or is reasonably likely to materially affect, theCompany’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.

 

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On August 15, 2008, themembers 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 of California,County of San Francisco (the “California Derivative Action”). We are named as anominal defendant. The complaint in the California Derivative Action assertsclaims against the Kostecka Individual Defendants for breaches of fiduciaryduty, abuse of control, gross mismanagement, waste of corporate assets, andunjust enrichment in connection with the conduct at issue in the CharterLitigation, including the filing of the April 2, 2007 Registration Statementwith 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 and certain ofour executive officers (the “Haley Individual Defendants”) were named in ashareholder 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”). We are named as a nominaldefendant. The complaint in the New York Derivative Action asserts claimsagainst the Haley Individual Defendants for breaches of fiduciary duty, breachesof the duty of full disclosure, and for contribution in connection with theconduct at issue in the Charter Litigation, including the filing of the April 2,2007 registration statement with alleged material misstatements and omissions. Byorder dated June 18, 2009, the Court approved the parties’ stipulation to staythe proceedings in the New York Derivative Action until the Charter Litigationis dismissed on the pleadings or we file an answer to the Charter Litigation.

 

**Item 1A. RiskFactors**

 

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**

 

Our 2009 annual meeting of shareholders was held on May7, 2009. A total of 134,135,023 of our shares were present or voted by proxy atthe meeting. This represented more than 88% of the total number of votingrights outstanding and entitled to vote at the annual meeting. The followingmatters were voted upon and received the votes as set forth below:

 

1. Shareholders elected twelve directors to one-yearterms that will expire at the annual meeting of the shareholders in 2010. Thevote tabulation for individual directors was:

 
| **DIRECTOR**         | ** ** | **FOR**     | ** ** | **WITHHELD** | ** ** |
|----------------------|------------|-------------|------------|--------------|------------|
| William F. Aldinger  |       | 128,642,565 |       | 5,492,456    |       |
| Tracy L. Collins     |       | 128,809,681 |       | 5,325,340    |       |
| V. Paul Finigan      |       | 128,827,695 |       | 5,307,326    |       |
| Paul M. Hazen        |       | 128,477,286 |       | 5,657,735    |       |
| R. Glenn Hubbard     |       | 128,735,409 |       | 5,399,612    |       |
| Ross J. Kari         |       | 128,661,288 |       | 5,473,733    |       |
| Ely L. Licht         |       | 127,996,036 |       | 6,138,985    |       |
| Deborah H. McAneny   |       | 128,790,222 |       | 5,344,799    |       |
| Scott C. Nuttall     |       | 128,736,361 |       | 5,398,660    |       |
| Scott A. Ryles       |       | 128,730,904 |       | 5,404,117    |       |
| William C. Sonneborn |       | 128,788,286 |       | 5,346,735    |       |
| Willy R. Strothotte  |       | 114,585,564 |       | 19,549,457   |       |

 

2. The election of Deloitte & Touche LLP as ourindependent registered public accounting firm for the year ending December 31,2009 was ratified with 132,035,199 shares voting for, 1,624,535 shares votingagainst, 475,286 shares abstaining and no broker nonvotes.

 

3. The amendment of our Amended and Restated OperatingAgreement to increase the total number of common shares authorized for issuanceto 500,000,000 was ratified with 116,035,371 shares voting for, 17,555,500shares voting against, 544,146 shares abstaining and no broker nonvotes.

 

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**Item 5. OtherInformation**

 

None.

 

**Item 6. Exhibits**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                               |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                          |
| 3.1                 |       | Amended and Restated  Operating Agreement of the Registrant, dated May 3, 2007, as amended May 7,  2009                                                                                                                                                                                                                                                                                                       |
| 10.1                |       | Amendment No. 1, dated  August 5, 2009, to the $300 million Credit Agreement dated November 10, 2008 among  the Registrant, KKR TRS Holdings, Ltd., KKR Financial Holdings II, LLC, KKR  Financial Holdings III, LLC, KKR Financial Holdings, Inc. and KKR Financial  Holdings, Ltd., as Borrowers, Bank of America, N.A. as Administrative Agent  and a Lender and Citicorp North America, Inc., as a Lender |
| 31.1                |       | Chief Executive Officer  Certification                                                                                                                                                                                                                                                                                                                                                                        |
| 31.2                |       | Chief Financial Officer  Certification                                                                                                                                                                                                                                                                                                                                                                        |
| 32                  |       | Certification Pursuant  to 18 U.S.C. Section 1350                                                                                                                                                                                                                                                                                                                                                             |

 

58

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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:August 6, 2009

 

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