**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,  2008**                                                                                            |
| ** **                                                                                                                                        |
| **or**                                                                                                                                            |
| ** **                                                                                                                                        |
| **o**                                                                                                                                             | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
| ** **                                                                                                                                        |
| **For the transition period  from         to         ** |

 

**Commissionfile number: 001-33437**

 

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**KKR FINANCIAL HOLDINGS LLC**

(Exact name ofregistrant as specified in its charter)

 

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

 

Registrant’stelephone number, including area code: **(415) 315-3620**

 

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Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days. x Yes  o No

 

Indicate by check mark whether the registrantis a large accelerated filer, an accelerated filer, a non-accelerated filer, ora smaller reporting company. See the definitions of “large accelerated filer,” “acceleratedfiler” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.(Check one):

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

 

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

 

The number of shares of the registrant’scommon shares outstanding as of August 1, 2008 was 150,881,500.

 

 

 

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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**

 

**Item1. Financial Statements**

 

**KKRFinancial Holdings LLC and Subsidiaries Condensed Consolidated Balance Sheets**

**(Unaudited)**

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

 
| ** **                                                                                                                                                                                  | ** ** | **As of****June 30****, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| **Assets**                                                                                                                                                                                  |       |                                          |       |                                        |       |
| Cash and cash equivalents                                                                                                                                                                   |       | $                                             | 189,008    |                                        | $          | 524,080 |   |
| Restricted cash and cash equivalents                                                                                                                                                        |       | 730,303                                       |       | 1,067,797                                   |       |
| Securities available-for-sale, $1,087,747  and $1,346,247 pledged as collateral as of June 30, 2008 and December 31, 2007, respectively                                           |       | 1,117,788                                     |       | 1,359,541                                   |       |
| Corporate loans, net of allowance for loan  losses of $35,000 and $25,000 as of June 30,  2008 and December 31, 2007, respectively                                                |       | 8,708,005                                     |       | 8,634,208                                   |       |
| Residential mortgage-backed securities, at  estimated fair value, $72,668 and $117,833 pledged as collateral as of  June 30, 2008 and December 31, 2007, respectively             |       | 115,652                                       |       | 131,688                                     |       |
| Residential mortgage loans, at estimated  fair value                                                                                                                                        |       | 3,394,996                                     |       | 3,921,323                                   |       |
| Corporate loans held for sale                                                                                                                                                               |       | 66,652                                        |       | —                                      |       |
| Derivative assets                                                                                                                                                                           |       | 28,436                                        |       | 18,737                                      |       |
| Interest and principal receivable                                                                                                                                                           |       | 111,038                                       |       | 162,465                                     |       |
| Non-marketable equity securities                                                                                                                                                            |       | 20,079                                        |       | 20,084                                      |       |
| Reverse repurchase agreements                                                                                                                                                               |       | —                                        |       | 69,840                                      |       |
| Other assets                                                                                                                                                                                |       | 78,459                                        |       | 86,504                                      |       |
| Assets of discontinued operations                                                                                                                                                           |       | —                                        |       | 3,049,758                                   |       |
| **Total assets**                                                                                                                                                                            |       | $                                             | 14,560,416 |                                        | $          | 19,046,025 |   |
| **Liabilities**                                                                                                                                                                             |       |                                          |       |                                        |       |
| Repurchase agreements                                                                                                                                                                       |       | $                                             | —     |                                        | $          | 2,808,066 |   |
| Collateralized loan obligation senior  secured notes                                                                                                                                        |       | 7,549,318                                     |       | 5,948,610                                   |       |
| Collateralized loan obligation junior  secured notes to affiliates                                                                                                                          |       | 525,420                                       |       | 525,420                                     |       |
| Secured revolving credit facility                                                                                                                                                           |       | 378,306                                       |       | 167,024                                     |       |
| Secured demand loan                                                                                                                                                                         |       | —                                        |       | 24,151                                      |       |
| Convertible senior notes                                                                                                                                                                    |       | 300,000                                       |       | 300,000                                     |       |
| Junior subordinated notes                                                                                                                                                                   |       | 293,826                                       |       | 329,908                                     |       |
| Subordinated notes to affiliates                                                                                                                                                            |       | 80,000                                        |       | 152,574                                     |       |
| Residential mortgage-backed securities  issued, at estimated fair value                                                                                                                     |       | 3,204,392                                     |       | 3,169,353                                   |       |
| Accounts payable, accrued expenses and  other liabilities                                                                                                                                   |       | 13,392                                        |       | 7,390                                       |       |
| Accrued interest payable                                                                                                                                                                    |       | 97,749                                        |       | 114,035                                     |       |
| Accrued interest payable to affiliates                                                                                                                                                      |       | 55,375                                        |       | 44,121                                      |       |
| Related party payable                                                                                                                                                                       |       | 5,439                                         |       | 9,694                                       |       |
| Securities sold, not yet purchased                                                                                                                                                          |       | 22,890                                        |       | 100,394                                     |       |
| Derivative liabilities                                                                                                                                                                      |       | 116,880                                       |       | 56,663                                      |       |
| Liabilities of discontinued operations                                                                                                                                                      |       | —                                        |       | 3,644,083                                   |       |
| **Total liabilities**                                                                                                                                                                       |       | 12,642,987                                    |       | 17,401,486                                  |       |
| **Shareholders’ Equity**                                                                                                                                                               |       |                                          |       |                                        |       |
| Preferred shares, no par value, 50,000,000  shares authorized and none issued and outstanding at June 30, 2008 and December 31, 2007                                              |       | —                                        |       | —                                      |       |
| Common shares, no par value, 250,000,000  shares authorized, and 150,843,151 and 115,248,990 shares issued and  outstanding at June 30,  2008 and December 31, 2007, respectively |       | —                                        |       | —                                      |       |
| Paid-in-capital                                                                                                                                                                             |       | 2,551,800                                     |       | 2,167,156                                   |       |
| Accumulated other comprehensive loss                                                                                                                                                        |       | (202,586                                      | )          | (157,245                                    | )          |
| Accumulated deficit                                                                                                                                                                         |       | (431,785                                      | )          | (365,372                                    | )          |
| **Total shareholders’ equity**                                                                                                                                                         |       | 1,917,429                                     |       | 1,644,539                                   |       |
| **Total liabilities and shareholders’ equity**                                                                                                                                         |       | $                                             | 14,560,416 |                                        | $          | 19,046,025 |   |

 

See notes tocondensed consolidated financial statements.

 

3

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**KKRFinancial Holdings LLC and Subsidiaries Condensed Consolidated Statements of Operations**

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

** **
| ** **                                                                                                                                                                                          | ** ** | **For the three** | ** ** | **For the three** | ** ** | **For the six**   | ** ** | **For the six**   | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                          | ** ** | **months ended**       | ** ** | **months ended**       | ** ** | **months ended**       | ** ** | **months ended**       | ** ** |
| ** **                                                                                                                                                                                          | ** ** | **June 30, 2008** | ** ** | **June 30, 2007** | ** ** | **June 30, 2008** | ** ** | **June 30, 2007** | ** ** |
| **Net investment income:**                                                                                                                                                                          |       |                        |       |                        |       |                        |       |                        |       |
| Securities interest income                                                                                                                                                                          |       | $                           | 34,788     |                        | $          | 27,262                      |       | $                           | 74,597     |   | $ | 49,935 |   |
| Loan interest income                                                                                                                                                                                |       | 184,550                     |       | 146,435                     |       | 401,087                     |       | 277,812                     |       |
| Dividend income                                                                                                                                                                                     |       | 1,092                       |       | 965                         |       | 1,908                       |       | 1,940                       |       |
| Other interest income                                                                                                                                                                               |       | 4,998                       |       | 5,674                       |       | 16,074                      |       | 8,251                       |       |
| Total investment income                                                                                                                                                                             |       | 225,428                     |       | 180,336                     |       | 493,666                     |       | 337,938                     |       |
| Interest expense                                                                                                                                                                                    |       | (128,037                    | )          | (124,265                    | )          | (282,102                    | )          | (236,050                    | )          |
| Interest expense to affiliates                                                                                                                                                                      |       | (19,707                     | )          | (8,256                      | )          | (47,525                     | )          | (8,256                      | )          |
| Provision for loan losses                                                                                                                                                                           |       | (10,000                     | )          | —                      |       | (10,000                     | )          | —                      |       |
| Net investment income                                                                                                                                                                               |       | 67,684                      |       | 47,815                      |       | 154,039                     |       | 93,632                      |       |
| **Other (loss) income:**                                                                                                                                                                            |       |                        |       |                        |       |                        |       |                        |       |
| Net realized and unrealized (loss) gain on  derivatives and foreign exchange                                                                                                                        |       | (5,918                      | )          | 6,481                       |       | (52,934                     | )          | 13,619                      |       |
| Net realized and unrealized (loss) gain on  investments                                                                                                                                             |       | (17,217                     | )          | 26,739                      |       | (30,976                     | )          | 33,764                      |       |
| 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 |       | (5,594                      | )          | 1,526                       |       | (14,772                     | )          | (1,691                      | )          |
| Net realized and unrealized gain on  securities sold, not yet purchased                                                                                                                             |       | 1,664                       |       | 575                         |       | 8,650                       |       | 575                         |       |
| Gain on extinguishment of debt                                                                                                                                                                      |       | 17,225                      |       | —                      |       | 17,225                      |       | —                      |       |
| Other income                                                                                                                                                                                        |       | 513                         |       | 2,540                       |       | 5,469                       |       | 4,588                       |       |
| Total other (loss) income                                                                                                                                                                           |       | (9,327                      | )          | 37,861                      |       | (67,338                     | )          | 50,855                      |       |
| **Non-investment expenses:**                                                                                                                                                                        |       |                        |       |                        |       |                        |       |                        |       |
| Related party management compensation                                                                                                                                                               |       | 10,387                      |       | 15,114                      |       | 19,546                      |       | 34,413                      |       |
| General, administrative and directors  expenses                                                                                                                                                     |       | 5,752                       |       | 3,991                       |       | 10,274                      |       | 10,252                      |       |
| Professional services                                                                                                                                                                               |       | 1,071                       |       | 759                         |       | 2,928                       |       | 1,300                       |       |
| Loan servicing                                                                                                                                                                                      |       | 2,391                       |       | 2,939                       |       | 4,960                       |       | 6,023                       |       |
| Total non-investment expenses                                                                                                                                                                       |       | 19,601                      |       | 22,803                      |       | 37,708                      |       | 51,988                      |       |
| Income from continuing operations before  equity in income of unconsolidated affiliate and income tax expense                                                                                       |       | 38,756                      |       | 62,873                      |       | 48,993                      |       | 92,499                      |       |
| Equity in income of unconsolidated  affiliate                                                                                                                                                       |       | —                      |       | 5,725                       |       | —                      |       | 12,706                      |       |
| Income from continuing operations before  income tax expense                                                                                                                                        |       | 38,756                      |       | 68,598                      |       | 48,993                      |       | 105,205                     |       |
| Income tax expense                                                                                                                                                                                  |       | (116                        | )          | (83                         | )          | (116                        | )          | (859                        | )          |
| Income from continuing operations                                                                                                                                                                   |       | 38,640                      |       | 68,515                      |       | 48,877                      |       | 104,346                     |       |
| (Loss) income from discontinued operations                                                                                                                                                          |       | (1,079                      | )          | (15,544                     | )          | 2,668                       |       | (2,951                      | )          |
| Net income                                                                                                                                                                                          |       | $                           | 37,561     |                        | $          | 52,971                      |       | $                           | 51,545     |   | $ | 101,395 |   |
|                                                                                                                                                                                                |       |                        |       |                        |       |                        |       |                        |       |
| Net income per common share:                                                                                                                                                                        |       |                        |       |                        |       |                        |       |                        |       |
| Basic                                                                                                                                                                                               |       |                        |       |                        |       |                        |       |                        |       |
| Income per share from continuing operations                                                                                                                                                         |       | $                           | 0.26       |                        | $          | 0.85                        |       | $                           | 0.38       |   | $ | 1.30 |   |
| (Loss) income per share from discontinued  operations                                                                                                                                               |       |                        | —     |                        |       | (0.19                       | )          |                        | 0.02       |   |   | (0.04 | ) |
| Net income per share                                                                                                                                                                                |       | $                           | 0.26       |                        | $          | 0.66                        |       | $                           | 0.40       |   | $ | 1.26 |   |
| Diluted                                                                                                                                                                                             |       |                        |       |                        |       |                        |       |                        |       |
| Income per share from continuing operations                                                                                                                                                         |       | $                           | 0.26       |                        | $          | 0.84                        |       | $                           | 0.37       |   | $ | 1.28 |   |
| (Loss) income per share from discontinued  operations                                                                                                                                               |       |                        | —     |                        |       | (0.19                       | )          |                        | 0.02       |   |   | (0.04 | ) |
| Net income per share                                                                                                                                                                                |       | $                           | 0.26       |                        | $          | 0.65                        |       | $                           | 0.39       |   | $ | 1.24 |   |
|                                                                                                                                                                                                |       |                        |       |                        |       |                        |       |                        |       |
| Weighted-average number of common shares  outstanding:                                                                                                                                              |       |                        |       |                        |       |                        |       |                        |       |
| Basic                                                                                                                                                                                               |       | 146,025                     |       | 80,241                      |       | 130,289                     |       | 80,240                      |       |
| Diluted                                                                                                                                                                                             |       | 146,749                     |       | 81,933                      |       | 130,964                     |       | 81,805                      |       |
|                                                                                                                                                                                                |       |                        |       |                        |       |                        |       |                        |       |
| Distributions declared per common share                                                                                                                                                             |       | $                           | 0.40       |                        | $          | 0.56                        |       | $                           | 0.90       |   | $ | 1.10 |   |

 

See notes tocondensed consolidated financial statements.

 

4

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**KKRFinancial Holdings LLC and SubsidiariesCondensed Consolidated 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, 2008**                             |       | 115,249            |       | $                    | 2,167,156  |                                            | $          | (157,245                 | )          | $                         | (365,372   | )                                     |       |   | $ | 1,644,539 |   |
| Net income                                                      |       | —             |       | —               |       | —                                          |       | 51,545                   |       | $                         | 51,545     |                                  | 51,545     |   |
| Net change in unrealized gain on cash flow  hedges              |       | —             |       | —               |       | 839                                             |       | —                   |       | 839                       |       | 839                                   |       |
| Net change in unrealized loss on securities  available-for-sale |       | —             |       | —               |       | (46,180                                         | )          |                     |       | (46,180                   | )          | (46,180                               | )          |
| Comprehensive income                                            |       |               |       |                 |       |                                            |       |                     |       | $                         | 6,204      |                                  |       |   |
| Cash distributions on common shares                             |       | —             |       | —               |       | —                                          |       | (117,958                 | )          |                      |       | (117,958                              | )          |
| Cancellation of restricted common shares                        |       | (3                 | )          | —               |       | —                                          |       |                     |       |                      |       | —                                |       |
| Grant of restricted common shares to the  Manager               |       | 1,097              |       | —               |       | —                                          |       | —                   |       |                      |       | —                                |       |
| Proceeds from issuance of common shares,  net of offering costs |       | 34,500             |       | 383,631              |       | —                                          |       | —                   |       |                      |       | 383,631                               |       |
| Amortization of restricted common shares                        |       | —             |       | 1,013                |       | —                                          |       | —                   |       |                      |       | 1,013                                 |       |
| **Balance at June 30, 2008**                               |       | 150,843            |       | $                    | 2,551,800  |                                            | $          | (202,586                 | )          | $                         | (431,785   | )                                     |       |   | $ | 1,917,429 |   |

 

See notes tocondensed consolidated financial statements.

 

5

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**KKRFinancial Holdings LLC and SubsidiariesCondensed****Consolidated Statements of Cash Flows**

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

** **
| ** **                                                                                                                                  | ** ** | **For the six  months ended  June 30, 2008** | ** ** | **For the six  months ended  June 30, 2007** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| **Cash flows from operating activities:**                                                                                                   |       |                                                                  |       |                                                                  |       |
| Net income                                                                                                                                  |       | $                                                                     | 51,545     |                                                                  | $          | 101,395 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities:                                                          |       |                                                                  |       |                                                                  |       |
| Net realized and unrealized loss (gain) on  derivatives, foreign exchange, and securities sold, not yet purchased                           |       | 44,284                                                                |       | (14,194                                                               | )          |
| Gain on extinguishment of debt                                                                                                              |       | (17,225                                                               | )          | —                                                                |       |
| Write-off of debt issuance costs                                                                                                            |       | 1,071                                                                 |       | 2,247                                                                 |       |
| Lower of cost or estimated fair value  adjustment on corporate loans held for sale and provision for loan losses                            |       | 12,637                                                                |       | —                                                                |       |
| Impairment of securities available-for-sale                                                                                                 |       | 9,688                                                                 |       | —                                                                |       |
| Share-based compensation                                                                                                                    |       | 1,013                                                                 |       | 6,692                                                                 |       |
| Net unrealized loss (gain) on residential mortgage-backed  securities, residential mortgage loans, and liabilities at estimated fair  value |       | (4,824                                                                | )          | 14,491                                                                |       |
| Net realized loss (gain) on sales of  investments                                                                                           |       | 20,150                                                                |       | (33,560                                                               | )          |
| Depreciation and net amortization                                                                                                           |       | (14,516                                                               | )          | 3,869                                                                 |       |
| Equity in income of unconsolidated  affiliate                                                                                               |       | —                                                                |       | (12,706                                                               | )          |
| Changes in assets and liabilities:                                                                                                          |       |                                                                  |       |                                                                  |       |
| Interest receivable                                                                                                                         |       | 41,049                                                                |       | (2,068                                                                | )          |
| Other assets                                                                                                                                |       | (7,325                                                                | )          | (38,332                                                               | )          |
| Related party payable                                                                                                                       |       | (4,255                                                                | )          | 4,289                                                                 |       |
| Accounts payable, accrued expenses and  other liabilities                                                                                   |       | (43,235                                                               | )          | (1,843                                                                | )          |
| Accrued interest payable                                                                                                                    |       | (16,808                                                               | )          | (35,983                                                               | )          |
| Accrued interest payable to affiliates                                                                                                      |       | 36,614                                                                |       | 8,256                                                                 |       |
| Income tax liability                                                                                                                        |       | 12                                                                    |       | (101                                                                  | )          |
| Net cash provided by operating activities                                                                                                   |       | 109,875                                                               |       | 2,452                                                                 |       |
| **Cash flows from investing activities:**                                                                                                   |       |                                                                  |       |                                                                  |       |
| Principal payments from investments                                                                                                         |       | 966,000                                                               |       | 2,264,015                                                             |       |
| Proceeds from sale of investments                                                                                                           |       | 823,721                                                               |       | 1,119,841                                                             |       |
| Purchases of investments                                                                                                                    |       | (1,337,887                                                            | )          | (1,756,054                                                            | )          |
| Net proceeds, purchases, and settlements of  derivatives                                                                                    |       | 18,131                                                                |       | 4,140                                                                 |       |
| Net change in reverse repurchase agreements                                                                                                 |       | 69,840                                                                |       | —                                                                |       |
| Net additions to restricted cash and cash  equivalents                                                                                      |       | 337,847                                                               |       | (575,154                                                              | )          |
| Restricted cash and cash equivalents  acquired due to consolidation of KKR Financial CLO 2007-1, Ltd.                                       |       | —                                                                |       | 57,104                                                                |       |
| Additions of leasehold improvements and  equipment                                                                                          |       | —                                                                |       | (232                                                                  | )          |
| Investment in unconsolidated affiliate                                                                                                      |       | —                                                                |       | (60,327                                                               | )          |
| Net cash provided by investing activities                                                                                                   |       | 877,652                                                               |       | 1,053,333                                                             |       |
| **Cash flows from financing activities:**                                                                                                   |       |                                                                  |       |                                                                  |       |
| Net change in repurchase agreements,  secured revolving credit facility, and secured demand loan                                            |       | (2,620,935                                                            | )          | (3,870,407                                                            | )          |
| Net change in asset-backed secured  liquidity notes                                                                                         |       | (136,596                                                              | )          | 237,226                                                               |       |
| Repayment of residential mortgage-backed  securities issued                                                                                 |       | (363,500                                                              | )          | —                                                                |       |
| Issuance of collateralized loan obligation  senior secured notes                                                                            |       | 1,600,000                                                             |       | 2,368,500                                                             |       |
| Net change in subordinated notes to  affiliates                                                                                             |       | (47,880                                                               | )          | 262,103                                                               |       |
| Net change in junior subordinated notes                                                                                                     |       | (18,857                                                               | )          | 70,000                                                                |       |
| Net proceeds from common share offering                                                                                                     |       | 383,631                                                               |       | —                                                                |       |
| Distributions on common shares                                                                                                              |       | (117,958                                                              | )          | (88,511                                                               | )          |
| Other capitalized costs                                                                                                                     |       | (504                                                                  | )          | (16,340                                                               | )          |
| Net cash used in financing activities                                                                                                       |       | (1,322,599                                                            | )          | (1,037,429                                                            | )          |
| **Net (decrease) increase in cash and cash  equivalents**                                                                                   |       | (335,072                                                              | )          | 18,356                                                                |       |
| **Cash and cash equivalents at beginning of  period**                                                                                       |       | 524,080                                                               |       | 5,125                                                                 |       |
| **Cash and cash equivalents at end of period**                                                                                              |       | $                                                                     | 189,008    |                                                                  | $          | 23,481 |   |
| **Supplemental cash flow information:**                                                                                                     |       |                                                                  |       |                                                                  |       |
| Cash paid for interest                                                                                                                      |       | $                                                                     | 357,894    |                                                                  | $          | 424,725 |   |
| Cash paid for income taxes                                                                                                                  |       | $                                                                     | 99         |                                                                  | $          | 1,590 |   |
| **Non-cash investing and financing  activities:**                                                                                           |       |                                                                  |       |                                                                  |       |
| Net receivable for securities sold                                                                                                          |       | $                                                                     | (660       | )                                                                     | $          | (312,553 | ) |
| Conversion from corporate loans to  corporate securities                                                                                    |       | $                                                                     | 228,350    |                                                                  | $          | — |   |
| Distributions of securities to the  asset-backed secured liquidity noteholders                                                              |       | $                                                                     | 3,623,049  |                                                                  | $          | — |   |
| Affiliate contributions for collateralized  loan obligation junior secured notes                                                            |       | $                                                                     | —     |                                                                  | $          | 169,209 |   |

 

See notes tocondensed consolidated financial statements.

 

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**KKR Financial Holdings LLC and Subsidiaries**

 

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

 

**Note 1. Organization**

 

KKR Financial Holdings LLC together withits subsidiaries (the “Company” or “KKR Financial”) is a specialty financecompany that uses leverage with the objective of generating competitiverisk-adjusted returns. The Company invests in financial assets primarilyconsisting of corporate loans and securities, including senior secured andunsecured loans, mezzanine loans, high yield corporate bonds, distressed andstressed debt securities, marketable and non-marketable equity securities, andcredit default and total rate of return swaps. The Company also makesopportunistic investments in other asset classes from time to time.

 

KKR Financial Holdings LLC is a Delawarelimited liability company and was organized on January 17, 2007. KKRFinancial Holdings LLC is the successor to KKR Financial Corp. (the “REITSubsidiary”), a Maryland corporation. The REIT Subsidiary was originally incorporatedin the State of Maryland in July 2004 and elected to be treated as a realestate investment trust (“REIT”) for U.S. federal income tax purposes. On May 4,2007, KKR Financial completed a restructuring transaction (the “RestructuringTransaction”), pursuant to which the REIT Subsidiary became a subsidiary of KKRFinancial and each outstanding share of the REIT Subsidiary’s common stock wasconverted into one of KKR Financial’s common shares, which are publicly tradedon the New York Stock Exchange (“NYSE”) under the symbol “KFN”. KKR Financialintends to continue to operate so as to qualify as a partnership, and not as anassociation or publicly traded partnership that is taxable as a corporation,for U.S. federal income tax purposes. The Restructuring Transaction has beenaccounted for as a reorganization of entities under common control whereby theconsolidated assets and liabilities of the Company were recorded at thehistorical cost of the REIT Subsidiary, as reflected on its condensed consolidatedfinancial statements. The Company is considered the REIT Subsidiary’s successorfor accounting purposes, and the REIT Subsidiary’s condensed consolidatedfinancial statements for prior periods are the Company’s historical condensedconsolidated financial statements presented herein. On June 30, 2008, the Company completedthe sale of a controlling interest in the REIT Subsidiary to Rock Capital 2 LLC,which did not result in a gain or loss.

 

KKR Financial Advisors LLC (the “Manager”),a wholly-owned subsidiary of Kohlberg Kravis Roberts & Co.(Fixed Income) LLC (previously known as KKR Financial LLC ),manages the Company pursuant to a management agreement (the “ManagementAgreement”). In June 2008, KohlbergKravis Roberts & Co. (Fixed Income) LLC became a wholly-ownedsubsidiary of Kohlberg Kravis Roberts &Co. L.P. (“KKR”).

 

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

 

**Basis of Presentation**

 

The accompanying condensed consolidatedfinancial statements have been prepared in conformity with accountingprinciples generally accepted in the United States of America (“GAAP”). Thecondensed consolidated financial statements include the accounts of theCompany, consolidated residential mortgage loan securitization trusts where theCompany is the primary beneficiary, and entities established to completesecured financing transactions that are considered to be variable interestentities and for which the Company is the primary beneficiary. The REITSubsidiary, which was sold on June 30, 2008, is presented as discontinuedoperations for financial statement purposes. Previously, the Company’sresidential mortgage investment operations were also classified as discontinuedoperations; however, the Company no longer deems a sale or transfer of itsremaining residential mortgage portfolio to be probable in the near term.Accordingly, the Company’s remaining residential mortgage investment operationsare presented as continuing operations and the associated prior period amountsfor existing residential mortgage assets and liabilities as of June 30,2008 were reclassified as such for comparative purposes. See Note 3 forfurther discussion.

 

These financial statements should be read inconjunction with the consolidated financial statements and notes thereto includedin the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2007. The Company’s results for any interim period are notnecessarily indicative of results for a full year or any other interim period.In the opinion of management, all normal recurring adjustments have beenincluded for a fair statement of this interim financial information.

 

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**Use of Estimates**

 

The preparation of financial statements inconformity with GAAP requires management to make estimates and assumptions thataffect the amounts reported in the Company’s condensed consolidated financialstatements and accompanying notes. Actual results could differ from management’sestimates.

 

**Consolidation**

 

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

 

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

 

All inter-company balances and transactionshave been eliminated in consolidation.

 

**Fair Value of Financial Instruments**

 

Effective January 1, 2007, the Companyadopted SFAS No. 157, *Fair ValueMeasurements* (“SFAS No. 157”), which requires additionaldisclosures about the Company’s assets and liabilities that are measured atfair value.

 

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

 

Level 1: Inputs are unadjusted, quotedprices in active markets for identical assets or liabilities at the measurementdate.

 

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

 

Level 2: Inputs other than quoted pricesincluded in level 1 that are observable for the asset or liability, eitherdirectly or indirectly. Level 2 inputs include quoted prices for similarinstruments in active markets, and inputs other than quoted prices that areobservable for the asset or liability.

 

Fair value assets and liabilities that aregenerally included in this category are certain corporate debt securities andcertain financial instruments classified as derivatives where the fair value isbased on observable market inputs.

 

Level 3: Inputs are unobservable inputsfor the asset or liability, and include situations where there is little, ifany, market activity for the asset or liability. In certain cases, the inputsused to measure fair value may fall into different levels of the fair valuehierarchy. In such cases, the level in the fair value hierarchy within which thefair value measurement in its entirety falls has been determined based on thelowest level input that is significant to the fair value measurement in itsentirety. The Company’s assessment of the significance of a particular input tothe fair value measurement in its entirety requires judgment and the considerationof factors specific to the asset.

 

Generally, assets and liabilities carried atfair value and included in this category are certain corporate debt securities,residential mortgage-backed securities, residential mortgage loans, residentialmortgage-backed securities issued and certain derivatives.

 

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The availability of observable inputs canvary depending on the financial asset or liability and is affected by a widevariety of factors, including, for example, the type of product, whether theproduct is new, whether the product is traded on an active exchange or in thesecondary market, and the current market condition. To the extent thatvaluation is based on models or inputs that are less observable or unobservablein the market, the determination of fair value requires more judgment.Accordingly, the degree of judgment exercised by the Company in determiningfair value is greatest for instruments categorized in level 3. In certaincases, the inputs used to measure fair value may fall into different levels ofthe fair value hierarchy. In such cases, for disclosure purposes, the level inthe fair value hierarchy within which the fair value measurement in itsentirety falls is determined based on the lowest level input that issignificant to the fair value measurement in its entirety.

 

Fair value is a market-based measureconsidered from the perspective of a market participant who holds the asset orowes the liability rather than an entity-specific measure. Therefore, even whenmarket assumptions are not readily available, the Company’s own assumptions areset to reflect those that management believes market participants would use inpricing the asset or liability at the measurement date.

 

Many financial assets and liabilities havebid and ask prices that can be observed in the marketplace. Bid prices reflectthe highest price that the Company and others are willing to pay for an asset.Ask prices represent the lowest price that the Company and others are willingto accept for an asset. For financial assets and liabilities whose inputs arebased on bid-ask prices, the Company does not require that fair value always bea predetermined point in the bid-ask range. The Company’s policy is to allowfor mid-market pricing and adjusting to the point within the bid-ask range thatmeets the Company’s best estimate of fair value.

 

Assets and liabilities that are valued usinglevel 3 of the fair value hierarchy primarily consist of certain corporate debtsecurities, residential mortgage-backed securities, residential mortgage loans,residential mortgage-backed securities issued and certain over-the-counter (“OTC”)derivative contracts. The valuation techniques used for these are describedbelow.

 

*Residential Mortgage-Backed Securities, ResidentialMortgage Loans, and Residential Mortgage-BackedSecurities Issued:* Residential mortgage-backed securities,residential mortgage loans, and residential mortgage-backed securities issuedare initially valued at transaction price and are subsequently valued usingmarket data for similar instruments (e.g., recent transactions, nationallyrecognized pricing services, or broker quotes), comparisons to benchmarkderivative indices or movements in underlying credit spreads.

 

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

 

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

 

**Cash and Cash Equivalents**

 

Cash and cash equivalents include cash onhand, cash held in banks and highly liquid investments with original maturitiesof three months or less. Interest income earned on cash and cash equivalents isrecorded in other interest income.

 

**Restricted Cash and Cash Equivalents**

 

Restricted cash and cash equivalentsrepresent amounts that are held by third parties under certain of the Company’sfinancing and derivative transactions. Interest income earned on restrictedcash and cash equivalents is recorded in other interest income.

 

**Residential Mortgage-Backed Securities**

 

Effective January 1, 2007, the Companyadopted SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities-Including an Amendment of Statement115*(“SFAS No. 159”)*,* and electedthe option of carrying its residential**mortgage-backed securities at estimated fairvalue, with unrealized gains and losses reported in income. Estimated fairvalues are based on estimates provided by independent 

 

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pricing sources or dealers who make markets in such securities. Uponthe sale of a security, the realized net gain or loss is computed on aweighted-average cost basis.

 

**Securities Available-for-Sale**

 

The Company classifies its investments in corporatedebt securities and marketable equity securities as available-for-sale as theCompany may sell them prior to maturity and does not hold them principally forthe purpose of selling them in the near term. These investments are carried atestimated fair value, with unrealized gains and losses reported in accumulatedother comprehensive income (loss). Estimated fair values are based on quotedmarket prices, when available, or on estimates provided by independent pricingsources or dealers who make markets in such securities. Upon the sale of asecurity, the realized net gain or loss is computed on a weighted-average costbasis. Purchases and sales of securities are recorded on the trade date.

 

The Company monitors its available-for-salesecurities portfolio for impairments. A loss is recognized when it isdetermined that a decline in the estimated fair value of a security below itsamortized cost is other-than-temporary. The Company considers many factors indetermining 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,the amount of the unrealized loss, the intent and ability of the Company tohold the security for a period of time sufficient for a recovery in value,recent events specific to the issuer or industry, external credit ratings andrecent changes in such ratings.

 

Unamortized premiums and unaccreted discountson securities available-for-sale are recognized in interest income over thecontractual life, adjusted for actual prepayments, of the securities using theeffective interest method.

 

**Non-marketable Equity Securities**

 

Non-marketable equity securities consistprimarily of private equity investments. These investments are accounted forunder the cost method. The Company reviews these investments quarterly forpossible other-than-temporary impairment. The Company reduces the carryingvalue of the investment and recognizes a loss when the Company considers adecline in estimated fair value below the cost basis of the security to beother-than-temporary.

 

**Securities Sold, Not Yet Purchased**

 

Securities sold, not yet purchased consist ofequity and debt securities that the Company has sold, but did not own prior tothe sale. In order to facilitate a short sale, the Company borrows thesecurities from another party and delivers the securities to the buyer. TheCompany will be required to “cover” its short sale in the future through thepurchase of the security in the market at the prevailing market price anddeliver it to the counterparty from which it borrowed. The Company is exposedto a loss to the extent that the security price increases during the time from whenthe Company borrowed the security to when the Company purchases it in themarket to cover the short sale. Changes in the value of these securities arereflected in net realized and unrealized gain on securities sold, not yet purchasedon the Company’s condensed consolidated statements of operations.

 

**Corporate Loans**

 

The Company purchases participations andassignments in corporate leveraged loans in the primary and secondary market.Loans are held for investment and the Company initially records loans at theirpurchase prices. The Company subsequently accounts for loans based on theiroutstanding principal plus or minus unaccreted purchase discounts andunamortized purchase premiums. In certain instances, where the creditfundamentals underlying a particular loan have materially changed in such amanner that the Company’s expected return may decrease, the Company may electto sell a loan held for investment.

 

Interest income on loans includes interest atstated coupon rates adjusted for accretion of purchase discounts and theamortization of purchase premiums. Unamortized premiums and unaccreteddiscounts are recognized in interest income over the contractual life, adjustedfor actual prepayments, of the loans using the effective interest method.

 

**Residential Mortgage Loans**

 

Effective January 1, 2007, the Companyadopted SFAS No. 159 and elected the option to carry its residentialmortgage loans at estimated fair value, with unrealized gains and lossesreported in income. Estimated fair values are based on estimates provided byindependent pricing sources or dealers who make markets in such securities.

 

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**Corporate Loans Held for Sale**

 

Corporate loans held for sale consist of leveraged loans that theCompany has determined to no longer hold for investment. Corporate loans heldfor sale are stated at lower of cost or estimated fair value.

 

**Allowance for Loan Losses**

 

The Company’s allowance for estimated loanlosses represents its estimate of probable credit losses inherent in the loanportfolio as of the balance sheet date. When determining the adequacy of theallowance for loan losses, the Company considers historical and industry lossexperience, economic conditions and trends, the estimated fair values of itsloans, credit quality trends and other factors that it determines are relevant.Additions to the allowance for loan losses are charged to current periodearnings through the provision for loan losses. The Company’s allowance forloan 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’sallowance for loan losses consists of individual loans that are impaired andfor which the estimated allowance for loan losses is determined in accordancewith SFAS No. 114, *Accounting byCreditors for Impairment of a Loan.* The Company considers a loan tobe impaired when, based on current information and events, it believes it isprobable that it will be unable to collect all amounts due to it based on thecontractual terms of the loan. An impaired loan may be left on accrual statusduring the period the Company is pursuing repayment of the loan; however, theloan is placed on non-accrual status at such time as: (i) managementbelieves that scheduled debt service payments may not be paid whencontractually due; (ii) the loan becomes 90 days delinquent; (iii) managementdetermines the borrower is incapable of, or has ceased efforts toward, curingthe cause of the impairment; or (iv) the net realizable value of theunderlying collateral securing the loan decreases below the Company’s carryingvalue of such loan. While on non-accrual status, previously recognized accruedinterest is reversed and interest income is recognized only upon actualreceipt.

 

The unallocated component of the Company’sallowance for loan losses is determined in accordance with SFAS No. 5, *Accounting for Contingencies*. Thiscomponent of the allowance for loan losses represents the Company’s estimate oflosses inherent, but unidentified, in its portfolio as of the balance sheetdate. The unallocated component of the allowance for loan losses is estimatedbased upon a review of the Company’s loan portfolio’s risk characteristics,risk grouping of loans in the portfolio based upon estimated probability ofdefault and severity of loss based on loan type, and consideration of generaleconomic conditions and trends.

 

**Leasehold Improvements and Equipment**

 

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

 

**Borrowings**

 

The Company finances the acquisition of itsinvestments, including loans, residential mortgage-backed securities, and securitiesavailable-for-sale, primarily through the use of secured borrowings in the formof securitization transactions structured as secured financings, repurchaseagreements, warehouse facilities, demand loans, and other secured and unsecuredborrowings. The Company recognizes interest expense on all borrowings on anaccrual basis.

 

**Trust Preferred Securities**

 

Trusts formed by the Company for the solepurpose of issuing trust preferred securities are not consolidated by theCompany in accordance with FIN 46R as the Company has determined that itis not the primary beneficiary of such trusts. The Company’s investment in thecommon securities of such trusts is included in other assets on the Company’scondensed consolidated financial statements.

 

**Derivative Financial Instruments**

 

The Company recognizes all derivatives atestimated fair value. On the date the Company enters into a derivativecontract, the Company designates and documents each derivative contract as oneof the following at the time the contract is executed: (i) a hedge of arecognized asset or liability (“fair value” hedge); (ii) a hedge of aforecasted transaction or of the variability of cash flows to be received orpaid related to a recognized asset or liability (“cash flow” hedge); (iii) ahedge of a net investment in a foreign operation; or (iv) a derivativeinstrument not designated as a hedging instrument (“free-standing derivative”).For a fair value hedge, the Company records changes in the estimated fair valueof the derivative and, to the extent that it is effective, changes in the fair 

 

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value of the hedged asset or liability attributable to the hedged risk,in the current period earnings in the same financial statement category as thehedged item. For a cash flow hedge, the Company records changes in theestimated fair value of the derivative to the extent that it is effective inother comprehensive (loss) income. The Company subsequently reclassifies thesechanges in estimated fair value to net income in the same period(s) thatthe hedged transaction affects earnings in the same financial statementcategory as the hedged item. For free-standing derivatives, the Company reportschanges in the fair values in current period other income.

 

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

 

**Foreign Currency**

 

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

 

**Manager Compensation**

 

The Management Agreement provides for thepayment of a base management fee to the Manager, as well as an incentive fee ifthe Company’s financial performance exceeds certain benchmarks. Additionally,the Management Agreement provides for the Manager to be reimbursed for certainexpenses incurred on the Company’s behalf. See Note 14 for the specificterms of the computation and payment of the incentive fee. The base managementfee and the incentive fee are accrued and expensed during the period for whichthey are earned by the Manager.

 

**Share-Based Compensation**

 

The Company accounts for share-basedcompensation issued to its directors and to its Manager using the fair valuebased methodology prescribed by SFAS No. 123(R), *Share-Based Payment* (“SFAS No. 123(R)”).Compensation cost related to restricted common shares issued to the Company’sdirectors is measured at its estimated fair value at the grant date, and isamortized and expensed over the vesting period on a straight-line basis.Compensation cost related to restricted common shares and common share optionsissued to the Manager is initially measured at estimated fair value at the grantdate, and is remeasured on subsequent dates to the extent the awards areunvested. The Company has elected to use the graded vesting attribution andstraight-line 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 is no longer treated as a REITfor U.S. federal income tax purposes; however, the Company intends to continueto operate so as to qualify as a partnership, and not as an association orpublicly traded partnership that is taxable as a corporation, for U.S. federalincome tax purposes. Therefore, the Company is not subject to U.S. federalincome tax at the entity level, but is subject to limited state income taxes.Holders of the Company’s shares will be required to take into account theirallocable share of each item of the Company’s income, gain, loss, deduction,and credit for the taxable year of the Company ending within or with theirtaxable year.

 

KKR Financial Holdings II, LLC (“KFH II”), awholly-owned subsidiary of the Company which holds certain real estatemortgage-backed securities, elected to be taxed as a REIT and is required tocomply with the provisions of the Internal Revenue Code of 1986, as amended(the “Code”), with respect thereto. KFH II is not subject to federal income taxto the extent that it currently distributes its income and satisfies certainasset, income and ownership tests, and recordkeeping requirements. Even thoughKFH II qualified for federal taxation as a REIT, it may be subject to someamount of federal, state, local and foreign taxes based on their taxableincome.

 

KKR TRS Holdings, Ltd. (“TRS Ltd.”),CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A, and Wayzata are notconsolidated for federal income tax return purposes. For financial reportingpurposes, current and deferred taxes are provided for on the portion ofearnings recognized by the Company with respect to its interest in KFN PEIVII, LLC (“PEI VII”), a domestic 

 

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taxable corporate subsidiary, because it is taxed as a regularsubchapter C corporation under the provisions of the Code.

 

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

 

**Earnings Per Share**

 

In accordance with SFAS No. 128, *Earnings per Share* (“SFAS No. 128”),the Company presents both basic and diluted earnings per common share (“EPS”)in its condensed consolidated financial statements and footnotes thereto. Basicearnings per common share (“Basic EPS”) excludes dilution and is computed bydividing net income or loss by the weighted-average number of common shares,including vested restricted common shares, outstanding for the period. Dilutedearnings 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 4 for earnings per commonshare computations.

 

A rights offering whose exercise price atissuance is less than the fair value of the stock is considered to have a bonuselement, resulting in an adjustment of the prior period number of sharesoutstanding used to calculate basic and diluted earnings per share. As a resultof the $270.0 million common share rights offering that occurred during thethird quarter of 2007, prior period weighted-average number of shares andearnings per share outstanding have been adjusted to reflect the issuance atless than fair value.

 

**Recent Accounting Pronouncements**

 

In February 2008, the FASBissued FASB Staff Position (“FSP”) SFAS 140-3, *Accountingfor Transfers of Financial Assets and Repurchase Financing Transactions*(“FSPSFAS No. 140-3”). FSP SFAS No. 140-3 assumes that an initial transferof a financial asset and a repurchase financing are considered part of the samearrangement, or a linked transaction. However, if certain criteria are met, theinitial transfer and repurchase financing shall not be evaluated as a linkedtransaction and shall be evaluated separately under SFAS No. 140. FSP SFASNo. 140-3 is effective for the Company for repurchase financings in whichthe initial transfer is entered into after December 31, 2008and early adoption is not permitted. TheCompany does not expect the adoption of FSP SFAS No. 140-3 to have amaterial impact on its financial statements.

 

In March 2008, the FASBissued SFAS No. 161, *Disclosures aboutDerivative Instruments and Hedging Activities, an Amendment of FASB Statement No. 133*(“SFAS No. 161”). SFAS No. 161 requires enhancedqualitative disclosures about objectives and strategies for using derivatives,quantitative disclosures about fair value amounts of gains and losses onderivative instruments, and disclosures about credit-risk-related contingentfeatures in derivative agreements.  Theadditional disclosures required by SFAS No. 161 must be included in theCompany’s consolidated financial statements beginning with the first quarter of2009.

 

In May 2008, the FASB issuedFSP No. APB 14-1, *Accountingfor Convertible Debt Instruments That May Be Settled in Cash uponConversion (Including Partial Cash Settlement)* (“FSP APB 14-1”). This FSP requires thatissuers of convertible debt instruments that may be settled wholly or partly incash when converted should separately account for the liability and equity(conversion feature) components of the instruments. As a result, interestexpense should be imputed and recognized based upon the entity’s nonconvertibledebt borrowing rate, which will result in lower net income. Prior to theadoption of FSP APB 14-1, APB No. 14, *Accounting for ConvertibleDebt and Debt Issued with Stock Purchase Warrants*, provided that noportion of the proceeds from the issuance of the instrument should be attributableto the conversion feature. The 7.00% convertible senior notes issued by theCompany in July 2007 will be subject to FSP ABP 14-1. FSP APB 14-1 iseffective for the Company retroactively on January 1, 2009 and earlyadoption is prohibited. The Company has determined that the adoption of FSP APB14-1 does not have a material impact on its financial statements.

 

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In May 2008,FASB issued SFAS No. 163, *Accounting for FinancialGuarantee Insurance Contracts – an interpretation of FASB Statement No. 60*(“SFAS No. 163”). SFAS No. 163 requires recognition of aninsurance claim liability prior to an event of default (insured event) whenthere is evidence that credit deterioration has occurred in an insuredfinancial obligation. SFAS No. 163 is effective for financial statementsissued for fiscal years beginning after December 15, 2008 and all interimperiods within those fiscal years, and early application is not permitted. TheCompany does not expect the adoption of SFAS No. 163 to have a materialimpact on its financial statements.

 

**Note 3. Discontinued Operations**

 

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

 

As of June 30,2008, the Company substantially completed its plan to exit its residentialmortgage investment operations through the sale of certain of its residentialmortgage-backed securities in the third quarter of 2007 and the agreement withthe Noteholders related to the Facilities described above. In addition, on June 30,2008, the Company completed the sale of a controlling interest in the REITSubsidiary to Rock Capital 2 LLC, which did not result in a gain or loss.Accordingly, the REIT Subsidiary is presented as discontinuedoperations for financial statement purposes for all periods presented.

 

The Company no longer deems a sale or transfer of its remainingresidential mortgage portfolio to be probable in the near term. As such, theCompany’s remaining residential mortgage investment operations, which werepreviously presented as discontinued operations, are presented as continuingoperations and the associated prior period amounts presented in the Company’scondensed consolidated financial statements relating to the Company’s existingresidential mortgage assets and liabilities as of June 30, 2008 have beenreclassified for comparative presentation.

 

As of June 30, 2008, the Company’s remaining residential mortgageportfolio consisted of $315.2 million of RMBS, of which $279.6 million wasrated investment grade or higher and $35.6 million was rated below investmentgrade. Of the $315.2 million of RMBS, $199.5 million represented interests inresidential mortgage securitization trusts that were not structured as QSPEs.  TheCompany consolidated these trusts as it was the primary beneficiary of theseentities and therefore reported total assets of $3.4 billion and totalliabilities of $3.2 billion for these trusts in continuing operations as of June 30,2008.

 

Summarized financial information fordiscontinued operations is as follows (amounts in thousands):

 
| ** **                                          | ** ** | **As of  June 30, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| **Assets**                                          |       |                                    |       |                                        |       |
| Restricted cash and cash equivalents                |       | $                                       | —     |                                        | $          | 353 |   |
| Investments in securities and loans, at  fair value |       | —                                  |       | 3,043,193                                   |       |
| Interest and principal receivable                   |       | —                                  |       | 3,734                                       |       |
| Other assets                                        |       | —                                  |       | 2,478                                       |       |
| Assets of discontinued operations                   |       | $                                       | —     |                                        | $          | 3,049,758 |   |

 

14

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| ** **                                                | ** ** | **As of  June 30, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|-----------------------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| **Liabilities**                                           |       |                                    |       |                                        |       |
| Asset-backed secured liquidity notes, at  fair value      |       | $                                       | —     |                                        | $          | 3,519,860 |   |
| Accounts payable, accrued expenses and  other liabilities |       | —                                  |       | 123,701                                     |       |
| Accrued interest payable                                  |       | —                                  |       | 522                                         |       |
| Liabilities of discontinued operations                    |       | $                                       | —     |                                        | $          | 3,644,083 |   |

 

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

 
| ** **                                 | ** ** | **Three months ended** | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** | **Six months ended** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                 | ** ** | **June 30, 2008**      | ** ** | **June 30, 2007**      | ** ** | **June 30, 2008**    | ** ** | **June 30, 2007**    | ** ** |
| Net investment income                      |       | $                                | —     |                             | $          | 3,841                          |       | $                              | 16,795     |   | $ | 10,969 |   |
| Other loss                                 |       | —                           |       | (18,909                          | )          | (5,361                         | )          | (13,004                        | )          |
| Non-investment expenses                    |       | (1,079                           | )          | (476                             | )          | (8,766                         | )          | (916                           | )          |
| (Loss) income from discontinued operations |       | $                                | (1,079     | )                                | $          | (15,544                        | )          | $                              | 2,668      |   | $ | (2,951 | ) |

 

**Note 4. Earnings per Share**

 

The Company calculates basic net income percommon share by dividing net income for the period by the weighted-averageshares of its common shares outstanding for the period. Diluted net income percommon share is calculated by dividing net income by the weighted-averagenumber of common shares plus potentially dilutive common shares outstandingduring the period. Potentially dilutive common shares include the assumedexercise of outstanding common share options and assumed vesting of outstandingrestricted common shares using the treasury stock method, as well as theassumed conversion of convertible senior notes using the if-converted method,if they are not anti-dilutive.

 

The following table presents a reconciliationof basic and diluted net income per common share for the three and six months endedJune 30, 2008 and 2007 (amounts in thousands, except per shareinformation):

 
| ** **                                                                               | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                               | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| Income from continuing operations                                                        |       | $                                                   | 38,640     |                                              | $          | 68,515 |   | $ | 48,877 |   | $ | 104,346 |   |
| (Loss) income from discontinued operations                                               |       | (1,079                                              | )          | (15,544                                           | )          | 2,668 |   | (2,951 | ) |
| Net income                                                                               |       | $                                                   | 37,561     |                                              | $          | 52,971 |   | $ | 51,545 |   | $ | 101,395 |   |
|                                                                                     |       |                                                |       |                                              |       |   |   |   |   |
| **Basic:**                                                                               |       |                                                |       |                                              |       |   |   |   |   |
| Basic weighted-average shares outstanding                                                |       | 146,025                                             |       | 80,241                                            |       | 130,289 |   | 80,240 |   |
| Income per share from continuing operations                                              |       | $                                                   | 0.26       |                                              | $          | 0.85 |   | $ | 0.38 |   | $ | 1.30 |   |
| (Loss) income per share from discontinued  operations                                    |       |                                                | —     |                                              |       | (0.19 | ) |   | 0.02 |   |   | (0.04 | ) |
| Net income per share                                                                     |       | $                                                   | 0.26       |                                              | $          | 0.66 |   | $ | 0.40 |   | $ | 1.26 |   |
|                                                                                     |       |                                                |       |                                              |       |   |   |   |   |
| **Diluted:**                                                                             |       |                                                |       |                                              |       |   |   |   |   |
| Basic weighted-average shares outstanding                                                |       | 146,025                                             |       | 80,241                                            |       | 130,289 |   | 80,240 |   |
| Dilutive effect of share options and  restricted common shares using the treasury method |       | 724                                                 |       | 1,692                                             |       | 675 |   | 1,565 |   |
| Diluted weighted-average shares outstanding  (1)                                         |       | 146,749                                             |       | 81,933                                            |       | 130,964 |   | 81,805 |   |
| Income per share from continuing operations                                              |       | $                                                   | 0.26       |                                              | $          | 0.84 |   | $ | 0.37 |   | $ | 1.28 |   |
| (Loss) income per share from discontinued  operations                                    |       |                                                | —     |                                              |       | (0.19 | ) |   | 0.02 |   |   | (0.04 | ) |
| Net income per share                                                                     |       | $                                                   | 0.26       |                                              | $          | 0.65 |   | $ | 0.39 |   | $ | 1.24 |   |

 

----

| (1) |   | Potential anti-dilutive common shares excluded from diluted income  earnings per share for the three and six months ended June 30, 2008 were  9,677,430 and 4,825,458, respectively, related to convertible debt  securities, and 1,932,279 related to common share options. There were 1,932,279  of potential anti-dilutive common share options for the three and six months  ended June 30, 2007. |
|-----|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

15

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** **

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

 

Securities sold, not yet purchased consist of equity and debtsecurities that the Company has sold short. As of June 30, 2008, theCompany had securities sold, not yet purchased with a cost basis of$27.2 million and accumulated net unrealized gain of $4.3 million. Asof December 31, 2007, the Company had securities sold, not yet purchasedwith a cost basis of $103.1 million and accumulated net unrealized gain of$2.7 million.

 

For the three and six months ended June 30, 2008, the Company hadnet realized gains on securities sold, not yet purchased of $1.1 millionand $7.1 million, respectively, and net unrealized gains on securities sold,not yet purchased of $0.6 million and $1.6 million, respectively. For thethree and six months ended June 30, 2007, the Company had net realizedgains on securities sold, not yet purchased of $0.1 million and net unrealizedgains on securities sold, not yet purchased of $0.4 million, respectively.

 

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

 

The following table summarizes the Company’s securities classified asavailable-for-sale as of June 30, 2008, which are carried at estimatedfair value (amounts in thousands):

 
| **Description**              | ** ** | **Amortized Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated Fair   Value** | ** ** |
|------------------------------|------------|-------------------------|------------|------------------------------|------------|-------------------------------|------------|--------------------------------------|------------|
| Corporate debt securities    |       | $                       | 1,272,932  |                         | $          | 5,977                         |       | $                                    | (178,787   | ) | $ | 1,100,122 |   |
| Marketable equity securities |       | 28,155                  |       | —                       |       | (10,489                       | )          | 17,666                               |       |
| Total                        |       | $                       | 1,301,087  |                         | $          | 5,977                         |       | $                                    | (189,276   | ) | $ | 1,117,788 |   |

 

The following table shows the gross unrealized losses and estimated fairvalue of the Company’s available-for-sale securities, aggregated by length oftime that the individual securities have been in a continuous unrealized lossposition, as of June 30, 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 debt securities    |       | $                                      | 398,514    |                                 | $          | (29,259                        | )          | $ | 515,739 |   | $ | (149,528 | ) | $ | 914,253 |   | $ | (178,787 | ) |
| Marketable equity securities |       | 17,666                                 |       | (10,489                              | )          | —                         |       | — |   | 17,666 |   | (10,489 | ) |
| Total                        |       | $                                      | 416,180    |                                 | $          | (39,748                        | )          | $ | 515,739 |   | $ | (149,528 | ) | $ | 931,919 |   | $ | (189,276 | ) |

 

The unrealized losses inthe above table exclude one investment in a preferred stock that is deemed to havean other-than-temporary impairment of $9.7 million. This other-than-temporaryimpairment was recognized in net realized and unrealized (loss) gain oninvestments in the condensed consolidated statements of operations. Whenevaluating whether an impairment is other-than-temporary, the Company performsan analysis of the anticipated future cash flows and the ability and intent tohold the investment for a sufficient amount of time to recover the unrealized losses.Additionally, the Company considers the current events specific to the issueror industry including widening credit spreads and external credit ratings, aswell as interest rate volatility.

 

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

 

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

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

 

16

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The following table shows the gross unrealized losses and estimated fairvalue of the Company’s available-for-sale securities, aggregated by length oftime that the individual securities have been in a continuous unrealized lossposition, as of December 31, 2007 (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    |       | $                                      | 1,075,296  |                                 | $          | (134,969                       | )          | $ | — |   | $ | — |   | $ | 1,075,296 |   | $ | (134,969 | ) |
| Marketable equity securities |       | 35,402                                 |       | (7,664                               | )          | 9,321                          |       | (3,112 | ) | 44,723 |   | (10,776 | ) |
| Total                        |       | $                                      | 1,110,698  |                                 | $          | (142,633                       | )          | $ | 9,321 |   | $ | (3,112 | ) | $ | 1,120,019 |   | $ | (145,745 | ) |

 

The unrealized losses in the above table exclude one investment in acorporate security that was deemed to be an other-than-temporary impairment of$5.9 million. The decline in fair value was deemed to beother-than-temporary in the fourth quarter of 2007 based on the Company’sintent to sell the security during 2008. This corporate security was soldduring the first quarter 2008 at approximately the same value it was carried atas of December 31, 2007. When evaluating whether an impairment isother-than-temporary, the Company performs an analysis of the anticipatedfuture cash flows and the ability and intent to hold the investment for asufficient amount of time to recover the unrealized losses. Additionally, theCompany considers the current events specific to the issuer or industryincluding widening credit spreads and external credit ratings, as well asinterest rate volatility.

 

All other unrealized losses in the table above are considered to betemporary impairments due to market factors and are not reflective of creditdeterioration. The Company has performed credit analyses in relation to theseinvestments and believes the carrying value of these investments to be fullyrecoverable over their expected holding period. Because the Company has theintent and ability to hold these investments until recovery, the relatedunrealized losses are not considered to be other-than-temporary impairments.

 

During the three and six months ended June 30, 2008, the Companyhad gross realized gains from the sales of securities available-for-sale of$2.4 million 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. During the three and six months ended June 30,2007, the Company had gross realized gains from the sales of securitiesavailable-for-sale of $27.4 million and $32.1 million, respectively, and gross realizedlosses from the sales of securities available-for-sale of $1.5 million and$2.2 million, respectively. Note 10 to these condensed consolidatedfinancial statements describes the Company’s borrowings under which the Companyhas pledged securities available-for-sale for borrowings. The following tablesummarizes the estimated fair value of securities available-for-sale pledged ascollateral for borrowings as of June 30, 2008 (amounts in thousands):

 
| ** **                                                                                                            | ** ** | **Corporate Debt  Securities** | ** ** | **Marketable  Equity  Securities** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------------|------------|
| Pledged as collateral for borrowings under secured revolving credit  facility                                         |       | $                              | 252,911    |                               | $          | — |   |
| Pledged as collateral for collateralized loan obligation senior secured  notes and junior secured notes to affiliates |       | 744,776                        |       | —                             |       |
| Pledged as collateral for subordinated notes to affiliates                                                            |       | 90,060                         |       | —                             |       |
| Total                                                                                                                 |       | $                              | 1,087,747  |                               | $          | — |   |

 

The following table summarizes the estimated fair value of securitiespledged as collateral for borrowings as of December 31, 2007 (amounts inthousands):

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

 

**Note 7. Corporate Loans and Allowance for LoanLosses**

 

The following table summarizes the Company’s corporate loans as of June 30,2008 and December 31, 2007 (amounts in thousands):

 
| ** **                             | ** ** | **As of June 30, 2008** | ** ** | **As of December 31, 2007** | ** ** |
|----------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------------|------------|
| Corporate loans, at net amortized cost |       | $                                           | 8,743,005  |                                            | $          | 8,659,208 |   |
| Less: Allowance for loan losses        |       | (35,000                                     | )          | (25,000                                         | )          |
| Total                                  |       | $                                           | 8,708,005  |                                            | $          | 8,634,208 |   |

 

17

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The following table summarizes the components of the net carrying valueof the Company’s corporate loans as of June 30, 2008 and December 31,2007 (amounts in thousands):

 
| ** **                              | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| **Description**                         | ** ** | **Principal**               | ** ** | **Net  Unamortized  Discount**  | ** ** | **Estimated  Fair  Value  Adjustment** | ** ** | **Net Carrying  Value** | ** ** | **Principal** | ** ** | **Net  Unamortized  Discount** | ** ** | **Net Carrying  Value** | ** ** |
| Corporate loans held for investment (1) |       | $                           | 8,981,931  |                            | $          | (238,926 | ) | $ | — |   | $ | 8,743,005 |   | $ | 8,766,169 |   | $ | (106,961 | ) | $ | 8,659,208 |   |
| Corporate loans held for sale           |       | 70,843                      |       | (1,554                          | )          | (2,637 | ) | 66,652 |   | — |   | — |   | — |   |
| Total loans                             |       | $                           | 9,052,774  |                            | $          | (240,480 | ) | $ | (2,637 | ) | $ | 8,809,657 |   | $ | 8,766,169 |   | $ | (106,961 | ) | $ | 8,659,208 |   |

 

----

(1)               Excludes allowance for loanlosses of $35.0 million and $25.0 million as of June 30, 2008 and December 31,2007, respectively.

 

As of June 30, 2008, approximately $66.7 million of corporateloans were classified as held for sale. The Company recorded a $2.6 million charge to earnings in net realizedand unrealized gain on investments related to these loans to adjust theircarrying value to the lower of cost or estimated fair value. The Company had noloans held for sale as of December 31, 2007.  Note 10 to these condensed consolidatedfinancial statements describes the Company’s borrowings under which the Companyhas pledged loans for borrowings. The following table summarizes the carryingvalue of corporate loans, at net amortized cost, pledged as collateral forborrowings as of June 30, 2008 and December 31, 2007 (amounts inthousands):

 
| ** **                                                                                                            | ** ** | **As of June 30, 2008** | ** ** | **As of December 31, 2007** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------------|------------|
| Pledged as collateral for borrowings under repurchase agreements                                                      |       | $                                           | —     |                                            | $          | 1,994,999 |   |
| Pledged as collateral for borrowings under secured revolving credit  facility                                         |       | 52,189                                      |       | 48,142                                          |       |
| Pledged as collateral for collateralized loan obligation senior  secured notes and junior secured notes to affiliates |       | 7,972,850                                   |       | 6,276,882                                       |       |
| Pledged as collateral for subordinated notes to affiliates                                                            |       | 602,265                                     |       | 27,886                                          |       |
| Total                                                                                                                 |       | $                                           | 8,627,304  |                                            | $          | 8,347,909 |   |

 

The following tablesummarizes the changes in the allowance for loan losses for the Company’scorporate loan portfolio for the six months ended June 30, 2008 (amountsin thousands):

 
| Balance at January 1, 2008 |   | $      | 25,000 |   |
|---------------------------------|--------|--------|--------|--------|
| Provision for loan losses       |   | 10,000 |   |
| Charge-offs                     |   | — |   |
| Balance at June 30, 2008   |   | $      | 35,000 |   |

 

The $35.0 million allowance for loan losses is unallocated as of June 30,2008 because the Company has not deemed any individual loans as being impairedas of that date. A provision for loan losses of $10.0 million was recordedduring the three and six months ended June 30, 2008. No provision for loanlosses was recorded during the three and six months ended June 30, 2007.

 

**Note 8.Residential****Mortgage-Backed Securities**

 

Upon adoption of SFAS No. 159as of January 1, 2007, the Company elected the option of carrying itsinvestments in residential mortgage-backed securities at estimated fair value. As of June 30, 2008 and December 31, 2007, residential mortgage-backed securities totaled $115.7 million and$131.7 million, respectively.

 

Note 10 to thesecondensed consolidated financial statements describes the Company’s borrowingsunder which the Company has pledged residential mortgage-backed securities. The followingtable summarizes the estimated fair value of residential mortgage-backed securitiespledged as collateral under repurchase agreements and a secured revolvingcredit facility as of June 30, 2008 and December 31, 2007 (amounts inthousands):

 
| ** **                                                                    | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| Pledged as collateral for borrowings under repurchase agreements              |       | $                           | —     |                            | $          | 112,465 |   |
| Pledged as collateral for borrowings under secured revolving credit  facility |       | 72,668                      |       | 5,368                           |       |
| Total                                                                         |       | $                           | 72,668     |                            | $          | 117,833 |   |

 

18

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**Note 9. Residential Mortgage Loans**

 

The following table summarizes the Company’s residential mortgage loansas of June 30, 2008 and December 31, 2007 (amounts in thousands):

** **
| ** **                                              | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|---------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| Residential mortgage loans, at estimated fair value (1) |       | $                           | 3,394,996  |                            | $          | 3,921,323 |   |
|                                                         |            |                             |            |                                 |            |  |  |

 

----

(1)               Excludes real estate owned(“REO”) by the Company as a result of foreclosure on delinquent loans of $8.9million and $7.2 million as of June 30, 2008 and December 31, 2007, respectively.REO is recorded within other assets on the Company’s condensed consolidatedbalance sheets.

 

The following table summarizes the estimated fair value of residentialmortgage loans pledged as collateral for borrowings as of June 30, 2008and December 31, 2007 (amounts in thousands):

 
| ** **                                                                    | ** ** | **As of June 30, 2008** | ** ** | **As of December 31, 2007** | ** ** |
|-------------------------------------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------------|------------|
| Pledged as collateral for borrowings under repurchase agreements              |       | $                                           | —     |                                            | $          | 163,586 |   |
| Pledged as collateral for borrowings under secured revolving credit  facility |       | 153,181                                     |       | 25,162                                          |       |
| Total                                                                         |       | $                                           | 153,181    |                                            | $          | 188,748 |   |

 

The following table summarizes the delinquency statistics of theCompany’s residential mortgage loans as of June 30, 2008 and December 31,2007 (dollar amounts in thousands):

 
| ** **                  | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-----------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| **Delinquency Status** | ** ** | **Number of  Loans**   | ** ** | **Principal  Amount**           | ** ** | **Number of  Loans** | ** ** | **Principal  Amount** | ** ** |
| 30 to 59 days          |       | 58                          |       | $                               | 18,510     |   | 96 |   | $ | 30,163 |   |
| 60 to 89 days          |       | 23                          |       | 8,921                           |       | 18 |   | 6,151 |   |
| 90 days or more        |       | 54                          |       | 20,146                          |       | 43 |   | 14,045 |   |
| In foreclosure              |       | 59                          |       | 20,493                          |       | 38 |   | 11,800 |   |
| Total                       |       | 194                         |       | $                               | 68,070     |   | 195 |   | $ | 62,159 |   |

 

As of June 30, 2008,the loss exposure or uncollected principal amount related to the Company’sdelinquent residential mortgage loans in the table above exceeded their fairvalue by $5.0 million. As of June 30, 2008, 28 of the residential mortgageloans owned by the Company with an outstanding balance of $8.9 million (notincluded in the table above) were REO as a result of foreclosure on delinquentloans. As of December 31, 2007, 25 of the residential mortgage loans ownedby the Company with an outstanding balance of $7.2 million (not included in thetable above) were REO as a result of foreclosure on delinquent loans.

 

**Note 10. Borrowings**

 

The Company leverages its portfolio of securities and loans through theuse of repurchase agreements, warehouse facilities, demand loans, andsecuritization transactions structured as secured financings.

 

19

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Certain information with respect to the Company’s borrowings as of June 30,2008 is summarized in the following table (dollar amounts in thousands):

 
| ** **                                       | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted-  Average  Borrowing  Rate** | ** ** | **Weighted-  Average  Remaining  Maturity (in  days)** | ** ** | **Estimated  Fair Value  of Collateral(1)** | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|-----------------------------------------|------------|-------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Secured revolving credit facility(2)             |       | $                           | 378,306    |                                    | 3.38       | %                                                           | 442        |                                                  | $          | 515,293 |   |
| CLO 2005-1 senior secured notes                  |       | 831,726                     |       | 3.23                                    |       | 3,222                                                       |       | 847,174                                               |       |
| CLO 2005-2 senior secured notes                  |       | 808,292                     |       | 2.95                                    |       | 3,436                                                       |       | 873,195                                               |       |
| CLO 2006-1 senior secured notes                  |       | 727,500                     |       | 3.00                                    |       | 3,708                                                       |       | 880,007                                               |       |
| CLO 2007-1 senior secured notes                  |       | 2,368,500                   |       | 3.20                                    |       | 4,702                                                       |       | 2,503,250                                             |       |
| CLO 2007-1 junior secured notes to affiliates(3) |       | 431,292                     |       | —                                  |       | 4,702                                                       |       | 455,830                                               |       |
| CLO 2007-A senior secured notes                  |       | 1,213,300                   |       | 5.59                                    |       | 3,394                                                       |       | 1,225,797                                             |       |
| CLO 2007-A junior secured notes to affiliates(4) |       | 94,128                      |       | —                                  |       | 3,394                                                       |       | 95,097                                                |       |
| Wayzata senior secured notes                     |       | 1,600,000                   |       | 3.48                                    |       | 1,599                                                       |       | 1,862,791                                             |       |
| Convertible senior notes                         |       | 300,000                     |       | 7.00                                    |       | 1,476                                                       |       | —                                                |       |
| Junior subordinated notes                        |       | 293,826                     |       | 6.56                                    |       | 10,308                                                      |       | —                                                |       |
| Subordinated notes to affiliates(5)              |       | 80,000                      |       | —                                  |       | 1,599                                                       |       | 93,140                                                |       |
| Total                                            |       | $                           | 9,126,870  |                                    |       |                                                        |       |                                                  | $          | 9,351,574 |   |

 

----

(1)                                  Collateral forborrowings consists of residentialmortgage-backed securities, securities available-for-sale, andcorporate and residential mortgage loans.

 

(2)                                  Includes$133.3 million in borrowings collateralized by retained rated mezzaninenotes and unrated subordinated notes issued by the Company’s CLO subsidiaries.

 

(3)                                  CLO 2007-1junior secured notes to affiliates consist of (x) $244.7 million of mezzaninenotes with a weighted-average borrowing rate of 7.53% and (y) $186.6 millionof subordinated notes that do not have a contractual coupon rate, but insteadreceive a pro rata amount of the net distributions from CLO 2007-1.

 

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

 

(5)                                  Subordinatednotes do not have a contractual coupon rate, but instead receive a pro rataamount of the net distributions from Wayzata.

 

In the second quarter of 2008, the Company retired $35.0 million of juniorsubordinated notes, which resulted in a gain on extinguishment of $17.2million, partially offset by a $1.1 million write-off of debt issuance costsand $0.7 million of other associated costs. 

 

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

 
| ** **                                       | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted-  Average  Borrowing  Rate** | ** ** | **Weighted-  Average  Remaining  Maturity (in  days)** | ** ** | **Estimated  Fair Value  of Collateral(1)** | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|-----------------------------------------|------------|-------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Repurchase agreements(2)                         |       | $                           | 2,808,066  |                                    | 5.41       | %                                                           | 132        |                                                  | $          | 2,745,166 |   |
| Secured revolving credit facility(3)             |       | 167,024                     |       | 5.65                                    |       | 540                                                         |       | 122,550                                               |       |
| Secured demand loan                              |       | 24,151                      |       | 5.00                                    |       | 31                                                          |       | 34,483                                                |       |
| CLO 2005-1 senior secured notes                  |       | 831,428                     |       | 5.39                                    |       | 3,404                                                       |       | 894,548                                               |       |
| CLO 2005-2 senior secured notes                  |       | 807,882                     |       | 5.34                                    |       | 3,618                                                       |       | 905,552                                               |       |
| CLO 2006-1 senior secured notes                  |       | 727,500                     |       | 5.39                                    |       | 3,890                                                       |       | 937,287                                               |       |
| CLO 2007-1 senior secured notes                  |       | 2,368,500                   |       | 5.39                                    |       | 4,884                                                       |       | 2,641,046                                             |       |
| CLO 2007-1 junior secured notes to affiliates(4) |       | 431,292                     |       | —                                  |       | 4,884                                                       |       | 480,922                                               |       |
| CLO 2007-A senior secured notes                  |       | 1,213,300                   |       | 5.57                                    |       | 3,576                                                       |       | 1,095,328                                             |       |
| CLO 2007-A junior secured notes to affiliates(5) |       | 94,128                      |       | —                                  |       | 3,576                                                       |       | 84,976                                                |       |
| Convertible senior notes                         |       | 300,000                     |       | 7.00                                    |       | 1,658                                                       |       | —                                                |       |
| Junior subordinated notes                        |       | 329,908                     |       | 7.54                                    |       | 10,524                                                      |       | —                                                |       |
| Subordinated notes to affiliates(6)              |       | 152,574                     |       | —                                  |       |                                                        |       | 163,437                                               |       |
| Total                                            |       | $                           | 10,255,753 |                                    |       |                                                        |       |                                                  | $          | 10,105,295 |   |

 

----

(1)                                  Collateral forborrowings consists of residential mortgage-backedsecurities, securities available-for-sale and corporate and residentialmortgage loans.

 

20

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

 

(3)                                  Includes$100.0 million in borrowings collateralized by retained rated mezzaninenotes and unrated subordinated notes issued by the Company’s CLO subsidiaries.

 

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

 

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

 

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

 

**Note 11. 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 the counterparties,the Company is potentially exposed to losses. The counterparties to theCompany’s derivative agreements have investment grade ratings and, as a result,the Company does not anticipate that any of the counterparties will fail tofulfill 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 hedging instrumentfor accounting purposes. Such derivative contracts may include credit defaultswaps, foreign exchange contracts, and interest rate derivatives. Free-standingderivatives also include investment financing arrangements (total rate ofreturn swaps) whereby the Company receives the sum of all interest, fees andany positive change in fair value amounts from a reference asset with aspecified notional amount and pays interest on such notional amount plus anynegative change in fair value amounts from such reference asset.

 

The table below summarizes the aggregate notional amount and estimatednet fair value of the derivative instruments as of June 30, 2008 and December 31,2007 (amounts in thousands):

 
| ** **                      | ** ** | **As of   June 30, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|---------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **Notional**                                  | ** ** | **Estimated  Fair Value**              | ** ** | **Notional** | ** ** | **Estimated  Fair Value** | ** ** |
| **Cash Flow Hedges:**           |       |                                          |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | $                                             | 383,333    |                                        | $          | (19,282 | ) | $ | 383,333 |   | $ | (19,018 | ) |
| **Fair Value Hedges:**          |       |                                          |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | 32,000                                        |       | (1,219                                      | )          | 32,000 |   | (1,212 | ) |
| **Free-Standing Derivatives:**  |       |                                          |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | 188,820                                       |       | 709                                         |       | 690,799 |   | (7,959 | ) |
| Credit default swaps—long  |       | 103,500                                       |       | (1,733                                      | )          | 66,000 |   | (1,154 | ) |
| Credit default swaps—short |       | 196,820                                       |       | 21,386                                      |       | 268,000 |   | 12,613 |   |
| Total rate of return swaps      |       | 477,877                                       |       | (88,256                                     | )          | 442,204 |   | (21,998 | ) |
| Foreign exchange contracts      |       | 26,702                                        |       | (140                                        | )          | 9,711 |   | 3 |   |
| Common stock warrants           |       | —                                        |       | 91                                          |       | — |   | 799 |   |
| Total                           |       | $                                             | 1,409,052  |                                        | $          | (88,444 | ) | $ | 1,892,047 |   | $ | (37,926 | ) |

 

21

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For all hedgeswhere hedge accounting is being applied, effectiveness testing and otherprocedures to ensure the ongoing validity of the hedges are performed at leastquarterly. During the three and six months ended June 30, 2008 and June 30,2007, the Company recognized an immaterial amount of ineffectiveness in incomeon the condensed consolidated statements of operations.

 

**Note 12. Accumulated Other ComprehensiveLoss**

 

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

 
| ** **                                                                                                                               | ** ** | **As of  June 30, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| Net unrealized losses on available-for-sale  securities                                                                                  |       | $                                       | (184,407   | )                                           | $          | (159,802 | ) |
| Net unrealized losses on cash flow hedges                                                                                                |       | (18,179                                 | )          | (19,018                                     | )          |
| Transition adjustment to accumulated  deficit in conjunction with fair value option election for residential  mortgage-backed securities |       | —                                  |       | 21,575                                      |       |
| Accumulated other comprehensive loss                                                                                                     |       | $                                       | (202,586   | )                                           | $          | (157,245 | ) |

 

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

 
| ** **                                                                                                                                | ** ** | **Three months**       | ** ** | **Three months**       | ** ** | **Six months**         | ** ** | **Six months**         | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                | ** ** | **ended**                   | ** ** | **ended**                   | ** ** | **ended**                   | ** ** | **ended**                   | ** ** |
| ** **                                                                                                                                | ** ** | **June 30, 2008** | ** ** | **June 30, 2007** | ** ** | **June 30, 2008** | ** ** | **June 30, 2007** | ** ** |
| Unrealized (losses) gains on securities  available-for-sale:                                                                              |       |                        |       |                        |       |                        |       |                        |       |
| Unrealized holding gains (losses) arising  during period                                                                                  |       | $                           | 18,131     |                        | $          | (6,273                      | )          | $                           | (65,977    | ) | $ | 641 |   |
| Translation adjustment to accumulated  deficit in conjunction with fair value option election for residential  mortgage-backed securities |       | —                      |       | —                      |       | —                      |       | 21,575                      |       |
| Reclassification adjustments for losses  (gains) realized in net income (1)                                                               |       | 10,648                      |       | (25,340                     | )          | 19,797                      |       | (29,148                     | )          |
| Unrealized losses on available-for-sale  securities from investment in unconsolidated affiliate                                           |       | —                      |       | (8,810                      | )          | —                      |       | (7,898                      | )          |
| Unrealized (losses) gains on securities  available-for-sale                                                                               |       | 28,779                      |       | (40,423                     | )          | (46,180                     | )          | (14,830                     | )          |
| Unrealized gains on cash flow hedges  arising during period                                                                               |       | 19,076                      |       | 28,251                      |       | 839                         |       | 10,078                      |       |
| Other comprehensive (loss) income                                                                                                         |       | $                           | 47,855     |                        | $          | (12,172                     | )          | $                           | (45,341    | ) | $ | (4,752 | ) |

 

----

(1) 2008 amounts include an impairment of $9.7 million for oneinvestment in a preferred stock security which was determined to beother-than-temporary.

 

**Note 13. Share Options and RestrictedShares**

 

The Companyhas adopted an amended and restated share incentive plan (the “2007 ShareIncentive Plan”) that provides for the grant of qualified incentive commonshare options that meet the requirements of Section 422 of the Code,non-qualified common share options, share appreciation rights, restrictedcommon shares and other share-based awards. The 2007 Share Incentive Plan wasadopted on May 4, 2007. Prior to the 2007 Share Incentive Plan, theCompany had adopted the 2004 Stock Incentive Plan that provided for the grantof qualified incentive common stock options that met the requirements of Section 422of the Code, non-qualified common stock options, stock appreciation rights,restricted common stock and other share-based awards. The 2004 Stock IncentivePlan was amended on May 26, 2005. The Compensation Committee of the boardof directors administers the plan. Share options and other share-based awardsmay be granted to the Manager, directors, officers and any key employees of theManager and to any other individual or entity performing services for theCompany.

 

The exerciseprice for any share option granted under the 2007 Share Incentive Plan may notbe less than 100% of the fair market value of the common shares at the time thecommon share option is granted. Each option to acquire a common share mustterminate no more than ten years from the date it is granted. As of June 30,2008, the 2007 Share Incentive Plan authorizes a total of 

 

22

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8,339,625 shares that may beused to satisfy awards under the 2007 Share Incentive Plan. On February 19,2008, the Compensation Committee of the board of directors granted the Manager1,097,000 restricted common shares that vest on February 19, 2011. Thefollowing table summarizes restricted common share transactions:

 
| ** **                                     | ** ** | **Manager** | ** ** | **Directors** | ** ** | **Total** | ** ** |
|------------------------------------------------|------------|-------------|------------|---------------|------------|-----------|------------|
| **Unvested shares as of January 1, 2008** |       | 625,000     |       | 72,657        |       | 697,657   |       |
| Issued                                         |       | 1,097,000   |       | —        |       | 1,097,000 |       |
| Vested                                         |       | —      |       | (16,120       | )          | (16,120   | )          |
| Cancelled                                      |       | —      |       | (2,839        | )          | (2,839    | )          |
| Forfeited                                      |       | —      |       | —        |       | —    |       |
| **Unvested shares as of June 30, 2008**   |       | 1,722,000   |       | 53,698        |       | 1,775,698 |       |

 

Pursuant toSFAS No. 123(R), the Company is required to value any unvested restrictedcommon shares granted to the Manager at the current market price. The Companyvalued the unvested restricted common shares granted to the Manager at $10.50and $24.91 per share at June 30, 2008 and June 30, 2007,respectively. There were $10.6 million and $6.4 million of totalunrecognized compensation costs related to unvested restricted common sharesgranted as of June 30, 2008 and June 30, 2007, respectively.

 

The followingtable summarizes common share option transactions:

 
| ** **                                 | ** ** | **Number of  Options** | ** ** | **Weighted-Average  Exercise Price** | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|-------------------------------------------|------------|
| **Outstanding as of January 1, 2008** |       | 1,932,279                   |       | $                                         | 20.00      |   |
| Granted                                    |       | —                      |       | —                                    |       |
| Exercised                                  |       | —                      |       | —                                    |       |
| Forfeited                                  |       | —                      |       | —                                    |       |
| **Outstanding as of June 30, 2008**   |       | 1,932,279                   |       | $                                         | 20.00      |   |

 

As of June 30,2008 and December 31, 2007, 1,932,279 common share options wereexercisable. As of June 30, 2008 and December 31, 2007, the commonshare options were fully vested and expire in August 2014. For the threeand six months ended June 30, 2008 and 2007, the components of share-basedcompensation expense are as follows (amounts in thousands):

 
| ** **                                      | ** ** | **For the three** | ** ** | **For the three** | ** ** | **For the six**   | ** ** | **For the six**   | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                      | ** ** | **months ended**       | ** ** | **months ended**       | ** ** | **months ended**       | ** ** | **months ended**       | ** ** |
| ** **                                      | ** ** | **June 30, 2008** | ** ** | **June 30, 2007** | ** ** | **June 30, 2008** | ** ** | **June 30, 2007** | ** ** |
| Options granted to Manager                      |       | $                           | —     |                        | $          | (184                        | )          | $                           | —     |   | $ | 438 |   |
| Restricted shares granted to Manager            |       | 196                         |       | 930                         |       | 658                         |       | 6,040                       |       |
| Restricted shares granted to certain  directors |       | 177                         |       | 108                         |       | 355                         |       | 214                         |       |
| Total share-based compensation expense          |       | $                           | 373        |                        | $          | 854                         |       | $                           | 1,013      |   | $ | 6,692 |   |

 

**Note 14. Management Agreement andRelated Party Transactions**

 

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

 

23

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The ManagementAgreement contains certain provisions requiring the Company to indemnify theManager with respect to all losses or damages arising from acts notconstituting bad faith, willful misconduct, or gross negligence. The Companyhas evaluated the impact of these guarantees on its condensed consolidatedfinancial statements and determined that they are not material.

 

For the three and six monthsended June 30, 2008, the Company incurred $8.9 million and $16.4million, 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 13). The Company also reimbursed the Manager $2.6 millionand $5.1 million, respectively, for expenses for the three and six months endedJune 30, 2008. For the three and six months ended June 30, 2007, the Company incurred $7.1 million and$14.3 million, respectively, in base management fees. In addition, the Companyrecognized share-based compensation expense related to common stock options andrestricted common stock granted to the Manager of $0.7 million and $6.5million, respectively, for the threeand six months ended June 30,2007 (see Note 13). The Company also reimbursed the Manager $2.2 million and$3.9 million, respectively, forexpenses for the three and six months ended June 30, 2007. Base management fees incurredand share-based compensation expense relating to common share options andrestricted common shares granted to the Manager are included in related partymanagement compensation on the consolidated statements of operations. Expensesincurred by the Manager and reimbursed by the Company are reflected in therespective condensed consolidated statements of operations, non-investmentexpense category based on the nature of the expense.

 

The Manager iswaiving base management fees related to the $230.4 million common shareoffering and $270.0 million common share rights offering that occurredduring the third quarter of 2007 until such time as the Company’s common shareclosing price on the NYSE is $20.00 or more for five consecutive trading days.Accordingly, the Manager permanently waived approximately $2.2 million and$4.4 million of base management fees during the three and six months ended June 30,2008, respectively.

 

No incentivefees were earned by the Manager during the three and six months ended June 30,2008, but $6.2 million and $12.6 million were earned by the Manager duringthe three and six months ended June 30, 2007, respectively. An affiliateof the Company’s Manager has entered into separate management agreements withthe respective investment vehicles for CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO2007-1, CLO 2007-A and Wayzata and is entitled to receive fees for the servicesperformed as collateral manager. The collateral manager has permanently waivedfees of approximately $22.5 million and $11.6 million as of June 30,2008 and June 30, 2007, respectively. Beginning April 15, 2007, thecollateral manager ceased waiving fees for CLO 2005-1. The Company recorded anexpense of $1.2 million and $2.5 million for collateral management feesfor CLO 2005-1 for the three and six months ended June 30, 2008,respectively. The collateral manager evaluates such waivers on a quarterlybasis and there are no assurances that the collateral manager will waive suchmanagement fees subsequent to June 30, 2008.

 

The Company has invested in corporate loans and bonds of entities thatare affiliates of KKR. As of June 30, 2008, the aggregate paramount of these affiliated investments totaled $3.9 billion, or approximately36% of the total investment portfolio, consisting of twenty-two issuers. Thetotal $3.9 billion in investments were comprised of $2.9 billion of loans,$636.8 million of corporate debt securities available for sale, and $306.5million of loans financed under total rate of return swaps (included inderivative assets and liabilities on the condensed consolidated balance sheet).

 

**Note 15. Fair Value Disclosure**

 

The followingtable 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, 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  June 30, 2008** | ** ** |
|------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|------------------------------------------------------|------------|
| **Assets:**                                    |       |                                                                                                |       |                                                               |       |                                                      |       |                                                 |       |
| Securities available-for-sale                  |       | $                                                                                                   | 17,666     |                                                               | $          | 1,054,779                                                 |       | $                                                    | 45,343     |   | $ | 1,117,788 |   |
| Residential mortgage-backed securities         |       | —                                                                                              |       | —                                                             |       | 115,652                                                   |       | 115,652                                              |       |
| Residential mortgage loans                     |       | —                                                                                              |       | —                                                             |       | 3,394,996                                                 |       | 3,394,996                                            |       |
| REO                                            |       | —                                                                                              |       | —                                                             |       | 8,919                                                     |       | 8,919                                                |       |
| Corporate loans held for sale                  |       | —                                                                                              |       | 66,652                                                             |       | —                                                    |       | 66,652                                               |       |
| Total                                          |       | $                                                                                                   | 17,666     |                                                               | $          | 1,121,431                                                 |       | $                                                    | 3,564,910  |   | $ | 4,704,007 |   |
| **Liabilities:**                               |       |                                                                                                |       |                                                               |       |                                                      |       |                                                 |       |
| Derivatives, net                               |       | $                                                                                                   | —     |                                                               | $          | (91,915                                                   | )          | $                                                    | 3,471      |   | $ | (88,444 | ) |
| Residential mortgage-backed securities  issued |       | —                                                                                              |       | —                                                             |       | (3,204,392                                                | )          | (3,204,392                                           | )          |
| Securities sold, not yet purchased             |       | (22,890                                                                                             | )          | —                                                             |       | —                                                    |       | (22,890                                              | )          |
| Total                                          |       | $                                                                                                   | (22,890    | )                                                                  | $          | (91,915                                                   | )          | $                                                    | (3,200,921 | ) | $ | (3,315,726 | ) |

 

24

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The followingtable presents information about the Company’s assets and liabilities (includingderivatives that are presented net) measured at fair value on a recurring basisas of December 31, 2007, and indicates the fair value hierarchy of thevaluation techniques utilized by the Company to determine such fair value(amounts in thousands):

 
| ** **                                     | ** ** | **Quoted Prices in  Active Markets  for Identical Assets  (Level 1)** | ** ** | **Significant Other  Observable Inputs  (Level 2)** | ** ** | **Significant  Unobservable Inputs  (Level 3)** | ** ** | **Balance as of  December 31, 2007** | ** ** |
|------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| **Assets:**                                    |       |                                                                                                |       |                                                               |       |                                                      |       |                                                     |       |
| Securities available-for-sale                  |       | $                                                                                                   | 47,777     |                                                               | $          | 1,212,266                                                 |       | $                                                        | 99,498     |   | $ | 1,359,541 |   |
| Residential mortgage-backed securities         |       | —                                                                                              |       | 131,688                                                            |       | —                                                    |       | 131,688                                                  |       |
| Residential mortgage loans                     |       | —                                                                                              |       | 3,921,323                                                          |       | —                                                    |       | 3,921,323                                                |       |
| REO                                            |       | —                                                                                              |       | 7,200                                                              |       | —                                                    |       | 7,200                                                    |       |
| Total                                          |       | $                                                                                                   | 47,777     |                                                               | $          | 5,272,477                                                 |       | $                                                        | 99,498     |   | $ | 5,419,752 |   |
| **Liabilities:**                               |       |                                                                                                |       |                                                               |       |                                                      |       |                                                     |       |
| Derivatives, net                               |       | $                                                                                                   | —     |                                                               | $          | (38,728                                                   | )          | $                                                        | 802        |   | $ | (37,926 | ) |
| Residential mortgage-backed securities  issued |       | —                                                                                              |       | (3,169,353                                                         | )          | —                                                    |       | (3,169,353                                               | )          |
| Securities sold, not yet purchased             |       | (32,704                                                                                             | )          | (67,690                                                            | )          | —                                                    |       | (100,394                                                 | )          |
| Total                                          |       | $                                                                                                   | (32,704    | )                                                                  | $          | (3,275,771                                                | )          | $                                                        | 802        |   | $ | (3,307,673 | ) |

 

The followingtable presents additional information about assets, including derivatives, thatare measured at fair value on a recurring basis for which the Company hasutilized level 3 inputs to determine fair value, for the three monthsended June 30, 2008 and 2007 (amounts in thousands):

 
| ** **                                                                                                                                                                                 | ** ** | **Three months ended June 30, 2008** | ** ** | **Three months ended June  30, 2007** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                                                                                                                                 | ** ** | **Securities   Available-  For-Sale**                    | ** ** | **Residential  Mortgage-  Backed  Securities**            | ** ** | **Residential  Mortgage   Loans** | ** ** | **REO** | ** ** | **Derivatives,  net** | ** ** | **Residential  Mortgage-  Backed  Securities  Issued** | ** ** | **Securities   Available-  For-Sale** | ** ** | **Derivatives,  net** | ** ** |
| Beginning balance as of April 1                                                                                                                                                       |       | $                                                             | 78,654     |                                                      | $          | 121,324 |   | $ | 3,605,233 |   | $ | 8,046 |   | $ | 1,049 |   | $ | (3,410,163 | ) | $ | 105,352 |   | $ | 1,109 |   |
| Total gains or losses (realized and  unrealized):                                                                                                                                          |       |                                                          |       |                                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Included in earnings                                                                                                                                                                       |       | —                                                        |       | (1,192                                                    | )          | 4,081 |   | — |   | (297 | ) | (6,775 | ) | — |   | 208 |   |
| Included in other comprehensive loss                                                                                                                                                       |       | (586                                                          | )          | —                                                    |       | — |   | — |   | — |   | — |   | — |   | — |   |
| Net transfers into (out of) level 3                                                                                                                                                   |       | (32,725                                                       | )          | —                                                    |       | — |   | 873 |   | 2,811 |   | — |   | — |   | — |   |
| Purchases, sales, other settlements and  issuances, net                                                                                                                                    |       | —                                                        |       | (4,480                                                    | )          | (214,318 | ) | — |   | (92 | ) | 212,546 |   | (48,352 | ) |   |   |
| Ending balance as of June 30                                                                                                                                                          |       | $                                                             | 45,343     |                                                      | $          | 115,652 |   | $ | 3,394,996 |   | $ | 8,919 |   | $ | 3,471 |   | $ | (3,204,392 | ) | $ | 57,000 |   | $ | 1,317 |   |
| 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 | ) | $ | — |   | $ | 208 |   |

 

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(1)                                  Amounts are included in net realized andunrealized (loss) gain 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.

 

25

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The followingtable presents additional information about assets, including derivatives thatare measured at fair value on a recurring basis for which the Company hasutilized level 3 inputs to determine fair value, for the six months ended June 30,2008 and 2007 (amounts in thousands):

 
| ** **                                                                                                                                                                                 | ** ** | **Six months ended June 30, 2008** | ** ** | **Six months ended June 30,  2007** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                                                                                                                 | ** ** | **Securities  Available-  For-Sale**                        | ** ** | **Residential  Mortgage-  Backed  Securities**          | ** ** | **Residential  Mortgage  Loans** | ** ** | **REO** | ** ** | **Derivatives,  net** | ** ** | **Residential  Mortgage-  Backed  Securities   Issued** | ** ** | **Securities   Available-  For-Sale** | ** ** | **Derivatives,  net** | ** ** |
| Beginning balance as of January 1                                                                                                                                                     |       | $                                                           | 99,498     |                                                    | $          | — |   | $ | — |   | $ | — |   | $ | 802 |   | $ | — |   | $ | 104,498 |   | $ | — |   |
| Total gains or losses (realized and  unrealized):                                                                                                                                          |       |                                                        |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Included in earnings                                                                                                                                                                       |       | —                                                      |       | (7,137                                                  | )          | (140,783 | ) | — |   | 467 |   | 147,252 |   | — |   | 1,317 |   |
| Included in other comprehensive loss                                                                                                                                                       |       | (4,090                                                      | )          | —                                                  |       | — |   | — |   | — |   | — |   | — |   | — |   |
| Net transfers into (out of) level 3                                                                                                                                                   |       | (32,725                                                     | )          | 131,688                                                 |       | 3,921,323 |   | 8,919 |   | 2,811 |   | (3,169,353 | ) | — |   | — |   |
| Purchases, sales, other settlements and  issuances, net                                                                                                                                    |       | (17,340                                                     | )          | (8,899                                                  | )          | (385,544 | ) | — |   | (609 | ) | (182,291 | ) | (47,498 | ) |   |   |
| Ending balance as of June 30                                                                                                                                                          |       | $                                                           | 45,343     |                                                    | $          | 115,652 |   | $ | 3,394,996 |   | $ | 8,919 |   | $ | 3,471 |   | $ | (3,204,392 | ) | $ | 57,000 |   | $ | 1,317 |   |
| 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 |   | $ | — |   | $ | 1,317 |   |

 

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(1)                                  Amounts are included in net realized andunrealized (loss) gain 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.

 

As of June 30,2008 and December 31, 2007, the Company did not have any assets orliabilities measured at fair value on a non-recurring basis.

 

**Note 16. Subsequent Events**

 

On July 1, 2008, thecompensation committee of the board of directors granted 38,349 restrictedcommon shares and 29,720 of phantom common shares to the Company’s directorspursuant to the 2007 Share Incentive Plan.

 

On July 9,2008, the Company retired $5.0 million of junior subordinated notes, whichresulted in a gain on extinguishment of $3.1 million, partially offset by a$0.2 million write-off of debt issuance costs and $0.1 million of other associatedcosts.

 

On August 7,2008, the Company’s board of directors declared a cash distribution for thequarter ended June 30, 2008 on the Company’s common shares of $0.40 pershare. The distribution is payable on August 29, 2008 to shareholders ofrecord as of the close of business on August 15, 2008.

 

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

 

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

 

**Forward Looking Statements**

 

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

 

**Executive Overview**

 

We are aspecialty finance company that uses leverage with the objective of generatingcompetitive risk-adjusted returns. We invest in financial assets primarilyconsisting of corporate loans and securities, including senior secured andunsecured loans, mezzanine loans, high yield corporate bonds, distressed andstressed debt securities, marketable and non-marketable equity securities, andcredit default and total rate of return swaps. We also make opportunisticinvestments in other asset classes from time to time.

 

Our objectiveis to provide competitive returns to our investors through a combination ofdistributions and capital appreciation. As part of our investment strategy, weseek to invest opportunistically in those asset classes that can generate competitiveleveraged risk-adjusted returns, subject to maintaining our exemption fromregulation under the Investment Company Act of 1940, as amended (the “InvestmentCompany Act”).

 

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

 

We are aDelaware limited liability company and were organized on January 17, 2007.We are the successor to KKR Financial Corp. (the “REIT Subsidiary”), a Marylandcorporation. The REIT Subsidiary was originally incorporated in the State ofMaryland on July 7, 2004 and elected to be treated as a real estateinvestment trust (“REIT”) for U.S. federal income tax purposes. On May 4,2007, we completed a restructuring transaction (the “Restructuring Transaction”),pursuant to which the REIT Subsidiary became our subsidiary and eachoutstanding share of the REIT Subsidiary’s common stock was converted into oneof our common shares, which are publicly traded on the New York Stock Exchange(“NYSE”) under the symbol “KFN”. Although we have not elected to be treated asa REIT for U.S. federal income tax purposes, we intend to continue to operateso as to qualify as a partnership, and not as an association or publicly tradedpartnership taxable as a corporation, for U.S. federal income tax purposes.

 

On March 31, 2008, we entered into adefinitive agreement with Rock Capital 2 LLC pursuant to which Rock Capital 2LLC would acquire a controlling interest in the REIT Subsidiary. This transactionclosed on June 30, 2008 and did not result in a gain or loss.

 

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We manage our liquidity withthe intention of maintaining the continuing ability to fund our operations andfulfill our commitments on a timely and cost-effective basis.  Based on changes in our working capital, forany given period, the cash flows provided by operating activities may be lessthan the cumulative distributions paid on our shares for such period and suchshortfall, if any, may be funded through the issuance of unsecured indebtednessor through the borrowing of additional amounts through the pledging of certainof our assets.  Our board of directorsconsiders available liquidity when declaring distributions to shareholders.  As of June 30, 2008, we had unrestrictedcash and cash equivalents totaling $189.0 million.

 

Our Manager, a wholly owned subsidiary of KohlbergKravis Roberts & Co. (Fixed Income) LLC (previously known asKKR Financial LLC), manages us pursuant to the Management Agreement. TheManager is an affiliate of KKR. In June 2008, Kohlberg Kravis Roberts & Co. (FixedIncome) LLC became a wholly-owned subsidiary of KKR.

 

***Discontinued Operations***

 

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

 

As of June 30, 2008, we substantially completed our plan to exitour residential mortgage investment operations through the sale of certain ofour sale of residential mortgage-backed securities in the third quarter of 2007and the agreement with the Noteholders related to the Facilities describedabove. In addition, on June 30, 2008, we completed the sale of acontrolling interest in the REIT Subsidiary to Rock Capital 2 LLC, which didnot result in a gain or loss. Accordingly, the REIT Subsidiary is presented asdiscontinued operations for financial statement purposes for all periodspresented.

 

We have determined that a sale or transfer of our remaining residentialmortgage portfolio to no longer be probable in the near term. As such, ourremaining residential mortgage investment operations, which were previouslypresented as discounted operations, are presented as continuing operations andthe associated prior period amounts presented in our condensed consolidatedfinancial statements relating to our existing residential mortgage assets andliabilities as of June 30, 2008 have been reclassified for comparativepresentation.

 

***Extinguishment of Debt***

 

During thesecond quarter of 2008, we retired $35.0 million of junior subordinated notes,which resulted in a gain on extinguishment of $17.2 million, partiallyoffset by a $1.1 million write-off of debt issuance costs and $0.7 million of otherassociated costs. The net gain on extinguishment of debt is recorded on ourcondensed consolidated statement of operations as other income.

 

***Common Share Offering***

 

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

 

28

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***Cash Distributions to Shareholders***

 

On August 7, 2008, ourboard of directors declared a cash distribution for the quarter ended June 30,2008 on our common shares of $0.40 per share. The distribution is payable on August 29,2008 to shareholders of record as of the close of business on August 15,2008.

 

***Investment Portfolio***

 

As of June 30, 2008, our investments incorporate loans and debt securities totaled $9.9 billion, which represents a 0.6%decrease from $10.0 billion as of December 31, 2007. Additionally, ourinvestments in RMBS totaled $315.2 million as of June 30, 2008, whichrepresents a decrease of 6.6% from $337.6 million as of December 31, 2007.  As described under Discontinued Operationsabove, we consolidate both the assets and liabilities of certain residentialmortgage-backed securitization trusts in accordance with accounting principlesgenerally accepted in the United States of America (“GAAP”) and as a result,$199.5 million of our $315.2 million of RMBS investments are included in theconsolidation of these entities and the $199.5 million represents the netdifference between residential mortgage loans of $3.4 billion and residentialmortgage-backed securities issued of $3.2 billion, plus $8.9 million of realestate owned (included in other assets on our condensed consolidated balancesheet in our condensed consolidated financial statements).

 

**Critical Accounting Policies**

 

Our condensedconsolidated financial statements are prepared by management in conformity withGAAP. Our significant accounting policies are fundamental to understanding ourfinancial condition and results of operations because some of these policiesrequire that we make significant estimates and assumptions that may affect thevalue of our assets or liabilities and financial results. We believe thatcertain of our policies are critical because they require us to make difficult,subjective, and complex judgments about matters that are inherently uncertain.We have reviewed these critical accounting policies with our board of directorsand our audit committee.

 

***Fair Value of Financial Instruments***

 

Effective January 1,2007, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 157,*Fair Value Measurements* (“SFAS No. 157”),which requires additional disclosures about our assets and liabilities that aremeasured at fair value.

 

As defined inSFAS No. 157, fair value is the price that would be received to sell anasset or paid to transfer a liability in an orderly transaction between marketparticipants at the measurement date. Where available, fair value is based onobservable market prices or parameters or derived from such prices orparameters. Where observable prices or inputs are not available, valuationmodels are applied. These valuation techniques involve some level of managementestimation and judgment, the degree of which is dependent on the pricetransparency for the instruments or market and the instruments’ complexity fordisclosure purposes. Beginning in January 2007, assets and liabilitiesrecorded at fair value in the consolidated balance sheets are categorized basedupon the level of judgment associated with the inputs used to measure theirvalue. Hierarchical levels, as defined in SFAS No. 157 and directlyrelated to the amount of subjectivity associated with the inputs to fairvaluations of these assets and liabilities, are as follows:

 

Level 1:Inputs are unadjusted, quoted prices in active markets for identical assets orliabilities at the measurement date.

 

The types ofassets carried at level 1 fair value generally are equity securities listedin active markets.

 

Level 2:Inputs other than quoted prices included in level 1 that are observablefor the asset or liability, either directly or indirectly. Level 2 inputsinclude quoted prices for similar instruments in active markets, and inputsother than quoted prices that are observable for the asset or liability.

 

Fair valueassets and liabilities that are generally included in this category are certaincorporate debt securities and certain financial instruments classified asderivatives where the fair value is based on observable market inputs.

 

Level 3:Inputs are unobservable inputs for the asset or liability, and includesituations where there is little, if any, market activity for the asset orliability. In certain cases, the inputs used to measure fair value may fallinto different 

 

29

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levels of thefair value hierarchy. In such cases, the level in the fair value hierarchywithin which the fair value measurement in its entirety falls has beendetermined based on the lowest level input that is significant to the fairvalue measurement in its entirety. Our assessment of the significance of aparticular input to the fair value measurement in its entirety requiresjudgment and the consideration of factors specific to the asset.

 

Generally,assets and liabilities carried at fair value and included in this category arecertain corporate debt securities, residential mortgage-backed securities,residential mortgage loans, residential mortgage-backed securities issued andcertain derivatives.

 

Theavailability of observable inputs can vary depending on the financial asset orliability 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 tradedon an active exchange or in the secondary market, and the current marketcondition. To the extent that valuation is based on models or inputs that areless observable or unobservable in the market, the determination of fair valuerequires more judgment. Accordingly, the degree of judgment exercised by us indetermining fair value is greatest for instruments categorized in level 3.In certain cases, the inputs used to measure fair value may fall into differentlevels of the fair value hierarchy. In such cases, for disclosure purposes thelevel in the fair value hierarchy within which the fair value measurement inits entirety falls is determined based on the lowest level input that issignificant to the fair value measurement in its entirety.

 

Fair value isa market-based measure considered from the perspective of a market participantwho holds the asset or owes the liability rather than an entity-specificmeasure. Therefore, even when market assumptions are not readily available, ourown assumptions are set to reflect those that market participants would use inpricing the asset or liability at the measurement date.

 

Many financialassets and liabilities have bid and ask prices that can be observed in themarketplace. Bid prices reflect the highest price that we and others are willingto pay for an asset. Ask prices represent the lowest price that we and othersare willing to accept for an asset. For financial assets and liabilities whoseinputs are based on bid-ask prices, we do not require that fair value always bea predetermined point in the bid-ask range. Our policy is to allow formid-market pricing and adjusting to the point within the bid-ask range thatmeets our best estimate of fair value.

 

Assets andliabilities that are valued using level 3 of the fair value hierarchy primarilyconsist of certain corporate debt securities, residential mortgage-backedsecurities, residential mortgage loans, residential mortgage-backed securitiesissued and certain over-the-counter (“OTC”) derivative contracts.  The valuation techniques used for these aredescribed below.

 

*Residential Mortgage-BackedSecurities, Residential Mortgage Loans, and Residential Mortgage-BackedSecurities Issued:* Residential mortgage-backedsecurities, residential mortgage loans, and residential mortgage-backedsecurities issued are initially valued at transaction price and aresubsequently valued using market data for similar instruments (e.g., recenttransactions, nationally recognized pricing services, or broker quotes),comparisons to benchmark derivative indices or movements in underlying creditspreads.

 

*CorporateDebt Securities:* Corporate debt securities areinitially valued at transaction price and are subsequently valued using marketdata for similar instruments (e.g., recent transactions or broker quotes),comparisons to benchmark derivative indices or movements in underlying creditspreads.

 

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

 

***Share-Based Compensation***

 

We account forshare-based compensation issued to members of our board of directors and ourManager using the fair value based methodology in accordance with SFAS No. 123(R),*Share-based Compensation* (“SFAS No. 123(R)”).We do not have any employees, although we believe that members of our board ofdirectors are deemed to be employees for purposes of interpreting and applyingaccounting principles relating to share-based compensation. We record ascompensation costs the restricted common shares that we issued to members ofour board of directors at estimated fair value as of the grant date and weamortize the cost into expense over the three-year vesting period using thestraight-line method. We record compensation costs for restricted common sharesand common share options that we issued to our Manager at estimated fair valueas of the grant date and we remeasure the amount on subsequent reporting datesto the extent the awards have not vested. Unvested restricted common shares arevalued using observable secondary market prices. Unvested common share optionsare valued using the Black-Scholes model and assumptions based on 

 

30

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observable market data forcomparable companies. We amortize compensation expense related to therestricted common share and common share options that we granted to our Managerusing the graded vesting attribution and straight-line method in accordancewith SFAS No. 123(R). As of June 30, 2008, the common share options were fully vested.

 

Because weremeasure the amount of compensation costs associated with the unvestedrestricted common shares and unvested common share options that we issued toour Manager as of each reporting period, our share-based compensation expensereported in our condensed consolidated financial statements will change basedon the estimated fair value of our common shares and this may result inearnings volatility. For the three and six months ended June 30, 2008, share-basedcompensation totaled $0.4 million and $1.0 million, respectively. As of June 30, 2008, substantially allof the non-vested restricted common shares issued that are subject to SFAS No. 123(R) aresubject to remeasurement. As of June 30,2008, a $1 increase in the price of our common shares would have increased ourfuture share-based compensation expense by approximately $1.7 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 30,2008, future unamortized share-based compensation totaled $10.6 million, ofwhich $2.2 million, $4.0 million, and $4.4 million will berecognized in 2008, 2009, and beyond, respectively.

 

***Accounting for Derivative Instruments andHedging Activities***

 

We recognizeall derivatives on our condensed consolidated balance sheets at estimated fairvalue. On the date we enter into a derivative contract, we designate anddocument each derivative contract as one of the following at the time thecontract is executed: (i) a hedge of a recognized asset or liability (“fairvalue” hedge); (ii) a hedge of a forecasted transaction or of thevariability of cash flows to be received or paid related to a recognized assetor liability (“cash flow” hedge); (iii) a hedge of a net investment in aforeign operation; or (iv) a derivative instrument not designated as ahedging instrument (“free-standing derivative”). For a fair value hedge, werecord changes in the estimated fair value of the derivative and, to the extentthat it is effective, changes in the fair value of the hedged asset orliability attributable to the hedged risk, in the current period earnings inthe same financial statement category as the hedged item. For a cash flowhedge, we record changes in the estimated fair value of the derivative to theextent that it is effective in other comprehensive income. We subsequentlyreclassify 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,we report changes in the fair values in current period other (loss) income.

 

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

 

We are notrequired to account for our derivative contracts using hedge accounting asdescribed above. If we decide not to designate the derivative contracts ashedges or if we fail to fulfill the criteria necessary to qualify for hedgeaccounting, then the changes in the estimated fair values of our derivativecontracts would affect periodic earnings immediately potentially resulting inthe increased volatility of our earnings. The qualification requirements forhedge accounting are complex and as a result, we must evaluate, designate, andthoroughly document each hedge transaction at inception and performineffectiveness analysis and prepare related documentation at inception and ona recurring basis thereafter. As of June 30, 2008, the estimated fairvalue of our net derivative liabilities totaled $88.4 million.

 

***Impairments***

 

We evaluate our investmentportfolio for impairment as of each quarter end or more frequently if we becomeaware of any material information that would lead us to believe that aninvestment may be impaired. We evaluate whether the investment is consideredimpaired and whether the impairment is other-than-temporary. If we make adetermination that the impairment is other-than-temporary, we recognize animpairment loss equal to the difference between the amortized cost basis andthe estimated fair value of the investment. Evaluating whether the impairmentof an investment is other-than-temporary requires significant judgment andrequires us to make certain estimates and assumptions. We consider many factorsin determining whether the impairment of an investment is other-than-temporary,including but not limited to the length of time the security has had a declinein estimated fair value below its amortized cost, the amount of the loss, theintent and our financial ability to hold the investment for a period of timesufficient for a recovery in its estimated fair value, recent events specificto the issuer or industry, external credit ratings and recent downgrades insuch ratings. As of June 30,2008, we had aggregate unrealized losses on our securities classified asavailable-for-sale of approximately $189.3 million, which if not recoveredmay result in the recognition of future losses. As of June 30, 2008, there was 

 

31

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an impairment of $9.7 million which was determined to beother-than-temporary which has been recorded as a loss in the condensed consolidatedstatements of operations.

 

***Allowance for Loan Losses***

 

Our allowancefor estimated loan losses represents our estimate of probable credit lossesinherent in the loan portfolio as of the balance sheet date. When determiningthe adequacy of the allowance for loan losses, we consider historical andindustry loss experience, economic conditions and trends, the estimated fairvalues of our loans, credit quality trends and other factors that we determineare relevant. Additions to the allowance for loan losses are charged to currentperiod earnings through the provision for loan losses. Amounts determined to beuncollectible are charged directly to the allowance for loan losses. Ourallowance for loan losses consists of two components, an allocated componentand an unallocated component.

 

The allocatedcomponent of our allowance for loan losses consists of individual loans thatare impaired and for which the estimated allowance for loan losses isdetermined 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 andinterest income is recognized only upon actual receipt.

 

Theunallocated component of our allowance for loan losses is determined inaccordance 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 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, 2008, our allowance forloan losses totaled $35.0 million.

 

**Recent Accounting Pronouncements**

 

In February 2008, the FASB issued FSP FAS 140-3, *Accounting for Transfers of Financial Assets and Repurchase FinancingTransactions*(“FSP SFAS No. 140-3”). FSP SFAS No. 140-3assumes that an initial transfer of a financial asset and a repurchasefinancing are considered part of the same arrangement, or a linked transaction.However, if certain criteria are met, the initial transfer and repurchasefinancing shall not be evaluated as a linked transaction and shall be evaluatedseparately under SFAS No. 140, *Accounting for Transfersand Servicing of Financial Assets and Extinguishments of Liabilities*(“SFAS No. 140”). FSP SFAS No. 140-3 is effective for us for repurchasefinancings in which the initial transfer is entered into after December 31,2008 and early adoption is not permitted. We do not expect the adoption of FSP SFAS No. 140-3 to have amaterial impact on our condensedconsolidated financial statements.

 

In March 2008, the FASB issued SFAS No. 161, *Disclosures about Derivative Instruments and Hedging Activities, anAmendment of FASB Statement No. 133*(“SFAS No. 161”). SFASNo. 161 requires enhanced qualitative disclosures about objectives andstrategies for using derivatives, quantitative disclosures about fair valueamounts of gains and losses on derivative instruments, and disclosures aboutcredit-risk-related contingent features in derivative agreements. Theadditional disclosures required by SFAS No. 161 must be included in ourconsolidated financial statements beginning with the first quarter of 2009.

 

In May 2008, the FASB issuedFSP No. APB 14-1, *Accountingfor Convertible Debt Instruments That May Be Settled in Cash uponConversion (Including Partial Cash Settlement)* (“FSP APB 14-1”). This FSP requires thatissuers of convertible debt instruments that may be settled wholly or partly incash when converted should separately account for the liability and equity(conversion feature) components of the instruments. As a result, interestexpense should be imputed and recognized based upon the entity’s nonconvertibledebt borrowing rate, which will result in lower net income. Prior to theadoption of FSP APB 14-1, APB No. 14, *Accounting for ConvertibleDebt and Debt Issued with Stock Purchase Warrants*, provided that noportion of the proceeds from the issuance of the instrument should beattributable to the conversion feature. The 7.00% convertible senior notesissued by us in July 2007 will be subject to FSP ABP 14-1. FSP APB 14-1 iseffective for us retroactively on January 1, 2009 and early adoption isprohibited. We have determined that the adoption of FSP APB 14-1 does not havea material impact on our financial statements.

 

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In May 2008, FASB issued SFAS No. 163,*Accounting for Financial Guarantee InsuranceContracts — an interpretation of FASB Statement No. 60*(“SFAS No. 163”).SFAS No. 163 requires recognition of an insurance claim liability prior toan event of default (insured event) when there is evidence that creditdeterioration has occurred in an insured financial obligation. SFAS No. 163is effective for financial statements issued for fiscal years beginning after December 15,2008 and all interim periods within those fiscal years, and early applicationis not permitted. We do not expect the adoption of SFAS No. 163 to have amaterial impact on our financial statements.

 

**Results of Operations**

 

**Three and six months ended June 30, 2008compared to three and six months ended June 30, 2007**

 

*Summary*

 

Our net incomefor the three and six months ended June 30, 2008 totaled $37.6 million (or $0.26 perdiluted common share) and $51.5 million (or $0.39 per diluted common share),respectively, as compared to net income of $53.0 million (or $0.65 perdiluted common share) and $101.4 million (or $1.24 per diluted common share),respectively, for the three and six months ended June 30, 2007. Income from continuing operations for thethree and six months ended June 30,2008 totaled $38.6 million (or $0.26 per diluted common share) and $48.9million (or $0.37 per diluted common share), respectively, as compared to $68.5 million(or $0.84 per diluted common share) and $104.3 million (or $1.28 per dilutedcommon share), respectively, for the three and six months ended June 30, 2007. The decrease inincome from continuing operations of $29.9 million, or 43.6%, and $55.5million, or 53.2%, from the three and six months ended June 30, 2007 to2008, respectively, is primarily attributable to a significant increase in netrealized and unrealized losses on investments, derivatives and foreignexchange.

 

*Net Investment Income*

 

The followingtable presents the components of our net investment income for the three andsix months ended June 30,2008 and 2007:

 

**Comparative Net Investment Income Components**

**(Amounts in thousands)**

 
| ** **                                                 | ** ** | **For the three  months ended  June 30, 2008** | ** ** | **For the three  months ended  June 30, 2007** | ** ** | **For the six  months ended  June 30, 2008** | ** ** | **For the six  months ended  June 30, 2007** | ** ** |
|------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| Investment Income:                                         |       |                                                                    |       |                                                                    |       |                                                                  |       |                                                                  |       |
| Corporate loans and securities interest  income            |       | $                                                                       | 163,830    |                                                                    | $          | 108,696                                                               |       | $                                                                     | 363,190    |   | $ | 193,891 |   |
| Residential mortgage loans and securities  interest income |       | 44,643                                                                  |       | 64,504                                                                  |       | 92,847                                                                |       | 132,693                                                               |       |
| Other interest income                                      |       | 4,998                                                                   |       | 5,674                                                                   |       | 16,074                                                                |       | 8,251                                                                 |       |
| Dividend income                                            |       | 1,092                                                                   |       | 965                                                                     |       | 1,908                                                                 |       | 1,940                                                                 |       |
| Net discount accretion                                     |       | 10,865                                                                  |       | 497                                                                     |       | 19,647                                                                |       | 1,163                                                                 |       |
| Total investment income                                    |       | 225,428                                                                 |       | 180,336                                                                 |       | 493,666                                                               |       | 337,938                                                               |       |
| Interest Expense:                                          |       |                                                                    |       |                                                                    |       |                                                                  |       |                                                                  |       |
| Repurchase agreements                                      |       | 4,467                                                                   |       | 19,211                                                                  |       | 33,437                                                                |       | 40,620                                                                |       |
| Collateralized loan obligation senior  secured notes       |       | 71,889                                                                  |       | 48,095                                                                  |       | 146,407                                                               |       | 80,155                                                                |       |
| Secured revolving credit facility                          |       | 3,140                                                                   |       | 2,402                                                                   |       | 5,773                                                                 |       | 3,390                                                                 |       |
| Secured demand loan                                        |       | 25                                                                      |       | 611                                                                     |       | 348                                                                   |       | 1,215                                                                 |       |
| Convertible senior notes                                   |       | 5,623                                                                   |       | —                                                                  |       | 11,010                                                                |       | —                                                                |       |
| Junior subordinated notes                                  |       | 6,349                                                                   |       | 5,036                                                                   |       | 12,104                                                                |       | 10,021                                                                |       |
| Residential mortgage-backed securities  issued             |       | 34,001                                                                  |       | 48,420                                                                  |       | 68,432                                                                |       | 99,573                                                                |       |
| Other interest expense                                     |       | 272                                                                     |       | 634                                                                     |       | 1,022                                                                 |       | 1,267                                                                 |       |
| Interest rate swap                                         |       | 2,271                                                                   |       | (144                                                                    | )          | 3,569                                                                 |       | (191                                                                  | )          |
| Total interest expense                                     |       | 128,037                                                                 |       | 124,265                                                                 |       | 282,102                                                               |       | 236,050                                                               |       |
| Interest expense to affiliates                             |       | 19,707                                                                  |       | 8,256                                                                   |       | 47,525                                                                |       | 8,256                                                                 |       |
| Provision for loan losses                                  |       | 10,000                                                                  |       | —                                                                  |       | 10,000                                                                |       | —                                                                |       |
| Net investment income                                      |       | $                                                                       | 67,684     |                                                                    | $          | 47,815                                                                |       | $                                                                     | 154,039    |   | $ | 93,632 |   |

 

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As presented in the table above, netinvestment income increased $19.9 million, or 41.6%, and $60.4 million, or64.5%, from the three and six months ended June 30, 2007 compared to thethree and six months ended June 30, 2008. The increase is primarily attributableto the additional investments in our investment portfolio during 2008. As of June 30,2008, we held $9.9 billion of investments in corporate loans andsecurities, excluding the allowance for loan losses of $35.0 million. Incomparison, as of June 30, 2007, investments in corporate loans andsecurities totaled $6.6 billion.

 

Net investment income in the table above doesnot include equity in income of unconsolidated affiliate of nil for the threeand six months ended June 30, 2008 and $5.7 million and $12.7 millionfor the three and six months ended June 30, 2007, respectively. Equity inincome of unconsolidated affiliate reflects our pro rata interest in the netincome of a limited partnership that was formed to hold the subordinatedinterests in three entities formed to execute secured financing transactions inthe form of collateralized loan obligations (“CLOs”).

 

*Other (Loss) Income*

 

The following table presents the componentsof other (loss) income for the three and six months ended June 30, 2008and 2007:

 

**Comparative Other (Loss) Income Components**

**(Amounts in thousands)**

 
| ** **                                                                                                                                                                             | ** ** | **For the three  months ended  June 30, 2008** | ** ** | **For the three  months ended  June 30, 2007** | ** ** | **For the six  months ended  June 30, 2008** | ** ** | **For the six  months ended  June 30, 2007** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| Net realized and unrealized (loss) gain on  derivatives and foreign exchange:                                                                                                          |       |                                                                    |       |                                                                    |       |                                                                  |       |                                                                  |       |
| Interest rate swaptions                                                                                                                                                                |       | $                                                                       | —     |                                                                    | $          | 15                                                                    |       | $                                                                     | —     |   | $ | — |   |
| Interest rate swaps                                                                                                                                                                    |       | (268                                                                    | )          | —                                                                  |       | 3,526                                                                 |       | —                                                                |       |
| Credit default swaps                                                                                                                                                                   |       | (2,955                                                                  | )          | 1,015                                                                   |       | 10,334                                                                |       | 973                                                                   |       |
| Total rate of return swaps                                                                                                                                                             |       | (3,820                                                                  | )          | 5,602                                                                   |       | (66,445                                                               | )          | 12,369                                                                |       |
| Common stock warrants                                                                                                                                                                  |       | (20                                                                     | )          | (144                                                                    | )          | (707                                                                  | )          | 286                                                                   |       |
| Foreign contract                                                                                                                                                                       |       | (6                                                                      | )          | —                                                                  |       | —                                                                |       | —                                                                |       |
| Foreign exchange translation                                                                                                                                                           |       | 1,151                                                                   |       | (7                                                                      | )          | 358                                                                   |       | (9                                                                    | )          |
| Total realized and unrealized (loss) gain  on derivatives and foreign exchange                                                                                                         |       | (5,918                                                                  | )          | 6,481                                                                   |       | (52,934                                                               | )          | 13,619                                                                |       |
| Net realized loss on residential loans  carried at estimated fair value                                                                                                                |       | (744                                                                    | )          | (124                                                                    | )     | (1,499                                                                | )          | (201                                                                  | )     |
| Net unrealized (loss) gain on residential mortgage-backed  securities, residential mortgage loans, and residential mortgage-backed  securities issued, carried at estimated fair value |       | (4,850                                                                  | )          | 1,650                                                                   |       | (13,273                                                               | )          | (1,490                                                                | )          |
| Net realized (loss) gain on investments                                                                                                                                                |       | (4,892                                                                  | )          | 26,739                                                                  |       | (18,651                                                               | )          | 33,764                                                                |       |
| Impairment of securities available for sale                                                                                                                                            |       | (9,688                                                                  | )          | —                                                                  |       | (9,688                                                                | )          | —                                                                |       |
| Lower of cost or estimated fair value  adjustment to loans held for sale                                                                                                               |       | (2,637                                                                  | )          | —                                                                  |       | (2,637                                                                | )          | —                                                                |       |
| Gain on extinguishment of debt                                                                                                                                                         |       | 17,225                                                                  |       | —                                                                  |       | 17,225                                                                |       | —                                                                |       |
| Net realized and unrealized gain on  securities sold, not yet purchased                                                                                                                |       | 1,664                                                                   |       | 575                                                                     |       | 8,650                                                                 |       | 575                                                                   |       |
| Other income                                                                                                                                                                           |       | 513                                                                     |       | 2,540                                                                   |       | 5,469                                                                 |       | 4,588                                                                 |       |
| Total other (loss) income                                                                                                                                                              |       | $                                                                       | (9,327     | )                                                                       | $          | 37,861                                                                |       | $                                                                     | (67,338    | ) | $ | 50,855 |   |

 

As presented in the table above, total other loss totaled$9.3 million and $67.3 million for the three and six months ended June 30,2008, respectively, as compared to other income of $37.9 million and $50.9million for the three and six months ended June 30, 2007, respectively.The change in total other (loss) income for the three months ended June 30,2008 is primarily attributable to a $5.9 million net realized andunrealized loss on derivatives and foreign exchange, of which $3.8 millionwas related to total rate of return swaps, a $4.9 million unrealized loss onthe estimated fair value of our residential mortgage positions, an $5.6 millionrealized loss on sales of investments, and a $9.7 million loss on theimpairment of a security available-for-sale, all partially offset by a $17.2million gain on the extinguishment of junior subordinated notes. The change intotal other (loss) income for the six months ended June 30, 2008 isprimarily attributable to a $52.9 million net realized and unrealized losson derivatives and foreign exchange, of which $66.4 million was related tototal rate of return swaps, a $13.3 million unrealized loss on the estimatedfair value of our residential mortgage positions, a $20.2 million realized losson sales of investments, and $9.7 million loss on the impairment of a securityavailable-for-sale, all partially offset by a $17.2 million gain on the extinguishmentof junior subordinated notes.

 

 

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*Non-Investment Expenses*

 

The following table presents the componentsof non-investment expenses for the three and six months ended June 30,2008 and 2007:

 

**Comparative Non-Investment Expense Components**

**(Amountsin thousands)**

 
| ** **                             | ** ** | **For the three  months ended  June 30, 2008** | ** ** | **For the three  months ended  June 30, 2007** | ** ** | **For the six  months ended  June 30, 2008** | ** ** | **For the six  months ended  June 30, 2007** | ** ** |
|----------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| Related party management compensation: |       |                                                                    |       |                                                                    |       |                                                                  |       |                                                                  |       |
| Base management fees                   |       | $                                                                       | 8,927      |                                                                    | $          | 7,077                                                                 |       | $                                                                     | 16,360     |   | $ | 14,273 |   |
| Incentive fee                          |       | —                                                                  |       | 6,249                                                                   |       | —                                                                |       | 12,620                                                                |       |
| Share-based compensation               |       | 196                                                                     |       | 746                                                                     |       | 658                                                                   |       | 6,478                                                                 |       |
| CLO management fees                    |       | 1,264                                                                   |       | 1,042                                                                   |       | 2,528                                                                 |       | 1,042                                                                 |       |
| Related party management compensation  |       | 10,387                                                                  |       | 15,114                                                                  |       | 19,546                                                                |       | 34,413                                                                |       |
| Professional services                  |       | 1,071                                                                   |       | 759                                                                     |       | 2,928                                                                 |       | 1,300                                                                 |       |
| Loan servicing expense                 |       | 2,391                                                                   |       | 2,939                                                                   |       | 4,960                                                                 |       | 6,023                                                                 |       |
| Insurance expense                      |       | 158                                                                     |       | 192                                                                     |       | 319                                                                   |       | 386                                                                   |       |
| Directors expenses                     |       | 315                                                                     |       | 285                                                                     |       | 716                                                                   |       | 605                                                                   |       |
| General and administrative expenses    |       | 5,279                                                                   |       | 3,514                                                                   |       | 9,239                                                                 |       | 9,261                                                                 |       |
| Total non-investment expenses          |       | $                                                                       | 19,601     |                                                                    | $          | 22,803                                                                |       | $                                                                     | 37,708     |   | $ | 51,988 |   |

 

As presented in the table above, ournon-investment expenses decreased by $3.2 million and $14.3 million forthe three and six months ended June 30, 2008, respectively compared to June 30,2007. The significant components of non-investment expense are described below.

 

Management compensation to related partiesconsists of base management fees payable to our Manager pursuant to theManagement Agreement, incentive fees, collateral management fees, andshare-based compensation related to restricted common shares and common shareoptions granted to our Manager. The base management fee payable was calculatedin accordance with the Management Agreement and is based on an annual rate of1.75% times our “equity” as defined in the Management Agreement. Our Manager isalso entitled to a quarterly incentive fee provided that our quarterly “netincome,” as defined in the Management Agreement, before the incentive feeexceeds a defined return hurdle. The Manager did not earn an incentive feeduring the three and six months ended June 30, 2008, respectively. For thethree and six months ended June 30, 2007, incentive fees of $6.2 millionand $12.6 million were earned by the Manager.

 

General and administrative expenses consistof expenses incurred by our Manager on our behalf that are reimbursable to ourManager pursuant to the Management Agreement. Professional services expensesconsist of legal, accounting and other professional services. Directors’expenses represent share-based compensation, as well as expenses andreimbursables due to the board of directors for their services. The decrease innon-investment expense is primarily due to a decrease in share-basedcompensation related to the vesting of restricted common shares and commonshare options granted to our Manager, decline in estimated fair value ofrestricted common shares granted to our Manager, and the absence of incentivefees.

 

*Income Tax Provision*

 

After the Restructuring Transaction, we are nolonger treated as a REIT for U.S. federal income tax purposes; however, weintend to continue to operate so as to qualify as a partnership, and not as anassociation or publicly traded partnership that is taxable as a corporation,for U.S. federal income tax purposes. Therefore, we generally are not subjectto U.S. federal income tax at the entity level, but are subject to limitedstate income taxes. Holders of our shares are required to take into accounttheir allocable share of each item of our income, gain, loss, deduction, andcredit for our taxable year end ending within or with their taxable year.

 

KKR Financial Holdings II, LLC (“KFH II”), awholly-owned subsidiary of the Company which holds certain real estatemortgage-backed securities, elected to be taxed as a REIT and we believe thatit has complied with the provisions of the Internal Revenue Code of 1986, asamended, (the “Code”), with respect thereto. KFH II is not subject to federal 

 

35

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income tax to the extent that it currently distributes its income andsatisfies certain asset, income and ownership tests, and recordkeepingrequirements.

 

KKR Financial CLO 2005-1, Ltd.(“CLO 2005-1”), KKR Financial CLO 2005-2, Ltd.(“CLO 2005-2”), KKR Financial CLO 2006-1, Ltd.(“CLO 2006-1”), KKR Financial CLO 2007-1, Ltd. (“CLO 2007-1”), and KKRFinancial CLO 2007-A, Ltd. (“CLO 2007-A”) are foreign taxable corporate subsidiariesthat were established to facilitate securitization transactions, structured assecured financing transactions, and KKR TRS Holdings, Ltd. (“TRS Ltd.”),is a foreign taxable corporate subsidiary that was formed to make certainforeign investments from time to time. They are organized as exempted companiesincorporated with limited liability under the laws of the Cayman Islands, andare generally not subject to federal and state income tax at the corporateentity level because they restrict their activities in the United States totrading in stock and securities for their own account. Therefore, despite theirstatus as taxable corporate subsidiaries, they generally will not be subject tocorporate income tax in our financial statements on their earnings, and noprovisions for income taxes for the three months and six months ended June 30,2008 and 2007 were recorded; however, we are generally required to includetheir current taxable income in our calculation of taxable income allocable toshareholders.

 

**Investment Portfolio**

 

***Corporate Investment Summary***

 

The tables below summarize the carryingvalue, amortized cost, and estimated fair value of our corporate investmentportfolio as of June 30, 2008 and December 31, 2007, classified byinterest rate type. Carrying value is the value that investments are recordedon our condensed consolidated balance sheets and is estimated fair value forsecurities, amortized cost for loans held for investment, and the lower of costor estimated fair value for loans held for sale. Estimated fair values setforth in the tables below are based on dealer quotes and/or nationallyrecognized pricing services.

 

The table below summarizes our corporateinvestment portfolio as of June 30, 2008 classified by interest rate type:

 

**Corporate Investment Portfolio**

**(Dollaramounts in thousands)**

 
| ** **                                             | ** ** | **Carrying   Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Portfolio Mix   % by Fair Value** | ** ** |
|--------------------------------------------------------|------------|---------------------------|------------|---------------------|------------|--------------------------------|------------|--------------------------------------------------------------|------------|
| **Floating Rate:**                                     |       |                      |       |                |       |                           |       |                                                         |       |
| Corporate Loans                                        |       | $                         | 8,616,043  |                | $          | 8,616,043                      |       | $                                                            | 8,026,579  |   | 85.9 | % |
| Corporate Debt Securities                              |       | 200,051                   |       | 236,240             |       | 200,051                        |       | 2.1                                                          |       |
| Total Floating Rate                                    |       | 8,816,094                 |       | 8,852,283           |       | 8,226,630                      |       | 88.0                                                         |       |
| **Fixed Rate:**                                        |       |                      |       |                |       |                           |       |                                                         |       |
| Corporate Loans                                        |       | 193,614                   |       | 193,614             |       | 187,298                        |       | 2.0                                                          |       |
| Corporate Debt Securities                              |       | 900,071                   |       | 1,036,692           |       | 900,071                        |       | 9.6                                                          |       |
| Total Fixed Rate                                       |       | 1,093,685                 |       | 1,230,306           |       | 1,087,369                      |       | 11.6                                                         |       |
| **Marketable and Non-Marketable Equity  Securities:**  |       |                      |       |                |       |                           |       |                                                         |       |
| Marketable Equity Securities                           |       | 17,666                    |       | 28,155              |       | 17,666                         |       | 0.2                                                          |       |
| Non-Marketable Equity Securities                       |       | 20,079                    |       | 20,079              |       | 20,079                         |       | 0.2                                                          |       |
| Total Marketable and Non-Marketable Equity  Securities |       | 37,745                    |       | 48,234              |       | 37,745                         |       | 0.4                                                          |       |
| Total(1)                                               |       | $                         | 9,947,524  |                | $          | 10,130,823                     |       | $                                                            | 9,351,744  |   | 100.0 | % |

 

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(1)           Total carrying valueexcludes allowance for loan losses of $35.0 million and includes loansheld for sale.

 

The schedule above excludes equity securitiessold, not yet purchased, with a cost of $27.2 million and for which we hadaccumulated net unrealized gains of $4.3 million as of June 30, 2008.

 

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The table below summarizes our investmentportfolio as of December 31, 2007 classified by interest rate type:

** **

**Corporate Investment Portfolio**

**(Dollaramounts in thousands)**

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

 

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

 

The schedule above excludes equity securitiessold, not yet purchased, with a cost of $103.1 million and for which wehad accumulated net unrealized gains of $2.7 million as of December 31,2007.

 

*Corporate Loans*

 

Our corporate loan portfolio totaled $8.8billion as of June 30, 2008 and $8.7 billion as of December 31,2007. Our corporate loan portfolio consists of debt obligations ofcorporations, partnerships and other entities in the form of first and secondlien loans, mezzanine loans and bridge loans. As of June 30, 2008, $8.6billion, or 97.8%, of our corporate loan portfolio was floating rate and $0.2billion, or 2.2%, was fixed rate.  As of December 31,2007, $8.6 billion, or 99.2%, our corporate loan portfolio was floating rateand $0.1 billion, or 0.8%, was fixed rate.

 

All of our floating rate corporate loans have index reset frequenciesof less than twelve months with the majority resetting at least quarterly. Theweighted-average coupon on our floating rate corporate loans was 5.63% and7.85% as of June 30, 2008 and December 31, 2007, respectively, andthe weighted-average coupon spread to London Interbank Offered Rates (“LIBOR”)of our floating rate corporate loan portfolio was 2.88% and 2.87% as of June 30,2008 and December 31, 2007, respectively. The weighted-average years tomaturity of our floating rate corporate loans was 5.3 years and 5.7 years as ofJune 30, 2008 and December 31, 2007, respectively.

 

As of June 30, 2008, our fixed ratecorporate loans had a weighted-average coupon of 13.59% and a weighted-averageyears to maturity of 5.9 years, as compared to 11.01% and 5.8 years,respectively, as of December 31, 2007.

 

As of June 30, 2008 and December 31,2007, there were no corporate loan balances placed on non-accrual status. Weevaluate and monitor the asset quality of our investment portfolio byperforming detailed credit reviews and by monitoring key credit statistics andtrends. The key credit statistics and trends we monitor to evaluate the qualityof our investments include credit ratings of both our investments and theissuer, financial performance of the issuer including earnings trends, freecash flows of the issuer, debt service coverage ratios of the issuer, financialleverage of the issuer, and industry trends that have or may impact theissuer’s current or future financial performance and debt service ability. Asof June 30, 2008, none of our corporate loan investments were delinquenton principal or interest payments and none of the investments were in defaultstatus. Our allowance for loan losses totaled $35.0 million and $25.0 millionas of June 30, 2008 and December 31, 2007, respectively. There wereno charge-offs and a $10.0 million provision for additional losses was recordedduring the quarter ended June 30, 2008.

 

We recorded a $2.6 million charge to earningsduring the quarter ended June 30, 2008 for the lower of cost or estimatedfair value adjustment for loans held for sale which had an estimated fair valueof $66.7 million as of June 30, 2008. We had no loans held for sale as of December 31,2007.

 

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The following table summarizes the par valueof our corporate loan portfolio stratified by Moody’s Investors Service, Inc.(“Moody’s”) and Standard & Poor’s Ratings Services (“Standard &Poor’s”) ratings category as of June 30, 2008 and December 31, 2007:

 

**Corporate Loans**

**(Amountsin thousands)**

 
| **Ratings Category**        | ** ** | **As of  June 30, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|----------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                          |       | $                                       | —     |                                        | $          | — |   |
| Aa1/AA+ through Aa3/AA–     |       | —                                  |       | —                                      |       |
| A1/A+ through A3/A–         |       | —                                  |       | —                                      |       |
| Baa1/BBB+ through Baa3/BBB– |       | —                                  |       | 10,353                                      |       |
| Ba1/BB+ through Ba3/BB–     |       | 4,393,281                               |       | 4,595,862                                   |       |
| B1/B+ through B3/B–         |       | 4,118,178                               |       | 3,391,638                                   |       |
| Caa1/CCC+ and lower              |       | 541,315                                 |       | 405,584                                     |       |
| Non-rated                        |       | —                                  |       | 362,731                                     |       |
| Total                            |       | $                                       | 9,052,774  |                                        | $          | 8,766,168 |   |

 

*Corporate Debt Securities*

 

Our corporate debt securities portfoliototaled $1.1 billion as of June 30, 2008 and $1.3 billion as of December 31,2007. Our corporate debt securities portfolio consists of debt obligations ofcorporations, partnerships and other entities in the form of senior secured andsubordinated notes. As of June 30, 2008, $0.9 billion, or 81.8%, of ourcorporate debt securities portfolio was fixed rate and $0.2 billion, or 18.2%,was floating rate.  As of December 31,2007, $1.1 billion, or 84.7%, of our corporate debt securities portfolio wasfixed rate and $0.2 billion, or 15.3%, was floating rate.

 

As of June 30, 2008, our fixed ratecorporate debt securities had a weighted-average coupon of 10.48% and aweighted-average years to maturity of 7.3 years, as compared to 10.42% and 7.5years, respectively, as of December 31, 2007.

 

All of our floating rate corporate debt securitieshave index reset frequencies of less than twelve months.  The weighted-average coupon on our floatingrate corporate debt securities was 6.00% and 8.39% as of June 30, 2008 andDecember 31, 2007, respectively, and the weighted-average coupon spread toLIBOR of our floating rate corporate debt securities was 3.29% and 3.28% as of June 30,2008 and December 31, 2007, respectively. The weighted-average years tomaturity of our floating rate corporate debt securities was 5.2 years and 5.4years as of June 30, 2008 and December 31, 2007, respectively.

 

We evaluate and monitor the asset quality ofour investment portfolio by performing detailed credit reviews and bymonitoring key credit statistics and trends. The key credit statistics andtrends we monitor to evaluate the quality of our investments include creditratings of both our investments and the issuer, financial performance of theissuer including earnings trends, free cash flows of the issuer, debt servicecoverage ratios of the issuer, financial leverage of the issuer, and industrytrends that have or may impact the issuer’s current or future financialperformance and debt service ability. As of June 30, 2008, none of ourinvestments in corporate debt securities were delinquent on principal or interestpayments and none of the investments were in default status.

 

The following table summarizes the par valueof our corporate debt securities portfolio stratified by Moody’s and Standard &Poor’s ratings category as of June 30, 2008 and December 31, 2007:

 

**Corporate Debt Securities**

**(Amountsin thousands)**

 
| **Ratings Category**        | ** ** | **As of  June 30, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|----------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                          |       | $                                       | —     |                                        | $          | — |   |
| Aa1/AA+ through Aa3/AA–     |       | —                                  |       | —                                      |       |
| A1/A+ through A3/A–         |       | —                                  |       | —                                      |       |
| Baa1/BBB+ through Baa3/BBB– |       | —                                  |       | —                                      |       |
| Ba1/BB+ through Ba3/BB–     |       | 206,500                                 |       | 236,553                                     |       |
| B1/B+ through B3/B–         |       | 490,531                                 |       | 431,478                                     |       |
| Caa1/CCC+ and lower              |       | 595,747                                 |       | 772,315                                     |       |
| Non-Rated                        |       | 7,143                                   |       | 30,000                                      |       |
| Total                            |       | $                                       | 1,299,921  |                                        | $          | 1,470,346 |   |

 

***Residential Mortgage InvestmentSummary***

 

Our residential mortgage investment portfolioconsists of investments in RMBS with an estimated fair value of $315.2 millionas of June 30, 2008. The $315.2 million of RMBS is comprised of $279.6 millionof RMBS that are rated investment grade or higher and $35.6 million of RMBSthat are related below investment grade. Of the $315.2 million of RMBSinvestments we hold, $199.5 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. Thisresults in us reflecting the financial position and results of these trusts inour condensed consolidated financial statements. Consolidation of these sixentities does not impact our net assets or net income; however, it does resultin us showing the consolidated assets, liabilities, revenues and expenses onour condensed consolidated financial statements. On our condensed consolidatedbalance sheet as of June 30, 2008, the $315.2 million of RMBS is computed asour investments in RMBS of $115.7 million, plus $199.5 million, whichrepresents the difference between residential mortgage loans of $3.4 billionless residential mortgage-backed securities issued of $3.2 billion plus $8.9million of real estate owned that is included in other assets on our condensedconsolidated balance sheet. The $315.2 million of RMBS as of June 30, 2008represents a decrease of 6.6% from $337.6 million as of December 31, 2007. 

 

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As our condensed consolidated financial statements included in thisForm 10-Q 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 a consolidatedbasis consistent with the disclosures in our condensed consolidated financialstatements. 

 

The tables below summarize the carryingvalue, amortized cost, and estimated fair value of our residential mortgageinvestments as of June 30, 2008 and December 31, 2007, classified byinterest rate type. Carrying value is the value that investments are recordedon our condensed consolidated balance sheets and is estimated fair value forresidential mortgage-backed securities and residential mortgage loans.Estimated fair values set forth in the tables below are based on dealer quotesand/or nationally recognized pricing services.

 

The table below summarizes our residentialmortgage investment portfolio as of June 30, 2008 classified by interestrate type:

 

**Residential Mortgage Investment Portfolio**

**(Dollaramounts in thousands)**

 
| ** **                                                    | ** ** | **Carrying  Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Portfolio Mix   % by Fair Value** | ** ** |
|---------------------------------------------------------------|------------|---------------------|------------|---------------------|------------|--------------------------------|------------|--------------------------------------------------------------|------------|
| **Floating Rate:**                                            |       |                |       |                |       |                           |       |                                                         |       |
| Residential Adjustable Rate Mortgage  (“ARM”) Loans |       | $                   | 512,647    |                | $          | 606,107                        |       | $                                                            | 512,647    |   | 14.6 | % |
| Residential ARM Securities                                    |       | 41,346              |       | 51,350              |       | 41,346                         |       | 1.2                                                          |       |
| Total Floating Rate                                           |       | 553,993             |       | 657,457             |       | 553,993                        |       | 15.8                                                         |       |
| **Hybrid Rate:**                                              |       |                |       |                |       |                           |       |                                                         |       |
| Residential Hybrid ARM Loans                                  |       | 2,882,349           |       | 3,048,678           |       | 2,882,349                      |       | 82.1                                                         |       |
| Residential Hybrid ARM Securities                             |       | 74,306              |       | 83,186              |       | 74,306                         |       | 2.1                                                          |       |
| Total Hybrid Rate                                             |       | 2,956,655           |       | 3,131,864           |       | 2,956,655                      |       | 84.2                                                         |       |
| Total                                                         |       | $                   | 3,510,648  |                | $          | 3,789,321                      |       | $                                                            | 3,510,648  |   | 100.0 | % |

 

The table below summarizes our residentialmortgage investment portfolio as of December 31, 2007 classified byinterest rate type:

 

**Residential Mortgage Investment Portfolio**

**(Dollar amounts in thousands)**

 
| ** **                        | ** ** | **Carrying  Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Portfolio Mix  % by Fair Value** | ** ** |
|-----------------------------------|------------|---------------------|------------|---------------------|------------|--------------------------------|------------|--------------------------------------------------------|------------|
| **Floating Rate:**                |       |                |       |                |       |                           |       |                                                   |       |
| Residential ARM Loans             |       | $                   | 628,745    |                | $          | 667,000                        |       | $                                                      | 628,745    |   | 15.5 | % |
| Residential ARM Securities        |       | 51,964              |       | 55,930              |       | 51,964                         |       | 1.3                                                    |       |
| Total Floating Rate               |       | 680,709             |       | 722,930             |       | 680,709                        |       | 16.8                                                   |       |
| **Hybrid Rate:**                  |       |                |       |                |       |                           |       |                                                   |       |
| Residential Hybrid ARM Loans      |       | 3,292,578           |       | 3,374,696           |       | 3,292,578                      |       | 81.2                                                   |       |
| Residential Hybrid ARM Securities |       | 79,724              |       | 85,391              |       | 79,724                         |       | 2.0                                                    |       |
| Total Hybrid Rate                 |       | 3,372,302           |       | 3,460,087           |       | 3,372,302                      |       | 83.2                                                   |       |
| Total                             |       | $                   | 4,053,011  |                | $          | 4,183,017                      |       | $                                                      | 4,053,011  |   | 100.0 | % |

 

*ResidentialARM Securities*

 

Our residential ARM securities portfoliototaled $41.3 million as of June 30, 2008 and $52.0 million as of December 31,2007.  As of June 30, 2008 and December 31,2007, substantially all of our residential ARM securities were comprised ofone-month LIBOR floating rate securities that reprice monthly and were subjectto a weighted-average maximum net interest rate of 11.35% and 11.36%,respectively, which was materially above the then current weighted-average netcoupon of 6.27% and 7.03%, respectively.

 

**Residential ARM Securities**

**(Amountsin thousands)**

 
| **Ratings Category**        | ** ** | **As of  June 30, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|----------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                          |       | $                                       | 26,935     |                                        | $          | 34,960 |   |
| Aa1/AA+ through Aa3/AA–     |       | —                                  |       | —                                      |       |
| A1/A+ through A3/A–         |       | 6,169                                   |       | 7,326                                       |       |
| Baa1/BBB+ through Baa3/BBB– |       | 4,177                                   |       | 4,466                                       |       |
| Ba1/BB+ through Ba3/BB–     |       | 1,780                                   |       | 2,049                                       |       |
| B1/B+ through B3/B–         |       | 1,156                                   |       | 1,196                                       |       |
| Caa1/CCC+ and lower              |       | —                                  |       | —                                      |       |
| Non-Rated                        |       | 1,129                                   |       | 1,967                                       |       |
| Total                            |       | $                                       | 41,346     |                                        | $          | 51,964 |   |

 

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* *

*Residential Hybrid ARMSecurities*

 

Our residential hybrid ARMsecurities portfolio totaled $74.3 million as of June 30, 2008 and$79.7 million as of December 31, 2007. As of June 30, 2008 and December 31,2007, all of our residential hybrid ARM securities had underlying mortgageloans that were originated as 5/1 hybrid ARM loans. The weighted-average couponon the portfolio of residential hybrid securities was 4.19% and 4.18% as of June 30,2008 and December 31, 2007, respectively. As of June 30, 2008 and December 31,2007, our weighted-average months until roll date for the mortgage loansunderlying our residential hybrid ARM securities was 6 and 12, respectively.

 

**ResidentialHybrid ARM Securities**

**(Amounts inthousands)**

 

| **Ratings Category**        | ** ** | **As of  June 30, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|----------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                          |       | $                                       | 20,715     |                                        | $          | 23,083 |   |
| Aa1/AA+ through Aa3/AA–     |       | 25,624                                  |       | 26,756                                      |       |
| A1/A+ through A3/A–         |       | 14,760                                  |       | 14,898                                      |       |
| Baa1/BBB+ through Baa3/BBB– |       | 6,127                                   |       | 9,002                                       |       |
| Ba1/BB+ through Ba3/BB–     |       | 3,022                                   |       | 2,915                                       |       |
| B1/B+ through B3/B–         |       | 1,520                                   |       | 1,356                                       |       |
| Caa1/CCC+ and lower              |       | —                                  |       | —                                      |       |
| Non-Rated                        |       | 2,538                                   |       | 1,714                                       |       |
| Total                            |       | $                                       | 74,306     |                                        | $          | 79,724 |   |

 

*ResidentialARM Loans*

 

Our residential ARM loans portfolio totaled$512.6 million as of June 30, 2008 and $628.7 million as of December 31,2007. As of June 30, 2008 and December 31, 2007, all of ourresidential ARM loans were comprised of one-month LIBOR floating rate loansthat reprice monthly and were subject to a weighted-average maximum netinterest rate of 11.93% which was well above the then current weighted-averagenet coupon of 3.98% and 6.19%, respectively.

 

*ResidentialHybrid ARM Loans*

 

Our residential hybrid ARM loans portfoliototaled $2.9 billion as of June 30, 2008 and $3.3 billion as of December 31,2007. As of June 30, 2008 and December 31, 2007, all of ourresidential hybrid ARM loans were originated as either 3/1 or 5/1 hybrid ARMloans. The weighted-average net coupon on the portfolio of residential hybridloans was 4.88% as of June 30, 2008 and December 31, 

 

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2007. As of June 30, 2008 and December 31, 2007, the weighted-averagemonths until roll date for the mortgage loans underlying our residential hybridARM securities was 18 and 22, respectively.

 

**Portfolio Purchases**

 

We purchased $0.6 billion and$1.3 billion par amount of investments during the three and six monthsended June 30, 2008, comparedto $2.6 billion and $2.9 billion for the three and six months ended June 30, 2007, respectively.

 

The table below summarizes our investmentportfolio purchases for the periods indicated and includes the par amount ofthe securities and loans that were purchased:

 

**InvestmentPortfolio Purchases**

**(Dollaramounts in thousands)**

 
| ** **                         | ** ** | **Three months ended  June 30, 2008** | ** ** | **Three months ended  June 30, 2007** | ** ** | **Six months ended  June 30, 2008** | ** ** | **Six months ended  June 30, 2007** | ** ** |
|------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                         | ** ** | **Par Amount**                                       | ** ** | **%**                                                     | ** ** | **Par Amount**                                     | ** ** | **%**                                                   | ** ** | **Par Amount** | ** ** | **%** | ** ** | **Par Amount** | ** ** | **%** | ** ** |
| Securities:                        |       |                                                      |       |                                                      |       |                                                    |       |                                                    |       |   |   |   |   |   |   |   |   |
| Corporate Debt Securities          |       | $                                                         | 83,747     |                                                      | 14.8       | %                                                       | $          | 724,000                                                 |       | 28.3 | % | $ | 126,747 |   | 9.7 | % | $ | 758,000 |   | 26.1 | % |
| Marketable Equity Securities       |       | 4,969                                                     |       | 0.9                                                       |       | 22,906                                                  |       | 0.9                                                     |       | 6,496 |   | 0.5 |   | 40,634 |   | 1.4 |   |
| Non-Marketable Equity Securities   |       | —                                                    |       | —                                                    |       | —                                                  |       |                                                    |       | — |   | — |   | 7,500 |   | 0.2 |   |
| Total Securities Principal Balance |       | 88,716                                                    |       | 15.7                                                      |       | 746,906                                                 |       | 29.2                                                    |       | 133,243 |   | 10.2 |   | 806,134 |   | 27.7 |   |
| Loans:                             |       |                                                      |       |                                                      |       |                                                    |       |                                                    |       |   |   |   |   |   |   |   |   |
| Corporate Loans                    |       | 476,680                                                   |       | 84.3                                                      |       | 1,814,145                                               |       | 70.8                                                    |       | 1,171,253 |   | 89.8 |   | 2,101,831 |   | 72.3 |   |
| Grand Total Principal Balance      |       | $                                                         | 565,396    |                                                      | 100.0      | %                                                       | $          | 2,561,051                                               |       | 100.0 | % | $ | 1,304,496 |   | 100.0 | % | $ | 2,907,965 |   | 100.0 | % |

 

The schedule above excludes equity securitiessold, not yet purchased, with a cost of $27.2 million as of June 30, 2008.There were no equity securities sold, not yet purchased as of June 30,2007.

 

**Discontinued Operations**

 

Summarized financial information fordiscontinued operations is as follows (amounts in thousands):

 
| ** **                             | ** ** | **As of  June 30, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|----------------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| Assets of discontinued operations      |       | $                                       | —     |                                        | $          | 3,049,758 |   |
| Liabilities of discontinued operations |       | $                                       | —     |                                        | $          | 3,644,083 |   |

 

(Loss) income from discontinued operations isas follows (amounts in thousands):

 
| ** **                                 | ** ** | **Three months ended** | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** | **Six months ended** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                 | ** ** | **June 30, 2008**      | ** ** | **June 30, 2007**      | ** ** | **June 30, 2008**    | ** ** | **June 30, 2007**    | ** ** |
| (Loss) income from discontinued operations |       | $                                | (1,079     | )                                | $          | (15,544                        | )          | $                              | 2,668      |   | $ | (2,951 | ) |
|                                            |            |                                  |            |                                  |            |                                |            |                                |            |  |  |  |  |

 

**Shareholders’ Equity**

 

Our shareholders’ equity at June 30, 2008 and December 31,2007 totaled $1.9 billion and $1.6 billion, respectively. Included in ourshareholders’ equity as of June 30,2008 and December 31, 2007, was accumulated other comprehensive losstotaling $202.6 million and $157.2 million, respectively.

 

41

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Our average shareholders’ equity and returnon average shareholders’ equity for the three and six months ended June 30, 2008 was $1.9 billionand 8.0% and $1.7 billion and 6.0%, respectively. Our average shareholders’equity and return on average shareholders’ equity for the three and six monthsended June 30, 2007 was $1.7 billion and 12.4% and $1.7 billion and 11.9%,respectively. Return on average shareholders’ equity is defined as net incomedivided by weighted-average shareholders’ equity. Our book value per share asof June 30, 2008 and December 31,2007 was $12.71 and $14.27, respectively, and is computed based on 150,843,151and 115,248,990 shares issued and outstanding as of June 30, 2008 and December 31, 2007, respectively.

 

On August 7, 2008, our board ofdirectors declared a cash distribution for the quarter ended June 30, 2008 on our common sharesof $0.40 per share. The distribution is payable on August 29, 2008 toshareholders of record as of the close of business on August 15, 2008.

 

**Liquidity and Capital Resources**

 

We manage our liquidity with the intention ofmaintaining the continuing ability to fund our operations and fulfill ourcommitments on a timely and cost-effective basis. Based on changes in ourworking capital, for any given period the cash flows provided by operatingactivities may be less than the cumulative distributions paid on our shares forsuch period and such shortfall, if any, may be funded through the issuance ofunsecured indebtedness or through the borrowing of additional amounts throughthe pledging of certain of our assets. Our board of directors considers availableliquidity when declaring distributions to shareholders. As of June 30, 2008, we had unrestrictedcash and cash equivalents totaling $189.0 million.

 

We believe that our liquidity level andaccess to additional financing are in excess of that necessary to sufficientlyenable us to meet our anticipated liquidity requirements including, but notlimited to, funding our purchases of investments, required cash payments andadditional collateral under our borrowings and our derivative transactions, requiredperiodic cash payments related to our derivative transactions, payment of feesand expenses related to our Management Agreement, payment of general corporateexpenses and general corporate capital expenditures, distributions to ourshareholders and implementing our long-term business strategy, although therecan be no assurance in this regard. As of June 30, 2008, we owed ourManager $5.4 million for the payment of management fees, collateralmanagement fees and reimbursable expenses pursuant to the Management Agreement.

 

Our ability to meet our long-term liquidityand capital resource requirements may be subject to our ability to obtainadditional debt financing and equity capital. We may increase our capitalresources through offerings of equity securities (possibly including commonshares and one or more classes of preferred shares), commercial paper,medium-term notes, securitization transactions structured as securedfinancings, and senior or subordinated notes. If we are unable to renew,replace or expand our sources of financing on acceptable terms, it may have anadverse effect on our business and results of operations and our ability tomake distributions to shareholders. Upon liquidation, holders of our debtsecurities and lenders with respect to other borrowings will receive, and anyholders of preferred shares that we may issue in the future may receive, adistribution of our available assets prior to holders of our common shares. Thedecisions by investors and lenders to enter into equity, and financingtransactions with us will depend upon a number of factors, including ourhistorical and projected financial performance, compliance with the terms ofour current credit arrangements, industry and market trends, the availabilityof capital and our investors’ and lenders’ policies and rates applicablethereto, and the relative attractiveness of alternative investment or lendingopportunities.

 

**Sources of Funds**

 

*Common Share Offering*

 

On April 8, 2008, we completed a public offering of34.5 million common shares at a price of $11.85 per common share. Netproceeds from the transaction before expenses totaled $384.3 million,which we will use for general corporate purposes.

 

*Repurchase Agreements*

 

As of June 30,2008, we had nil outstanding on repurchase facilities. Because we borrow underrepurchase agreements based on the estimated fair value of our pledgedinvestments and changes in interest rates can negatively impact the valuationof our pledged investments, our ongoing ability to borrow under our repurchasefacilities may be limited and our lenders may initiate margin calls in theevent interest rates change or the value of our pledged securities decline as aresult of adverse changes in interest rates or credit spreads.

 

42

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* *

*Secured Credit Facility*

 

On December 14, 2007, we amended ourSecond Amended and Restated Credit Agreement, dated May 4, 2007, with Bankof America, N.A., as Administrative Agent and the lender parties thereto, andTRS Ltd., KFH II, KFH III, KKR Financial Holdings, Inc. and KKRFinancial Holdings, Ltd. The amendment decreased the size of the creditfacility from $800.0 million to $500.0 million. Outstandingborrowings under the credit facility bear interest at either (a) aninterest rate per annum equal to the LIBOR rate for the applicable interestperiod plus 0.825% for borrowings under tranche A of the facility and1.075% for borrowings under tranche B of the facility or (b) analternate base rate per annum equal to the greater of (i) the prime ratein effect on such day and (ii) the federal funds rate in effect on suchday plus 0.50%. In addition, pursuant to this amendment our financial covenantswere amended to now require that we:

 

·                  maintain adjustedconsolidated tangible net worth of at least $1.437 billion plus an amountequal to 85% of the net proceeds, subject to certain exceptions, from theissuance of equity interests (as defined in the amendment) subsequent to September 30,2007;

 

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

 

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

 

*JuniorSubordinated Notes*

 

In the second quarter of 2008, we retired$35.0 million of junior subordinated notes, which resulted in a gain onextinguishment of $17.2 million, partially offset by a $1.1 million write-offof debt issuance costs and $0.7 million of other associated costs.

 

*Capital Utilization and Leverage*

 

As of June 30,2008 and December 31, 2007, we had shareholders’ equity totaling $1.9billion and $1.6 billion, respectively and our leverage was 4.8 times and6.2 times equity, respectively.

 

*Off-Balance Sheet Commitments*

 

As of June 30,2008, we had committed to purchase corporate loans with aggregate commitmentstotaling $253.5 million. In a typical loan syndication, there is a delaybetween the time we are informed of our allocable portion of such loan and theactual funding of such loan.

 

We participate in certain financingarrangements, including revolvers and delayed draw facilities, whereby we arecommitted to provide funding at the discretion of the borrower up to a specificpredetermined amount. As of June 30,2008, we had unfunded financing commitments totaling $128.3 million.

 

**Partnership****Tax****Matters**

 

As of June 30, 2008, we believe that theCompany continued to qualify as a partnership, and not as an associationor publicly traded partnership taxable as a corporation,for U.S. federal incometax purposes. In general, if a partnership is“publicly traded” (as defined in the Code), itwill be treated as a corporationfor U.S. federal income tax purposes.A publicly traded partnership will,however, be taxed as a partnership,and not as a corporation, for U.S. federal income tax purposes, so long as it is****not required toregister under the Investment Company Act and at least 90% of its grossincome for each taxable year constitutes “qualifying income” within the meaning of Section 7704(d) of the Code. Werefer to this exception as the “qualifying incomeexception.”  Qualifying income generallyincludes rents, dividends, interest (to the extent such interest is neither derived from the “conduct of a financial orinsurance business” nor based, directly or indirectly, upon “income or profits” ofany person), and capital gains from the sale orother disposition of stocks, bonds and real property. Qualifying incomealso includes other income derivedfrom the business ofinvesting in, among other things, stocks and securities. However, the sections of the Code and thecorresponding U.S. Treasury Regulations thatrelate to the “qualifying income exception” are highlytechnical and complex, and the Company’s satisfaction of the “qualifyingincome exception” will depend upon its actual annual operating results.  Accordingly, no assurancecan be given that the Companyhas operated, or will continue tooperate, in a manner so**as to satisfy the “qualifyingincome exception.”

 

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**Exemption from Regulation under the Investment CompanyAct**

 

We intend to conduct our operations so thatwe are not required to register as an investment company under the InvestmentCompany Act. Section 3(a)(l)(C) of the Investment Company Act definesas an investment company any issuer that is engaged or proposes to engage inthe business of investing, reinvesting, owning, holding or trading insecurities and owns or proposes to acquire investment securities having a valueexceeding 40% of the value of the issuer’s total assets (exclusive of U.S.government securities and cash items) on an unconsolidated basis. Excluded fromthe term “investment securities,” among other things, are securities issued bymajority-owned subsidiaries that are not themselves investment companies andare not relying on the exception from the definition of an investment companyset forth in Section 3(c)(l) or Section 3(c)(7) of theInvestment Company Act.

 

After the Restructuring Transaction, we wereorganized as a holding company that conducts its businesses primarily throughmajority-owned subsidiaries. As a result, the securities issued to us by oursubsidiaries that are excepted from the definition of an “investment company”by Section 3(c)(l) or 3(c)(7) of the Investment Company Act,together with any other “investment securities” we may own, may not have acombined value in excess of 40% of the value of our total assets on anunconsolidated basis. The determination of whether an entity is amajority-owned subsidiary of ours is made by us. The Investment Company Actdefines a majority-owned subsidiary of a person as a company 50% or more of theoutstanding voting securities of which are owned by such person, or by anothercompany which is a majority-owned subsidiary of such person. The InvestmentCompany Act further defines voting securities as any security presentlyentitling the owner or holder thereof to vote for the election of directors ofa company. We treat companies, including CLO issuers, in which we own at leasta majority of the outstanding voting securities as majority-owned subsidiariesfor purposes of the 40% test.

 

Our subsidiaries that issue CLOs generallywill rely on Rule 3a-7, an exemption from the Investment Company Actprovided for certain structured financing vehicles. Accordingly, each of ourCLO subsidiaries that rely on Rule 3a-7 is subject to specific guidelinesand restrictions, including a prohibition on the CLO issuers from acquiring anddisposing of assets primarily for the purposes of recognizing gains ordecreasing losses resulting from market value changes. Certain sales andpurchases of assets may be made so long as the CLOs do not violate ourguidelines and are not based primarily on the changes in market value. We can,however, sell assets without limitation if we believe the credit profile of theobligor will deteriorate. The proceeds of permitted dispositions may bereinvested in collateral that is consistent with the credit profile of the CLOunder specific and predetermined guidelines.

 

In addition, the combined value of theinvestment securities issued by our subsidiaries that are excepted by Section 3(c)(1) or3(c)(7) of the Investment Company Act, together with any other investmentsecurities we may own, may not exceed 40% of the value of our total assets onan unconsolidated basis. This requirement limits the types of businesses inwhich we may engage through these subsidiaries.

 

To the extent that the SEC provides morespecific or different guidance regarding the application of Rule 3a-7 ofthe Investment Company Act, we may be required to adjust our investmentstrategy accordingly. Any additional guidance from the SEC could provideadditional flexibility to us, or it could further inhibit our ability to pursuethe investment strategy we have chosen, which could have a material adverseeffect on our operations.

 

**Quantitative and Qualitative Disclosures About MarketRisk**

 

*Currency Risks*

 

From time to time, we may make investmentsthat are denominated in a foreign currency through which we may be subject toforeign currency exchange risk.

 

*Liquidity Risk*

 

Liquidity risk is defined as the risk that wewill be unable to fulfill our obligations on a timely basis, continuouslyborrow funds in the market on a cost-effective basis to fund actual or proposedcommitments, or liquidate assets when needed at a reasonable price.

 

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A material event that impacts capital marketsparticipants may impair our ability to access additional liquidity. If our cashresources are at any time insufficient to satisfy our liquidity requirements,we may have to sell assets or issue debt or additional equity securities.

 

Our ability to meet our long-term liquidityand capital resource requirements may be subject to our ability to obtainadditional debt financing and equity capital. We may increase our capitalresources through offerings of equity securities (possibly including commonshares and one or more classes of preferred shares), commercial paper,medium-term notes, securitization transactions structured as securedfinancings, and senior or subordinated notes. If we are unable to renew,replace or expand our sources of financing on acceptable terms, it may have anadverse effect on our business and results of operations and our ability tomake distributions to shareholders. Upon liquidation, holders of our debtsecurities and lenders with respect to other borrowings will receive, and anyholders of preferred shares that we may issue in the future may receive, adistribution of our available assets prior to holders of our common shares. Thedecisions by investors and lenders to enter into equity, and financing transactionswith us will depend upon a number of factors, including our historical andprojected financial performance, compliance with the terms of our currentcredit arrangements, industry and market trends, the availability of capitaland our investors’ and lenders’ policies and rates applicable thereto, and therelative attractiveness of alternative investment or lending opportunities.

 

We have established a formal liquiditycontingency plan which provides guidelines for liquidity management. We determineour current liquidity position and forecast liquidity based on anticipatedchanges in the balance sheet. We also stress test our liquidity position underseveral different stress scenarios. A stress test aims at capturing the impactof extreme (but rare) market rate changes on the market value of equity and netinterest income. This scenario is applied on a daily basis to our balance sheetand the resulting 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.

 

*Credit Spread Exposure*

 

Our investments are subject to spread risk.Our investments in floating rate loans and securities are valued based on amarket credit spread over LIBOR and are affected similarly by changes in LIBORspreads. Our investments in fixed rate loans and securities are valued based ona market credit spread over the rate payable on fixed rate U.S. Treasuries oflike maturity. Increased credit spreads, or credit spread widening, will havean adverse impact on the value of our investments while decreased creditspreads, or credit spread tightening, will have a positive impact on the valueof our investments.

 

*Interest Rate Risk*

 

Interest rate risk is defined as thesensitivity of our current and future earnings to interest rate volatility,variability of spread relationships, the difference in repricing intervalsbetween our assets and liabilities and the effect that interest rates may haveon our cash flows and the prepayment rates experienced on our investments thathave imbedded borrower optionality. The objective of interest rate risk managementis to achieve earnings, preserve capital and achieve liquidity by minimizingthe negative impacts of changing interest rates, asset and liability mix, andprepayment activity.

 

We are exposed to basis risk between ourinvestments and our borrowings. Interest rates on our floating rate investmentsand our variable rate borrowings do not reset on the same day or with the samefrequency and, as a result, we are exposed to basis risk with respect to indexreset frequency. Our floating rate investments may reprice on indices that aredifferent than the indices that are used to price our variable rate borrowingsand, as a result, we are exposed to basis risk with respect to repricing index.The basis risks noted above, in addition to other forms of basis risk thatexist between our investments and borrowings, may be material and couldnegatively impact future net interest margins.

 

Interest rate risk impacts our interestincome, interest expense, prepayments, and the fair value of our investments,interest rate derivatives, and liabilities. During periods of increasinginterest rates we are biased to purchase investments that are floating rate andwe have had that bias since our inception. We manage our interest rate riskusing various techniques ranging from the purchase of floating rate investmentsto the use of interest rate derivatives. We generally fund our variable rateinvestments with variable rate borrowings with similar interest rate resetfrequencies. We generally fund our fixed rate and our hybrid investments withshort-term variable rate borrowings and we may use interest rate derivatives tohedge the variability of the cash flows associated with our existing orforecasted variable rate borrowings.

 

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The following table summarizes the estimatednet fair value of our derivative instruments held at June 30, 2008 and December 31, 2007 (amounts inthousands):

 

**DerivativeFair Value**

 
| ** **                      | ** ** | **As of  June 30, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **Notional**                            | ** ** | **Estimated  Fair Value**              | ** ** | **Notional** | ** ** | **Estimated  Fair Value** | ** ** |
| **Cash Flow Hedges:**           |       |                                    |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | $                                       | 383,333    |                                        | $          | (19,282 | ) | $ | 383,333 |   | $ | (19,018 | ) |
| **Fair Value Hedges:**          |       |                                    |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | 32,000                                  |       | (1,219                                      | )          | 32,000 |   | (1,212 | ) |
| **Free-Standing Derivatives:**  |       |                                    |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | 188,820                                 |       | 709                                         |       | 690,799 |   | (7,959 | ) |
| Credit default swaps—long  |       | 103,500                                 |       | (1,733                                      | )          | 66,000 |   | (1,154 | ) |
| Credit default swaps—short |       | 196,820                                 |       | 21,386                                      |       | 268,000 |   | 12,613 |   |
| Total rate of return swaps      |       | 477,877                                 |       | (88,256                                     | )          | 442,204 |   | (21,998 | ) |
| Foreign exchange contracts      |       | 26,702                                  |       | (140                                        | )          | 9,711 |   | 3 |   |
| Common stock warrants           |       | —                                  |       | 91                                          |       | — |   | 799 |   |
| Total                           |       | $                                       | 1,409,052  |                                        | $          | (88,444 | ) | $ | 1,892,047 |   | $ | (37,926 | ) |

** **

**Item 3.**                          Quantitative andQualitative Disclosures About Market Risk

** **

See discussion of quantitative and qualitativedisclosures about market risk in “Quantitative and Qualitative DisclosuresAbout Market Risk” section of Management’s Discussion and Analysis of FinancialCondition and Results of Operations.

 

**Item 4.**                          Controls and Procedures

** **

The Company’s managementevaluated, with the participation of the Company’s principal executive andprincipal financial officer, the effectiveness of the Company’s disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of June 30,2008. Based on their evaluation, the Company’s principal executive andprincipal financial officer concluded that the Company’s disclosure controlsand procedures as of June 30,2008 were designed and were functioningeffectively to provide reasonable assurance that the information required to bedisclosed by the Company in reports filed under the Exchange Act is (i) recorded,processed, summarized, and reported within the time periods specified in theSEC’s rules and forms, and (ii) accumulated and communicated tomanagement, including the principal executive and principal financial officers,as appropriate, to allow timely decisions regarding disclosure.

 

There has been no change in theCompany’s internal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) that occurred during the Company’s threeand six months ending June 30, 2008, that has materially affected, or isreasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

**PART II.OTHER INFORMATION**

 

**Item 1.**                          *LegalProceedings*

** **

None.

 

**Item 1A.**                 *RiskFactors*

** **

There have been no materialchanges in our risk factors from those disclosed in our Annual Report on Form 10-Kfor the year ended December 31, 2007.

 

**Item 2 *.******                      ******Unregistered Sales of EquitySecurities and Use of Proceeds***

 

None.

 

**Item 3.**                          *DefaultsUpon Senior Securities*

** **

None.

 

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

 

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Our 2008 annualmeeting of the shareholders was held on May 1, 2008. A total of 94,530,468of our shares were present or voted by proxy at the meeting. This representedmore than 81% of the total number of voting rights outstanding and entitled tovote at the annual meeting. The following matters were voted upon and receivedthe votes as set forth below:

 

1. Shareholders electedeleven directors to one-year terms that will expire at the annual meeting ofthe shareholders in 2009.

The vote tabulation forindividual directors was:

 
| **DIRECTOR**        | ** ** | **FOR**    | ** ** | **WITHHELD** | ** ** |
|---------------------|------------|------------|------------|--------------|------------|
| William F. Aldinger |       | 91,759,391 |       | 2,771,077    |       |
| Tracy L. Collins    |       | 92,712,122 |       | 1,818,346    |       |
| Saturnino S. Fanlo  |       | 92,907,037 |       | 1,623,431    |       |
| V. Paul Finigan     |       | 93,013,334 |       | 1,517,134    |       |
| Paul M. Hazen       |       | 93,029,341 |       | 1,501,127    |       |
| R. Glenn Hubbard    |       | 91,755,960 |       | 2,774,508    |       |
| Ross J. Kari        |       | 93,030,529 |       | 1,499,939    |       |
| Ely L. Licht        |       | 91,858,135 |       | 2,672,333    |       |
| Deborah H. McAneny  |       | 93,022,422 |       | 1,508,046    |       |
| Scott C. Nuttall    |       | 92,925,000 |       | 1,605,468    |       |
| Willy R. Strothotte |       | 93,009,872 |       | 1,520,596    |       |

 

2. The election ofDeloitte & Touche LLP as our independent registered public accountingfirm for the year ending December 31, 2008 was ratified with 93,068,524shares voting for, 734,030 shares voting against, 727,914 shares abstaining andno broker non-votes.

 

**Item 5.**                          *OtherInformation*

** **

None.

 

**Item 6.**                          *Exhibits*

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

 

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** **

**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/ SATURNINO S. FANLO    |       | Chief Executive Officer (Principal Executive Officer)                |
| **Saturnino S. Fanlo**    | ** ** | ** **                                                           |
| ** **                | ** ** | ** **                                                           |
| /s/  JEFFREY B. VAN HORN  |       | Chief Financial Officer (Principal Financial and Accounting Officer) |
| **Jeffrey B. Van Horn**   | ** ** | ** **                                                           |
| ** **                | ** ** | ** **                                                           |
| Date: August 7, 2008 |       |                                                                 |

 

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