Table ofContents

 

 

 

**UNITED STATES**

**SECURITIESAND 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 SECURITIESEXCHANGE ACT OF 1934**

 

**For the quarterly period ended September 30, 2010**

 

**or**

 

**o****         TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**For the transition period from              to              **

 

**Commissionfile number: 001-33437**

 

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**KKRFINANCIAL HOLDINGS LLC**

(Exact name of registrant asspecified in its charter)

 

| **Delaware**                    | ** ** | **11-3801844**      |
|---------------------------------|------------|---------------------|
| (State or other jurisdiction of |       | (I.R.S. Employer    |
| incorporation or organization)  |       | Identification No.) |

 
| **555 California Street, 50****th**** Floor** |       |       |
|----------------------------------------------------|------------|------------|
| **San Francisco, CA**                              | ** ** | **94104**  |
| (Address of principal executive offices)           |       | (Zip Code) |

 

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

 

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

 

Indicate by check mark whether the registrant has submittedelectronically and posted on its corporate Web site, if any, every InteractiveData File required to be submitted and posted pursuant to Rule 405 ofRegulation S-T (§232.405 of this chapter) during the preceding 12 months (orfor such shorter period that the registrant was required to submit and postsuch files). Yes o  No o

 

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

 

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

 

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

 

The number of shares of the registrant’s common shares outstanding asof October 28, 2010 was 158,412,565.

 

 

 

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Table of Contents

** **

**TABLE OF CONTENTS**

 
| **PART I.**      | ** **                                                                                  | ** ** |
|-----------------------|---------------------------------------------------------------------------------------------|------------|
| FINANCIAL INFORMATION | ** **                                                                                  | ** ** |
| Item 1.               | Financial Statements                                                                        |       | 3 |
| Item 2.               | Management’s Discussion  and Analysis of Financial Condition and Results of Operations |       | 33 |
| Item 3.               | Quantitative  and Qualitative Disclosures about Market Risk                                 |       | 56 |
| Item 4.               | Controls and  Procedures                                                                    |       | 56 |
| **PART II.**     | ** **                                                                                  | ** ** |
| OTHER  INFORMATION    | ** **                                                                                  | ** ** |
| Item 1.               | Legal Proceedings                                                                           |       | 56 |
| Item 1A.              | Risk Factors                                                                                |       | 57 |
| Item 2.               | Unregistered  Sales of Equity Securities and Use of Proceeds                                |       | 61 |
| Item 3.               | Defaults Upon  Senior Securities                                                            |       | 62 |
| Item 4.               | Submission of  Matters to a Vote of Security Holders                                        |       | 62 |
| Item 5.               | Other Information                                                                           |       | 62 |
| Item 6.               | Exhibits                                                                                    |       | 62 |

 

2

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Tableof Contents

 

**PART I.   FINANCIALINFORMATION**

 

**Item 1.Financial Statements**

 

**KKR Financial Holdings LLC and Subsidiaries**

**Condensed Consolidated Balance Sheets**

**(Unaudited)**

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

 
| ** **                                                                                                                                                                                      | ** ** | **September 30,  2010** | ** ** | **December 31,  2009** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                      |       |                         |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                       |       | $                            | 96,991     |                        | $          | 97,086 |   |
| Restricted cash and cash equivalents                                                                                                                                                            |       | 365,220                      |       | 342,706                     |       |
| Securities available-for-sale, $727,485 and  $740,949 pledged as collateral as of September 30, 2010 and  December 31, 2009, respectively                                             |       | 849,022                      |       | 755,686                     |       |
| Corporate loans, net of allowance for loan losses  of $209,030 and $237,308 as of September 30, 2010 and December 31, 2009,  respectively                                                  |       | 5,815,544                    |       | 5,617,925                   |       |
| Corporate loans held for sale                                                                                                                                                                   |       | 667,196                      |       | 925,718                     |       |
| Residential mortgage-backed securities, at estimated  fair value, $4,235 and $47,572 pledged as collateral as of September 30,  2010 and December 31, 2009, respectively              |       | 106,252                      |       | 47,572                      |       |
| Residential mortgage loans, at estimated fair  value                                                                                                                                            |       | —                       |       | 2,097,699                   |       |
| Equity investments, at estimated fair value, $13,286  and $110,812 pledged as collateral as of September 30, 2010 and  December 31, 2009, respectively                                |       | 84,307                       |       | 120,269                     |       |
| Derivative assets                                                                                                                                                                               |       | 20,004                       |       | 15,784                      |       |
| Interest and principal receivable                                                                                                                                                               |       | 83,195                       |       | 98,313                      |       |
| Reverse repurchase agreements                                                                                                                                                                   |       | —                       |       | 80,250                      |       |
| Other assets                                                                                                                                                                                    |       | 72,325                       |       | 100,997                     |       |
| **Total assets**                                                                                                                                                                                |       | $                            | 8,160,056  |                        | $          | 10,300,005 |   |
| **Liabilities**                                                                                                                                                                                 |       |                         |       |                        |       |
| Collateralized loan obligation secured notes                                                                                                                                                    |       | $                            | 5,630,141  |                        | $          | 5,667,716 |   |
| Collateralized loan obligation junior secured  notes to affiliates                                                                                                                              |       | 371,062                      |       | 533,786                     |       |
| Senior secured credit facility                                                                                                                                                                  |       | —                       |       | 175,000                     |       |
| Convertible senior notes                                                                                                                                                                        |       | 343,863                      |       | 275,800                     |       |
| Junior subordinated notes                                                                                                                                                                       |       | 283,517                      |       | 283,517                     |       |
| Residential mortgage-backed securities issued, at  estimated fair value                                                                                                                         |       | —                       |       | 2,034,772                   |       |
| Accounts payable, accrued expenses and other  liabilities                                                                                                                                       |       | 27,312                       |       | 7,240                       |       |
| Accrued interest payable                                                                                                                                                                        |       | 17,538                       |       | 25,297                      |       |
| Accrued interest payable to affiliates                                                                                                                                                          |       | 3,846                        |       | 2,911                       |       |
| Related party payable                                                                                                                                                                           |       | 12,431                       |       | 3,367                       |       |
| Securities sold, not yet purchased                                                                                                                                                              |       | —                       |       | 77,971                      |       |
| Derivative liabilities                                                                                                                                                                          |       | 108,697                      |       | 45,970                      |       |
| **Total liabilities**                                                                                                                                                                           |       | 6,798,407                    |       | 9,133,347                   |       |
| **Shareholders’ Equity**                                                                                                                                                                   |       |                         |       |                        |       |
| Preferred shares, no par value, 50,000,000 shares  authorized and none issued and outstanding at September 30, 2010 and  December 31, 2009                                            |       | —                       |       | —                      |       |
| Common shares, no par value, 500,000,000 shares  authorized, and 158,412,565 and 158,359,757 shares issued and outstanding at  September 30, 2010 and December 31, 2009, respectively |       | —                       |       | —                      |       |
| Paid-in-capital                                                                                                                                                                                 |       | 2,578,945                    |       | 2,563,634                   |       |
| Accumulated other comprehensive income                                                                                                                                                          |       | 85,474                       |       | 152,728                     |       |
| Accumulated deficit                                                                                                                                                                             |       | (1,302,770                   | )          | (1,549,704                  | )          |
| **Total shareholders’ equity**                                                                                                                                                             |       | 1,361,649                    |       | 1,166,658                   |       |
| **Total liabilities and  shareholders’ equity**                                                                                                                                            |       | $                            | 8,160,056  |                        | $          | 10,300,005 |   |

 

See notes to condensedconsolidated financial statements.

 

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**KKR Financial Holdings LLC and Subsidiaries**

**Condensed Consolidated Statements of Operations**

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

** **
| ** **                                                                                                                                                                                           | ** ** | **For the three  months ended  September 30,  2010** | ** ** | **For the three  months ended  September 30,  2009** | ** ** | **For the nine  months ended  September 30,  2010** | ** ** | **For the nine  months ended  September 30,  2009** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| **Net investment income:**                                                                                                                                                                           | ** ** | ** **                                                               | ** ** | ** **                                                               | ** ** | ** **                                                              | ** ** | ** **                                                              | ** ** |
| Loan interest income                                                                                                                                                                                 |       | $                                                                        | 96,814     |                                                                     | $          | 113,460                                                                 |       | $                                                                       | 282,812    |   | $ | 364,583 |   |
| Securities interest income                                                                                                                                                                           |       | 25,406                                                                   |       | 21,701                                                                   |       | 79,067                                                                  |       | 73,805                                                                  |       |
| Other interest income                                                                                                                                                                                |       | 29                                                                       |       | 75                                                                       |       | 2,086                                                                   |       | 824                                                                     |       |
| Total investment income                                                                                                                                                                              |       | 122,249                                                                  |       | 135,236                                                                  |       | 363,965                                                                 |       | 439,212                                                                 |       |
| Interest expense                                                                                                                                                                                     |       | 30,051                                                                   |       | 57,340                                                                   |       | 100,402                                                                 |       | 219,625                                                                 |       |
| Interest expense to affiliates                                                                                                                                                                       |       | 5,791                                                                    |       | 5,171                                                                    |       | 17,072                                                                  |       | 16,355                                                                  |       |
| Provision for loan losses                                                                                                                                                                            |       | 8,087                                                                    |       | —                                                                   |       | 8,087                                                                   |       | 39,795                                                                  |       |
| Net investment income                                                                                                                                                                                |       | 78,320                                                                   |       | 72,725                                                                   |       | 238,404                                                                 |       | 163,437                                                                 |       |
| **Other income (loss):**                                                                                                                                                                             | ** ** | ** **                                                               | ** ** | ** **                                                               | ** ** | ** **                                                              | ** ** | ** **                                                              | ** ** |
| Net realized and unrealized gain (loss) on  investments                                                                                                                                              |       | 19,441                                                                   |       | 21,181                                                                   |       | 83,803                                                                  |       | (85,576                                                                 | )          |
| Net realized and unrealized gain (loss) on  derivatives and foreign exchange                                                                                                                         |       | 3,831                                                                    |       | 19,930                                                                   |       | (3,437                                                                  | )          | 58,831                                                                  |       |
| Net realized and unrealized gain (loss) on  residential mortgage-backed securities, residential mortgage loans, and  residential mortgage-backed securities issued, carried at estimated fair  value |       | 1,492                                                                    |       | (17,681                                                                  | )          | (7,764                                                                  | )          | (44,545                                                                 | )          |
| Net realized and unrealized (loss) gain on  securities sold, not yet purchased                                                                                                                       |       | —                                                                   |       | (996                                                                     | )          | (756                                                                    | )          | 2,920                                                                   |       |
| Net (loss) gain on restructuring and  extinguishment of debt                                                                                                                                         |       | —                                                                   |       | (10,627                                                                  | )          | 39,999                                                                  |       | 30,836                                                                  |       |
| Other income                                                                                                                                                                                         |       | 1,863                                                                    |       | 1,239                                                                    |       | 9,085                                                                   |       | 4,150                                                                   |       |
| Total other income (loss):                                                                                                                                                                           |       | 26,627                                                                   |       | 13,046                                                                   |       | 120,930                                                                 |       | (33,384                                                                 | )          |
| **Non-investment expenses:**                                                                                                                                                                         | ** ** | ** **                                                               | ** ** | ** **                                                               | ** ** | ** **                                                              | ** ** | ** **                                                              | ** ** |
| Related party management compensation                                                                                                                                                                |       | 17,551                                                                   |       | 14,616                                                                   |       | 52,518                                                                  |       | 36,132                                                                  |       |
| General, administrative and directors expenses                                                                                                                                                       |       | 3,561                                                                    |       | 1,539                                                                    |       | 10,127                                                                  |       | 6,917                                                                   |       |
| Professional services                                                                                                                                                                                |       | 1,041                                                                    |       | 441                                                                      |       | 3,335                                                                   |       | 5,916                                                                   |       |
| Loan servicing                                                                                                                                                                                       |       | —                                                                   |       | 1,925                                                                    |       | —                                                                  |       | 6,117                                                                   |       |
| Total non-investment expenses                                                                                                                                                                        |       | 22,153                                                                   |       | 18,521                                                                   |       | 65,980                                                                  |       | 55,082                                                                  |       |
| Income before income tax expense                                                                                                                                                                     |       | 82,794                                                                   |       | 67,250                                                                   |       | 293,354                                                                 |       | 74,971                                                                  |       |
| Income tax expense                                                                                                                                                                                   |       | 452                                                                      |       | 63                                                                       |       | 489                                                                     |       | 151                                                                     |       |
| Net income                                                                                                                                                                                           |       | $                                                                        | 82,342     |                                                                     | $          | 67,187                                                                  |       | 292,865                                                                 |       | $ | 74,820 |   |
|                                                                                                                                                                                                 |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Net income per common share:                                                                                                                                                                         |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Basic                                                                                                                                                                                                |       | $                                                                        | 0.52       |                                                                     | $          | 0.42                                                                    |       | $                                                                       | 1.85       |   | $ | 0.49 |   |
| Diluted                                                                                                                                                                                              |       | $                                                                        | 0.52       |                                                                     | $          | 0.42                                                                    |       | $                                                                       | 1.85       |   | $ | 0.49 |   |
|                                                                                                                                                                                                 |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Weighted-average number of common shares  outstanding:                                                                                                                                               |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Basic                                                                                                                                                                                                |       | 157,057                                                                  |       | 156,997                                                                  |       | 157,018                                                                 |       | 152,664                                                                 |       |
| Diluted                                                                                                                                                                                              |       | 157,461                                                                  |       | 156,997                                                                  |       | 157,294                                                                 |       | 152,664                                                                 |       |
| Distributions declared per common shares                                                                                                                                                             |       | $                                                                        | 0.12       |                                                                     | —     |                                                                    | $          | 0.29                                                                    |       | — |   |

 

See notes to condensedconsolidated financial statements.

 

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**KKR Financial Holdings LLC and Subsidiaries**

**Condensed Consolidated Statement of Changes in Shareholders’ Equity**

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

 
| ** **                                                                 | ** ** | **Common  Shares** | ** ** | **Paid-In  Capital** | ** ** | **Accumulated Other  Comprehensive  Income** | ** ** | **Accumulated  Deficit** | ** ** | **Comprehensive  Income** | ** ** | **Total  Shareholders’  Equity** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------|------------|----------------------|------------|---------------------------------------------------|------------|--------------------------|------------|---------------------------|------------|---------------------------------------|------------|
| **Balance at January 1, 2010**                                        |       | 158,360            |       | $                    | 2,563,634  |                                              | $          | 152,728                  |       | $                         | (1,549,704 | )                                     |       |   | $ | 1,166,658 |   |
| Net income                                                                 |       | —             |       | —               |       | —                                            |       | 292,865                  |       | $                         | 292,865    |                                  | 292,865    |   |
| Net change in unrealized loss on cash flow  hedges                    |       | —             |       | —               |       | (44,432                                           | )          | —                   |       | (44,432                   | )          | (44,432                               | )          |
| Net change in unrealized gain on securities  available-for-sale            |       | —             |       | —               |       | (22,822                                           | )          | —                   |       | (22,822                   | )          | (22,822                               | )          |
| Comprehensive income                                                       |       |               |       |                 |       |                                              |       |                     |       | $                         | 225,611    |                                  |       |   |
| Cash distributions on common shares                                        |       | —             |       | —               |       | —                                            |       | (45,931                  | )          |                      |       | (45,931                               | )          |
| Issuance of common shares                                                  |       | 53                 |       | —               |       | —                                            |       | —                   |       |                      |       | —                                |       |
| Equity component of convertible notes issuance                             |       | —             |       | 9,973                |       | —                                            |       | —                   |       |                      |       | 9,973                                 |       |
| Share-based compensation expense related to  restricted common shares |       | —             |       | 5,338                |       | —                                            |       | —                   |       |                      |       | 5,338                                 |       |
| **Balance at September 30,  2010**                                    |       | 158,413            |       | $                    | 2,578,945  |                                              | $          | 85,474                   |       | $                         | (1,302,770 | )                                     |       |   | $ | 1,361,649 |   |

 

See notes to condensed consolidated financial statements.

 

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**KKR Financial Holdings LLC and Subsidiaries**

**Condensed Consolidated Statements of Cash Flows**

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

 
| ** **                                                                                                                                                                                             | ** ** | **For the nine  months ended  September 30, 2010** | ** ** | **For the nine  months ended  September 30, 2009** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| **Cash flows from operating  activities:**                                                                                                                                                             |       |                                                                        |       |                                                                        |       |
| Net income                                                                                                                                                                                             |       | $                                                                           | 292,865    |                                                                        | $          | 74,820 |   |
| 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                                                                           |       | 4,695                                                                       |       | (61,751                                                                     | )          |
| Net gain on restructuring and extinguishment of  debt                                                                                                                                                  |       | (39,999                                                                     | )          | (59,635                                                                     | )          |
| Write-off of debt issuance costs                                                                                                                                                                       |       | 8,160                                                                       |       | 4,611                                                                       |       |
| Lower of cost or estimated fair value adjustment  on corporate loans held for sale                                                                                                           |       | 21,362                                                                      |       | 38,898                                                                      |       |
| Provision for loan losses                                                                                                                                                                              |       | 8,087                                                                       |       | 39,795                                                                      |       |
| Impairment on securities available-for-sale and  private equity at cost                                                                                                                                |       | 9,979                                                                       |       | 40,013                                                                      |       |
| Share-based compensation                                                                                                                                                                               |       | 5,338                                                                       |       | 2,605                                                                       |       |
| Net realized and unrealized loss on residential  mortgage-backed securities, residential mortgage loans, and residential  mortgage-backed securities issued, carried at estimated fair value |       | 7,764                                                                       |       | 44,545                                                                      |       |
| Net realized and unrealized (gain) loss on  investments                                                                                                                                                |       | (115,144                                                                    | )          | 6,665                                                                       |       |
| Deferred interest expense                                                                                                                                                                              |       | 4,427                                                                       |       | —                                                                      |       |
| Depreciation and net amortization                                                                                                                                                                      |       | (65,653                                                                     | )          | (38,731                                                                     | )          |
| Changes in assets and liabilities:                                                                                                                                                                     |       |                                                                        |       |                                                                        |       |
| Interest receivable                                                                                                                                                                                    |       | 8,080                                                                       |       | 50,057                                                                      |       |
| Other assets                                                                                                                                                                                           |       | (1,182                                                                      | )          | (11,911                                                                     | )          |
| Related party payable                                                                                                                                                                                  |       | 9,064                                                                       |       | 10,017                                                                      |       |
| Accounts payable, accrued expenses and other  liabilities                                                                                                                                              |       | 505                                                                         |       | (47,847                                                                     | )          |
| Accrued interest payable                                                                                                                                                                               |       | (7,759                                                                      | )          | (37,278                                                                     | )          |
| Accrued interest payable to affiliates                                                                                                                                                                 |       | 935                                                                         |       | 18,893                                                                      |       |
| Net cash provided by operating activities                                                                                                                                                              |       | 151,524                                                                     |       | 73,766                                                                      |       |
| **Cash flows from investing  activities:**                                                                                                                                                             |       |                                                                        |       |                                                                        |       |
| Principal payments from investments                                                                                                                                                                    |       | 1,068,644                                                                   |       | 879,235                                                                     |       |
| Proceeds from sale of investments                                                                                                                                                                      |       | 1,335,757                                                                   |       | 1,069,201                                                                   |       |
| Purchases of investments                                                                                                                                                                               |       | (2,304,444                                                                  | )          | (685,456                                                                    | )          |
| Net proceeds, purchases, and settlements of  derivatives                                                                                                                                               |       | 12,740                                                                      |       | 20,530                                                                      |       |
| Net change in reverse repurchase agreements                                                                                                                                                            |       | 80,250                                                                      |       | 7,908                                                                       |       |
| Net change to restricted cash and cash equivalents                                                                                                                                                     |       | (22,514                                                                     | )          | 1,045,434                                                                   |       |
| Net cash provided by investing activities                                                                                                                                                              |       | 170,433                                                                     |       | 2,336,852                                                                   |       |
| **Cash flows from financing  activities:**                                                                                                                                                             |       |                                                                        |       |                                                                        |       |
| Repayment of senior secured credit facility                                                                                                                                                            |       | (227,805                                                                    | )          | (88,133                                                                     | )          |
| Proceeds from senior secured credit facility                                                                                                                                                           |       | 50,319                                                                      |       | —                                                                      |       |
| Repayment of residential mortgage-backed  securities issued                                                                                                                                            |       | —                                                                      |       | (442,984                                                                    | )          |
| Retirement of collateralized loan obligation  secured notes                                                                                                                                            |       | (104,510                                                                    | )          | (1,788,694                                                                  | )          |
| Retirement of collateralized loan obligation  junior secured notes to affiliates                                                                                                                       |       | (62,581                                                                     | )          | —                                                                      |       |
| Net change in junior subordinated notes                                                                                                                                                                |       | —                                                                      |       | (1,238                                                                      | )          |
| Proceeds from convertible senior notes                                                                                                                                                                 |       | 167,325                                                                     |       | —                                                                      |       |
| Repayment of convertible senior notes                                                                                                                                                                  |       | (93,922                                                                     | )          | —                                                                      |       |
| Distributions on common shares                                                                                                                                                                         |       | (45,931                                                                     | )          | —                                                                      |       |
| Other capitalized costs                                                                                                                                                                                |       | (4,947                                                                      | )          | (5,137                                                                      | )          |
| Net cash used in financing activities                                                                                                                                                                  |       | (322,052                                                                    | )          | (2,326,186                                                                  | )          |
| **Net (decrease) increase in cash  and cash equivalents**                                                                                                                                              |       | (95                                                                         | )          | 84,432                                                                      |       |
| **Cash and cash equivalents at  beginning of period**                                                                                                                                                  |       | 97,086                                                                      |       | 41,430                                                                      |       |
| **Cash and cash equivalents at  end of period**                                                                                                                                                        |       | $                                                                           | 96,991     |                                                                        | $          | 125,862 |   |
| **Supplemental cash flow  information:**                                                                                                                                                               |       |                                                                        |       |                                                                        |       |
| Cash paid for interest                                                                                                                                                                                 |       | $                                                                           | 99,308     |                                                                        | $          | 247,029 |   |
| Cash paid for income taxes                                                                                                                                                                             |       | $                                                                           | 580        |                                                                        | $          | 373 |   |
| **Non-cash investing and  financing:**                                                                                                                                                                 |       |                                                                        |       |                                                                        |       |
| Deconsolidation of residential mortgage loans                                                                                                                                                          |       | $                                                                           | 2,034,772  |                                                                        | $          | — |   |
| Deconsolidation of residential mortgage-backed  securities issued                                                                                                                                      |       | $                                                                           | (2,034,772 | )                                                                           | $          | — |   |
| Subordinate tranche of the residential mortgage  loan securitization trusts included in residential mortgage-backed securities                                                                         |       | $                                                                           | 74,366     |                                                                        | $          | — |   |
| Equity component of the convertible senior notes                                                                                                                                                       |       | $                                                                           | 9,973      |                                                                        | $          | — |   |
| Net payable (receivable) for securities purchased                                                                                                                                                      |       | $                                                                           | —     |                                                                        | $          | 28,238 |   |
| Conversion of corporate loan to private equity  investment                                                                                                                                             |       | $                                                                           | —     |                                                                        | $          | 48,467 |   |
| Exchange of convertible senior notes to equity                                                                                                                                                         |       | $                                                                           | —     |                                                                        | $          | 8,808 |   |
| Exchange of CLO 2009-1 subordinated notes to  affiliate for its interest in CLO 2009-1 assets                                                                                                          |       | $                                                                           | —     |                                                                        | $          | 90,429 |   |

 

See notes to condensed consolidated financial statements.

 

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Table ofContents

 

**KKR Financial Holdings LLC and Subsidiaries**

**Notes toCondensed Consolidated Financial Statements (Unaudited)**

 

**Note 1. Organization**

 

KKR Financial Holdings LLC together with its subsidiaries (the “Company”or “KKR Financial”) is a specialty finance company with expertise in a range ofasset classes. The Company primarily invests in financial assets includingbelow investment grade corporate debt, including senior secured and unsecuredloans, mezzanine loans, high yield corporate bonds, distressed and stresseddebt securities, marketable equity securities, and private equity.Additionally, the Company has made or may make investments in other assetclasses including natural resources and real estate. The corporate loans theCompany invests in are generally referred to as syndicated bank loans, orleveraged loans, and are purchased via assignment or participation in eitherthe primary or secondary market. The majority of the Company’s corporate debtinvestments are held in collateralized loan obligation (“CLO”) transactionsthat the Company uses as long term financing for these investments. The Company’sCLO transactions are structured as on-balance sheet securitizations ofcorporate loans and high yield debt securities. The senior secured notes issuedby the CLO transactions are generally owned by third party investors who areunaffiliated with the Company and the Company owns the majority of thesubordinated notes in the CLO transactions. The Company executes its corebusiness strategy through majority-owned subsidiaries, including CLOs.

 

KKR Financial Advisors LLC (the “Manager”), a wholly ownedsubsidiary of KKR Asset Management LLC (formerly known as Kohlberg Kravis Roberts & Co.(Fixed Income) LLC), manages the Company pursuant to a managementagreement (the “Management Agreement”). KKR Asset Management LLC is awholly-owned subsidiary of Kohlberg Kravis Roberts & Co. L.P. (“KKR”).

 

**Note 2. Summary of Significant AccountingPolicies**

 

**Basis of Presentation**

 

The accompanying condensed consolidated financial statements have beenprepared in conformity with accounting principles generally accepted in theUnited States of America (“GAAP”). The condensed consolidated financialstatements include the accounts of the Company and entities established tocomplete secured financing transactions that are considered to be variableinterest entities and for which the Company is the primary beneficiary.

 

These condensed consolidated financial statements should be read inconjunction with the consolidated financial statements and notes theretoincluded in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2009. The Company’s results for any interim period are not necessarilyindicative of results for a full year or any other interim period. In theopinion of management, all normal recurring adjustments have been included fora fair statement of this interim financial information.

 

**Use of Estimates**

 

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

 

**Consolidation**

 

Effective January 1, 2010, the Company adopted new guidance whichamended the accounting for the transfers of financial assets, eliminated theconcept of a qualified special purpose entity and significantly changed the criteriaby which an enterprise determines whether or not it must consolidate a variableinterest entity (“VIE”). Under the new guidance, consolidation of a VIErequires both the power to direct the activities that most significantly impactthe VIE’s economic performance and the obligation to absorb losses of the VIEor the right to receive benefits of the VIE that could potentially besignificant to the VIE.

 

As a result of the adoptionof the new guidance regarding the amended consolidation model based on powerand economics, the Company determined that six residential mortgage loansecuritization trusts, which were previously consolidated by the Company as itwas deemed to be the primary beneficiary, were required to be deconsolidated.The Company determined that it did not have the power to direct the activitiesthat most significantly impact the economic performance of the securitizationtrusts or the performance of the securitization trusts’ underlying assets asthe Company was never the servicer of the trusts nor did it participate in anyservicing activities. Accordingly, the Company determined that it was no longerthe primary beneficiary of the six securitization trusts under the new guidanceand deconsolidated them as of January 1, 2010. This resulted in thereduction of both assets and liabilities of approximately $2.0 billion. Inaddition, loan interest income, interest expense, loan servicing expense, andnet unrealized and realized 

 

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gain (loss) associated withthe residential mortgage loan securitization trusts will no longer be reportedon the Company’s condensed consolidated financial statements. The deconsolidationof the six residential mortgage loan securitization trusts had no net impact onthe Company’s shareholders’ equity, results of operations and cash flows. Referto Note 6 to these condensed consolidated financial statements for furtherdiscussion of the Company’s residential mortgage-backed securities (“RMBS”) andto Note 7 to these condensed consolidated financial statements for the impactof the deconsolidation.

 

KKR Financial CLO 2005-1, Ltd. (“CLO2005-1”), KKR Financial CLO 2005-2, Ltd. (“CLO 2005-2”), KKRFinancial CLO 2006-1, Ltd. (“CLO 2006-1”), KKR FinancialCLO 2007-1, Ltd. (“CLO 2007-1”) and KKR Financial CLO2007-A, Ltd. (“CLO 2007-A”) are entities established to complete securedfinancing transactions. These entities are VIEs which the Company consolidatesas the Company has determined it has the power to direct the activities thatmost significantly impact these entities’ economic performance and the Companyhas both the obligation to absorb losses of these entities and the right toreceive benefits from these entities that could potentially be significant tothese entities.

 

Thesefive CLOs, through which the Company finances the majority of its corporatedebt investments, include $7.3 billion par amount, or $6.8 billion estimatedfair value, of corporate debt investments. The assets in each CLO can be usedonly to settle the related entities’ debt which in aggregate total $5.6 billionof senior and junior secured notes outstanding and $371.1 million of juniornotes outstanding that are held by an affiliate of the Manager. In CLOtransactions, subordinated notes have the first risk of loss and conversely,the residual value upside of the transactions. As such, these CLOs areconsidered non-recourse leverage.

 

Inaddition, the Company continues to consolidate all non-VIEs in which it holds agreater than 50 percent voting interest.

 

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

 

**Fair Value of Financial Instruments**

 

Fair value is the price that would be received to sell an asset or paidto transfer a liability in an orderly transaction between market participantsat the measurement date. Where available, fair value is based on observablemarket prices 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.Assets and liabilities recorded at fair value in the condensed consolidatedbalance sheets are categorized based upon the level of judgment associated withthe inputs used to measure their value. Hierarchical levels, as defined underGAAP, are directly related to the amount of subjectivity associated with theinputs to fair valuations of these assets and liabilities, and are as follows:

 

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

 

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

 

Level 2: Inputs, other than quoted prices included inlevel 1, are observable for the asset or liability, either directly orindirectly. Level 2 inputs include quoted prices for similar instrumentsin active markets, and inputs other than quoted prices that are observable forthe asset or liability.

 

Fair value assets and liabilities that are generally included in thiscategory are certain corporate debt securities, certain corporate loans heldfor sale, certain equity investments at estimated fair value, certainsecurities sold, not yet purchased and certain financial instruments classifiedas derivatives.

 

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

 

Assets and liabilities carried at fair value and included in thiscategory are certain corporate debt securities, certain corporate loans heldfor sale, certain equity investments at estimated fair value, RMBS, residentialmortgage loans, residential mortgage-backed securities issued (“RMBS Issued”)and certain derivatives.

 

Asignificant decrease in the volume and level of activity for the asset orliability is an indication that transactions or quoted prices may not berepresentative of fair value because in such market conditions there may beincreased instances of transactions that are not orderly. In thosecircumstances, further analysis of transactions or quoted prices is needed, anda significant adjustment to the transactions or quoted prices may be necessaryto estimate fair value.

 

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The availability of observable inputs can vary depending on thefinancial asset or liability and is affected by a wide variety of factors,including, for example, the type of product, whether the product is new,whether the product is traded on an active exchange or in the secondary market,and the current market condition. To the extent that valuation is based on modelsor inputs that are less observable or unobservable in the market, thedetermination of fair value requires more judgment. Accordingly, the degree ofjudgment exercised by the Company in determining fair value is greatest forinstruments categorized in level 3. In certain cases, the inputs used tomeasure fair value may fall into different levels of the fair value hierarchy.In such cases, for disclosure purposes, the level in the fair value hierarchywithin which the fair value measurement in its entirety falls is determinedbased on the lowest level input that is significant to the fair valuemeasurement in its entirety. The variability of the observable inputs affectedby the factors described above may cause transfers between levels 1, 2, and/or3, which the Company recognizes at the end of the reporting period.

 

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

 

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

 

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

 

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

 

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

 

**Cash and Cash Equivalents**

 

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

 

**Restricted Cash and Cash Equivalents**

 

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

 

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

 

**Residential Mortgage-Backed Securities**

 

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

 

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**Securities Available-for-Sale**

 

The Company classifies its investments in securities asavailable-for-sale as the Company may sell them prior to maturity and does nothold them principally for the purpose of selling them in the near term. Theseinvestments are carried at estimated fair value, with unrealized gains andlosses reported in accumulated other comprehensive income (loss). Estimatedfair values are based on quoted market prices, when available, on estimatesprovided by independent pricing sources or dealers who make markets in suchsecurities, or internal valuation models when external sources of fair valueare not available. Upon the sale of a security, the realized net gain or lossis computed on a weighted-average cost basis. Purchases and sales of securitiesare recorded on the trade date.

 

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

 

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

 

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

 

**Equity Investments, at Estimated Fair Value**

 

TheCompany has elected the fair value option of accounting for certain marketableand private equity investments. The Company elects the fair value option ofaccounting for private equity investments received through restructuring debttransactions or issued by an entity in which the Company may have significantinfluence. The Company elected the fair value option for certain equityinvestments for the purpose of enhancing the transparency of its financialcondition as fair value is consistent with how the Company manages the risks ofthese equity investments. Equity investments, at estimated fair value, aremanaged based on overall value and potential returns. Investments carried atfair value are presented separately on the condensed consolidated balancesheets with unrealized gains and losses reported in net realized and unrealizedgains and losses on investments on the condensed consolidated statements ofoperations.

 

**Securities Sold, Not Yet Purchased**

 

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

 

**Corporate Loans**

 

The Company purchases participations and assignments in corporate loansin the primary and secondary market. Loans are held for investment and theCompany initially records loans at their purchase prices. The Companysubsequently accounts for loans based on their outstanding principal plus orminus unaccreted purchase discounts and unamortized purchase premiums. Interestincome on loans includes interest at stated coupon rates adjusted for accretionof purchase discounts and the amortization of purchase premiums. Unamortizedpremiums and unaccreted discounts are recognized in interest income over thecontractual life, adjusted for actual prepayments, of the loans using theeffective interest method.

 

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A loan is typically placed on non-accrual status at such time as:(i) management believes that scheduled debt service payments may not bepaid when contractually due; (ii) the loan becomes 90 daysdelinquent; (iii) management determines the borrower is incapable of, orhas ceased efforts toward, curing the cause of the impairment; or (iv) thenet realizable value of the underlying collateral securing the loan decreasesbelow the Company’s carrying value of such loan. As such, loans placed onnon-accrual status may or may not be contractually past due at the time of suchdetermination. While on non-accrual status, previously recognized accruedinterest is reversed if it is determined that such amounts are not collectible andinterest income is recognized using the cost-recovery method, cash-basis methodor some combination of the two methods. A loan is placed back on accrual statuswhen the ultimate collectability of the principal and interest is not in doubt.

 

**Corporate Loans Held for Sale**

 

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

 

**Allowance for Loan Losses**

 

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

 

Theunallocated component of the Company’s allowance for loan losses reflects itsestimate of probable losses inherent in the loan portfolio as of the balancesheet date where the specific loan that the loan loss relates to isindeterminable. The Company estimates the unallocated component of theallowance for loan losses through a comprehensive review of its loan portfolioand identifies certain loans that demonstrate possible indicators ofimpairment. This assessment excludes all loans that are determined to beimpaired and as a result, an allocated reserve has been recorded. Such indicatorsinclude, but are not limited to, the current and/or forecasted financialperformance and liquidity profile of the issuer, specific industry or economicconditions that may impact the issuer, and the observable trading price of theloan if available. Loans that demonstrate possible indicators of impairment areaggregated on a watch list for monitoring and are sub-divided forcategorization based on the seniority of the loan in the issuer’s capitalstructure, whether the loan is secured or unsecured, and the nature of thecollateral securing the loan, for purposes of applying possible default andloss severity ranges based on the nature of the issuer and the specific loan.The Company applies a range of default and loss severity estimates in order to estimatea range of loss outcomes upon which to base its estimate of probable lossesthat results in the determination of the unallocated component of the Company’sallowance for loan losses.

 

**Leasehold Improvements and Equipment**

 

Leasehold improvements and equipment are carried at cost lessdepreciation and amortization and are reviewed for impairment whenever eventsor changes in circumstances indicate that the carrying amount of the assetsmight not be recoverable. Equipment is depreciated using the straight-linemethod over the estimated useful lives of the respective assets of three years.Leasehold improvements are amortized on a straight-line basis over the shorterof their estimated useful lives or lease terms. Leasehold improvements andequipment, net of accumulated depreciation and amortization, are included inother assets.

 

**Borrowings**

 

The Company finances the acquisition of its investments, includingloans, residential mortgage-backed securities and securitiesavailable-for-sale, primarily through the use of secured borrowings in the formof securitization transactions structured as secured financings and othersecured and unsecured borrowings. The Company recognizes interest expense onall borrowings on an accrual basis.

 

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**Trust Preferred Securities**

 

Trusts formed by the Company for the sole purpose of issuing trustpreferred securities are not consolidated by the Company as the Company hasdetermined that it is not the primary beneficiary of such trusts. The Company’sinvestment in the common securities of such trusts is included in other assetson the Company’s condensed consolidated financial statements.

 

**Derivative Financial Instruments**

 

The Company recognizes all derivatives on the condensed consolidatedbalance sheet at estimated fair value. On the date the Company enters into aderivative contract, the Company designates and documents each derivative contractas one of the following at the time the contract is executed: (i) a hedgeof a recognized 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) a hedge of a net investment in a foreign operation; or (iv) aderivative instrument not designated as a hedging instrument (“free-standingderivative”). For a fair value hedge, the Company records changes in theestimated fair value of the derivative instrument and, to the extent that it iseffective, changes in the fair value of the hedged asset or liability in thecurrent period earnings in the same financial statement category as the hedgeditem. For a cash flow hedge, the Company records changes in the estimated fairvalue of the derivative to the extent that it is effective in othercomprehensive (loss) income and subsequently reclassifies these changes inestimated fair value to net income in the same period(s) that the hedgedtransaction affects earnings. The effective portion of the cash flow hedges isrecorded in the same financial statement category as the hedged item. Forfree-standing derivatives, the Company reports changes in the fair values inother (loss) income.

 

The Company formally documents at inception its hedge relationships,including identification of the hedging instruments and the hedged items, itsrisk management objectives, strategy for undertaking the hedge transaction andthe Company’s evaluation of effectiveness of its hedged transactions.Periodically, the Company also formally assesses whether the derivative itdesignated in each hedging relationship is expected to be and has been highlyeffective in offsetting changes in estimated fair values or cash flows of thehedged item using either the dollar offset or the regression analysis method.If the Company determines that a derivative is not highly effective as a hedge,it discontinues hedge accounting.

 

**Foreign Currency**

 

The Company makes investments in non-United States dollar denominatedsecurities and loans. As a result, the Company is subject to the risk offluctuation in the exchange rate between the United States dollar and theforeign currency in which it makes an investment. In order to reduce thecurrency risk, the Company may hedge the applicable foreign currency. Allinvestments denominated in a foreign currency are converted to the UnitedStates dollar using prevailing exchange rates on the balance sheet date. Income,expenses, gains and losses on investments denominated in a foreign currency areconverted to the United States dollar using the prevailing exchange rates onthe dates when they are recorded. Foreign exchange gains and losses arerecorded in the condensed consolidated statements of operations.

 

**Manager Compensation**

 

The Management Agreement provides for the payment of a base managementfee to the Manager, as well as an incentive fee if the Company’s financialperformance exceeds certain benchmarks. Additionally, the Management Agreementprovides for the Manager to be reimbursed for certain expenses incurred on theCompany’s behalf. See Note 13 to these condensed consolidated financialstatements for additional discussion on the payment of the base management feeand incentive fee. The base management fee and the incentive fee are accruedand expensed during the period for which they are earned by the Manager.

 

**Share-Based Compensation**

 

The Company accounts for share-based compensation issued to itsdirectors and to its Manager using the fair value based methodology inaccordance with accounting guidance. Compensation cost related to restrictedcommon shares issued to the Company’s directors is measured at its estimatedfair value at the grant date, and is amortized and expensed over the vestingperiod on a straight-line basis. Compensation cost related to restricted commonshares and common share options issued to the Manager is initially measured atestimated fair value at the grant date, and is remeasured on subsequent datesto the extent the awards are unvested. The Company has elected to use thegraded vesting attribution method to amortize compensation expense for therestricted common shares and common share options granted to the Manager.

 

**Income Taxes**

 

The Company intends to continue to operate so as to qualify as apartnership, and not as an association or publicly traded partnership that istaxable as a corporation, for United States federal income tax purposes.Therefore, the Company generally is not 

 

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subjectto United States federal income tax at the entity level, but is subject tolimited state and foreign taxes. Holders of the Company’s shares will berequired to take into account their allocable share of each item of the Company’sincome, gain, loss, deduction, and credit for the taxable year of the Companyending within or with their taxable year.

 

During 2010, the Company owned an equity interest in KKR FinancialHoldings II, LLC (“KFH II”) which elected to be taxed as a real estateinvestment trust (a “REIT”) under the Internal Revenue Code of 1986, as amended(the “Code”). KFH II holds certain real estate mortgage-backed securities. AREIT generally is not subject to United States federal income tax to the extentthat it currently distributes its income and satisfies certain asset, incomeand ownership tests, and recordkeeping requirements, but it may be subject tosome amount of federal, state, local and foreign taxes based on its taxableincome.

 

The Company has wholly-owneddomestic and foreign subsidiaries that are taxable as corporations for UnitedStates federal income tax purposes and thus are not consolidated with theCompany for United States federal income tax purposes. For financial reportingpurposes, current and deferred taxes are provided for on the portion ofearnings recognized by the Company with respect to its interest in the domestictaxable corporate subsidiaries, because each is taxed as a regular corporationunder the Code. Deferred income tax assets and liabilities are computed basedon temporary differences between the GAAP consolidated financial statements andthe United States federal income tax basis of assets and liabilities as of eachconsolidated balance sheet date. The foreign corporate subsidiaries were formedto make certain foreign and domestic investments from time to time. The foreigncorporate subsidiaries are organized as exempted companies incorporated withlimited liability under the laws of the Cayman Islands, and are anticipated tobe exempt from United States 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. However, the Companywill be required to include their current taxable income in the Company’scalculation of its taxable income allocable to shareholders. CLO 2005-1, CLO2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and KKR Financial CLO 2009-1, Ltd.(“CLO 2009-1”) are foreign subsidiaries of the Company that elected to betreated as disregarded entities or partnerships for United States federalincome tax purposes. These subsidiaries were established to facilitatesecuritization transactions, structured as secured financing transactions.

 

**Earnings Per Share**

 

The Company calculates earnings per share (“EPS”) using the two-classmethod which is an earnings allocation formula that determines EPS for commonshares and participating securities. Unvested share-based payment awards thatcontain non-forfeitable rights to dividends or dividend equivalents (whetherpaid or unpaid) are participating securities and shall be included in thecomputation of EPS using the two-class method. Accordingly, all earnings(distributed and undistributed) are allocated to common shares andparticipating securities based on their respective rights to receive dividends.

 

The Company presents both basic and diluted earnings (loss) per commonshare in its condensed consolidated financial statements and footnotes thereto.Basic earnings (loss) per common share (“Basic EPS”) excludes dilution and is computedby dividing net income or loss by the weighted-average number of common shares,including vested restricted common shares, outstanding for the period. Dilutedearnings (loss) per share (“Diluted EPS”) reflects the potential dilution ofcommon share options and unvested restricted common shares using the treasurymethod, as well as the potential dilution of convertible senior notes using thenumber of shares it would take to satisfy the excess conversion obligation(average Company share price for the period in excess of the conversion pricerelated to the Company’s convertible senior notes), if they are notanti-dilutive.  See Note 3 to thesecondensed consolidated financial statements for earnings per common sharecomputations.

 

**Recent Accounting Pronouncements**

 

*Consolidation*

 

In February 2010, theFinancial Accounting Standards Board (“FASB”) issued new guidance deferring theapplication of the amended consolidation requirements related to VIEs for areporting entity’s interest in an entity that has all the attributes of aninvestment company or for which it is applies measurement principles that areconsistent with those followed by investment companies. The guidance wasexpected to most significantly affect reporting entities in the investment managementindustry. Entities including, but not limited to, securitization entities orentities with multiple levels of subordinated investors such as a CLO for whichthe primary purpose of the capital structure of the entity is to provide creditenhancement to senior interest holders, will not qualify for the deferral.  The guidance was effective for interim andannual reporting periods beginning after November 15, 2009. The adoptionof this new guidance did not have an effect on the Company’s condensed consolidatedfinancial statements.

 

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*FinancingReceivables and Allowance for Credit Losses*

 

In July 2010, the FASBissued new guidance to amend existing disclosure requirements to provide agreater level of disaggregated information about the credit quality offinancing receivables and allowance for credit losses. The two levels ofdisaggregation defined by the FASB are portfolio segment and class of financingreceivable. The amendments also require an entity to disclose credit qualityindicators, past due information, and modifications of financing receivables.The guidance is effective for interim and annual reporting periods ending on orafter December 15, 2010. The Company will include the required disclosuresbeginning with its consolidated financial statements for the year endingDecember 31, 2010.

 

**Note 3. Earnings per Share**

 

The following table presents a reconciliation of basic and diluted netincome per common share, as well as the distributions declared per common sharefor the three and nine months ended September 30, 2010 and 2009 (amountsin thousands, except per share information):

 
| ** **                                                                        | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                        | ** ** | **2010**                                             | ** ** | **2009**                                            | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net income                                                                        |       | $                                                    | 82,342     |                                                | $          | 67,187 |   | $ | 292,865 |   | $ | 74,820 |   |
| Less: Dividends and undistributed earnings  allocated to participating securities |       | 687                                                  |       | 574                                                 |       | 2,482 |   | 657 |   |
| Net income applicable to common shareholders                                      |       | $                                                    | 81,655     |                                                | $          | 66,613 |   | $ | 290,383 |   | $ | 74,163 |   |
|                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| **Basic:**                                                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Basic weighted-average shares outstanding                                         |       | 157,057                                              |       | 156,997                                             |       | 157,018 |   | 152,664 |   |
| Net income per share                                                              |       | $                                                    | 0.52       |                                                | $          | 0.42 |   | $ | 1.85 |   | $ | 0.49 |   |
|                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| **Diluted:**                                                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Diluted weighted-average shares outstanding (1)                                   |       | 157,461                                              |       | 156,997                                             |       | 157,294 |   | 152,664 |   |
| Net income per share                                                              |       | $                                                    | 0.52       |                                                | $          | 0.42 |   | $ | 1.85 |   | $ | 0.49 |   |
|                                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Distributions declared per common share                                           |       | $                                                    | 0.12       |                                                | $          | — |   | $ | 0.29 |   | $ | — |   |

 

----

(1)                        An immaterialconversion premium related to the convertible senior notes was included in thediluted earnings per share for the three and nine months endedSeptember 30, 2010. Potential anti-dilutive common shares excluded fromdiluted earnings per share related to common share options were 1,932,279 forboth the three and nine months ended September 30, 2010 and 2009.

 

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

 

Thefollowing table summarizes the Company’s securities classified asavailable-for-sale as of September 30, 2010 and December 31, 2009,which are carried at estimated fair value (amounts in thousands):

 
| ** **                 | ** ** | **September 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|----------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | **Amortized  Cost**              | ** ** | **Gross  Unrealized  Gains**    | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
| Corporate debt securities  |       | $                                | 677,508    |                            | $          | 176,599 |   | $ | (5,085 | ) | $ | 849,022 |   | $ | 560,637 |   | $ | 198,242 |   | $ | (4,470 | ) | $ | 754,409 |   |
| Common and preferred stock |       | —                           |       | —                          |       | — |   | — |   | 713 |   | 564 |   | — |   | 1,277 |   |
| Total                      |       | $                                | 677,508    |                            | $          | 176,599 |   | $ | (5,085 | ) | $ | 849,022 |   | $ | 561,350 |   | $ | 198,806 |   | $ | (4,470 | ) | $ | 755,686 |   |

 

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The following table shows the gross unrealized losses and estimatedfair value of the Company’s available-for-sale securities, aggregated by lengthof time that the individual securities have been in a continuous unrealizedloss position, as of September 30, 2010 and December 31, 2009(amounts in thousands):

 
| ** **                  | ** ** | **Less Than 12 months** | ** ** | **12 Months or More** | ** ** | **Total**                      | ** ** |
|-----------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|--------------------------------|------------|
| ** **                  | ** ** | **Estimated  Fair Value**         | ** ** | **Unrealized  Losses**               | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
|                        |       |                                   |       |                                 |       |                           |       |   |   |   |   |   |   |
| **September 30, 2010** |       |                                   |       |                                 |       |                           |       |   |   |   |   |   |   |
| Corporate debt securities   |       | $                                      | 73,364     |                                 | $          | (2,646                         | )          | $ | 36,443 |   | $ | (2,439 | ) | $ | 109,807 |   | $ | (5,085 | ) |
|                        |       |                                   |       |                                 |       |                           |       |   |   |   |   |   |   |
| **December 31, 2009**  |       |                                   |       |                                 |       |                           |       |   |   |   |   |   |   |
| Corporate debt securities   |       | $                                      | 8,437      |                                 | $          | (113                           | )          | $ | 70,967 |   | $ | (4,357 | ) | $ | 79,404 |   | $ | (4,470 | ) |

 

Theunrealized losses in the table above are considered to be temporary impairmentsdue to market factors and are not reflective of credit deterioration. TheCompany considers many factors when evaluating whether an impairment isother-than-temporary. For corporate debt securities included in the tableabove, the Company does not intend to sell them and does not believe that it ismore likely than not that the Company will be required to sell any of itscorporate debt securities prior to recovery. In addition, based on the analysesperformed by the Company on each of its corporate debt securities, the Companybelieves that it should be able to recover the entire amortized cost amount ofthe corporate debt securities included in the table above.

 

During the three and nine months ended September 30, 2010, theCompany recognized losses totaling $0.5 million and $1.7 million, respectively,for corporate debt securities that it determined to be other-than-temporarilyimpaired based on the criteria above. During the three and nine months endedSeptember 30, 2009, the Company recognized losses totaling nil and$40.0 million, respectively, for corporate debt securities that itdetermined to be other-than-temporarily impaired based on the criteria above.The Company intends to sell these securities and as a result, the entire amountis recorded through earnings in net realized and unrealized gain (loss) oninvestments in the condensed consolidated statements of operations.

 

As of September 30, 2010 and December 31, 2009, the Companyhad no corporate debt securities in default.

 

The following table shows the net realized gains (losses) on the salesof securities (amounts in thousands):

 
| ** **                  | ** ** | **For the three  months ended  September 30, 2010** | ** ** | **For the three  months ended  September 30, 2009** | ** ** | **For the nine  months ended  September 30, 2010** | ** ** | **For the nine  months ended  September 30, 2009** | ** ** |
|-----------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| Gross realized gains        |       | $                                                                            | 17,598     |                                                                         | $          | 22                                                                          |       | $                                                                           | 60,398     |   | $ | 9,975 |   |
| Gross realized losses       |       | —                                                                       |       | (1,994                                                                       | )          | —                                                                      |       | (9,350                                                                      | )          |
| Net realized gains (losses) |       | $                                                                            | 17,598     |                                                                         | $          | (1,972                                                                      | )          | $                                                                           | 60,398     |   | $ | 625 |   |

 

Note 8 to these condensed consolidated financial statements describesthe Company’s borrowings under which the Company has pledged securitiesavailable-for-sale for borrowings. The following table summarizes the estimatedfair value of securities available-for-sale pledged as collateral as ofSeptember 30, 2010 and December 31, 2009 (amounts in thousands):

 
| ** **                                                                                                     | ** ** | **As of  September 30, 2010** | ** ** | **As of  December 31, 2009** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| Pledged as collateral for borrowings under senior  secured credit facility                                     |       | $                                            | —     |                                        | $          | 107,845 |   |
| Pledged as collateral for collateralized loan  obligation secured notes and junior secured notes to affiliates |       | 727,485                                      |       | 633,104                                     |       |
| Total                                                                                                          |       | $                                            | 727,485    |                                        | $          | 740,949 |   |

 

**Note 5. Corporate Loans and Allowance for Loan Losses**

 

The following table summarizes the Company’s corporate loans as ofSeptember 30, 2010 and December 31, 2009 (amounts in thousands):

 
| ** **                             | ** ** | **September 30, 2010** | ** ** | **December 31, 2009**                   | ** ** |
|----------------------------------------|------------|----------------------------------|------------|---------------------------------------------------|------------|
| ** **                             | ** ** | **Corporate  Loans**             | ** ** | **Corporate Loans  Held for Sale** | ** ** | **Total Corporate  Loans** | ** ** | **Corporate  Loans** | ** ** | **Corporate Loans  Held for Sale** | ** ** | **Total Corporate  Loans** | ** ** |
| Principal(1)                           |       | $                                | 6,371,687  |                                              | $          | 705,007 |   | $ | 7,076,694 |   | $ | 6,180,028 |   | $ | 1,033,383 |   | $ | 7,213,411 |   |
| Unamortized discount                   |       | (347,113                         | )          | (23,253                                           | )          | (370,366 | ) | (324,795 | ) | (76,028 | ) | (400,823 | ) |
| Total amortized cost                   |       | 6,024,574                        |       | 681,754                                           |       | 6,706,328 |   | 5,855,233 |   | 957,355 |   | 6,812,588 |   |
| Lower of cost or fair value adjustment |       | —                           |       | (14,558                                           | )          | (14,558 | ) | — |   | (31,637 | ) | (31,637 | ) |
| Allowance for loan losses              |       | (209,030                         | )          | —                                            |       | (209,030 | ) | (237,308 | ) | — |   | (237,308 | ) |
| Net carrying value                     |       | $                                | 5,815,544  |                                              | $          | 667,196 |   | $ | 6,482,740 |   | $ | 5,617,925 |   | $ | 925,718 |   | $ | 6,543,643 |   |

 

----

(1)                                Principalamount is net of charge-offs and other adjustments totaling $42.9 million and$158.8 million as of September 30, 2010 and December 31, 2009,respectively.

 

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The following table summarizes the changes in the allowance for loanlosses for the Company’s corporate loan portfolio during the three and ninemonths ended September 30, 2010 and 2009 (amounts in thousands):

 
| ** **                     | ** ** | **For the three  months ended  September 30, 2010** | ** ** | **For the three  months ended  September 30, 2009** | ** ** | **For the nine  months ended  September 30, 2010** | ** ** | **For the nine  months ended  September 30, 2009** | ** ** |
|--------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| Balance at beginning of period |       | $                                                                            | 210,218    |                                                                         | $          | 473,202                                                                     |       | $                                                                           | 237,308    |   | $ | 480,775 |   |
| Provision for loan losses      |       | 8,087                                                                        |       | —                                                                       |       | 8,087                                                                       |       | 39,795                                                                      |       |
| Charge-offs                    |       | (9,275                                                                       | )          | (2,978                                                                       | )          | (36,365                                                                     | )          | (50,346                                                                     | )          |
| Balance at end of period       |       | $                                                                            | 209,030    |                                                                         | $          | 470,224                                                                     |       | $                                                                           | 209,030    |   | $ | 470,224 |   |

 

Asof September 30, 2010 and December 31, 2009, the Company had anallowance for loan losses of $209.0 million and $237.3 million, respectively.As described in Note 2 to these condensed consolidated financial statements,the allowance for loan losses represents the Company’s estimate of probablecredit losses inherent in its loan portfolio as of the balance sheet date. TheCompany’s allowance for loan losses consists of two components, an allocatedcomponent and an unallocated component. The allocated component of theallowance for loan losses consists of individual loans that are impaired. Theunallocated component of the allowance for loan losses represents the Company’sestimate of losses inherent, but not identified, in its portfolio as of thebalance sheet date.

 

Asof September 30, 2010, the allocated component of the allowance for loanlosses totaled $53.0 million and relates to investments in certain loans issuedby six issuers with an aggregate par amount of $228.0 million and an aggregateamortized cost amount of $151.0 million. In addition, certain impaired loansfrom three of these issuers with an aggregate par amount of $85.1 million andan aggregate amortized cost amount of $16.9 million had no associated allowancefor loan losses as the Company’s amortized cost basis for these loans was belowthe estimated fair value as of September 30, 2010. As of December 31,2009, the allocated component of the allowance for loan losses totaled $81.7million and relates to investments in loans issued by six issuers with anaggregate par amount of $223.6 million and an aggregate amortized cost amountof $121.2 million.

 

Theunallocated component of the allowance for loan losses totaled $156.0 millionand $155.6 million as of September 30, 2010 and December 31, 2009,respectively. During the three and nine months ended September 30, 2010,the Company recorded charge-offs totaling $9.3 million and $36.4 million,respectively, comprised primarily of loans transferred to loans held for sale.The Company recorded charge-offs totaling $3.0 million and $50.4 million forthe three and nine months ended September 30, 2009, respectively.

 

As of September 30, 2010, the Company had $667.2 million of loansheld for sale, a decrease of $258.5 million from December 31, 2009.

 

As of September 30, 2010 and December 31, 2009, the Companyhad loans on non-accrual status with a total amortized cost of $167.1 millionand $439.9 million, respectively. The average investment in impaired loansduring the three and nine months ended September 30, 2010 was $178.4million and $262.5 million, respectively, and during the three and nine monthsended September 30, 2009, average recorded investment in the impairedloans was $717.3 million and $544.2 million, respectively. As ofSeptember 30, 2010 and 2009, the allocated component of the allowance forloan losses included all impaired loans for the respective periods. The amountof interest income recognized using the cash-basis method during the timewithin the period that the loans were impaired was $4.1 million and $11.1million for the three and nine months ended September 30, 2010,respectively, and $8.2 million and $15.0 million for the three and nine monthsended September 30, 2009, respectively.

 

As of September 30, 2010, the Company held corporate loans thatwere in default with a total amortized cost of $19.7 million from two issuers.As of December 31, 2009, the Company held loans that were in default witha total amortized cost of $392.5 million from seven issuers. The majority ofcorporate loans in default during 2010 and 2009 were included in the loans forwhich the allocated component of the Company’s allowance for losses was relatedto, or for which the Company determined were loans held for sale as ofSeptember 30, 2010 and December 31, 2009, respectively.

 

Note 8 to these condensed consolidated financial statements describesthe Company’s borrowings under which the Company has pledged loans forborrowings. The following table summarizes the amortized cost of totalcorporate loans, including corporate loans held for sale, pledged as collateralas of September 30, 2010 and December 31, 2009 (amounts inthousands):

 
| ** **                                                                                                          | ** ** | **As of  September 30, 2010** | ** ** | **As of  December 31, 2009** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| Pledged as collateral for borrowings under senior  secured credit facility                                          |       | $                                            | —     |                                        | $          | 425,740 |   |
| Pledged as collateral for collateralized loan  obligation secured notes and junior secured notes to affiliates |       | 6,307,611                                    |       | 6,354,382                                   |       |
| Total                                                                                                               |       | $                                            | 6,307,611  |                                        | $          | 6,780,122 |   |

 

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**Note 6. Residential Mortgage-Backed Securities**

 

TheCompany held RMBS with an estimated fair value of $106.3 million and $47.6million as September 30, 2010 and December 31, 2009,respectively.  As of January 1,2010, RMBS increased $74.4 million due to the deconsolidation of sixresidential mortgage loan securitization trusts (see “Consolidation” under Note2 to these condensed consolidated financial statements). The $74.4 millionrepresents the estimated fair value of the Company’s RMBS which were issued bythese six residential mortgage securitization trusts.

 

Note 8 to these condensed consolidated financial statements describesthe Company’s borrowings under which the Company has pledged RMBS. Thefollowing table summarizes the estimated fair value of RMBS pledged ascollateral as of September 30, 2010 and December 31, 2009 (amounts inthousands):

 
| ** **                                                                                                          | ** ** | **As of  September 30, 2010** | ** ** | **As of  December 31, 2009** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| Pledged as collateral for borrowings under senior  secured credit facility                                          |       | $                                            | —     |                                        | $          | 42,627 |   |
| Pledged as collateral for collateralized loan  obligation secured notes and junior secured notes to affiliates |       | 4,235                                        |       | 4,945                                       |       |
| Total                                                                                                               |       | $                                            | 4,235      |                                        | $          | 47,572 |   |

 

**Note 7. Deconsolidation of Residential Mortgage LoanSecuritization Trusts**

 

OnJanuary 1, 2010, the Company deconsolidated six residential mortgagesecuritization trusts as a result of the Company’s adoption of new guidanceregarding the consolidation model for variable interest entities. The Companyhas no exposure to loss in excess of the estimated fair value of the $74.4million RMBS which were issued by these six residential mortgage securitizationtrusts (see Note 6 to these condensed consolidated financial statements).

 

Thefollowing information represents the assets and liabilities removed from theCompany’s condensed consolidated balance sheet as of January 1, 2010 as aresult of the deconsolidation of the six residential mortgage loansecuritization trusts (amounts in thousands):

 
| ** **                                                                                     | ** ** | **As of  January 1, 2010** | ** ** |
|------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| **Assets**                                                                                     |       |                                      |       |
| Residential mortgage loans, at estimated fair  value (1)                                       |       | $                                         | 2,023,333  |   |
| Real estate owned (recorded within other assets on  the condensed consolidated balance sheets) |       | 11,439                                    |       |
| Interest receivable                                                                            |       | 4,529                                     |       |
|                                                                                           |       | $                                         | 2,039,301  |   |
|                                                                                           |       |                                      |       |
| **Liabilities**                                                                                |       |                                      |       |
| Residential mortgage-backed securities issued, at  estimated fair value                        |       | $                                         | 2,034,772  |   |
| Accrued interest payable                                                                       |       | 4,529                                     |       |
|                                                                                           |       | $                                         | 2,039,301  |   |

 

----

(1)                               Excludes $74.4million which represents the estimated fair value of the Company’s RMBS whichwere issued by the six residential mortgage loan securitization trusts thatwere deconsolidated under GAAP as of January 1, 2010.

 

Asa result of the deconsolidation of the six residential mortgage loansecuritization trusts, all references to residential mortgage loans interestincome, RMBS Issued interest expense, net realized and unrealized gain (loss)on residential mortgage loans and RMBS Issued, and loan servicing expenserelate to prior period balances and activities.

 

*Residential mortgage loans*

 

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

 

As of December 31, 2009, residential mortgage loans at estimatedfair value, totaled $2.1 billion, which excluded real estate owned (“REO”) as aresult of foreclosure on delinquent loans of $11.4 million as ofDecember 31, 2009. Loans were transferred to REO at the lower of cost orfair value. REO was recorded within other assets on the Company’s condensedconsolidated balance sheets.

 

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The following table summarizes the estimated fair value of residentialmortgage loans pledged as collateral as of December 31, 2009 (amounts inthousands):

 
| ** **                                                                 | ** ** | **As of  December 31, 2009** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| Pledged as collateral for borrowings under senior  secured credit facility |       | $                                           | 74,366     |   |
| Pledged as collateral for residential  mortgage-backed securities issued   |       | 2,023,333                                   |       |
|                                                                       |       | $                                           | 2,097,699  |   |

 

The following is a reconciliation of carrying amounts of residentialmortgage loans for the year ended December 31, 2009 (amounts inthousands):

 
| ** **                                                            | ** ** | **As of  December 31, 2009** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------------------------|------------|
| Beginning balance                                                     |       | $                                           | 2,620,021  |   |
| Principal payments                                                    |       | (585,429                                    | )          |
| Transfers in to REO                                                   |       | (646                                        | )          |
| Net change in unrealized and realized gain/loss  and premium/discount |       | 63,753                                      |       |
| Ending balance                                                        |       | $                                           | 2,097,699  |   |

 

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

 
| ** **                  | ** ** | **December 31, 2009** | ** ** |
|-----------------------------|------------|---------------------------------|------------|
| **Delinquency Status** | ** ** | **Number  of Loans**       | ** ** | **Principal  Amount** | ** ** |
| 30 to 59 days               |       | 84                              |       | $ | 37,261 |   |
| 60 to 89 days               |       | 47                              |       | 19,389 |   |
| 90 days or more             |       | 138                             |       | 55,697 |   |
| In foreclosure              |       | 139                             |       | 57,497 |   |
| Total                       |       | 408                             |       | $ | 169,844 |   |

 

As of December 31, 2009, 26 of the residential mortgage loansowned by the Company with an outstanding balance of $11.4 million were REOs asa result of foreclosure on delinquent loans. As of December 31, 2009, theCompany had 277 loans that were either 90 days or greater past due or inforeclosure and placed on non-accrual status.

 

As of December 31, 2009, the loss exposure or uncollectedprincipal amount related to the Company’s delinquent residential mortgage loansin the table above exceeded their fair value by $20.2 million.

 

*Residential mortgage-backedsecurities issued*

 

RMBS Issued consisted of the senior tranches of six residentialmortgage loan securitization trusts that the Company previously consolidatedunder GAAP and for which the Company reported the debt issued by these truststhat it did not hold on its condensed consolidated balance sheets. The Companycarried RMBS Issued at estimated fair value with unrealized gains and lossesreported in income. The Company elected the fair value option for its RMBSIssued for the purpose of enhancing the transparency of its financial conditionas fair value was consistent with how the Company managed the risks of itsresidential mortgage portfolio.

 

As of December 31, 2009, RMBS Issued had an outstanding amount of$2.6 billion and an estimated fair value of $2.0 billion. As ofDecember 31, 2009, the weighted average coupon of the RMBS Issued was 2.3%and the weighted average years to maturity were 25.8 years.

 

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**Note 8. Borrowings**

 

Certain information with respect to the Company’s borrowings as ofSeptember 30, 2010 is summarized in the following table (dollar amounts inthousands):

 
| ** **                                       | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted  Average  Borrowing  Rate** | ** ** | **Weighted  Average  Remaining  Maturity  (in days)** | ** ** | **Fair Value of  Collateral(1)** | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------|------------|
| CLO 2005-1 senior secured notes                  |       | $                           | 833,070    |                                   | 0.82       | %                                                          | 2,400      |                                       | $          | 910,695 |   |
| CLO 2005-2 senior secured notes                  |       | 801,119                     |       | 0.62                                   |       | 2,614                                                      |       | 891,745                                    |       |
| CLO 2006-1 senior secured notes                  |       | 683,265                     |       | 0.69                                   |       | 2,886                                                      |       | 882,003                                    |       |
| CLO 2007-1 senior secured notes                  |       | 2,075,040                   |       | 0.93                                   |       | 3,880                                                      |       | 2,363,265                                  |       |
| CLO 2007-1 junior secured notes to affiliates(2) |       | 305,610                     |       | —                                 |       | 3,880                                                      |       | 346,202                                    |       |
| CLO 2007-1 junior secured notes(3)          |       | 61,727                      |       | —                                 |       | 3,880                                                      |       | 70,301                                     |       |
| CLO 2007-A senior secured notes                  |       | 1,165,099                   |       | 1.42                                   |       | 2,572                                                      |       | 1,238,192                                  |       |
| CLO 2007-A junior secured notes to affiliates(4) |       | 65,452                      |       | —                                 |       | 2,572                                                      |       | 69,558                                     |       |
| CLO 2007-A junior secured notes(5)          |       | 10,821                      |       | —                                 |       | 2,572                                                      |       | 11,500                                     |       |
| Convertible senior notes                         |       | 343,863                     |       | 7.24                                   |       | 1,458                                                      |       | —                                     |       |
| Junior subordinated notes                        |       | 283,517                     |       | 5.50                                   |       | 9,535                                                      |       | —                                     |       |
| Total                                            |       | $                           | 6,628,583  |                                   |       |                                                       |       |                                       | $          | 6,783,461 |   |

 

----

(1)                               Collateral forborrowings consists of RMBS, securities available-for-sale, equity investmentsat estimated fair value and corporate loans.

 

(2)                               CLO 2007-1junior secured notes to affiliates consist of (x) $175.3 million ofmezzanine notes with a weighted average borrowing rate of 5.4% and(y) $130.3 million of subordinated notes that do not have acontractual coupon rate, but instead receive a pro rata amount of the netdistributions from CLO 2007-1.

 

(3)                               CLO 2007-1junior secured notes consist of (x) $55.9 million of mezzanine noteswith a weighted average borrowing rate of 3.7% and (y) $5.8 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) $55.0 million of mezzaninenotes with a weighted average borrowing rate of 6.7% and(y) $10.5 million of subordinated notes that do not have acontractual coupon rate, but instead receive a pro rata amount of the netdistributions from CLO 2007-A.

 

(5)                               CLO 2007-Ajunior secured notes consist of (x) $6.2 million of mezzanine noteswith a weighted average borrowing rate of 7.2% and (y) $4.6 millionof subordinated notes that do not have a contractual coupon rate, but insteadreceive a pro rata amount of the net distributions from CLO 2007-A.

 

Certain information with respect to the Company’s borrowings as ofDecember 31, 2009 is summarized in the following table (dollar amounts inthousands):

 
| ** **                                       | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted  Average  Borrowing  Rate** | ** ** | **Weighted  Average  Remaining  Maturity  (in days)** | ** ** | **Fair Value of  Collateral(1)** | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------|------------|
| Senior secured credit facility(2)                |       | $                           | 175,000    |                                   | 4.23       | %                                                          | 679        |                                       | $          | 739,640 |   |
| CLO 2005-1 senior secured notes                  |       | 832,622                     |       | 0.61                                   |       | 2,673                                                      |       | 868,291                                    |       |
| CLO 2005-2 senior secured notes                  |       | 800,504                     |       | 0.58                                   |       | 2,887                                                      |       | 859,457                                    |       |
| CLO 2006-1 senior secured notes                  |       | 683,266                     |       | 0.63                                   |       | 3,159                                                      |       | 858,317                                    |       |
| CLO 2007-1 senior secured notes                  |       | 2,176,805                   |       | 0.82                                   |       | 4,153                                                      |       | 2,337,779                                  |       |
| CLO 2007-1 junior secured notes to affiliates(3) |       | 437,730                     |       | —                                 |       | 4,153                                                      |       | 468,422                                    |       |
| CLO 2007-1 junior secured notes(4)          |       | 14,185                      |       | —                                 |       | 4,153                                                      |       | 15,237                                     |       |
| CLO 2007-A senior secured notes                  |       | 1,157,209                   |       | 1.16                                   |       | 2,845                                                      |       | 1,137,077                                  |       |
| CLO 2007-A junior secured notes to affiliates(5) |       | 96,056                      |       | —                                 |       | 2,845                                                      |       | 94,505                                     |       |
| CLO 2007-A junior secured notes(6)          |       | 3,125                       |       | —                                 |       | 2,845                                                      |       | 3,074                                      |       |
| Convertible senior notes                         |       | 275,800                     |       | 7.00                                   |       | 927                                                        |       | —                                     |       |
| Junior subordinated notes                        |       | 283,517                     |       | 5.41                                   |       | 9,747                                                      |       | —                                     |       |
| Total                                            |       | $                           | 6,935,819  |                                   |       |                                                       |       |                                       | $          | 7,381,799 |   |

 

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(1)                               Collateral forborrowings consists of RMBS, securities available-for-sale, equity investments,at estimated fair value, private equity investments, corporate and residentialmortgage loans and common stock warrants.

 

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

 

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(3)                               CLO 2007-1junior secured notes to affiliates consist of (x) $256.9 million ofmezzanine notes with a weighted average borrowing rate of 5.2% and(y) $180.8 million of subordinated notes that do not have acontractual coupon rate, but instead receive a pro rata amount of the netdistributions from CLO 2007-1.

 

(4)                               CLO 2007-1junior secured notes consist of (x) $8.4 million of mezzanine noteswith a weighted average borrowing rate of 5.2% and (y) $5.8 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) $81.5 million of mezzaninenotes with a weighted average borrowing rate of 6.5% and(y) $14.6 million of subordinated notes that do not have acontractual coupon rate, but instead receive a pro rata amount of the netdistributions from CLO 2007-A.

 

(6)                               CLO 2007-Ajunior secured notes consist of (x) $2.6 million of mezzanine noteswith a weighted average borrowing rate of 6.5% and (y) $0.5 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.

 

*CLONotes*

 

The indentures governing the Company’s CLO transactions includenumerous compliance tests, the majority of which relate to the CLO’s portfolioprofile. In the event that a portfolio profile test is not met, the indentureplaces restrictions on the ability of the CLO’s manager to reinvest availableprincipal proceeds generated by the collateral in the CLOs until the specifictest has been cured. In addition to the portfolio profile tests, the indenturesfor the CLO transactions include over-collateralization tests (“OC Tests”)which set the ratio of the collateral value of the assets in the CLO to thetranches of debt for which the test is being measured, as well as interestcoverage tests. If a CLO is not in compliance with an OC Test or an interestcoverage test, cash flows normally payable to the holders of junior classes ofnotes will be used by the CLO to amortize the most senior class of notes untilsuch point as the OC test is brought back into compliance. During the three andnine months ended September 30, 2010, the Company paid down nil and $90.3million of original CLO 2007-1 senior secured notes, respectively, due to thefailure of OC Tests. As of September 30, 2010, all of the Company’s CLOtransactions were in compliance with their respective OC and interest coveragetests.

 

During the three months ended March 31, 2010, in an open marketauction, the Company purchased $10.3 million of mezzanine notes issued by CLO2007-A for $5.5 million and $72.7 million of mezzanine and subordinate notesissued by CLO 2007-1 for $38.8 million, both of which were previously held byan affiliate of the Company’s manager. These transactions resulted in theCompany recording an aggregate gain on extinguishment of debt totaling $38.7million for the three months ended March 31, 2010.

 

*Senior Secured Credit Facility*

 

OnMay 3, 2010, the Company entered into a credit agreement for a four-year$210.0 million asset-based revolving credit facility (the “2014 Facility”),maturing on May 3, 2014, that is subject to, among other things, the termsof a borrowing base derived from the value of eligible specified financialassets. The borrowing base is subject to certain caps and concentrationlimits customary for financings of this type. The Company may obtain additionalcommitments under the 2014 Facility so long as the aggregate amount ofcommitments at any time does not exceed $600.0 million. On May 5, 2010,the Company obtained additional commitments of $40.0 million, bringing thetotal amount of commitments under the 2014 Facility to $250.0 million.

 

TheCompany has the right to prepay loans under the 2014 Facility in whole or inpart at any time. Loans under the 2014 Facility bear interest at a rate equalto the London interbank offered rate (“LIBOR”) plus 3.25% per annum. The 2014Facility contains customary covenants applicable to the Company, including arestriction from making distributions to holders of common shares in excess of65% of the Company’s estimated annual taxable income.

 

Asof September 30, 2010, the Company had no borrowings outstanding under the2014 Facility.

 

As of September 30, 2010, the Company believes it was incompliance with the 2014 Facility covenant requirements.

 

On May 26, 2010, the Company terminated its credit agreement,dated as of November 10, 2008, maturing on November 10, 2011 (the “2011Credit Agreement”). The 2011 Credit Agreement was terminated in connection withthe Company’s initial borrowing under its new credit facility entered into onMay 3, 2010 as described above. At the time of termination, there was$150.0 million of borrowings outstanding under the 2011 Credit Agreement whichthe Company prepaid. There were no early termination or prepayment feesassociated with the Company’s termination and repayment of all outstandingborrowings. The termination resulted in a $6.5 million write-off of unamortizeddebt issuance costs.

 

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*ConvertibleDebt*

 

During January and February 2010, the Company repurchased$95.2 million par amount of its 7.0% convertible senior notes maturing onJuly 15, 2012 (the “7.0% Notes”), reducing the amount outstanding from$275.8 million as of December 31, 2009 to $180.6 million as ofSeptember 30, 2010. These transactions resulted in the Company recording again of $1.3 million, which was partially offset by a write-off of $0.6 millionof unamortized debt issuance costs.

 

On January 15, 2010, the Company issued $172.5 million of7.5% Convertible Senior Notes due January 15, 2017 (“7.5% Notes”). The7.5% Notes bear interest at a rate of 7.5% per annum on the principal amount,accruing from January 15, 2010. Interest is payable semiannually in arrearson January 15 and July 15 of each year, beginning on July 15,2010. The 7.5% Notes will mature on January 15, 2017 unless previouslyredeemed, repurchased or converted in accordance with their terms prior to suchdate. Holders of the 7.5% Notes may convert their notes at the applicableconversion rate at any time prior to the close of business on the business dayimmediately preceding the stated maturity date subject to the Company’s rightto terminate the conversion rights of the notes. The Company may satisfy itsobligation with respect to the 7.5% Notes tendered for conversion by deliveringto the holder either cash, common shares, no par value, issued by the Companyor a combination thereof. The initial conversion rate for each $1,000 principalamount of 7.5% Notes is 122.2046 shares, which is equivalent to an initialconversion price of approximately $8.18 per share. The conversion rate isadjusted under certain circumstances, including the occurrence of certainfundamental change transactions and the payment of a quarterly cashdistribution in excess of $0.05 per share, but will not be adjusted for accruedand unpaid interest on the 7.5% Notes. As of September 30, 2010, theconversation rate for each $1,000 principal amount of 7.5% Notes was 124.3675shares. Net proceeds from the offering totaled $167.3 million, reflecting$172.5 million from the issuance less $5.2 million for underwritingfees.

 

Inaccordance with accounting for convertible debt instruments that may settled incash upon conversion, the Company separately accounted for the liability andequity components to reflect the nonconvertible debt borrowing rate. TheCompany determined that the equity component of the 7.5% Notes totaled $10.0million and is included in paid-in-capital on the Company’s condensedconsolidated balance sheet as of September 30, 2010. The remainingliability component of $163.3 million, included within convertible senior noteson the Company’s condensed consolidated balance sheet as of September 30,2010, is comprised of the principal $172.5 million less the unamortized debtdiscount of $9.2 million. The total debt discount amortization recognized forthe three and nine months ended September 30, 2010 was $0.3 million and$0.8 million, respectively. The debt discount will continue to be amortized atthe effective interest rate of 8.6%. For the three and nine months endedSeptember 30, 2010, the total interest expense recognized on the 7.5%Notes was $3.2 million and $9.2 million, respectively.

 

**Note 9. 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 portfolio management activities. The counterparties to the Company’sderivative agreements are major financial institutions with which the Companyand its affiliates may also have other financial relationships. In the event ofnonperformance by the counterparties, the Company is potentially exposed tolosses. The counterparties to the Company’s derivative agreements haveinvestment grade ratings and, as a result, the Company does not anticipate thatany of the counterparties will fail to fulfill their obligations.

 

**Cash Flow 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 as well as certain of its floating rate juniorsubordinated notes. The Company designates these financial instruments as cashflow hedges.

 

DuringJune 2010, the Company entered into a $100.0 million notional pay-fixed,receive-variable interest rate swap. The swap has been designated as a cashflow hedge, the objective of which is to eliminate the variability of cashflows in the interest payments of the Company’s floating rate juniorsubordinated notes debt due to fluctuations in the indexed rate. Changes invalue of the interest rate swap are recorded through other comprehensiveincome, with gains or losses representing hedge ineffectiveness, if any,recognized in earnings during the reporting period. The hedged transactionperiod is through October 2036, which is the stated maturity of thefloating rate debt.

 

**Free-Standing Derivatives**

 

Free-standing derivatives are derivatives that the Company has enteredinto in conjunction with its investment and risk management activities, but forwhich the Company has not designated the derivative contract as a hedginginstrument for accounting purposes. Such derivative contracts may includecredit default swaps (“CDS”), foreign exchange contracts, and interest ratederivatives. Free-standing derivatives also include investment financingarrangements (total rate of return swaps) whereby the 

 

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Companyreceives the sum of all interest, fees and any positive change in fair valueamounts from a reference asset with a specified notional amount and paysinterest on such notional amount plus any negative change in fair value amountsfrom such reference asset.

 

The table below summarizes the aggregate notional amount and estimatednet fair value of the derivative instruments as of September 30, 2010 andDecember 31, 2009 (amounts in thousands):

 
| ** **                                | ** ** | **As of September 30, 2010** | ** ** | **As of December 31, 2009** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                | ** ** | **Notional**                                     | ** ** | **Estimated  Fair Value**                  | ** ** | **Notional** | ** ** | **Estimated  Fair Value** | ** ** |
| **Cash Flow Hedges:**                     |       |                                             |       |                                            |       |   |   |   |   |
| Interest rate swaps                       |       | $                                                | 483,333    |                                            | $          | (88,808 | ) | $ | 383,333 |   | $ | (43,800 | ) |
| **Free-Standing Derivatives:**            |       |                                             |       |                                            |       |   |   |   |   |
| Interest rate swaps                       |       | 307,112                                          |       | 1,272                                           |       | 89,246 |   | (281 | ) |
| Credit default swaps—protection sold |       | 13,500                                           |       | 362                                             |       | 51,000 |   | (385 | ) |
| Total rate of return swaps                |       | —                                           |       | 135                                             |       | 104,446 |   | 11,809 |   |
| Foreign exchange forward contracts(1)     |       | (145,282                                         | )          | (19,889                                         | )          | — |   | — |   |
| Foreign exchange options(1)               |       | 136,340                                          |       | 15,309                                          |       | — |   | — |   |
| Common stock warrants                     |       | —                                           |       | 2,926                                           |       | — |   | 2,471 |   |
| Total                                     |       | $                                                | 795,003    |                                            | $          | (88,693 | ) | $ | 628,025 |   | $ | (30,186 | ) |

 

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(1)                               Representsforward contracts and options intended to offset the gains or losses resultingfrom the settlement of the underlying foreign currency denominated asset.Amounts presented were converted to U.S. dollars based on the exchange rates atthe end of each fiscal quarter.

 

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

 

Asof September 30, 2010 and December 31, 2009, the Company had soldprotection with a notional amount of approximately $13.5 million and $51.0million, respectively. The Company sells protection to replicate fixed incomesecurities and to complement the spot market when cash securities of thereferenced entity of a particular maturity are not available or when thederivative alternative is less expensive compared to other purchasingalternatives.

 

The following table shows the net realized gains on the Company’s CDSfor the three and nine months ended September 30, 2010 and 2009 (amountsin thousands):

 
| ** **            | ** ** | **For the three months  ended  September 30, 2010** | ** ** | **For the three months  ended  September 30, 2009** | ** ** | **For the nine months  ended  September 30, 2010** | ** ** | **For the nine months  ended  September 30, 2009** | ** ** |
|-----------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| Gross realized gains  |       | $                                                                            | —     |                                                                         | $          | —                                                                      |       | $                                                                           | —     |   | $ | 58,967 |   |
| Gross realized losses |       | —                                                                       |       | —                                                                       |       | —                                                                      |       | (996                                                                        | )          |
| Net realized gains    |       | $                                                                            | —     |                                                                         | $          | —                                                                      |       | $                                                                           | —     |   | $ | 57,971 |   |

 

For all hedges where hedge accounting is being applied, effectivenesstesting and other procedures to ensure the ongoing validity of the hedges areperformed at least quarterly. During the three and nine months endedSeptember 30, 2010 and 2009, the Company recognized an immaterial amountof ineffectiveness in income on the condensed consolidated statements ofoperations from its cash flow and fair value hedges.

 

Note 8 to these condensed consolidated financial statementsdescribes the Company’s borrowings under which the Company has pledged warrantsfor borrowings. The following table summarizes the estimated fair value ofwarrants pledged as collateral as of September 30, 2010 andDecember 31, 2009 (amounts in thousands):

 
| ** **                                                                                                     | ** ** | **As of  September 30,  2010** | ** ** | **As of  December 31, 2009** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Pledged as collateral for borrowings under senior  secured credit facility                                     |       | $                                        | —     |                                        | $          | 1,078 |   |
| Pledged as collateral for collateralized loan  obligation secured notes and junior secured notes to affiliates |       | —                                   |       | 1,393                                       |       |
| Total                                                                                                          |       | $                                        | —     |                                        | $          | 2,471 |   |

 

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** **

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

 

The components of accumulated other comprehensive income were asfollows (amounts in thousands):

 
| ** **                                             | ** ** | **As of  September 30, 2010** | ** ** | **As of  December 31, 2009** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| Net unrealized gains on available-for-sale  securities |       | $                                            | 171,514    |                                        | $          | 194,336 |   |
| Net unrealized losses on cash flow hedges              |       | (86,040                                      | )          | (41,608                                     | )          |
| Accumulated other comprehensive income                 |       | $                                            | 85,474     |                                        | $          | 152,728 |   |

 

The components of changes in other comprehensive income (loss) were asfollows (amounts in thousands):

 
| ** **                                                                 | ** ** | **Three months  ended  September 30, 2010** | ** ** | **Three months  ended  September 30, 2009** | ** ** | **Nine months  ended  September 30, 2010** | ** ** | **Nine months  ended  September 30, 2009** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Unrealized gains on securities available-for-sale:                         |       |                                                       |       |                                                       |       |                                                      |       |                                                      |       |
| Unrealized holding gains arising during period                             |       | $                                                          | 51,787     |                                                       | $          | 146,406                                                   |       | $                                                         | 41,676     |   | $ | 336,599 |   |
| Reclassification adjustments for (gains) losses  realized in net income(1) |       | (18,120                                                    | )          | 1,972                                                      |       | (64,498                                                   | )          | (625                                                      | )          |
| Unrealized gains (losses) on securities  available-for-sale                |       | 33,667                                                     |       | 148,378                                                    |       | (22,822                                                   | )          | 335,974                                                   |       |
| Unrealized (losses) gains on cash flow hedges                              |       | (17,609                                                    | )          | (7,422                                                     | )          | (44,432                                                   | )          | 24,569                                                    |       |
| Other comprehensive income (loss)                                          |       | $                                                          | 16,058     |                                                       | $          | 140,956                                                   |       | $                                                         | (67,254    | ) | $ | 360,543 |   |

 

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(1)                               Excludes animpairment charge of $0.5 million and $1.7 million for investmentswhich were determined to be other-than-temporary for the three and nine monthsended September 30, 2010, respectively, and nil and $40.0 million for thethree and nine months ended September 30, 2009, respectively.

 

**Note 11. Commitments and Contingencies**

 

***Loan Commitments***

 

As part of its strategy of investing in corporate loans, the Companycommits to purchase interests in primary market loan syndications, whichobligate the Company to acquire a predetermined interest in such loans at aspecified price on a to-be-determined settlement date. Consistent with standardindustry practices, once the Company has been informed of the amount of itssyndication allocation in a particular loan by the syndication agent, theCompany bears the risks and benefits of changes in the fair value of thesyndicated loan from that date forward. As of September 30, 2010 andDecember 31, 2009, the Company had committed to purchase corporate loanswith aggregate commitments totaling $108.2 million par and $156.5 millionpar, respectively. In addition, the Company participates in certain contingentfinancing arrangements, whereby the Company is committed to provide funding ofup to a specific amount at the discretion of the borrower. As ofSeptember 30, 2010 and December 31, 2009, the Company had unfundedfinancing commitments totaling $31.9 million and $40.5 million,respectively. The Company does not expect material losses related to thosecorporate loans for which it committed to purchase and fund.

 

***Contingencies***

 

The Company has been named as a party in various legal actions whichinclude the matters described below. It is inherently difficult to predict theultimate outcome, particularly in cases in which claimants seek substantial orunspecified damages, or where investigations or proceedings are at an earlystage and the Company cannot predict with certainty the loss or range of lossthat may be incurred. The Company has denied, or believes it has a meritoriousdefense and will deny liability in the significant cases pending against theCompany discussed below. Based on current discussion and consultation withcounsel, management believes that the resolution of these matters will not havea material impact on the Company’s condensed consolidated financial statements.

 

On July 10, 2009, the Company surrendered for cancellation,without consideration, approximately $64.0 million of mezzanine notesissued to the Company by CLO 2005-2 (the “2005-2 Notes”) and approximately$222.4 million of mezzanine and junior notes issued to the Company by CLO2006-1 (the “2006-1 Notes”), as well as certain other notes issued to theCompany by another CLO. The surrendered notes were cancelled by the trusteeunder the applicable indenture, and the obligations due under such surrenderednotes were deemed extinguished.

 

Holders constituting a majority of the controlling class of seniornotes of CLO 2005-2 (the “2005-2 Noteholders”) notified the related trustee ofpurported defaults under the indentures related to the surrender of the 2005-2Notes. The Company announced on November 29, 2009 that it reached anagreement on November 23, 2009 with the 2005-2 Noteholders pursuant towhich the 2005-2 

 

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Noteholdershave agreed, subject to the terms and conditions of the agreement, not tochallenge the July 2009 surrender for cancellation transaction. Inexchange, the Company has agreed to certain arrangements, including, amongother things, to refrain from undertaking a comparable surrender forcancellation, of any other mezzanine notes or junior notes issued to it by CLO2005-2. In addition, the Company has agreed with the 2005-2 Noteholders that,for so long as no legal action or similar challenge is brought to the Company’sprior surrender of notes in any of its CLO transactions, the Company will notundertake a comparable surrender for cancellation, without consideration, ofany mezzanine notes or junior notes issued to it by CLO 2005-1, CLO 2006-1, CLO2007-1 or CLO 2007-A.

 

In addition, during the first quarter of 2010, certain holders of thesenior notes of CLO 2006-1 (the “2006-1 Noteholders”) notified the relatedtrustee of purported defaults under the indenture related to the surrender ofthe 2006-1 Notes. The Company does not believe based on discussions withcounsel that an event of default has occurred and is engaged in discussionswith the 2006-1 Noteholders to resolve this matter. Accordingly, the Companydoes not believe that this matter will have a material effect on its financialcondition.

 

Theparent company of the Manager has furnished information to the SEC in responseto a request from the SEC for information in connection with its examination ofcertain investment advisors in order to review trading procedures and valuationpractices in the collateral pools of CLOs for which it acts as collateralmanager. The parent company of the Manager also provided information regardingthe surrender by the Company for cancellation, without consideration, of certainnotes that had been issued to the Company by collateral pools of CLOs. Theparent company of the Manager is fully cooperating with the SEC’s examination.

 

On August 7, 2008, the members of the Company’s board of directorsand certain of its former executive officers and the Company were named in aputative class action complaint filed by Charter Township of Clinton Police andFire Retirement System in the United States District Court for the SouthernDistrict of New York, or the Charter Litigation. On March 13, 2009, thelead plaintiff filed an amended complaint, which deleted as defendants themembers of the Company’s board of directors and named as defendants only theCompany’s former chief executive officer Saturnino S. Fanlo, the Company’sformer chief operating officer David A. Netjes, the Company’s former chieffinancial officer Jeffrey B. Van Horn and the Company. The amended complaintalleges that the Company’s April 2, 2007 registration statement andprospectus and the financial statements incorporated therein contained materialomissions in violation of Section 11 of the Securities Act, regarding therisks and potential losses associated with the Company’s real estate-relatedassets, the Company’s ability to finance its real estate-related assets and theadequacy of the Company’s loss reserves for its real estate-related assets. Theamended complaint further alleges that, pursuant to Section 15 of theSecurities Act, Messrs. Fanlo, Netjes and Van Horn each have legalresponsibility for the alleged Section 11 violation. On April 27,2009, the defendants filed a motion to dismiss the amended complaint forfailure to state a claim under the Securities Act. Oral argument on thedefendants’ motion to dismiss took place on October 5, 2010, and theparties are awaiting a decision from the Court.

 

On August 15, 2008, the members of the Company’s board ofdirectors and its executive officers (collectively, the “Kostecka IndividualDefendants”) were named in a shareholder derivative action brought by Raymond W.Kostecka, a purported shareholder, in the Superior Court of California, Countyof San Francisco (the “California Derivative Action”). The Company was named asa nominal defendant. The complaint in the California Derivative Action assertsclaims against the Kostecka Individual Defendants for breaches of fiduciaryduty, abuse of control, gross mismanagement, waste of corporate assets, andunjust enrichment in connection with the conduct at issue in the CharterLitigation, including the filing of the Company’s April 2, 2007registration statement with alleged material misstatements and omissions. Byorder dated January 8, 2009, the Court approved the parties’ stipulationto stay the proceedings in the California Derivative Action until the CharterLitigation is dismissed on the pleadings or the Company files an answer to theCharter Litigation.

 

On March 23, 2009, the members of theCompany’s board of directors and certain of its executive officers(collectively, the “Haley Individual Defendants”) were named in a shareholderderivative action brought by Paul B. Haley, a purported shareholder, in theUnited States District Court for the Southern District of New York (the “NewYork Derivative Action”). The Company was named as a nominal defendant. Thecomplaint in the New York Derivative Action asserts claims against the HaleyIndividual Defendants for breaches of fiduciary duty, breaches of the duty offull disclosure, and for contribution in connection with the conduct at issuein the Charter Litigation, including the filing of the Company’s April 2,2007 registration statement with alleged material misstatements and omissions.By order dated June 18, 2009, the Court approved the parties’ stipulationto stay the proceedings in the New York Derivative Action until the CharterLitigation is dismissed on the pleadings or the Company files an answer to theCharter Litigation.

 

**Note 12. Share Options and Restricted Shares**

 

On May 4, 2007, the Company adopted an amended and restated shareincentive plan (the “2007 Share Incentive Plan”) that provides for the grant ofqualified incentive common share options that meet the requirements ofSection 422 of the Code, non-qualified common share options, shareappreciation rights, restricted common shares and other share-based awards. TheCompensation Committee of the board of directors administers the plan. Shareoptions and other share-based awards may be granted to the Manager, directors,officers and any key employees of the Manager and to any other individual orentity performing services for the Company.

 

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The exercise price for any share option granted under the 2007 ShareIncentive Plan may not be less than 100% of the fair market value of the commonshares at the time the common share option is granted. Each option to acquire acommon share must terminate no more than ten years from the date it is granted.As of September 30, 2010, the 2007 Share Incentive Plan authorizes a totalof 8,464,625 shares that may be used to satisfy awards under the 2007 ShareIncentive Plan.

 

The following table summarizes restricted common share transactions:

 
| ** **                                         | ** ** | **Manager** | ** ** | **Directors** | ** ** | **Total** | ** ** |
|----------------------------------------------------|------------|-------------|------------|---------------|------------|-----------|------------|
| **Unvested shares as of  January 1, 2010**    |       | 1,097,000   |       | 255,618       |       | 1,352,618 |       |
| Issued                                             |       | —      |       | 52,808        |       | 52,808    |       |
| Vested                                             |       | —      |       | (95,822       | )          | (95,822   | )          |
| Cancelled                                          |       | —      |       | —        |       | —    |       |
| Forfeited                                          |       | —      |       | —        |       | —    |       |
| **Unvested shares as of  September 30, 2010** |       | 1,097,000   |       | 212,604       |       | 1,309,604 |       |

 

The Company is required to value any unvested restricted common sharesgranted to the Manager at the current market price. The Company valued theunvested restricted common shares granted to the Manager at $8.78 and $4.62 pershare at September 30, 2010 and September 30, 2009, respectively.There were $2.2 million and $3.1 million of total unrecognizedcompensation costs related to unvested restricted common shares granted as ofSeptember 30, 2010 and 2009, respectively. These costs are expected to berecognized over three years from the date of grant.

 

The following table summarizes common share option transactions:

 
| ** **                                     | ** ** | **Number of  Options** | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
|------------------------------------------------|------------|-----------------------------|------------|---------------------------------------------|------------|
| **Outstanding as of  January 1, 2010**    |       | 1,932,279                   |       | $                                           | 20.00      |   |
| Granted                                        |       | —                      |       | —                                      |       |
| Exercised                                      |       | —                      |       | —                                      |       |
| Forfeited                                      |       | —                      |       | —                                      |       |
| **Outstanding as of  September 30, 2010** |       | 1,932,279                   |       | $                                           | 20.00      |   |

 

As of September 30, 2010 and December 31, 2009, 1,932,279common share options were exercisable. As of September 30, 2010, thecommon share options were fully vested and expire in August 2014. For thethree and nine months ended September 30, 2010 and 2009, the components ofshare-based compensation expense are as follows (amounts in thousands):

 
| ** **                                     | ** ** | **For the three  months ended  September 30, 2010** | ** ** | **For the three  months ended  September 30, 2009** | ** ** | **For the nine  months ended  September 30, 2010** | ** ** | **For the nine  months ended  September 30, 2009** | ** ** |
|------------------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| Restricted shares granted to Manager           |       | $                                                                            | 1,943      |                                                                         | $          | 2,260                                                                       |       | $                                                                           | 4,437      |   | $ | 2,225 |   |
| Restricted shares granted to certain directors |       | 189                                                                          |       | 104                                                                          |       | 901                                                                         |       | 380                                                                         |       |
| Total share-based compensation expense         |       | $                                                                            | 2,132      |                                                                         | $          | 2,364                                                                       |       | $                                                                           | 5,338      |   | $ | 2,605 |   |

 

**Note 13. Management Agreement and Related PartyTransactions**

 

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

 

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

 

For the three and nine months ended September 30, 2010, theCompany incurred $4.9 million and $13.7 million, respectively, in basemanagement fees. In addition, the Company recognized share-based compensationexpense related to restricted common shares granted to the Manager of $1.9million and $4.4 million, respectively, for the three and nine months endedSeptember 30, 2010 (see Note 12 to these condensed consolidated financialstatements). For the three and nine months ended September 30, 2009, theCompany incurred $3.7 million and $11.0 million, respectively, in basemanagement fees. In addition, the Company recognized share-based compensationexpense related to restricted common shares granted to the Manager of $2.3 millionand $2.2 million, respectively, for the three and nine months endedSeptember 30, 2009 (see Note 12 to these condensed consolidated financialstatements).

 

Base management fees incurred and share-based compensation expenserelating to common share options and restricted common shares granted to theManager are included in related party management compensation on the condensedconsolidated statements of operations. Expenses incurred by the Manager andreimbursed by the Company are reflected in the respective condensedconsolidated statements of operations, non-investment expense category based onthe nature of the expense.

 

The Manager is waiving base management fees related to the$230.4 million common share offering and $270.0 million common sharerights offering that occurred during the third quarter of 2007 until such timeas the Company’s common share closing price on the NYSE is $20.00 or more forfive consecutive trading days. Accordingly, the Manager permanently waivedapproximately $2.2 million of base management fees during each of the threemonths ended September 30, 2010 and 2009 and $6.6 million during each ofthe nine months ended September 30, 2010 and 2009.

 

Duringthe three and nine months ended September 30, 2010, the Manager earned$9.4 million and $30.3 million, respectively, of incentive fees. The $30.3million of incentive fees earned for the nine months ended September 30,2010 is net of a $9.7 million amount waived. During the three months endedMarch 31, 2010, the Manager permanently waived payment of $9.7 million ofincentive fees that were related to the $38.7 million gain recorded by theCompany as a result of the repurchase of $83.0 million of mezzanine andsubordinate notes issued by CLO 2007-1 and CLO 2007-A. Incentive fees are includedin related party management compensation on the Company’s condensedconsolidated statement of operations. For both the three and nine months ended September 30,2009, the Manager earned $4.5 million of incentive fees.

 

An affiliate of the Manager has entered into separate managementagreements with the respective investment vehicles for CLO 2005-1,CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and CLO2009-1 and is entitled to receive fees for the services performed as collateralmanager.  Previously, the collateralmanager had waived the fees it earned for providing management services for theCompany’s CLOs. Beginning April 15, 2007, the collateral manager ceasedwaiving fees for CLO 2005-1 and beginning January 1, 2009, thecollateral manager ceased waiving fees for CLO 2005-2, CLO 2006-1,CLO 2007-1, CLO 2007-A and Wayzata Funding LLC (restructured andreplaced with CLO 2009-1 on March 31, 2009). Beginning in July 2009,the collateral manager reinstated waiving the CLO management fees for CLO 2005-2and CLO 2006-1. In addition, due to CLO 2007-A and CLO 2007-1 regainingcompliance with their respective OC Tests during the first quarter of 2010, thecollateral manager also reinstated waiving the CLO management fees for CLO2007-A and CLO 2007-1. For the three and nine months ended September 30,2010, the collateral manager waived an aggregate of $8.7 million and $21.9million, respectively, for CLO 2005-2, CLO 2006-1, CLO 2007-1 and CLO 2007-A.For each of the three and nine months ended September 30, 2009, thecollateral manager waived $2.6 million for CLO 2005-2 and CLO 2006-1. Inaddition, due to the deleveraging of CLO 2009-1 completed in July 2009whereby all the senior notes were retired, the collateral manager is no longerentitled to receive management fees from CLO 2009-1. The Company recorded anexpense for CLO management fees of $1.3 million and $4.1 million forthe three and nine months ended September 30, 2010, respectively. TheCompany recorded an expense for CLO management fees of $4.2 million and $18.4million for the three and nine months ended September 30, 2009,respectively.

 

In addition, beginning January 1, 2009, the Manager permanentlywaived reimbursable general and administrative expenses allocable to theCompany in an amount equal to the incremental CLO management fees received bythe Manager. Effective June 2010, all incremental CLO management feesreceived by the Manager in 2009 had been fully applied to offset reimbursablegeneral and administrative expenses allocable to the Company. Accordingly,reimbursable general and administrative expenses were charged and paid by theCompany beginning in June 2010.  Forthe three and nine months ended September 30, 2010, the Managerpermanently waived reimbursement of nil and $2.4 million in allocable generaland administrative expenses, respectively. For the three and nine months endedSeptember 30, 2009, the Manager permanently waived reimbursement of $2.4million and $7.7 million, respectively, in allocable general and administrativeexpenses.

 

The Company has invested in corporate loans, debt securities and otherinvestments of entities that are affiliates of KKR. As of September 30,2010, the aggregate par amount of these affiliated investments totaled$2.3 billion, or approximately 29% of the total investment portfolio, andconsisted of 24 issuers. The total $2.3 billion in affiliated investmentswere comprised of $2.0 billion of corporate loans, $339.0 million ofcorporate debt securities available-for-sale and $11.8 million of equityinvestments, at estimated fair value. As of December 31, 2009, theaggregate par amount of these affiliated investments totaled $2.8 billion,or approximately 35% of the total investment portfolio, and consisted of 21issuers. The total $2.8 billion in investments were comprised of$2.3 billion of corporate loans, $466.0 million of corporate debtsecurities available for sale, and $61.8 million notional amount of totalrate of return swaps referenced to corporate loans issued by affiliates of KKR(included in derivative assets and liabilities on the condensed consolidatedbalance sheet).

 

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**Note 14. Fair Value of Financial Instruments**

 

**Fair Value of Financial Instruments**

 

The fair value of certain instruments including securitiesavailable-for-sale, corporate loans, derivatives and loan commitments is basedon quoted market prices or estimates provided by independent pricing sources.The fair value of cash and cash equivalents, interest receivable and interestpayable, approximates cost as of September 30, 2010 and December 31,2009, due to the short-term nature of these instruments.

 

The table below discloses the carrying value and the estimated fairvalue of the Company’s financial instruments as of September 30, 2010 andDecember 31, 2009 (amounts in thousands):

 
| ** **                                                                                                                                          | ** ** | **As of September 30, 2010** | ** ** | **As of December 31, 2009** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                                                          | ** ** | **Carrying  Amount**                             | ** ** | **Estimated Fair  Value**                  | ** ** | **Carrying  Amount** | ** ** | **Estimated Fair  Value** | ** ** |
| Financial Assets:                                                                                                                                   |       |                                             |       |                                            |       |   |   |   |   |
| Cash, restricted cash, and cash equivalents                                                                                                         |       | $                                                | 462,211    |                                            | $          | 462,211 |   | $ | 439,792 |   | $ | 439,792 |   |
| Securities available-for-sale                                                                                                                       |       | 849,022                                          |       | 849,022                                         |       | 755,686 |   | 755,686 |   |
| Corporate loans, net of allowance for loan losses  of $209,030 and $237,308 as of September 30, 2010 and December 31,  2009, respectively |       | 5,815,544                                        |       | 5,806,905                                       |       | 5,617,925 |   | 5,459,273 |   |
| Corporate loans held for sale                                                                                                                       |       | 667,196                                          |       | 679,447                                         |       | 925,718 |   | 954,350 |   |
| Residential mortgage-backed securities                                                                                                              |       | 106,252                                          |       | 106,252                                         |       | 47,572 |   | 47,572 |   |
| Residential mortgage loans                                                                                                                          |       | —                                           |       | —                                          |       | 2,097,699 |   | 2,097,699 |   |
| Equity investments, at estimated fair value                                                                                                         |       | 84,307                                           |       | 84,307                                          |       | 120,269 |   | 120,269 |   |
| Interest and principal receivable                                                                                                                   |       | 83,195                                           |       | 83,195                                          |       | 98,313 |   | 98,313 |   |
| Derivative assets                                                                                                                                   |       | 20,004                                           |       | 20,004                                          |       | 15,784 |   | 15,784 |   |
| Reverse repurchase agreements                                                                                                                       |       | —                                           |       | —                                          |       | 80,250 |   | 80,250 |   |
| Private equity investments, at cost                                                                                                                 |       | 6,771                                            |       | 6,741                                           |       | 17,505 |   | 24,658 |   |
|                                                                                                                                                |       |                                             |       |                                            |       |   |   |   |   |
| Financial Liabilities:                                                                                                                              |       |                                             |       |                                            |       |   |   |   |   |
| Collateralized loan obligation secured notes                                                                                                        |       | $                                                | 5,630,141  |                                            | $          | 5,099,556 |   | $ | 5,667,716 |   | $ | 4,775,364 |   |
| Collateralized loan obligation junior secured  notes to affiliates                                                                                  |       | 371,062                                          |       | 251,136                                         |       | 533,786 |   | 221,755 |   |
| Senior secured credit facility                                                                                                                      |       | —                                           |       | —                                          |       | 175,000 |   | 175,000 |   |
| Convertible senior notes                                                                                                                            |       | 343,863                                          |       | 411,631                                         |       | 275,800 |   | 259,252 |   |
| Junior subordinated notes                                                                                                                           |       | 283,517                                          |       | 263,139                                         |       | 283,517 |   | 238,154 |   |
| Residential mortgage-backed securities issued                                                                                                       |       | —                                           |       | —                                          |       | 2,034,772 |   | 2,034,772 |   |
| Accounts payable, accrued expenses and other  liabilities                                                                                           |       | 27,312                                           |       | 27,312                                          |       | 7,240 |   | 7,240 |   |
| Accrued interest payable                                                                                                                            |       | 17,538                                           |       | 17,538                                          |       | 25,297 |   | 25,297 |   |
| Accrued interest payable to affiliates                                                                                                              |       | 3,846                                            |       | 3,846                                           |       | 2,911 |   | 2,911 |   |
| Related party payable                                                                                                                               |       | 12,431                                           |       | 12,431                                          |       | 3,367 |   | 3,367 |   |
| Securities sold, not yet purchased                                                                                                                  |       | —                                           |       | —                                          |       | 77,971 |   | 77,971 |   |
| Derivative liabilities                                                                                                                              |       | 108,697                                          |       | 108,697                                         |       | 45,970 |   | 45,970 |   |

 

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**Fair Value Measurements**

 

The following table presents information about the Company’s assets andliabilities measured at fair value on a recurring basis as ofSeptember 30, 2010, 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  September 30, 2010** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                    | ** ** | ** **                                                                                          | ** ** | ** **                                                         | ** ** | ** **                                            | ** ** | ** **                                                | ** ** |
| **Assets:**                                   | ** ** | ** **                                                                                          | ** ** | ** **                                                         | ** ** | ** **                                            | ** ** | ** **                                                | ** ** |
| Securities available-for-sale                 |       | $                                                                                                   | —     |                                                               | $          | 736,188                                               |       | $                                                         | 112,834    |   | $ | 849,022 |   |
| Residential mortgage-backed securities        |       | —                                                                                              |       | —                                                             |       | 106,252                                               |       | 106,252                                                   |       |
| Equity investments, at estimated fair value   |       | —                                                                                              |       | 15,375                                                             |       | 68,932                                                |       | 84,307                                                    |       |
| Free-standing derivatives interest rate swaps |       | —                                                                                              |       | —                                                             |       | 1,272                                                 |       | 1,272                                                     |       |
| Credit default swaps — protection sold   |       | —                                                                                              |       | 362                                                                |       | —                                                |       | 362                                                       |       |
| Total rate of return swaps                    |       | —                                                                                              |       | —                                                             |       | 135                                                   |       | 135                                                       |       |
| Foreign exchange options                      |       | —                                                                                              |       | —                                                             |       | 15,309                                                |       | 15,309                                                    |       |
| Common stock warrants                         |       | —                                                                                              |       | —                                                             |       | 2,926                                                 |       | 2,926                                                     |       |
| Total                                         |       | $                                                                                                   | —     |                                                               | $          | 751,925                                               |       | $                                                         | 307,660    |   | $ | 1,059,585 |   |
| ** **                                    | ** ** | ** **                                                                                          | ** ** | ** **                                                         | ** ** | ** **                                            | ** ** | ** **                                                | ** ** |
| **Liabilities:**                              | ** ** | ** **                                                                                          | ** ** | ** **                                                         | ** ** | ** **                                            | ** ** | ** **                                                | ** ** |
| Cash flow interest rate swaps                 |       | $                                                                                                   | —     |                                                               | $          | (88,808                                               | )          | $                                                         | —     |   | $ | (88,808 | ) |
| Foreign exchange forward contracts            |       | —                                                                                              |       | (19,889                                                            | )          | —                                                |       | (19,889                                                   | )          |
|                                          |       | $                                                                                                   | —     |                                                               | $          | (108,697                                              | )          | $                                                         | —     |   | $ | (108,697 | ) |

 

There were no transfers between levels 1 and 2 during the nine monthsended September 30, 2010.

 

The following table presents information about the Company’s assetsmeasured at fair value on a non-recurring basis as of September 30, 2010,and indicates the fair value hierarchy of the valuation techniques utilized bythe Company to determine such fair value (amounts in thousands). There were noliabilities measured at fair value on a non-recurring basis:

 
| ** **                    | ** ** | **Quoted Prices in  Active Markets  for Identical Assets  (Level 1)** | ** ** | **Significant Other  Observable Inputs  (Level 2)** | ** ** | **Significant  Unobservable Inputs  (Level 3)** | ** ** | **Balance as of  September 30, 2010** | ** ** |
|-------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Loans held for sale(1)        |       | $                                                                                                   | —     |                                                               | $          | 376,110                                                   |       | $                                                         | 49,559     |   | $ | 425,669 |   |
| Private equity investments(2) |       | —                                                                                              |       | —                                                             |       | 3,771                                                     |       | 3,771                                                     |       |
|                               |            |                                                                                                     |            |                                                                    |            |                                                           |            |                                                           |            |  |  |  |  |

 

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(1)         As of September 30,2010, total loans held for sale had a carrying value of $667.2 million of which$425.7 million was carried at estimated fair value and the remaining$241.5 million carried at amortized cost. Of the $425.7 millioncarried at estimated fair value, $376.1 million was classified as level 2given that the assets were valued using quoted prices and other observableinputs in an active market. The remaining $49.6 million was classified as level3 given that the Company applied unobservable inputs based on the bestavailable information to determine the estimated fair value.

 

(2)         Represents private equityinvestments accounted for under the cost method that were classified as level 3when the assets were impaired and measured at estimated fair value usingunobservable inputs.

 

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The following table presents information about the Company’s assets andliabilities measured at fair value on a recurring basis as of December 31,2009, and indicates the fair value hierarchy of the valuation techniquesutilized by the Company to determine such fair value (amounts in thousands):

 
| ** **                                    | ** ** | **Quoted Prices in  Active Markets  for Identical Assets  (Level 1)** | ** ** | **Significant Other  Observable Inputs  (Level 2)** | ** ** | **Significant  Unobservable Inputs  (Level 3)** | ** ** | **Balance as of  December 31, 2009** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| **Assets:**                                   | ** ** | ** **                                                                                          | ** ** | ** **                                                         | ** ** | ** **                                                | ** ** | ** **                                               | ** ** |
| Securities available-for-sale                 |       | $                                                                                                   | 1,277      |                                                               | $          | 673,121                                                   |       | $                                                        | 81,288     |   | $ | 755,686 |   |
| Residential mortgage-backed securities        |       | —                                                                                              |       | —                                                             |       | 47,572                                                    |       | 47,572                                                   |       |
| Residential mortgage loans                    |       | —                                                                                              |       | —                                                             |       | 2,097,699                                                 |       | 2,097,699                                                |       |
| Equity investments, at estimated fair value   |       | 26,483                                                                                              |       | 75,497                                                             |       | 18,289                                                    |       | 120,269                                                  |       |
| Total rate of return swaps                    |       | —                                                                                              |       | —                                                             |       | 11,809                                                    |       | 11,809                                                   |       |
| Common stock warrants                         |       | —                                                                                              |       | —                                                             |       | 2,471                                                     |       | 2,471                                                    |       |
| Total                                         |       | $                                                                                                   | 27,760     |                                                               | $          | 748,618                                                   |       | $                                                        | 2,259,128  |   | $ | 3,035,506 |   |
| **Liabilities:**                              |       |                                                                                                |       |                                                               |       |                                                      |       |                                                     |       |
| Cash flow interest rate swaps                 |       | $                                                                                                   | —     |                                                               | $          | (43,800                                                   | )          | $                                                        | —     |   | $ | (43,800 | ) |
| Free-standing derivatives interest rate swaps |       | —                                                                                              |       | —                                                             |       | (281                                                      | )          | (281                                                     | )          |
| Credit default swaps — protection sold   |       | —                                                                                              |       | (385                                                               | )          | —                                                    |       | (385                                                     | )          |
| Residential mortgage-backed securities issued |       | —                                                                                              |       | —                                                             |       | (2,034,772                                                | )          | (2,034,772                                               | )          |
| Securities sold, not yet purchased            |       | —                                                                                              |       | (77,971                                                            | )          | —                                                    |       | (77,971                                                  | )          |
| Total                                         |       | $                                                                                                   | —     |                                                               | $          | (122,156                                                  | )          | $                                                        | (2,035,053 | ) | $ | (2,157,209 | ) |

 

Thefollowing table presents information about the Company’s assets measured atfair value on a non-recurring basis as of December 31, 2009, and indicatesthe fair value hierarchy of the valuation techniques utilized by the Company todetermine such fair value (amounts in thousands). There were no liabilitiesmeasured at fair value on a non-recurring basis. There were no liabilitiesmeasured at fair value on a non-recurring basis:

 
| ** **             | ** ** | **Quoted Prices in  Active Markets  for Identical Assets  (Level 1)** | ** ** | **Significant Other  Observable Inputs  (Level 2)** | ** ** | **Significant  Unobservable Inputs  (Level 3)** | ** ** | **Balance as of  December 31, 2009** | ** ** |
|------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| Loans held for sale(1) |       | $                                                                                                   | —     |                                                               | $          | 533,308                                                   |       | $                                                        | —     |   | $ | 533,308 |   |
| REO                    |       | —                                                                                              |       | —                                                             |       | 11,439                                                    |       | 11,439                                                   |       |
| Total                  |       | $                                                                                                   | —     |                                                               | $          | 533,308                                                   |       | $                                                        | 11,439     |   | $ | 544,747 |   |

 

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(1)                                 As ofDecember 31, 2009, total loans held for sale had a carrying value of$925.7 million of which $533.3 million was carried at estimated fairvalue and the remaining $392.4 million carried at amortized cost. The$533.3 million carried at estimated fair value was classified aslevel 2 given that the assets were valued using quoted prices and otherobservable inputs in an active market.

 

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The following table presents additional information about assets,including derivatives that are measured at fair value on a recurring basis forwhich the Company has utilized level 3 inputs to determine fair value, forthe three months ended September 30, 2010 (amounts in thousands):

 
| ** **                                                                                                                                                                                 | ** ** | **Securities  Available-  For-Sale** | ** ** | **Residential  Mortgage-  Backed  Securities** | ** ** | **Equity  Investments,  at Estimated  Fair Value** | ** ** | **Total Rate of  Return  Swaps** | ** ** | **Common  Stock  Warrants** | ** ** | **Foreign  Exchange  Options** | ** ** | **Free-Standing  Derivatives  Interest Rate  Swaps** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------------------|------------|--------------------------------------------------------------|------------|--------------------------------------------|------------|-----------------------------|------------|--------------------------------|------------|-----------------------------------------------------------|------------|
| Beginning  balance as of July 1, 2010                                                                                                                                                      |       | $                                    | 72,773     |                                           | $          | 107,081                                                      |       | $                                          | 26,482     |                        | $          | 37                             |       | $                                                         | 126        |   | $ | — |   | $ | 4,764 |   |
| Total  gains or losses (realized and unrealized):                                                                                                                                          |       |                                 |       |                                           |       |                                                         |       |                                       |       |                        |       |                           |       |                                                      |       |
| Included  in earnings(1)                                                                                                                                                                   |       | 649                                  |       | 2,208                                          |       | (5,835                                                       | )          | 98                                         |       | 84                          |       | 15,309                         |       | (3,482                                                    | )          |
| Included  in other comprehensive income                                                                                                                                                    |       | 5,279                                |       | —                                         |       | —                                                       |       | —                                     |       | —                      |       | —                         |       | —                                                    |       |
| Transfers  in to level 3(2)                                                                                                                                                           |       | 22,287                               |       | —                                         |       | 41,740                                                       |       | —                                     |       | —                      |       | —                         |       | —                                                    |       |
| Purchases,  sales, other settlements and issuances, net                                                                                                                                    |       | 11,846                               |       | (3,037                                         | )          | 6,545                                                        |       | —                                     |       | 2,716                       |       | —                         |       | (10                                                       | )          |
| Ending  balance as of September 30, 2010                                                                                                                                                   |       | $                                    | 112,834    |                                           | $          | 106,252                                                      |       | $                                          | 68,932     |                        | $          | 135                            |       | $                                                         | 2,926      |   | $ | 15,309 |   | $ | 1,272 |   |
| The  amount of total gains or losses for the period included in earnings  attributable to the change in unrealized gains or losses relating to assets  still held at the reporting date(1) |       | $                                    | —     |                                           | $          | 7,698                                                        |       | $                                          | (5,835     | )                           | $          | —                         |       | $                                                         | 84         |   | $ | 15,309 |   | $ | (3,482 | ) |

 

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

(2)         Certain securities available-for-saleand equity investments, at estimated fair value, were transferred in to level 3reflecting reduced transparency of prices for these financial instruments as aresult of less trading activity.

 

The following table presents additional information about assets,including derivatives that are measured at fair value on a recurring basis forwhich the Company has utilized level 3 inputs to determine fair value, forthe nine months ended September 30, 2010 (amounts in thousands):

 
| ** **                                                                                                                                                                                 | ** ** | **Securities  Available-  For-Sale** | ** ** | **Residential  Mortgage-  Backed  Securities** | ** ** | **Equity  Investments,  at Estimated  Fair Value** | ** ** | **Total Rate of  Return  Swaps** | ** ** | **Common  Stock  Warrants** | ** ** | **Foreign  Exchange  Options** | ** ** | **Free-Standing  Derivatives  Interest Rate  Swaps** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------------------|------------|--------------------------------------------------------------|------------|--------------------------------------------|------------|-----------------------------|------------|--------------------------------|------------|-----------------------------------------------------------|------------|
| Beginning  balance as of January 1, 2010                                                                                                                                              |       | $                                    | 81,288     |                                           | $          | 47,572                                                       |       | $                                          | 18,289     |                        | $          | 11,809                         |       | $                                                         | 2,471      |   | $ | — |   | $ | (281 | ) |
| Transfers  in from deconsolidation (1)                                                                                                                                                     |       | —                               |       | 74,366                                         |       | —                                                       |       | —                                     |       | —                      |       | —                         |       | —                                                    |       |
| Total  gains or losses (realized and unrealized):                                                                                                                                          |       |                                 |       |                                           |       |                                                         |       |                                       |       |                        |       |                           |       |                                                      |       |
| Included  in earnings(2)                                                                                                                                                                   |       | 4,927                                |       | (5,076                                         | )          | (8,732                                                       | )          | 1,801                                      |       | 135                         |       | 15,309                         |       | 1,348                                                     |       |
| Included  in other comprehensive income                                                                                                                                                    |       | 6,957                                |       | —                                         |       | —                                                       |       | —                                     |       | —                      |       | —                         |       | —                                                    |       |
| Transfers  in to level 3(3)                                                                                                                                                                |       | 22,788                               |       | —                                         |       | 41,740                                                       |       | —                                     |       | —                      |       | —                         |       | —                                                    |       |
| Purchases,  sales, other settlements and issuances, net                                                                                                                                    |       | (3,126                               | )          | (10,610                                        | )          | 17,635                                                       |       | (13,475                                    | )          | 320                         |       | —                         |       | 205                                                       |       |
| Ending  balance as of September 30, 2010                                                                                                                                              |       | $                                    | 112,834    |                                           | $          | 106,252                                                      |       | $                                          | 68,932     |                        | $          | 135                            |       | $                                                         | 2,926      |   | $ | 15,309 |   | $ | 1,272 |   |
| 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(2) |       | $                                    | —     |                                           | $          | 5,383                                                        |       | $                                          | (8,732     | )                           | $          | —                         |       | $                                                         | 135        |   | $ | 15,309 |   | $ | 151 |   |

 

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(1)                                 Represents thesubordinate tranches of the residential mortgage loan securitization trusts asa result of the Company’s deconsolidation as of January 1, 2010, computedas $11.4 million of REO plus $62.9 million, which represents the differencebetween the residential mortgage loans of $2.1 billion less RMBS Issued, atestimated fair value, of $2.0 billion. See Note 2 for further discussion.

 

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

(3)                                 Certainsecurities available-for-sale and equity investments, at estimated fair value,were transferred in to level 3 reflecting reduced transparency of prices for thesefinancial instruments as a result of less trading activity.

 

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

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

 

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

 

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

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

 

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

 

**Note 15. Subsequent Events**

 

TheCompany entered into two definitive agreements to acquire certain naturalresources investments, including existing producing natural gas wells andinfrastructure in Texas, for an aggregate purchase price of $37.4 million. Onetransaction closed in October 2010 while the other is expected to close priorto year-end 2010.

 

On November 3, 2010, the Company’s boardof directors declared a cash distribution for the quarter endedSeptember 30, 2010 on the Company’s common shares of $0.14 per commonshare. The distribution is payable on December 1, 2010 to commonshareholders of record as of the close of business on November 17, 2010.

 

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

 

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

 

*The following discussion and analysis of ourfinancial condition and results of operations should be read in conjunctionwith our condensed consolidated financial statements and related notes includedelsewhere in this Quarterly Report on Form 10-Q.**Certaininformation contained in this Quarterly Report on Form 10-Q constitutes “forward-looking”statements within the meaning of Section 27A of the Securities Act of1933, as amended and Section 21E of the Securities Exchange Act of 1934,as amended, that are based on our current expectations, estimates andprojections. Statements that are not historical facts, including statementsabout our beliefs and expectations, are forward-looking statements. The words “believe,”“anticipate,” “intend,” “aim,” “expect,” “strive,” “plan,” “estimate,” and “project,”and similar words identify forward-looking statements. Such statements are notguarantees of future performance, events or results and involve potential risksand uncertainties. 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, financing and capital availability, changes in prepaymentrates, general economic and political conditions and events, changes in market conditions,particularly in the global fixed income, credit and equity markets, the impactof current, pending and future legislation, regulation and legal actions, andother factors not presently identified. Other factors that may impact ouractual results are discussed under “Risk Factors” in Item 1A of theCompany’s Annual Report on Form 10-K filed with the Securities ExchangeCommission, or the SEC, on March 1, 2010, as further supplemented by thedisclosure under “Risk Factors” in Item 1A of this Quarterly Report onForm 10-Q. We do not undertake, and specifically disclaim, any obligationto publicly release the result of any revisions that may be made to anyforward-looking statements to reflect the occurrence of anticipated orunanticipated events or circumstances after the date of such statements, exceptfor as required by federal securities laws.*

 

**Executive Overview**

 

We are a specialty finance company with expertise in a range of assetclasses. Our core business strategy is to leverage the proprietary resources ofKKR Financial Advisors LLC (our “Manager”) with the objective of generatingboth current income and capital appreciation. We primarily invest in financialassets including below investment grade corporate debt, including senior securedand unsecured loans, mezzanine loans, high yield corporate bonds, distressedand stressed debt securities, marketable equity securities and private equity.Additionally, we have made or may make investments in other asset classesincluding natural resources and real estate. The corporate loans we invest inare primarily referred to as syndicated bank loans, or leveraged loans, and arepurchased via assignment or participation in either the primary or secondarymarket. The majority of our corporate debt investments are held incollateralized loan obligation (“CLO”) transactions that are structured ason-balance sheet securitizations and are used as long term financing for theseinvestments. The senior secured notes issued by the CLO transactions are primarilyowned by unaffiliated third party investors and we own the majority of thesubordinated notes in the CLO transactions. Our CLO transactions consist offive cash flow CLO transactions, KKR Financial CLO 2005-1, Ltd. (“CLO 2005-1”), KKR Financial CLO 2005-2, Ltd. (“CLO2005-2”), KKR Financial CLO 2006-1, Ltd. (“CLO 2006-1”), KKR Financial CLO2007-1, Ltd. (“CLO 2007-1”) and KKR Financial CLO 2007-A, Ltd. (“CLO 2007-A”and, together with CLO 2005-1, CLO 2005-2, CLO 2006-1, and CLO 2007-1, each a “CashFlow CLO” and, collectively, the “Cash Flow CLOs”). We execute our corebusiness strategy through majority-owned subsidiaries, including CLOs.

 

***Summary of Results***

 

Ournet income for the three and nine months ended September 30, 2010 totaled$82.3 million (or $0.52 per diluted common share) and $292.9 million (or $1.85per diluted common share), respectively, as compared to a net income of$67.2 million (or $0.42 per diluted common share) and $74.8 million (or$0.49 per diluted common share), for the three and nine months endedSeptember 30, 2009, respectively. The increase in net income of $15.2million from the three months ended September 30, 2009 compared to thesame period in 2010 is attributable to an increase in net investment income of$5.6 million and an increase in other income of $13.6 million primarily due torealized gains on the sale of certain corporate debt securities and no loss onthe restructuring and extinguishment of debt, partially offset by an increasein non-investment expenses of $3.6 million. The increase in net income of$218.0 million from the nine months ended September 30, 2009 compared tothe same period in 2010 is attributable to an increase in net investment incomeof $75.0 million and an increase in other income of $154.3 million primarilydue to realized gains on the sale of certain corporate debt securities,partially offset by an increase in non-investment expenses of $10.9 million.The components of these amounts for the three and nine month periods ended September 30,2010 and 2009 are detailed this Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.

 

***Distributions to Shareholders***

 

On November 3, 2010, our board ofdirectors declared a cash distribution for the quarter ended September 30,2010 on our common shares of $0.14 per share. The distribution is payable on December 1,2010 to common shareholders of record as of the close of business on November 17,2010.

 

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The senior secured credit facility contains negative covenants thatrestrict our ability, among other things, to pay dividends or make certainother restricted payments, including a prohibition on distributions to ourshareholders in an amount in excess of 65% of our estimated annual taxableincome.

 

***Consolidation***

 

Effective January 1, 2010, we adopted new guidance that amendedthe accounting for the transfers of financial assets, eliminated the concept ofa qualified special purpose entity (“QSPE”) and significantly changed thecriteria by which an enterprise determines whether or not it must consolidate avariable interest entity (“VIE”). Under the new guidance, consolidation of aVIE requires both the power to direct the activities that most significantlyimpact the VIE’s economic performance and the obligation to absorb losses ofthe VIE or the right to receive benefits of the VIE that could potentially besignificant to the VIE.

 

Asa result of the adoption of the new guidance regarding the amendedconsolidation model based on power and economics, we determined that sixresidential mortgage loan securitization trusts, which were previouslyconsolidated by us as we were deemed to be the primary beneficiary, wererequired to be deconsolidated. We determined that we did not have the power todirect the activities that most significantly impacted the economic performanceof the securitization trusts or the performance of the securitization trusts’underlying asset and deconsolidated them as of January 1, 2010. Thisresulted in the reduction of both assets and liabilities of approximately$2.0 billion. In addition, loan interest income, interest expense, loanservicing expense, and net unrealized and realized gain (loss) associated withthe residential mortgage loan securitization trusts will no longer be reportedon our condensed consolidated financial statements. Our deconsolidation of thesix residential mortgage loan securitization trusts had no net impact onshareholders’ equity, results of operations and cash flows.

 

CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1,CLO 2007-A and KKR Financial CLO 2009-1, Ltd. (“CLO 2009-1”) are allVIEs that we consolidate as we have determined we have the power to direct theactivities that most significantly impact these entities’ economic performanceand we have both the obligation to absorb losses of these entities and theright to receive benefits from these entities that could potentially besignificant to these entities.

 

As our condensed consolidated financial statements in this QuarterlyReport on Form 10-Q are presented to reflect the consolidation of the CLOswe hold investments in, the information contained in this Management’s Discussionand Analysis of Financial Condition and Results of Operations reflects the CLOson a consolidated basis which is consistent with the disclosures in ourcondensed consolidated financial statements.

 

***Investment Portfolio***

 

*Overview*

 

As discussed above, the majority of our investments are held throughCLO transactions that are managed by an affiliate of our Manager and for whichwe own the majority, and in some cases all, of the economic interests in thetransaction through the subordinated notes in the transaction. On anunconsolidated basis, our investment portfolio primarily consists of thefollowing as of September 30, 2010: (i) mezzanine and subordinatedtranches of CLO transactions with an aggregate par amount of $1.1 billion;(ii) corporate loans with an aggregate par amount of $571.4 millionand an estimated fair value of $447.9 million; (iii) corporate debtsecurities with an aggregate par amount of $131.8 million and an estimated fairvalue of $121.5 million; (iv) residential mortgage-backed securities (“RMBS”)with a par amount of $240.5 million and estimated fair value of$102.0 million; (v) equity investments and private equity investmentswith an estimated fair value of $77.8 million. In addition, we hold otherinvestments including credit default swap transactions, foreign exchange hedgesand interest rate swaps.

 

*CorporateDebt Investments*

 

Our investments in corporate debt primarily consist of investments inbelow investment grade corporate loans, often referred to as syndicated bankloans or leveraged loans, and corporate debt securities. Loans that are notdeemed to be held for sale are carried at amortized cost net of allowance forloan losses on our condensed consolidated balance sheets. Loans that areclassified as held for sale are carried at the lower of net amortized cost orestimated fair value on our condensed consolidated balance sheets. Debtsecurities are carried at estimated fair value on our condensed consolidatedbalance sheets.

 

These investments have an aggregate par balance of $8.0 billion,an aggregate net amortized cost of $7.4 billion and an aggregate estimated fairvalue of $7.3 billion as of September 30, 2010. Included in theseamounts is $7.3 billion par amount or $6.8 billion estimated fair value ofinvestments held in our five Cash Flow CLOs through which we finance themajority of our corporate debt investments. These Cash Flow CLOs have aggregatesecured notes outstanding totaling $5.6 billion held by unaffiliated thirdparties and an aggregate of $371.1 million of junior notes outstandingthat are held by an affiliate of our Manager. In CLO transactions, subordinatednotes effectively represent the equity in such transactions as they have thefirst risk of loss and conversely, 

 

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theresidual value upside of the transactions. We consolidate all five of our CashFlow CLOs and reflect all income and losses related to the assets in these CLOson our condensed consolidated statement of operations even though a minorityamount of the subordinated notes issued by two of our CLO transactions are notheld by us.

 

*RMBSInvestments*

 

Our residential mortgage investment portfolio consists of investmentsin RMBS with an estimated fair value of $106.3 million as ofSeptember 30, 2010.

 

**Critical Accounting Policies**

 

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

 

***Fair Value of Financial Instruments***

 

Fair value is the price that would be received to sell an asset or paidto transfer a liability in an orderly transaction between market participantsat the measurement date. Where available, fair value is based on observablemarket prices 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.Assets and liabilities recorded at fair value in the condensed consolidatedbalance sheets are categorized based upon the level of judgment associated withthe inputs used to measure their value. Hierarchical levels, as defined underGAAP, are directly related to the amount of subjectivity associated with theinputs to fair valuations of these assets and liabilities, and are as follows:

 

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

 

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

 

Level 2: Inputs, other than quoted prices included inlevel 1, are observable for the asset or liability, either directly orindirectly. Level 2 inputs include quoted prices for similar instrumentsin active markets, and inputs other than quoted prices that are observable forthe asset or liability.

 

Fair value assets and liabilities that are included in this categoryare certain corporate debt securities, certain corporate loans held for sale,certain equity investments at estimated fair value, certain securities sold,not yet purchased and certain financial instruments classified as derivativeswhere the fair value is based on observable market inputs.

 

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

 

Assets and liabilities carried at fair value and included in thiscategory are certain corporate debt securities, certain corporate loans heldfor sale, certain equity investments at estimated fair value, residentialmortgage-backed securities, residential mortgage loans, residentialmortgage-backed securities issued and certain derivatives.

 

Asignificant decrease in the volume and level of activity for the asset orliability is an indication that transactions or quoted prices may not berepresentative of fair value because in such market conditions there may beincreased instances of transactions that are not orderly. In thosecircumstances, further analysis of transactions or quoted prices is needed, anda significant adjustment to the transactions or quoted prices may be necessaryto estimate fair value.

 

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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.

 

Many financial assets and liabilities have bid and ask prices that canbe observed in the marketplace. Bid prices reflect the highest price that weand others are willing to pay for an asset. Ask prices represent the lowestprice that we and others are willing to accept for an asset. For financialassets and liabilities whose inputs are based on bid-ask prices, we do notrequire that fair value always be a predetermined point in the bid-ask range.Our policy is to allow for mid-market pricing and adjusting to the point withinthe bid-ask range that meets our best estimate of fair value.

 

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

 

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

 

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

 

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

 

***Share-Based Compensation***

 

We account for share-based compensation issued to members of our boardof directors and our Manager using a fair value based methodology in accordancewith accounting guidance. We do not have any employees, although we believethat members of our board of directors are deemed to be employees for purposesof interpreting and applying accounting principles relating to share-basedcompensation. We record as compensation costs the restricted common shares thatwe issued to members of our board of directors at estimated fair value as ofthe grant date and we amortize the cost into expense over the three-yearvesting period using the straight-line method. We record compensation costs forrestricted common shares and common share options that we issued to our Managerat estimated fair value as of the grant date and we remeasure the amount onsubsequent reporting dates to the extent the awards have not vested. Unvestedrestricted common shares are valued using observable secondary market prices.Unvested common share options are valued using the Black-Scholes model andassumptions based on observable market data for comparable companies. Weamortize compensation expense related to the restricted common shareand common share options that we granted to our Manager using the gradedvesting attribution method.

 

Because we remeasure the amount of compensation costs associated withthe unvested restricted common shares and unvested common share options that weissued to our Manager as of each reporting period, our share-based compensationexpense reported in our condensed consolidated financial statements will changebased on the estimated fair value of our common shares and this may result inearnings volatility. For the three months ended September 30, 2010,share-based compensation was $2.1 million. As of September 30, 2010,substantially all of the non-vested restricted common shares issued are subjectto remeasurement. As of September 30, 2010, a $1 increase in the price of ourcommon shares would have increased our future share-based compensation expenseby approximately $1.1 million and this future share-based compensationexpense would be recognized over the remaining vesting periods of ouroutstanding restricted common shares and common share options. As ofSeptember 30, 2010, the common share options were fully vested and expirein August 2014. As of September 30, 2010, future unamortizedshare-based compensation totaled $2.2 million, of which $1.0 million,$1.0 million and $0.2 million will be recognized in 2010, 2011 and beyond,respectively.

 

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

 

We recognize all derivatives on our condensed consolidated balancesheets at estimated fair value. On the date we enter into a derivativecontract, we designate and document each derivative contract as one of thefollowing at the time the contract is executed: (i) a hedge of 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) a hedge of a net investment in a foreign operation; or (iv) aderivative instrument not designated as a hedging instrument (“free-standingderivative”). For a fair value hedge, we record changes in the estimated fairvalue of the derivative instrument and, to the extent that it is effective,changes in the fair value of the hedged asset or liability in the current periodearnings in the same financial statement category as the hedged item. For acash flow hedge, we record changes in the estimated fair value of thederivative to the extent that it is effective in other comprehensive income andsubsequently reclassify these changes in estimated fair value to net income inthe same period(s) that the hedged transaction affects earnings. Theeffective portion of the cash flow hedge is recorded in the same financialstatement category as the hedged item. For free-standing derivatives, we reportchanges in the fair values in other income (loss).

 

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

 

We are not required to account for our derivative contracts using hedgeaccounting as described above. If we decide not to designate the derivativecontracts as hedges or if we fail to fulfill the criteria necessary to qualifyfor hedge accounting, then the changes in the estimated fair values of ourderivative contracts would affect periodic earnings immediately potentiallyresulting in the increased volatility of our earnings. The qualificationrequirements for hedge accounting are complex and as a result, we must evaluate,designate, and thoroughly document each hedge transaction at inception andperform ineffectiveness analysis and prepare related documentation at inceptionand on a recurring basis thereafter. As of September 30, 2010, theestimated fair value of our net derivative liabilities totaled$88.7 million.

 

***Impairments***

 

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

 

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

 

This process involves a considerable amount of judgment by ourmanagement. As of September 30, 2010, we had aggregate unrealized losseson our securities classified as available-for-sale of approximately$5.1 million, which if not recovered may result in the recognition offuture losses. During the three and nine months ended September 30, 2010,we recorded charges for impairments of securities that we determined to beother-than-temporary totaling $0.5 million and $1.7 million, respectively.

 

***Allowance for Loan Losses***

 

Ourallowance for loan losses represents our estimate of probable credit lossesinherent in our corporate loan portfolio held for investment as of the balancesheet date.  Estimating our allowance forloan losses involves a high degree of management judgment and is based upon acomprehensive review of our loan portfolio that is performed on a quarterlybasis. Our allowance for loan losses 

 

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consistsof two components, an allocated component and an unallocated component. Theallocated component of our allowance for loan losses pertains to specific loansthat we have determined are impaired. We determine a loan is impaired when weestimate that it is probable that we will be unable to collect all amounts dueaccording to the contractual terms of the loan agreement. On a quarterly basiswe perform a comprehensive review of our entire loan portfolio and identifycertain loans that we have determined are impaired. Once a loan is identifiedas being impaired we place the loan on non-accrual status, unless the loan isalready on non-accrual status, and record a reserve that reflects our bestestimate of the loss that we expect to recognize from the loan. The expectedloss is estimated as being the difference between our current cost basis of theloan, including accrued interest receivable, and the loan’s estimated fairvalue.

 

Theunallocated component of our allowance for loan losses reflects our estimate ofprobable losses inherent in our loan portfolio as of the balance sheet datewhere the specific loan that the loan loss relates to is indeterminable. Weestimate the unallocated component of our allowance for loan losses through acomprehensive review of our loan portfolio and identify certain loans thatdemonstrate possible indicators of impairment. This assessment excludes allloans that are determined to be impaired and as a result, an allocated reservehas been recorded as described in the preceding paragraph. Such indicatorsinclude, but are not limited to, the current and/or forecasted financialperformance and liquidity profile of the issuer, specific industry or economicconditions that may impact the issuer, and the observable trading price of theloan if available. Loans that demonstrate possible indicators of impairment areaggregated on a watch list for monitoring and are sub-divided forcategorization based on the seniority of the loan in the issuer’s capitalstructure, whether the loan is secured or unsecured, and the nature of thecollateral securing the loan, for purposes of applying possible default andloss severity ranges based on the nature of the issuer and the specific loan.We apply a range of default and loss severity estimates in order to estimate arange of loss outcomes upon which to base our estimate of probable losses thatresults in the determination of the unallocated component of our allowance forloan losses. As of September 30, 2010, the range of outcomes used toestimate the probability of default was between 1% and 20% and the range of lossseverity assumptions for loans that may default was between 5% and 85%. Theestimates and assumptions we use to estimate our allowance for loan losses arebased on our estimated range of outcomes that are determined from industryinformation providing both historical and forecasted empirical performance ofthe type of corporate loans that we invest in, as well as from our ownestimates based on the nature of our corporate loan portfolio. These estimatesand assumptions are susceptible to change due to our corporate loan portfolioperformance as well as industry performance of the corporate loan asset classand general economic conditions. Changes in the assumptions and estimates usedto estimate our allowance for loan losses could have a material impact on ourfinancial condition and results of operations.

 

As of September 30, 2010, our allowance for loan losses totaled$209.0 million.

 

**Recent Accounting Pronouncements**

 

*Consolidation*

 

In February 2010, theFinancial Accounting Standards Board (“FASB”) issued new guidance deferring theapplication of the amended consolidation requirements related to VIEs for areporting entity’s interest in an entity that has all the attributes of aninvestment company or for which it is applies measurement principles that areconsistent with those followed by investment companies. The guidance wasexpected to most significantly affect reporting entities in the investmentmanagement industry. Entities including, but not limited to, securitizationentities or entities with multiple levels of subordinated investors such as aCLO for which the primary purpose of the capital structure of the entity is toprovide credit enhancement to senior interest holders, will not qualify for thedeferral. The guidance was effective for interim and annual reporting periodsbeginning after November 15, 2009. The adoption of this new guidance didnot have an effect on our condensed consolidated financial statements.

 

*FinancingReceivables and Allowance for Credit Losses*

 

In July 2010, the FASBissued new guidance to amend existing disclosure requirements to provide agreater level of disaggregated information about the credit quality offinancing receivables and allowance for credit losses. The two levels ofdisaggregation defined by the FASB are portfolio segment and class of financingreceivable. The amendments also require an entity to disclose credit qualityindicators, past due information, and modifications of financing receivables.The guidance is effective for interim and annual reporting periods ending on orafter December 15, 2010. We will include the required disclosuresbeginning with our consolidated financial statements for the year endedDecember 31, 2010.

 

**Results of Operations**

 

*Summary*

 

Ournet income for the three and nine months ended September 30, 2010 totaled$82.3 million (or $0.52 per diluted common share) and $292.9 million (or $1.85per diluted common share), respectively, as compared to a net income of$67.2 million (or $0.42 per diluted common share) and $74.8 million (or$0.49 per diluted common share), for the three and nine months endedSeptember 30, 2009, respectively.

 

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Theincrease in net income of $15.2 million for the three months ended September 30,2010 from the three months ended September 30, 2009 is attributable toseveral factors. Net investment income increased by $5.6 million resulting fromlower interest expense due to lower debt balances on our senior secured creditfacility and collateralized loan obligation secured notes. Other incomeincreased by $13.6 million due to net realized and unrealized gains oninvestments, derivatives and foreign exchange totaling $23.3 million.Other income for the three months ended September 30, 2009 consisted ofnet realized and unrealized gains on investments, derivatives and foreignexchange totaling $41.1 million that were offset by $28.3 million of netrealized and unrealized losses due to write-downs of our residentialmortgage-backed securities holdings and a loss from the restructuring andextinguishment of debt. The increases in net investment income and other incomewere partially offset by an increase in non-investment expenses of $3.6million.

 

Theincrease in net income of $218.0 million for the nine months ended September 30,2010 from the nine months ended September 30, 2009 is also attributable tovarious factors. Net investment income increased by $75.0 million resultingfrom lower interest expense due to lower debt balances on our senior securedcredit facility and collateralized loan obligation secured notes. Other incomeincreased by $154.3 million due to net realized and unrealized gains oninvestments, derivatives and foreign exchange totaling $80.4 million. Otherloss for the nine months ended September 30, 2009 primarily consisted ofnet realized and unrealized losses on investments, derivatives and foreignexchange totaling $26.7 million. The increases in net investment income andother income were partially offset by an increase in non-investment expenses of$10.9 million.

 

The following table presents the components of our net investmentincome for the three and nine months ended September 30, 2010 and 2009:

 

**ComparativeNet Investment Income Components**

**(Amounts inthousands)**

 
| ** **                                                 | ** ** | **For the three  months ended  September 30, 2010** | ** ** | **For the three  months ended  September 30, 2009** | ** ** | **For the nine  months ended  September 30, 2010** | ** ** | **For the nine  months ended  September 30, 2009** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| Investment Income:                                         |       |                                                                         |       |                                                                         |       |                                                                        |       |                                                                        |       |
| Corporate loans and securities interest income             |       | $                                                                            | 96,523     |                                                                         | $          | 92,549                                                                      |       | $                                                                           | 273,139    |   | $ | 295,133 |   |
| Residential mortgage loans and securities interest  income |       | 5,518                                                                        |       | 25,369                                                                       |       | 19,169                                                                      |       | 96,213                                                                      |       |
| Other interest income                                      |       | 27                                                                           |       | 49                                                                           |       | 140                                                                         |       | 511                                                                         |       |
| Dividend income                                            |       | 2                                                                            |       | 26                                                                           |       | 1,946                                                                       |       | 313                                                                         |       |
| Net discount accretion                                     |       | 20,179                                                                       |       | 17,243                                                                       |       | 69,571                                                                      |       | 47,042                                                                      |       |
| Total investment income                                    |       | 122,249                                                                      |       | 135,236                                                                      |       | 363,965                                                                     |       | 439,212                                                                     |       |
| Interest Expense:                                          |       |                                                                         |       |                                                                         |       |                                                                        |       |                                                                        |       |
| Collateralized loan obligation secured notes               |       | 16,490                                                                       |       | 19,247                                                                       |       | 44,271                                                                      |       | 98,872                                                                      |       |
| Senior secured credit facility                             |       | 628                                                                          |       | 5,164                                                                        |       | 12,299                                                                      |       | 13,022                                                                      |       |
| Convertible senior notes                                   |       | 6,966                                                                        |       | 4,969                                                                        |       | 21,193                                                                      |       | 15,474                                                                      |       |
| Junior subordinated notes                                  |       | 3,930                                                                        |       | 4,092                                                                        |       | 11,698                                                                      |       | 12,709                                                                      |       |
| Residential mortgage-backed securities issued              |       | —                                                                       |       | 18,940                                                                       |       | —                                                                      |       | 66,043                                                                      |       |
| Interest rate swap                                         |       | 2,022                                                                        |       | 3,915                                                                        |       | 10,730                                                                      |       | 10,245                                                                      |       |
| Other interest expense                                     |       | 15                                                                           |       | 1,013                                                                        |       | 211                                                                         |       | 3,260                                                                       |       |
| Total interest expense                                     |       | 30,051                                                                       |       | 57,340                                                                       |       | 100,402                                                                     |       | 219,625                                                                     |       |
| Interest expense to affiliates                             |       | 5,791                                                                        |       | 5,171                                                                        |       | 17,072                                                                      |       | 16,355                                                                      |       |
| Provision for loan losses                                  |       | 8,087                                                                        |       | —                                                                       |       | 8,087                                                                       |       | 39,795                                                                      |       |
| Net investment income                                      |       | $                                                                            | 78,320     |                                                                         | $          | 72,725                                                                      |       | $                                                                           | 238,404    |   | $ | 163,437 |   |

 

Due to our adoption of the new guidance related to consolidation ofvariable interest entities (as described above under “Executive Overview”),certain amounts for the three and nine months ended September 30, 2009,which were related to the six residential mortgage loan securitization truststhat we deconsolidated effective January 1, 2010, should be disregardedfor comparative purposes. For the three and nine months ended September 30,2009, residential mortgage-backed securities issued (“RMBS Issued”) interestexpense totaled $18.9 million and $66.0 million, respectively, and residentialmortgage loans interest income totaled $20.9 million and $72.2 million, respectively,related to the six residential mortgage loan securitization trusts which weredeconsolidated.

 

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Netinvestment income totaled $78.3 million and $238.4 million, respectively, forthe three and nine months ended September 30, 2010 as compared to $72.7million and $163.4 million, respectively, for the three and nine months endedSeptember 30, 2009. Excluding the amounts discussed above related to RMBSIssued and residential mortgage loans, the increase in net investment incomefrom the three months ended September 30, 2009 to the same period in 2010was primarily attributable to (i) a modest increase in corporate loans andsecurities interest income and (ii) a decline in interest expense due tothe paydown of the senior secured credit facility in July 2010 and a lowercollateralized loan obligations secured notes balance outstanding in 2010.These benefits were slightly offset by the provision for loan losses recordedin 2010.

 

Excludingthe amounts discussed above related to RMBS Issued and residential mortgageloans, the increase in net investment income from the nine months endedSeptember 30, 2009 to the same period in 2010 was partly attributable tolower provision for loan losses recorded in 2010. In addition, total interestexpense decreased due to a significant reduction in the collateralized loanobligation secured notes balance outstanding from 2009 to 2010. The decline incollateralized loan obligation secured notes was primarily due to paydowns as aresult of certain CLOs failing one or more of their respectiveover-collateralization tests (“OC Tests”), as well as the replacement ofWayzata Funding LLC (“Wayzata”) with CLO 2009-1 on March 31, 2009 and thesubsequent paydown of CLO 2009-1’s outstanding senior notes totaling $560.8million by July 2009.

 

*OtherIncome (Loss)*

 

The following table presents the components of other income (loss) forthe three and nine months ended September 30, 2010 and 2009:

 

**ComparativeOther Income (Loss) Components**

**(Amounts inthousands)**

 
| ** **                                                                                                                                                                                  | ** ** | **For the three  months ended  September 30, 2010** | ** ** | **For the three  months ended  September 30, 2009** | ** ** | **For the nine  months ended  September 30, 2010** | ** ** | **For the nine  months ended  September 30, 2009** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| Net realized and unrealized gain (loss) on  derivatives and foreign exchange:                                                                                                               |       |                                                                         |       |                                                                         |       |                                                                        |       |                                                                        |       |
| Interest rate swaps                                                                                                                                                                         |       | $                                                                            | (3,482     | )                                                                            | $          | (3,347                                                                      | )          | $                                                                           | 1,350      |   | $ | (2,780 | ) |
| Credit default swaps                                                                                                                                                                        |       | 448                                                                          |       | 3,928                                                                        |       | 1,703                                                                       |       | 16,836                                                                      |       |
| Total rate of return swaps                                                                                                                                                                  |       | 98                                                                           |       | 18,061                                                                       |       | 1,801                                                                       |       | 42,774                                                                      |       |
| Common stock warrants                                                                                                                                                                       |       | 84                                                                           |       | —                                                                       |       | 135                                                                         |       | —                                                                      |       |
| Foreign exchange(1)                                                                                                                                                                         |       | 6,683                                                                        |       | 1,288                                                                        |       | (8,426                                                                      | )          | 2,001                                                                       |       |
| Total net realized and unrealized gain (loss) on  derivatives and foreign exchange                                                                                                          |       | 3,831                                                                        |       | 19,930                                                                       |       | (3,437                                                                      | )          | 58,831                                                                      |       |
| Net realized loss on residential mortgage-backed  securities and residential mortgage loans, carried at estimated fair  value                                                          |       | (6,206                                                                       | )          | (1,742                                                                       | )          | (13,147                                                                     | )          | (13,418                                                                     | )          |
| Net unrealized gain (loss) on residential  mortgage-backed securities, residential mortgage loans, and residential  mortgage-backed securities issued, carried at estimated fair value |       | 7,698                                                                        |       | (15,939                                                                      | )          | 5,383                                                                       |       | (31,127                                                                     | )          |
| Net realized and unrealized gain (loss) on  investments(2)                                                                                                                                  |       | 21,705                                                                       |       | 21,181                                                                       |       | 93,782                                                                      |       | (45,563                                                                     | )          |
| Net realized and unrealized (loss) gain on  securities sold, not yet purchased                                                                                                              |       | —                                                                       |       | (996                                                                         | )          | (756                                                                        | )          | 2,920                                                                       |       |
| Impairment of securities available for sale and  private equity investments at cost                                                                                                         |       | (2,264                                                                       | )          | —                                                                       |       | (9,979                                                                      | )          | (40,013                                                                     | )          |
| Net (loss) gain on restructuring and  extinguishment of debt                                                                                                                                |       | —                                                                       |       | (10,627                                                                      | )          | 39,999                                                                      |       | 30,836                                                                      |       |
| Other income                                                                                                                                                                                |       | 1,863                                                                        |       | 1,239                                                                        |       | 9,085                                                                       |       | 4,150                                                                       |       |
| Total other income (loss)                                                                                                                                                                   |       | $                                                                            | 26,627     |                                                                         | $          | 13,046                                                                      |       | $                                                                           | 120,930    |   | $ | (33,384 | ) |

 

----

(1)                                  Includesforeign exchange contracts and foreign exchange gain or loss.

(2)                                  Includes lowerof cost or estimated fair value adjustment to corporate loans held for sale andunrealized gain (loss) on investments held at estimated fair value.

 

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For the three and nine months ended September 30, 2009, theaggregate realized and unrealized gain (loss) on residential mortgage loans andRMBS Issued related to the six residential mortgage loan securitization truststhat we deconsolidated effective January 1, 2010. The deconsolidation hadno net impact on our results of operations for the three and nine months endedSeptember 30, 2010.

 

Total other income totaled$26.6 million and $120.9 million, respectively, for the three and nine monthsended September 30, 2010 as compared to other income of $13.0 million andother loss of $33.4 million, respectively, for the three and nine months endedSeptember 30, 2009. Total other income increased from the three monthsended September 30, 2009 to 2010 primarily due to net unrealized gain onresidential mortgage-backed securities, carried at estimated fair valuerecognized in the third quarter of 2010 partially offset by net realized andunrealized loss on derivatives and foreign exchange. In addition, in the thirdquarter of 2009, there was a $10.6 million net loss on restructuring andextinguishment of debt representing the payment of a $28.8 million placementfee to the senior note holders of CLO 2009-1, partially offset by a $14.4million net gain recognized from the retirement of the CLO 2009-1 subordinatednotes and a $3.8 million gain on the repurchase of $5.0 million of juniorsubordinated notes in the third quarter of 2009. Total other income increasedfrom the nine months ended September 30, 2009 to 2010 primarily due to anincrease in bond and loan market values resulting in a reduction of impairmentwrite-downs and lower of cost or estimated fair value adjustments for corporateloans held for sale. In addition, net unrealized gain on residential mortgagebacked securities carried at estimated fair value was recognized in the ninemonths ended September 30, 2010. These gains were slightly offset byforeign exchange losses and realized and unrealized losses on total rate ofreturns, all of which we unwound during the first quarter of 2010. As ofSeptember 30, 2010, approximately 3.6% of our total corporate debtportfolio was foreign denominated, of which the majority was Euro based.

 

Netgain (loss) on restructuring and extinguishment of debt totaled nil and $(10.6)million for the three months ended September 30, 2010 and 2009,respectively, and net gain on restructuring and extinguishment of debt totaled$40.0 million and $30.8 million for the nine months ended September 30,2010 and 2009, respectively. For the nine months ended September 30, 2010,the $40.0 million primarily consisted of an aggregate gain on extinguishment ofdebt totaling $38.7 million which resulted from a purchase of $83.0 million ofnotes issued by CLO 2007-A and CLO 2007-1, both of which were previously heldby an affiliate of our Manager, during the first quarter of 2010. For the ninemonths ended September 30, 2009, the $30.8 million primarily consisted ofa $34.6 million gain on debt restructuring reflecting the reduction of thereported amount of debt held by an affiliate of our Manager upon thereplacement of Wayzata with CLO 2009-1 on March 31, 2009.

 

*Non-InvestmentExpenses*

 

The following table presents the components of non-investment expensesfor the three and nine months ended September 30, 2010 and 2009:

 

**ComparativeNon-Investment Expense Components**

**(Amounts inthousands)**

 
| ** **                             | ** ** | **For the three  months ended  September 30, 2010** | ** ** | **For the three  months ended  September 30, 2009** | ** ** | **For the nine  months ended  September 30, 2010** | ** ** | **For the nine  months ended  September 30, 2009** | ** ** |
|----------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| Related party management compensation: |       |                                                                         |       |                                                                         |       |                                                                        |       |                                                                        |       |
| Base management fees                   |       | $                                                                            | 4,870      |                                                                         | $          | 3,720                                                                       |       | $                                                                           | 13,708     |   | $ | 10,998 |   |
| Incentive fees                         |       | 9,424                                                                        |       | 4,472                                                                        |       | 30,306                                                                      |       | 4,472                                                                       |       |
| Share-based compensation               |       | 1,943                                                                        |       | 2,260                                                                        |       | 4,437                                                                       |       | 2,225                                                                       |       |
| CLO management fees                    |       | 1,314                                                                        |       | 4,164                                                                        |       | 4,067                                                                       |       | 18,437                                                                      |       |
| Related party management compensation  |       | 17,551                                                                       |       | 14,616                                                                       |       | 52,518                                                                      |       | 36,132                                                                      |       |
| Professional services                  |       | 1,041                                                                        |       | 441                                                                          |       | 3,335                                                                       |       | 5,916                                                                       |       |
| Loan servicing                         |       | —                                                                       |       | 1,925                                                                        |       | —                                                                      |       | 6,117                                                                       |       |
| Insurance                              |       | 584                                                                          |       | 636                                                                          |       | 1,857                                                                       |       | 1,242                                                                       |       |
| Directors expenses                     |       | 654                                                                          |       | 710                                                                          |       | 2,159                                                                       |       | 1,402                                                                       |       |
| General and administrative             |       | 2,323                                                                        |       | 193                                                                          |       | 6,111                                                                       |       | 4,273                                                                       |       |
| Total non-investment expenses          |       | $                                                                            | 22,153     |                                                                         | $          | 18,521                                                                      |       | $                                                                           | 65,980     |   | $ | 55,082 |   |

 

For the three and nine months ended September 30, 2009, the entireloan servicing expense of $1.9 million and $6.1 million, respectively, wasrelated to the six residential mortgage loan securitization trusts which wedeconsolidated effective January 1, 2010. As such, the $1.9 million and$6.1 million balances should be disregarded for comparative purposes.

 

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As presented in the table above, our non-investment expenses increasedby approximately $3.6 million from the three months ended September 30,2009 to 2010 and $10.9 million from the nine months ended September 30,2009 to 2010. The significant components of non-investment expense aredescribed below.

 

Management compensation to related parties consists of base managementfees payable to our Manager pursuant to our management agreement (“ManagementAgreement”), incentive fees, collateral management fees for our CLOs, andshare-based compensation related to restricted common shares and common shareoptions granted to our Manager.

 

Thebase management fee payable was calculated in accordance with the ManagementAgreement and is based on an annual rate of 1.75% times our “equity” as definedin the Management Agreement. Base management fees increased by $1.2 million and$2.7 million, from the three and nine months ended September 30, 2009 to2010, respectively. Our Manager is also entitled to a quarterly incentive feeprovided that our quarterly “net income,” as defined in the ManagementAgreement, before the incentive fee exceeds a defined return hurdle. During thethree and nine months ended September 30, 2010, our Manager earned $9.4million and $30.3 million, respectively, of incentive fees. The $30.3 millionof incentive fees earned for the nine months ended September 30, 2010 isnet of a $9.7 million amount waived. During the three months endedMarch 31, 2010, our Manager permanently waived payment of $9.7 million ofincentive fees that were related to the $38.7 million gain recorded by usas a result of the repurchase of $83.0 million of mezzanine and subordinatenotes issued by CLO 2007-1 and CLO 2007-A. Incentive fees are included inrelated party management compensation on our condensed consolidated statementof operations. During both the three and nine months ended September 30,2009, our Manager earned $4.5 million of incentive fees.

 

An affiliate of our Manager has entered into separate managementagreements with CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A andCLO 2009-1 and is entitled to receive fees for the services performed ascollateral manager. Previously, the collateral manager had waived the fees itearned for providing management services for our CLOs. Beginning April 15,2007, the collateral manager ceased waiving fees for CLO 2005-1 andbeginning January 1, 2009, the collateral manager ceased waiving fees forCLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and Wayzata(restructured and replaced with CLO 2009-1 on March 31, 2009). Beginningin July 2009, the collateral manager reinstated waiving the CLO managementfees for CLO 2005-2 and CLO 2006-1. In addition, due to CLO 2007-A and CLO2007-1 regaining compliance with their respective OC Tests during the firstquarter of 2010, the collateral manager also reinstated waiving the CLOmanagement fees for CLO 2007-A and CLO 2007-1. For the three and nine monthsended September 30, 2010, the collateral manager waived an aggregate of$8.7 million and $21.9 million, respectively, for CLO 2005-2, CLO 2006-1, CLO2007-1 and CLO 2007-A. In addition, due to the deleveraging of CLO 2009-1completed in July 2009 whereby all the senior notes were retired, thecollateral manager is no longer entitled to receive fees for CLO 2009-1.Accordingly, CLO management fees decreased $2.9 million from the three monthsended September 30, 2009 to 2010 and $14.4 million from the nine monthsended September 30, 2009 to 2010, to account for all six CLOs paying CLOmanagement fees during the first half of 2009.

 

In addition, beginning January 1, 2009, our Manager permanentlywaived reimbursable general and administrative expenses allocable to us in anamount equal to the incremental CLO management fees received by the Manager.Effective June 2010, all incremental CLO management fees received by theManager in 2009 had been fully applied to offset reimbursable general andadministrative expenses allocable to us. Accordingly, reimbursable general andadministrative expenses were charged and paid by us beginning in June 2010.For the three and nine months ended September 30, 2010, our Managerpermanently waived reimbursement of nil and $2.4 million, respectively, inallocable general and administrative expenses. For the three and nine monthsended September 30, 2009, the Manager permanently waived reimbursement of$2.4 million and $7.7 million, respectively, in allocable general andadministrative expenses.

 

General and administrative expenses include expenses incurred by ourManager on our behalf that are reimbursable to our Manager pursuant to theManagement Agreement. General and administrative expenses increased $2.1million and $1.8 million from the three and nine months ended September 30,2009 to 2010, respectively, primarily due to the fact that there were noremaining incremental CLO management fees to offset these expenses as describedabove. Professional services expenses consist of legal, accounting and otherprofessional services. Professional fees increased $0.6 million from the threemonths ended September 30, 2009 to 2010 and decreased $2.6 million fromthe nine months ended September 30, 2009 to 2010. Directors’ expensesrepresent share-based compensation, as well as expenses and reimbursables dueto the board of directors for their services.

 

*Income Tax Provision*

 

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

 

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During 2010, we owned an equity interest in KKR Financial HoldingsII, LLC (“KFH II”), which has elected to be taxed as a real estateinvestment trust (a “REIT”) under the Internal Revenue Code of 1986, as amended(the “Code”). KFH II holds certain real estate mortgage-backed securities. AREIT generally is not subject to United States federal income tax to the extentthat it currently distributes its income and satisfies certain asset, incomeand ownership tests, and recordkeeping requirements, but it may be subject tosome amount of federal, state, local and foreign taxes based on its taxableincome.

 

We have wholly-owneddomestic and foreign subsidiaries that are taxable as corporations for UnitedStates federal income tax purposes and thus are not consolidated with us forUnited States federal income tax purposes. For financial reporting purposes,current and deferred taxes are provided for on the portion of earningsrecognized by us with respect to our interest in the domestic taxable corporatesubsidiaries, because each is taxed as a regular corporation under the Code.Deferred income tax assets and liabilities are computed based on temporarydifferences between the GAAP consolidated financial statements and the UnitedStates federal income tax basis of assets and liabilities as of eachconsolidated balance sheet date. The foreign corporate subsidiaries were formedto make certain foreign and domestic investments from time to time. The foreigncorporate subsidiaries are organized as exempted companies incorporated withlimited liability under the laws of the Cayman Islands, and are anticipated tobe exempt from United States 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. No provisions for incometaxes for the quarter ended September 30, 2010 were recorded for theforeign corporate subsidiaries; however, we are generally required to includetheir current taxable income in our calculation of taxable income allocable toshareholders. CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A andCLO 2009-1 are our foreign subsidiaries that elected to be treated asdisregarded entities or partnerships for United States federal income taxpurposes. These subsidiaries were established to facilitate securitizationtransactions, structured as secured financing transactions.

 

**InvestmentPortfolio**

 

***Corporate Debt Investment PortfolioSummary***

 

Our corporate debt investment portfolio primarily consists ofinvestments in corporate loans and debt securities. Our corporate loansprimarily consist of senior secured, second lien and subordinated loans. Thecorporate loans we invest in are primarily below investment grade and arefloating rate indexed to either one-month or three-month LIBOR. Our investmentsin corporate debt securities primarily consist of investments in belowinvestment grade corporate bonds that are senior secured, senior unsecured andsubordinated. We evaluate and monitor the asset quality of our investmentportfolio by performing detailed credit reviews and by monitoring key creditstatistics and trends. The key credit statistics and trends we monitor toevaluate the quality of our investments include credit ratings of both ourinvestments and the issuer, financial performance of the issuer includingearnings trends, free cash flows of the issuer, debt service coverage ratios ofthe issuer, financial leverage of the issuer, and industry trends that have ormay impact the issuer’s current or future financial performance and debtservice ability.

 

*CorporateLoans*

 

Our corporate loan portfolio had an aggregate par value of $7.1 billionand $7.4 billion as of September 30, 2010 and December 31, 2009,respectively. Our corporate loan portfolio consists of debt obligations ofcorporations, partnerships and other entities in the form of senior securedloans, second lien loans and subordinated loans.

 

The following table summarizes our corporate loans portfolio stratifiedby type as of September 30, 2010 and December 31, 2009. Loans thatare not deemed to be held for sale are carried at amortized cost net ofallowance for loan losses on our condensed consolidated balance sheets. Loansthat are classified as held for sale are carried at the lower of net amortizedcost or estimated fair value on our condensed consolidated balance sheets.

 

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**CorporateLoans**

**(Amounts inthousands)**

 
| ** **                             | ** ** | **September 30, 2010 (1)** | ** ** | **December 31, 2009 (1)** | ** ** |
|----------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                             | ** ** | **Par**                                   | ** ** | **Carrying  Value**                      | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Par** | ** ** | **Carrying  Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| Senior secured                         |       | $                                         | 6,253,440  |                                     | $          | 5,967,363 |   | $ | 5,967,363 |   | $ | 5,794,733 |   | $ | 6,538,799 |   | $ | 6,093,463 |   | $ | 6,093,463 |   | $ | 5,774,248 |   |
| Second lien                            |       | 669,742                                   |       | 611,684                                  |       | 611,684 |   | 532,526 |   | 685,479 |   | 638,052 |   | 638,052 |   | 560,038 |   |
| Subordinated                           |       | 196,416                                   |       | 127,281                                  |       | 127,281 |   | 159,093 |   | 147,887 |   | 81,073 |   | 81,073 |   | 79,337 |   |
| Subtotal                               |       | 7,119,598                                 |       | 6,706,328                                |       | 6,706,328 |   | 6,486,352 |   | 7,372,165 |   | 6,812,588 |   | 6,812,588 |   | 6,413,623 |   |
| Lower of cost or fair value adjustment |       | —                                    |       | (14,558                                  | )          | — |   | — |   | — |   | (31,637 | ) | — |   | — |   |
| Allowance for loan losses              |       | —                                    |       | (209,030                                 | )          | — |   | — |   | — |   | (237,308 | ) | — |   | — |   |
| Total                                  |       | $                                         | 7,119,598  |                                     | $          | 6,482,740 |   | $ | 6,706,328 |   | $ | 6,486,352 |   | $ | 7,372,165 |   | $ | 6,543,643 |   | $ | 6,812,588 |   | $ | 6,413,623 |   |

 

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(1)                                  Includes loansheld for sale.

 

As of September 30, 2010, $7.1 billion, or 99.3%, of ourcorporate loan portfolio was floating rate and $48.7 million, or 0.7%, wasfixed rate. In addition, as of September 30, 2010, $270.4 million paramount, or 3.8%, of our corporate loan portfolio was denominated in foreigncurrencies, of which 94.5% was denominated in Euro. As of December 31,2009, $7.2 billion, or 98.3%, of our corporate loan portfolio was floatingrate and $0.1 billion, or 1.7%, was fixed rate. In addition, as ofDecember 31, 2009, $210.7 million par amount, or 2.9%, of our corporateloan portfolio was denominated in foreign currencies, of which 100% wasdenominated in Euro. Fixed and floating amounts and percentages are based onpar values.

 

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 of our floating rate corporate loans was 4.3% and 3.7%as of September 30, 2010 and December 31, 2009, respectively, and theweighted-average coupon spread to LIBOR of our floating rate corporate loan portfoliowas 3.6% and 3.1% as of September 30, 2010 and December 31, 2009,respectively. The weighted-average years to maturity of our floating ratecorporate loans was 4.3 years as of both September 30, 2010 andDecember 31, 2009. As of September 30, 2010 and December 31,2009, $1.5 billion par amount, or 21.2%, and $0.6 billion par amount, or 8.8%,respectively, of our floating rate corporate loan portfolio had interest ratefloors.

 

As of September 30, 2010, our fixed rate corporate loans had aweighted-average coupon of 12.8% and weighted-average years to maturity of4.3 years, as compared to 13.6% and 5.4 years, respectively, as ofDecember 31, 2009.

 

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

 

As of September 30, 2010 and December 31, 2009, we had loanson non-accrual status with a total amortized cost of $167.1 million and $439.9million, respectively. The average investment in impaired loans during thethree and nine months ended September 30, 2010 was $178.4 million and$262.5 million, respectively, and during the three and nine months endedSeptember 30, 2009, the average recorded investment in impaired loans was$717.3 million and $544.2 million, respectively. As of September 30, 2010and 2009, the allocated component of the allowance for loan losses included allimpaired loans for the respective periods. The amount of interest incomerecognized using the cash-basis method during the time within the period thatthe loans were impaired was $4.1 million and $11.1 million for the three andnine months ended September 30, 2010, respectively, and $8.2 million and$15.0 million for the three and nine months ended September 30, 2009,respectively.

 

As of September 30, 2010, we held corporate loans that were indefault with a total amortized cost of $19.7 million from two issuers. As ofDecember 31, 2009, we held corporate loans that were in default with atotal amortized cost of $392.5 million from seven issuers. The majority ofcorporate loans in default during 2010 and 2009 were included in the loans forwhich the allocated component of the allowance for losses was related to or inthose investments for which we determined were loans held for sale as ofSeptember 30, 2010 and December 31, 2009, respectively.

 

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The following table summarizes the changes in the allowance for loanlosses for the three and nine months ended September 30, 2010 and 2009(amounts in thousands):

 
| ** **                     | ** ** | **For the three  months ended  September 30, 2010** | ** ** | **For the three  months ended  September 30, 2009** | ** ** | **For the nine  months ended  September 30, 2010** | ** ** | **For the nine  months ended  September 30, 2009** | ** ** |
|--------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| Balance at beginning of period |       | $                                                                            | 210,218    |                                                                         | $          | 473,202                                                                     |       | $                                                                           | 237,308    |   | $ | 480,775 |   |
| Provision for loan losses      |       | 8,087                                                                        |       | —                                                                       |       | 8,087                                                                       |       | 39,795                                                                      |       |
| Charge-offs                    |       | (9,275                                                                       | )          | (2,978                                                                       | )          | (36,365                                                                     | )          | (50,346                                                                     | )          |
| Balance at end of period       |       | $                                                                            | 209,030    |                                                                         | $          | 470,224                                                                     |       | $                                                                           | 209,030    |   | $ | 470,224 |   |

 

Asof September 30, 2010 and December 31, 2009, we had an allowance forloan losses of $209.0 million and $237.3 million, respectively. Asdescribed under “Critical Accounting Policies”, our allowance for loan lossesrepresents our estimate of probable credit losses inherent in our corporateloan portfolio held for investment as of the balance sheet date. Estimating ourallowance for loan losses involves a high degree of management judgment and isbased upon a comprehensive review of our loan portfolio that is performed on aquarterly basis. Our allowance for loan losses consists of two components, anallocated component and an unallocated component. The allocated component ofour allowance for loan losses pertains to specific loans that we havedetermined are impaired. We determine a loan is impaired when we estimate thatit is probable that we will be unable to collect all amounts due according tothe contractual terms of the loan agreement. On a quarterly basis we perform acomprehensive review of our entire loan portfolio and identify certain loansthat we have determined are impaired. Once a loan is identified as beingimpaired we place the loan on non-accrual status, unless the loan is already onnon-accrual status, and record a reserve that reflects our best estimate of theloss that we expect to recognize from the loan. The expected loss is estimatedas being the difference between our current cost basis of the loan, includingaccrued interest receivable, and the loans’ estimated fair value.

 

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

 

As of September 30, 2010, the allocated component of the allowancefor loan losses totaled $53.0 million and relates to investments in certainloans issued by six issuers with an aggregate par amount of $228.0 million andan aggregate amortized cost amount of $151.0 million. In addition, certainimpaired loans from three of these issuers with an aggregate par amount of$85.1 million and an aggregate amortized cost amount of $16.9 million had noassociated allowance for loan losses as our amortized cost basis for theseloans was below the estimated fair value as of September 30, 2010. As ofDecember 31, 2009, the allocated component of the allowance for loanlosses totaled $81.7 million and relates to investments in loans issued by sixissuers with an aggregate par amount of $223.6 million and an aggregateamortized cost amount of $121.2 million.

 

The unallocated component of our allowance for loan losses totaled$156.0 million and $155.6 million as of September 30, 2010 andDecember 31, 2009, respectively. During the three and nine months endedSeptember 30, 2010, we recorded charge-offs totaling $9.3 million and$36.4 million, respectively, comprised primarily of loans transferred to loansheld for sale. We recorded charge-offs totaling $3.0 million and $50.4 millionfor the three and nine months ended September 30, 2009, respectively.

 

As of September 30, 2010, we had $667.2 million of loans held forsale, a decrease of $258.5 million from December 31, 2009 due to the saleof certain loans and the transfer of loans to held for investment for those wedetermined we no longer had the intention of selling. We reduced the lower ofcost or estimated fair value allowance by $8.8 million for the three monthsended September 30, 2010 and recorded a net charge to earnings of $21.4million for the nine months ended September 30, 2010 for certain loansheld for sale which had a carrying value of $667.2 million as ofSeptember 30, 2010. We reduced the lower of cost or estimated fair valueallowance by $0.8 million for the three months ended September 30, 2009and recorded a net charge to earnings of $38.9 million for the nine monthsended September 30, 2009 for certain loans held for sale which had acarrying value of $504.1 million as of September 30, 2009.

 

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*CorporateDebt Securities*

 

Our corporate debt securities portfolio had an aggregate par value of$892.9 million and $834.1 million as of September 30, 2010 andDecember 31, 2009, respectively. Our corporate debt securities portfolioconsists of debt obligations of corporations, partnerships and other entitiesin the form of senior secured, senior unsecured and subordinated bonds.

 

The following table summarizes our corporate debt securities portfolio,which is carried at estimated fair value, stratified by type as ofSeptember 30, 2010 and December 31, 2009:

 

**CorporateDebt Securities**

**(Amounts inthousands)**

 
| ** **       | ** ** | **September 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **       | ** ** | **Par**                          | ** ** | **Carrying  Value**             | ** ** | **Amortized  Cost** | ** ** | **Estimated Fair  Value** | ** ** | **Par** | ** ** | **Carrying  Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated Fair  Value** | ** ** |
| Senior secured   |       | $                                | 260,982    |                            | $          | 257,831 |   | $ | 243,798 |   | $ | 257,831 |   | $ | 178,503 |   | $ | 156,410 |   | $ | 99,202 |   | $ | 156,410 |   |
| Senior unsecured |       | 494,703                          |       | 478,677                         |       | 350,323 |   | 478,677 |   | 455,937 |   | 425,683 |   | 318,216 |   | 425,683 |   |
| Subordinated     |       | 137,231                          |       | 112,514                         |       | 83,387 |   | 112,514 |   | 199,690 |   | 172,316 |   | 143,219 |   | 172,316 |   |
| Total            |       | $                                | 892,916    |                            | $          | 849,022 |   | $ | 677,508 |   | $ | 849,022 |   | $ | 834,130 |   | $ | 754,409 |   | $ | 560,637 |   | $ | 754,409 |   |

 

As of September 30, 2010, $727.8 million, or 81.5%, of ourcorporate debt securities portfolio was fixed rate and $165.1 million, or18.5%, was floating rate. In addition, as of September 30, 2010, $15.8million par amount, or 1.8%, of our corporate debt securities portfolio, wasdenominated in foreign currencies, of which 56.7% was denominated in British poundsterling. As of December 31, 2009, $647.4 million, or 77.6%, of ourcorporate debt securities portfolio was fixed rate and $186.7 million, or22.4%, was floating rate. In addition, as of December 31, 2009, we had nocorporate debt securities denominated in foreign currencies. Fixed and floatingamounts and percentages are based on par values.

 

As of September 30, 2010, our fixed rate corporate debt securitieshad a weighted-average coupon of 9.2% and weighted-average years to maturity of6.3 years, as compared to 10.0% and 6.2 years, respectively, as ofDecember 31, 2009. All of our floating rate corporate debt securities haveindex reset frequencies of less than twelve months. The weighted-average couponon our floating rate corporate debt securities was 6.2% and 3.6% as ofSeptember 30, 2010 and December 31, 2009, respectively, and theweighted-average coupon spread to LIBOR of our floating rate corporate debtsecurities was 5.4% and 3.4% as of September 30, 2010 andDecember 31, 2009, respectively. The weighted-average years to maturity ofour floating rate corporate debt securities was 3.5 years and 4.1 years asof September 30, 2010 and December 31, 2009, respectively. As ofSeptember 30, 2010, $23.2 million par amount, or 14.0%, of our floatingrate corporate debt securities portfolio had interest rate floors and as ofDecember 31, 2009, none of our floating rate corporate debt securities hadinterest rate floors.

 

During the three and nine months ended September 30, 2010, werecorded impairment losses totaling $0.5 million and $1.7 million,respectively, for corporate debt and equity securities that we determined to beother-than-temporarily impaired. These securities were determined to beother-than-temporarily impaired either due to our determination that recoveryin value is no longer likely or because we decided to sell the respectivesecurity in response to specific credit concerns regarding the issuer. For thethree and nine months ended September 30, 2009, we recorded impairmentlosses totaling nil and $40.0 million, respectively, for corporate debt andequity securities that we determined to be other-than-temporarily impaired.

 

As of September 30, 2010 and December 31, 2009, we had nocorporate debt securities in default.

 

***Residential Mortgage Investment Summary***

 

Our residential mortgage investment portfolio consists of investmentsin RMBS with an estimated fair value of $106.3 million as ofSeptember 30, 2010.

 

As our condensed consolidated financial statements included in thisQuarterly Report on Form 10-Q are presented to reflect the deconsolidationof the aforementioned six residential mortgage securitization trusts beginningJanuary 1, 2010, the information contained in this Management’s Discussionand Analysis of Financial Condition and Results of Operations reflects ourresidential mortgage portfolio presented on a deconsolidated basis consistentwith the disclosures in our condensed consolidated financial statements. See “ExecutiveOverview — Consolidation” for further discussion.

 

The table below summarizes the carrying value, amortized cost andestimated fair value of our residential mortgage investment portfolio as ofSeptember 30, 2010 and December 31, 2009. Carrying value is the valuethat investments are recorded on our condensed consolidated balance sheets andis estimated fair value for RMBS and residential mortgage loans. Estimated fairvalues set forth in the tables below are based on dealer quotes, nationallyrecognized pricing services and/or management’s judgment when relevantobservable inputs do not exist.

 

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**ResidentialMortgage Investment Portfolio**

**(Amounts inthousands)**

 
| ** **                             | ** ** | **September 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                             | ** ** | **Carrying  Value**              | ** ** | **Amortized  Cost**             | ** ** | **Estimated  Fair Value** | ** ** | **Carrying  Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| Residential Mortgage Loans(1)          |       | $                                | —     |                            | $          | — |   | $ | — |   | $ | 2,097,699 |   | $ | 2,772,216 |   | $ | 2,097,699 |   |
| Residential Mortgage-Backed Securities |       | 106,252                          |       | 273,631                         |       | 106,252 |   | 47,572 |   | 95,483 |   | 47,572 |   |
| Total                                  |       | $                                | 106,252    |                            | $          | 273,631 |   | $ | 106,252 |   | $ | 2,145,271 |   | $ | 2,867,699 |   | $ | 2,145,271 |   |

 

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(1)                                  Excludes realestate owned (“REO”) as a result of foreclosure on delinquent loans of $11.4million as of December 31, 2009.

 

As of December 31, 2009, 26 of our residential mortgage loans ownedby us with an outstanding balance of $11.4 million were REO as a result offoreclosure on delinquent loans.

 

**Portfolio Purchases**

 

We purchased $0.5 billion and $2.3 billion par amount of corporatedebt investments during the three months and nine months endedSeptember 30, 2010, respectively, as compared to $0.3 billion and $0.9billion for the three and nine months ended September 30, 2009,respectively.

 

The table below summarizes our corporate debt investment portfoliopurchases for the three and nine months ended September 30, 2010 and 2009:

 

**InvestmentPortfolio Purchases**

**(Dollaramounts in thousands)**

 
| ** **                | ** ** | **Three months ended  September 30, 2010** | ** ** | **Three months ended  September 30, 2009** | ** ** | **Nine months ended  September 30, 2010** | ** ** | **Nine months ended  September 30, 2009** | ** ** |
|---------------------------|------------|----------------------------------------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                | ** ** | **Par Amount**                                            | ** ** | **%**                                                          | ** ** | **Par Amount**                                           | ** ** | **%**                                                         | ** ** | **Par Amount** | ** ** | **%** | ** ** | **Par Amount** | ** ** | **%** | ** ** |
| Corporate Debt Securities |       | $                                                              | 41,586     |                                                           | 8.4        | %                                                             | $          | 52,052                                                        |       | 20.1 | % | $ | 383,886 |   | 16.5 | % | $ | 94,615 |   | 10.2 | % |
| Corporate Loans           |       | 456,090                                                        |       | 91.6                                                           |       | 206,873                                                       |       | 79.9                                                          |       | 1,939,943 |   | 83.5 |   | 831,091 |   | 89.8 |   |
| Total                     |       | $                                                              | 497,676    |                                                           | 100.0      | %                                                             | $          | 258,925                                                       |       | 100.0 | % | $ | 2,323,829 |   | 100.0 | % | $ | 925,706 |   | 100.0 | % |

 

The table above excludes purchases of equity investments, at estimatedfair value, of $7.3 million and $20.1 million for the three and nine monthsended September 30, 2010, respectively, and nil for the three and ninemonths ended September 30, 2009.

 

The period immediately preceding 2009 was marked by historical assetprice declines, wider credit spreads and liquidity shortage. As such, duringthe beginning of 2009, the market continued to feel the effects of the 2008credit crisis. In contrast, due to greater access to liquidity and capitalappreciation during 2010, we had additional cash available for opportunisticpurchases. The majority of our purchases during the three and nine months endedSeptember 30, 2010 were through our Cash Flow CLOs.

 

**Shareholders’ Equity**

 

Our shareholders’ equity at September 30, 2010 andDecember 31, 2009 totaled $1.4 billion and $1.2 billion, respectively.Included in our shareholders’ equity as of September 30, 2010 andDecember 31, 2009 is accumulated other comprehensive income totaling $85.5million and $152.7 million, respectively.

 

Our average shareholders’ equity and return on average shareholders’equity for the three and nine months ended September 30, 2010 was$1.3 billion and 24.7% and $1.3 billion and 30.4%, respectively.  Our average shareholders’ equity and returnon average shareholders’ equity for the three and nine months endedSeptember 30, 2009 was $1.0 billion and 26.5%, and $841.8 million and11.9%, respectively. Return on average shareholders’ equity is defined as netincome divided by weighted average shareholders’ equity.

 

Our book value per share as of September 30, 2010 andDecember 31, 2009 was $8.60 and $7.37, respectively, and is computed basedon 158,412,565 and 158,359,757 shares issued and outstanding as ofSeptember 30, 2010 and December 31, 2009, respectively.

 

On April 29, 2010, our board of directors declared a cashdistribution of $0.10 per share to shareholders of record on May 14, 2010.The aggregate amount of the distribution of $15.8 million was paid onMay 28, 2010.

 

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On August 4, 2010, our board ofdirectors declared a cash distribution of $0.12 per share to shareholders ofrecord on August 18, 2010. The aggregate amount of the distribution of$19.0 million was paid on September 1, 2010.

 

On November 3, 2010, our board ofdirectors declared a cash distribution for the quarter ended September 30,2010 on our common shares of $0.14 per share. The distribution is payable onDecember 1, 2010 to common shareholders of record as of the close ofbusiness on November 17, 2010.

 

**Liquidity and Capital Resources**

 

Weactively manage our liquidity position with the objective of preserving ourability to fund our operations and fulfill our commitments on a timely andcost-effective basis. As of September 30, 2010, we had unrestricted cashand cash equivalents totaling $97.0 million.

 

Althoughwe believe our current sources of liquidity are adequate to preserve ourability to fund our operations and fulfill our commitments, we will continue toevaluate opportunities to deploy incremental capital based on the terms ofcapital available to us. This may include taking advantage of market timing toissue equity or refinance or replace indebtedness, including the issuance ofnew debt securities and retiring debt pursuant to privately negotiatedtransactions, open market purchases or otherwise.

 

The majority of our investments are held in our Cash Flow CLOs.Accordingly, the majority of our cash flows have historically been receivedfrom our investments in the mezzanine and subordinated notes of our Cash FlowCLOs. However, during the period in which a Cash Flow CLO is not in compliancewith an OC Test as outlined in its respective indenture, the cash flows wewould generally expect to receive from our Cash Flow CLO holdings are paid to thesenior note holders of the Cash Flow CLOs. During the quarter endedSeptember 30, 2010, all our Cash Flow CLOs were in compliance with certaincompliance tests (specifically, their respective OC Tests). As CLO 2007-A andCLO 2007-1 came into compliance during the first quarter of 2010, both CLOsresumed paying mezzanine and/or subordinate note holders, including us, during2010.

 

**Sources of Funds**

 

*Cash FlowCLO Transactions*

 

As of September 30, 2010, we had five Cash Flow CLOs outstanding.An affiliate of our Manager owns an interest in the junior notes of bothCLO 2007-1 and CLO 2007-A. The aggregate carrying amount of the juniornotes in CLO 2007-1 and CLO 2007-A held by the affiliate of our Manager is$371.1 million as of September 30, 2010 and is reflected ascollateralized loan obligation junior secured notes to affiliates on ourcondensed consolidated balance sheets.

 

In accordance with GAAP, we consolidate each of these Cash Flow CLOs aswe have the power to direct the activities of these VIEs, as well as theobligation to absorb losses of the VIEs and the right to receive benefits ofthe VIEs that could potentially be significant to the VIEs. We utilize CLOs tofund our investments in corporate loans and corporate debt securities. Theindentures governing our Cash Flow CLOs include numerous compliance tests, themajority of which relate to the CLO’s portfolio profile. In the event that aportfolio profile test is not met, the indenture places restrictions on theability of the CLO’s manager to reinvest available principal proceeds generatedby the collateral in the CLOs until the specific test has been cured. Inaddition to the portfolio profile tests, the indentures for the Cash Flow CLOsinclude OC Tests which set the ratio of the collateral value of the assets inthe CLO to the tranches of debt for which the test is being measured, as wellas interest coverage tests. For purposes of the calculation, collateral valueis the par value of the assets unless an asset is in default, is a discountedobligation, or is a CCC-rated asset in excess of the percentage of CCC-ratedasset limit specified for each Cash Flow CLO.

 

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

 

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

 

The indenture for each Cash Flow CLO specifies a CCC-threshold for thepercentage of total assets in the CLO that can be rated CCC. All assets inexcess of the CCC threshold specified for the respective CLO are included inthe OC Tests at market value and not par.

 

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Defaults of assets in Cash Flow CLOs, ratings downgrade of assets inCash Flow CLOs to CCC, price declines of CCC assets in excess of the proscribedCCC threshold amount, and price declines in assets classified as discountobligations may reduce the over-collateralization ratio such that a Cash FlowCLO is not in compliance. If a Cash Flow CLO is not in compliance with an OCTest, cash flows normally payable to the holders of junior classes of noteswill be used by the CLO to amortize the most senior class of notes until suchpoint as the OC Test is brought back into compliance. As a result of thehistoric declines in asset prices, particularly in the corporate loan and highyield securities asset classes during the fourth quarter of 2008, one or moreof our Cash Flow CLOs were out of compliance with the OC Tests for periods oftime. While being out of compliance with an OC Test would not impact our investmentportfolio or results of operations, it would impact our unrestricted cash flowsavailable for operations, new investments and dividend distributions. As ofSeptember 30, 2010, all of our Cash Flow CLOs were in compliance withtheir respective OC Tests. The following table summarizes several of thematerial tests and metrics for each of our Cash Flow CLOs. This information isbased on the September 2010 monthly reports which are prepared by theindependent third-party trustee for each Cash Flow CLO:

 

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

 

·                  Senior interestcoverage (“IC”) ratio minimum: Minimum required ratio of interest income earnedon investments to interest expense on the senior debt issued by the CLO per therespective CLO’s indenture.

 

·                  Actual seniorIC ratio: The ratio is interest income earned on the investments divided byinterest expense on the senior debt issued by the CLO.

 

·                  CCC amount: Thepar amount of assets rated CCC or below (excluding defaults, if any).

 

·                  CCC thresholdpercentage: Maximum amount of assets in portfolio that are rated CCC withoutbeing subject to being valued at fair value for purposes of the OC Tests.

 

·                  Senior OC Testminimum: Minimum senior over-collateralization requirement per the respectiveCLO’s indenture.

 

·                  Actual seniorOC Test: Actual senior over-collateralization amount as of theSeptember 2010 report date.

 

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

 

·                  Subordinated OCTest minimum: Minimum subordinated over-collateralization requirement per therespective CLO’s indenture.

 

·                  Actualsubordinated OC Test: Actual subordinated over-collateralization amount as ofSeptember 2010 report date.

 

·                  Subordinatecushion / (excess): Dollar amount that the OC Test is being passed, cushion, orfailed (excess).

 
| **(dollar amounts in thousands)** | ** ** | **CLO 2005-1** | ** ** | **CLO 2005-2** | ** ** | **CLO 2006-1** | ** ** | **CLO 2007-1** | ** ** | **CLO 2007-A** | ** ** |
|--------------------------------------------------|------------|---------------------|------------|---------------------|------------|---------------------|------------|---------------------|------------|---------------------|------------|
| Investments                                      |       | $                   | 1,041,099  |                | $          | 996,356             |       | $                   | 1,035,333  |                | $          | 3,315,598 |   | $ | 1,513,407 |   |
| Senior IC ratio minimum                          |       | 115.0               | %          | 125.0               | %          | 115.0               | %          | 115.0               | %          | 120.0               | %          |
| Actual senior IC ratio                           |       | 468.1               | %          | 843.8               | %          | 501.2               | %          | 667.0               | %          | 441.9               | %          |
| CCC amount                                       |       | $                   | 41,264     |                | $          | 39,377              |       | $                   | 157,253    |                | $          | 536,695 |   | $ | 219,458 |   |
| CCC percentage of portfolio                      |       | 4.0                 | %          | 4.0                 | %          | 15.2                | %          | 16.2                | %          | 14.5                | %          |
| CCC threshold percentage                         |       | 5.0                 | %          | 7.5                 | %          | 7.5                 | %          | 7.5                 | %          | 7.5                 | %          |
| Senior OC Test minimum                           |       | 119.4               | %          | 123.0               | %          | 143.1               | %          | 159.1               | %          | 119.7               | %          |
| Actual senior OC Test                            |       | 131.9               | %          | 133.8               | %          | 161.3               | %          | 178.1               | %          | 132.8               | %          |
| Cushion / (Excess)                               |       | $                   | 96,443     |                | $          | 80,134              |       | $                   | 110,728    |                | $          | 336,847 |   | $ | 144,495 |   |
| Subordinated OC Test minimum                     |       | 106.2               | %          | 106.9               | %          | 114.0               | %          | 120.1               | %          | 109.9               | %          |
| Actual subordinated OC Test                      |       | 112.8               | %          | 118.8               | %          | 137.7               | %          | 124.0               | %          | 114.9               | %          |
| Cushion / (Excess)                               |       | $                   | 59,357     |                | $          | 99,268              |       | $                   | 168,749    |                | $          | 100,131 |   | $ | 63,288 |   |

 

On January 4, 2010, CLO 2007-A was brought into compliance withits respective OC Tests. Also, on March 19, 2010, CLO 2007-1, our finalremaining Cash Flow CLO to be failing one or more of its respective OC Tests,was brought into compliance with all of its respective OC Tests. Accordingly,beginning in April 2010, CLO 2007-A resumed paying mezzanine andsubordinate note holders, including us. In addition, beginning in August 2010,CLO 2007-1 resumed paying mezzanine note holders, including us. As reflected inthe table above, each of our Cash Flow CLOs was in compliance with itsrespective IC ratio tests, senior OC Tests and subordinate OC Tests based onthe September 2010 monthly reports for the respective CLOs.

 

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During the three months ended March 31, 2010, in an open marketauction, we purchased $10.3 million of mezzanine notes issued by CLO 2007-A for$5.5 million and $72.7 million of mezzanine and subordinate notes issued by CLO2007-1 for $38.8 million, both of which were previously held by an affiliate ofour manager. These transactions resulted in us recording an aggregate gain onextinguishment of debt totaling $38.7 million during the first quarter of 2010.

 

*SeniorSecured Credit Facility*

 

OnMay 3, 2010, we entered into a credit agreement for a four-year $210.0million asset-based revolving credit facility (the “2014 Facility”), maturingon May 3, 2014, that is subject to, among other things, the terms of aborrowing base derived from the value of eligible specified financialassets. The borrowing base is subject to certain caps and concentrationlimits customary for financings of this type. We may obtain additionalcommitments under the 2014 Facility so long as the aggregate amount ofcommitments at any time does not exceed $600.0 million. On May 5, 2010, weobtained additional commitments of $40.0 million, bringing the total amount ofcommitments under the 2014 Facility to $250.0 million.

 

Wehave the right to prepay loans under the 2014 Facility in whole or in part atany time. Loans under the 2014 Facility bear interest at a rate equal to theLondon interbank offered rate (“LIBOR”) plus 3.25% per annum. The 2014 Facilitycontains customary covenants applicable to us, including a restriction frommaking annual distributions to holders of common shares in excess of 65% of ourestimated annual taxable income.

 

On May 26, 2010, we terminated our credit agreement, dated as ofNovember 10, 2008 and maturing on November 10, 2011 (the “2011 CreditAgreement”). The 2011 Credit Agreement was terminated in connection with ourinitial borrowing under our new credit facility entered into on May 3,2010 as described above. At the time of termination, there was $150.0 millionof borrowings outstanding under the 2011 Credit Agreement which we repaid.

 

As of September 30, 2010, we had no borrowings outstanding underthe 2014 Facility.

 

As of September 30, 2010, we believe we were in compliance withthe 2014 Facility covenant requirements.

 

*ConvertibleDebt*

 

On January 15, 2010, we issued $172.5 million of 7.5%Convertible Senior Notes due January 15, 2017. The 7.5% Notes bearinterest at a rate of 7.5% per year on the principal amount, accruing fromJanuary 15, 2010. Interest is payable semiannually in arrears onJanuary 15 and July 15 of each year, beginning on July 15, 2010.The 7.5% Notes will mature on January 15, 2017 unless previously redeemed,repurchased or converted in accordance with their terms prior to such date.Holders of the 7.5% Notes may convert their notes at the applicable conversionrate at any time prior to the close of business on the business day immediatelypreceding the stated maturity date subject to our right to terminate theconversion rights of the notes. We may satisfy our obligation with respect tothe 7.5% Notes tendered for conversion by delivering to the holder either cash,common shares, no par value, issued by us or a combination thereof. The initialconversion rate for each $1,000 principal amount of 7.5% Notes is 122.2046shares, which is equivalent to an initial conversion price of approximately$8.18 per share. The conversion rate is adjusted under certain circumstances,including the occurrence of certain fundamental change transactions and thepayment of a quarterly cash distribution in excess of $0.05 per share, but willnot be adjusted for accrued and unpaid interest on the 7.5% Notes. As of September 30,2010, the conversation rate for each $1,000 principal amount of 7.5% Notes was124.3675 shares. Net proceeds from the offering totaled $167.3 million,reflecting $172.5 million from the issuance less $5.2 million forunderwriting fees.

 

During the first quarter of 2010, we repurchased $95.2 million paramount of our 7.0% convertible senior notes due 2012, reducing the amountoutstanding from $275.8 million as of December 31, 2009 to$180.6 million as of September 30, 2010. These transactions resultedin us recording a gain of $1.3 million, which was partially offset by awrite-off of $0.6 million of unamortized debt issuance costs during the firstquarter of 2010.

 

*Off-Balance Sheet Commitments*

 

As of September 30, 2010, we had committed to purchase corporateloans with aggregate commitments totaling $108.2 million par. In addition,we participate in certain financing arrangements, including revolvers anddelayed draw facilities, whereby we are committed to provide funding at thediscretion of the borrower up to a specific predetermined amount. As ofSeptember 30, 2010, we had unfunded financing commitments totaling$31.9 million. We do not expect material losses related to the corporateloans for which we commit to purchase and fund.

 

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**Partnership Tax Matters**

 

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

 

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

 

***Qualifying Income Exception***

 

We intend to continue to operate so that we qualify as a partnership,and not as an association or a publicly traded partnership taxable as acorporation, for United States federal income tax purposes. In general, if apartnership is “publicly traded” (as defined in the Code), it will be treatedas a corporation for United States federal income purposes. A publicly tradedpartnership will, however, be taxed as a partnership, and not as a corporation,for United States federal income tax purposes, so long as it is not required toregister under the Investment Company Act and at least 90% of its gross incomefor each taxable year constitutes “qualifying income” within the meaning ofSection 7704(d) of the Code. We refer to this exception as the “qualifyingincome exception.” Qualifying income generally includes rents, dividends,interest (to the extent such interest is neither derived from the “conduct of afinancial or insurance business” nor based, directly or indirectly, upon “incomeor profits” of any person), income and gains derived from certain activitiesrelated to minerals and natural resources, and capital gains from the sale orother disposition of stocks, bonds and real property. Qualifying income alsoincludes other income derived from the business of investing in, among otherthings, stocks and securities.

 

If we fail to satisfy the “qualifying income exception” describedabove, items of income, gain, loss, deduction and credit would not pass throughto holders of our shares and such holders would be treated for United Statesfederal (and certain state and local) income tax purposes as shareholders in acorporation. In such case, we would be required to pay income tax at regularcorporate rates on all of our income. In addition, we would likely be liablefor state and local income and/or franchise taxes on all of our income.Distributions to holders of our shares would constitute ordinary dividendincome taxable to such holders to the extent of our earnings and profits, andthese distributions would not be deductible by us. If we were taxable as acorporation, it could result in a material reduction in cash flow and after-taxreturn for holders of our shares and thus could result in a substantialreduction in the value of our shares and any other securities we may issue.

 

***Tax Consequences of Investmentsin Natural Resources***

 

Asreferenced above, we have made certain investments in natural resources. It islikely that the income from such investments will be treated as effectivelyconnected with the conduct of a United States trade or business with respect toholders of our shares that are not “United States persons” within the meaningof Section 7701(a)(30) of the Code. Furthermore, any notional principal contracts that we enter into, ifany, in connection with investments in natural resources likely would generateincome that would be treated as effectively connected income with the conductof a United States trade or business.  Tothe extent our income is treated as effectively connected income, a holder whois a non-United States person generally would be required to (i) file aUnited States federal income tax return for such year reporting its allocableshare, if any, of our income or loss effectively connected with such trade orbusiness and (ii) pay United States federal income tax at regular UnitedStates tax rates on any such income. Moreover, if such a holder is a corporation,it might be subject to a United States branch profits tax on its allocableshare of our effectively connected income. In addition, distributions to such aholder would be subject to withholding at the highest applicable tax rate tothe extent of the holder’s allocable share of our effectively connected income.Any amount so withheld would be creditable against such holder’s United Statesfederal income tax liability, and such holder could claim a refund to theextent that the amount withheld exceeded such person’s United States federalincome tax liability for the taxable year. Finally, if we are engaged in aUnited States trade or business, a portion of any gain recognized by aninvestor who is a non-United States person on the sale or exchange of itsshares may be treated for United States federal income tax purposes aseffectively connected income, and hence such holder may be subject to UnitedStates federal income tax on the sale or exchange.

 

Inaddition, for all of our holders, investments in natural resources likelyconstitute doing business in the jurisdictions in which such assets arelocated.  As a result, holders of ourshares will likely be required to file foreign, state and local income tax returnsand pay foreign, state and local income taxes in some or all of these variousjurisdictions.  Further, holders may besubject to penalties for failure to comply with those requirements.

 

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**Our Investment Company Act Status**

 

Section 3(a)(1)(A) of the Investment Company Act defines aninvestment company as any issuer that is, holds itself out as being, orproposes to be, primarily engaged in the business of investing, reinvesting ortrading in securities and Section 3(a)(1)(C) of the InvestmentCompany Act defines an investment company as any issuer that is engaged orproposes to engage in the business of investing, reinvesting, owning, holdingor trading in securities and owns or proposes to acquire “investment securities”(within the meaning of the Investment Company Act) having a value exceeding 40%of the value of the issuer’s total assets (exclusive of U.S. governmentsecurities and cash items) on an unconsolidated basis (the “40% test”).Excluded from the term “investment securities” are, among others, securitiesissued by majority-owned subsidiaries unless the subsidiary is an investmentcompany or relies on the exceptions from the definition of an investmentcompany provided by Section 3(c)(1) or Section 3(c)(7) ofthe Investment Company Act (a “fund”). The Investment Company Act defines a “majority-ownedsubsidiary” of a person as any company 50% or more of the outstanding votingsecurities (i.e., those securities presently entitling the holder thereofto vote for the election of directors of the company) of which are owned bythat person, or by another company that is, itself, a majority owned subsidiaryof that person.

 

We are organized as a holding company. We conduct our operationsprimarily through our majority owned subsidiaries. Each of our subsidiaries iseither outside of the definition of an investment company in Sections3(a)(1)(A) and 3(a)(1)(C), described above, or excepted from the definitionof an investment company under the Investment Company Act. We believe that weare not, and that we do not propose to be, primarily engaged in the business ofinvesting, reinvesting or trading in securities and we do not believe that wehave held ourselves out as such. We intend to continue to conduct ouroperations so that we are not required to register as an investment companyunder the Investment Company Act.

 

We monitor our holdings regularly to confirm our continued compliancewith the 40% test. In calculating our position under the 40% test, we areresponsible for determining whether any of our subsidiaries is majority-owned.We treat subsidiaries in which we own at least 50% of the outstanding votingsecurities, including those that issue CLOs, as majority-owned for purposes ofthe 40% test. Some of our subsidiaries may rely solely onSection 3(c)(1) or Section 3(c)(7) of the InvestmentCompany Act. In order for us to satisfy the 40% test, our ownership interestsin those subsidiaries or any of our subsidiaries that are not majority-owned,together with any other “investment securities” that we may own, may not have acombined value in excess of 40% of the value of our total assets on anunconsolidated basis and exclusive of U.S. government securities and cashitems. However, most of our subsidiaries either fall outside of the generaldefinitions of an investment company or rely on exceptions provided byprovisions of, and rules and regulations promulgated under, the InvestmentCompany Act (other than Section 3(c)(1) orSection 3(c)(7) of the Investment Company Act) and, therefore, arenot defined or regulated as investment companies. In order to conform to theseexceptions, these subsidiaries are limited with respect to the assets in whicheach of them can invest and/or the types of securities each of them may issue.We must, therefore, monitor each subsidiary’s compliance with its applicableexception and our freedom of action, and that of our subsidiaries, may belimited as a result. For example, our subsidiaries that issue CLOs generallyrely on Rule 3a-7 under Investment Company Act, while KKR FinancialHoldings II, LLC, or “KFH II,” our subsidiary that is taxed as a REIT forU.S. federal income tax purposes, generally relies on Section 3(c)(5)(C) ofthe Investment Company Act. Each of these exceptions requires, among otherthings that the subsidiary (i) not issue redeemable securities and(ii) engage in the business of holding certain types of assets, consistentwith the terms of the exception. Similarly, any subsidiaries engaged in theownership of oil and gas assets may, depending on the nature of the assets, beoutside the definition of an investment company or rely on exceptions providedby Section 3(c)(5)(C) or Section 3(c)(9) of the InvestmentCompany Act.  WhileSection 3(c)(9) of the Investment Company Act does not limit thenature of the securities issued, it does impose business engagementrequirements that limit the types of assets that may be held.

 

We do not treat our interests in majority-owned subsidiaries that areoutside of the general definition of an investment company or that rely onSection 3(c)(5)(C) or Section 3(c)(9) of, or Rule 3a-7under, the Investment Company Act as investment securities when calculating our40% test.

 

We sometimes refer to our subsidiaries that rely on Rule 3a-7under the Investment Company Act as “CLO subsidiaries.” Rule 3a-7 underthe Investment Company Act is available to certain structured financingvehicles that are engaged in the business of holding financial assets that, bytheir terms, convert into cash within a finite time period and that issue fixedincome securities entitling holders to receive payments that depend primarilyon the cash flows from these assets, provided that, among other things, thestructured finance vehicle does not engage in certain portfolio managementpractices resembling those employed by mutual funds. Accordingly, each of theseCLO subsidiaries is subject to an indenture (or similar transaction documents)that contains specific guidelines and restrictions limiting the discretion ofthe CLO subsidiary and its collateral manager. In particular, these guidelinesand restrictions prohibit the CLO subsidiary from acquiring and disposing ofassets primarily for the purpose of recognizing gains or decreasing lossesresulting from market value changes. Thus, a CLO subsidiary cannot acquire ordispose of assets primarily to enhance returns to the owner of the equity inthe CLO subsidiary; however, subject to this limitation, sales and purchases ofassets may be made so long as doing so does not violate guidelines contained inthe CLO subsidiary’s relevant transaction documents. A CLO subsidiary generallycan, for example, sell an asset if the collateral manager believes that itscredit quality has declined since its acquisition or that the credit profile ofthe obligor will deteriorate and the proceeds of permitted dispositions may bereinvested in 

 

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additionalcollateral, subject to fulfilling the requirements set forth in Rule 3a-7under the Investment Company Act and the CLO subsidiary’s relevant transactiondocuments. As a result of these restrictions, our CLO subsidiaries may sufferlosses on their assets and we may suffer losses on our investments in those CLOsubsidiaries.

 

We sometimes refer to KFH II, our subsidiary that relies onSection 3(c)(5)(C) of the Investment Company Act, as our “REITsubsidiary.” Section 3(c)(5)(C) of the Investment Company Act isavailable to companies that are primarily engaged in the business of purchasingor otherwise acquiring mortgages and other liens on and interests in realestate. While the SEC has not promulgated rules to address precisely whatis required for a company to be considered to be “primarily engaged in thebusiness of purchasing or otherwise acquiring mortgages and other liens on andinterests in real estate,” the SEC’s Division of Investment Management, or the “Division,”has taken the position, through a series of no-action and interpretive letters,that a company may rely on Section 3(c)(5)(C) of the InvestmentCompany Act if, among other things, at least 55% of the company’s assets consistof mortgage loans, other assets that are considered the functional equivalentof mortgage loans and certain other interests in real property (collectively, “qualifyingreal estate assets”), and at least 25% of the company’s assets consist of realestate-related assets (reduced by the excess of the company’s qualifying realestate assets over the required 55%), leaving no more than 20% of the company’sassets to be invested in miscellaneous assets. The Division has also providedguidance as to the types of assets that can be considered qualifying realestate assets. Because the Division’s interpretive letters are not bindingexcept as they relate to the companies to whom they are addressed, if theDivision were to change its position as to, among other things, what assetsmight constitute qualifying real estate assets our REIT subsidiary might berequired to change its investment strategy to comply with the changed position.We cannot predict whether such a change would be adverse.

 

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

 

Most non-agency mortgage-backed securities do not constitute qualifyingreal estate assets because they represent less than the entire beneficialinterest in the related pool of mortgage loans; however, based on Divisionguidance, where our REIT subsidiary’s investment in non-agency mortgage- backedsecurities is the “functional equivalent” of owning the underlying mortgageloans, our REIT subsidiary may treat those securities as qualifying real estateassets. Moreover, investments in mortgage-backed securities that do not constitutequalifying real estate assets will be classified as real estate- relatedassets. Therefore, based upon the specific terms and circumstances related toeach non-agency mortgage-backed security that our REIT subsidiary owns, ourREIT subsidiary will make a determination of whether that security should beclassified as a qualifying real estate asset or as a real estate- relatedasset; and there may be instances where a security is recharacterized frombeing a qualifying real estate asset to a real estate-related asset, orconversely, from being a real estate-related asset to being a qualifying realestate asset based upon the acquisition or disposition or redemption of relatedclasses of securities from the same securitization trust. If our REIT subsidiaryacquires securities that, collectively, receive all of the principal andinterest paid on the related pool of underlying mortgage loans (less fees, suchas servicing and trustee fees, and expenses of the securitization), and thatsubsidiary has foreclosure rights with respect to those mortgage loans, thenour REIT subsidiary will consider those securities, collectively, to bequalifying real estate assets. If another entity acquires any of the securitiesthat are expected to receive cash flow from the underlying mortgage loans, thenour REIT subsidiary will consider whether it has appropriate foreclosure rightswith respect to the underlying loans and whether its investment is a first lossposition in deciding whether these securities should be classified asqualifying real estate assets. If our REIT subsidiary owns more than onesubordinate class, then, to determine the classification of subordinate classesother than the first loss class, our REIT subsidiary will consider whether suchclasses are contiguous with the first loss class (with no other classesabsorbing losses after the first loss class and before any other subordinateclasses that our REIT subsidiary owns), whether our REIT subsidiary owns theentire amount of each such class and whether our REIT subsidiary would continueto have appropriate foreclosure rights in connection with each such class ifthe more subordinate classes were no longer outstanding. If the answers to anyof these questions is no, then our REIT subsidiary would expect not to classifythat particular class, or classes senior to that class, as qualifying realestate assets.

 

We have made or may make oil and gas investments that are held throughone or more subsidiaries and would refer to those subsidiaries as our “Oil andGas Subsidiaries”.  Depending upon thenature of the oil and gas assets held by an Oil and Gas Subsidiary, such Oiland Gas Subsidiary may rely on Section 3(c)(5)(C) orSection 3(c)(9) of the Investment Company Act or may fall outside ofthe general definition of an investment company.  An Oil and Gas Subsidiary that does notengage primarily, propose to engage primarily or hold itself out as engagingprimarily in the business of investing, reinvesting or trading in securitieswill be outside of the general definition of an investment company providedthat it passes the 40% test.  This may bethe case where an Oil and Gas 

 

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Subsidiaryholds a sufficient amount of oil and gas assets constituting real estateinterests together with other assets that are not investment securities such asequipment.  Oil and Gas Subsidiaries thathold oil and gas assets that constitute real property interests, but are unableto pass the 40% test, may rely on Section 3(c)(5)(C), subject to therequirements and restrictions described above. Alternately, an Oil and Gas Subsidiary may rely on Section 3(c)(9) ofthe Investment Company Act if substantially all of its business consists ofowning or holding oil, gas or other mineral royalties or leases, certainfractional interests, or certificates of interest or participations in orinvestment contracts relating to such royalties, leases or fractional interests.  These various restrictions imposed on our Oiland Gas Subsidiaries by the Investment Company Act may have the effect oflimiting our freedom of action with respect to oil and gas assets (or otherassets) that may be held or acquired by such subsidiary or the manner in whichwe may deal in such assets.

 

As noted above, if the combined values of the investment securitiesissued by our subsidiaries that must rely on Section 3(c)(1) orSection 3(c)(7) of the Investment Company Act, together with anyother investment securities we may own, exceeds 40% of the value of our totalassets (exclusive of U.S. government securities and cash items) on anunconsolidated basis, we may be deemed to be an investment company. If we failto maintain an exception, exemption or other exclusion from the InvestmentCompany Act, we could, among other things, be required either (i) tochange substantially the manner in which we conduct our operations to avoidbeing subject to the Investment Company Act or (ii) to register as aninvestment company. Either of these would likely have a material adverse effecton us, our ability to service our indebtedness and to make distributions on ourshares, and on the market price of our shares and any other securities we mayissue. If we were required to register as an investment company under theInvestment Company Act, we would become subject to substantial regulation withrespect to our capital structure (including our ability to use leverage),management, operations, transactions with certain affiliated persons (withinthe meaning of the Investment Company Act), portfolio composition (includingrestrictions with respect to diversification and industry concentration) andother matters. Additionally, our Manager would have the right to terminate ourmanagement agreement. Moreover, if we were required to register as aninvestment company, we would no longer be eligible to be treated as apartnership for United States federal income tax purposes. Instead, we would beclassified as a corporation for tax purposes and would be able to avoidcorporate taxation only to the extent that we were able to elect and qualify asa regulated investment company (“RIC”) under applicable tax rules. Because oureligibility for RIC status would depend on our assets and sources of income atthe time that we were required to register as an investment company, there canbe no assurance that we would be able to qualify as a RIC. If we were to losepartnership status and fail to qualify as a RIC, we would be taxed as a regularcorporation. See “Partnership Tax Matters—*QualifyingIncome Exception*”.

 

We have not requested approval or guidance from the SEC or its staffwith respect to our Investment Company Act determinations, including, inparticular: our treatment of any subsidiary as majority-owned; the complianceof any subsidiary with Section 3(c)(5)(C) orSection 3(c)(9) of, or Rule 3a-7 under, the Investment CompanyAct, including any subsidiary’s determinations with respect to the consistencyof its assets or operations with the requirements thereof; or whether ourinterests in one or more subsidiaries constitute investment securities forpurposes of the 40% test. If the SEC were to disagree with our treatment of oneor more subsidiaries as being excepted from the Investment Company Act pursuantto Rule 3a-7, Section 3(c)(5)(C) or Section 3(c)(9), withour determination that one or more of our other holdings do not constituteinvestment securities for purposes of the 40% test, or with our determinationsas to the nature of the business in which we engage or the manner in which wehold ourselves out, we and/or one or more of our subsidiaries would need toadjust our operating strategies or assets in order for us to continue to passthe 40% test or register as an investment company, either of which could have amaterial adverse effect on us. Moreover, we may be required to adjust ouroperating strategy and holdings, or to effect sales of our assets in a mannerthat, or at a time or price at which, we would not otherwise choose, if thereare changes in the laws or rules governing our Investment Company Actstatus or that of our subsidiaries, or if the SEC or its staff provides morespecific or different guidance regarding the application of relevant provisionsof, and rules under, the Investment Company Act. Such guidance couldprovide additional flexibility, or it could further inhibit our ability, or theability of a subsidiary, to pursue a chosen operating strategy, which couldhave a material adverse effect on us.

 

If the SEC or a court of competent jurisdiction were to find that wewere required, but failed, to register as an investment company in violation ofthe Investment Company Act, we would have to cease business activities, wewould breach representations and warranties and/or be in default as to certainof our contracts and obligations, civil or criminal actions could be broughtagainst us, our contracts would be unenforceable unless a court were to requireenforcement and a court could appoint a receiver to take control of us andliquidate our business, any or all of which would have a material adverseeffect on our business.

 

**Quantitative and Qualitative Disclosures About MarketRisk**

 

***ForeignCurrency Risks***

 

From time to time, we may make investments that are denominated in aforeign currency through which we may be subject to foreign currency exchangerisk. As of September 30, 2010, $286.1 million par amount, or 3.6%, of ourcorporate debt portfolio was denominated in foreign currencies, of which 91.7% wasdenominated in Euro.

 

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***CreditSpread Exposure***

 

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

 

***Interest Rate Risk***

 

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

 

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

 

Interest rate risk impacts our interest income, interest expense,prepayments, and the fair value of our investments, interest rate derivatives,and liabilities. We manage our interest rate risk using various techniquesranging from the purchase of floating rate investments to the use of interestrate derivatives. The use of interest rate derivatives is a component of ourinterest risk management strategy. The contractual notional balance of ourinterest rate swaps was $483.3 million as of September 30, 2010.

 

***DerivativeRisk***

 

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

 

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

 

The following table summarizes the estimated net fair value of ourderivative instruments held as of September 30, 2010 and December 31,2009 (amounts in thousands):

 
| ** **                                | ** ** | **As of September 30,  2010** | ** ** | **As of December 31,  2009** | ** ** |
|-------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                | ** ** | **Notional**                                 | ** ** | **Estimated  Fair Value**              | ** ** | **Notional** | ** ** | **Estimated  Fair Value** | ** ** |
| **Cash Flow Hedges:**                     |       |                                         |       |                                        |       |   |   |   |   |
| Interest rate swaps                       |       | $                                            | 483,333    |                                        | $          | (88,808 | ) | $ | 383,333 |   | $ | (43,800 | ) |
| **Free-Standing Derivatives:**            |       |                                         |       |                                        |       |   |   |   |   |
| Interest rate swaps                       |       | 307,112                                      |       | 1,272                                       |       | 89,246 |   | (281 | ) |
| Credit default swaps—protection sold |       | 13,500                                       |       | 362                                         |       | 51,000 |   | (385 | ) |
| Total rate of return swaps                |       | —                                       |       | 135                                         |       | 104,446 |   | 11,809 |   |
| Foreign exchange forward contracts        |       | (145,282                                     | )          | (19,889                                     | )          | — |   | — |   |
| Foreign exchange options                  |       | 136,340                                      |       | 15,309                                      |       | — |   | — |   |
| Common stock warrants                     |       | —                                       |       | 2,926                                       |       | — |   | 2,471 |   |
| Total                                     |       | $                                            | 795,003    |                                        | $          | (88,693 | ) | $ | 628,025 |   | $ | (30,186 | ) |

 

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For our derivatives, our credit exposure is directly with ourcounterparties and continues until the maturity or termination of such contracts.The following table sets forth the fair values of our primary derivativeinvestments by remaining contractual maturity as of September 30, 2010(amounts in thousands):

 
| ** **                                | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 Years** | ** ** | **More than  5 years** | ** ** | **Total** | ** ** |
|-------------------------------------------|------------|---------------------------------|------------|--------------------|------------|--------------------|------------|----------------------------------|------------|-----------|------------|
| **Cash Flow Hedges:**                     |       |                            |       |               |       |               |       |                             |       |      |       |
| Interest rate swaps                       |       | $                               | —     |               | $          | —             |       | $                                | —     |      | $          | (88,808 | ) | $ | (88,808 | ) |
| **Free-Standing Derivatives:**            |       |                            |       |               |       |               |       |                             |       |      |       |
| Interest rate swaps                       |       | 1,272                           |       | —             |       | —             |       | —                           |       | 1,272     |       |
| Credit default swaps—protection sold |       | —                          |       | 362                |       | —             |       | —                           |       | 362       |       |
| Total rate of return swaps                |       | 135                             |       | —             |       | —             |       | —                           |       | 135       |       |
| Foreign exchange forward contracts        |       | —                          |       | (54                | )          | (19,835            | )          | —                           |       | (19,889   | )          |
| Foreign exchange options                  |       | —                          |       | —             |       | 15,309             |       | —                           |       | 15,309    |       |
| Total                                     |       | $                               | 1,407      |               | $          | 308                |       | $                                | (4,526     | )         | $          | (88,808 | ) | $ | (91,619 | ) |

 

***Management Estimates***

 

The preparation of our financial statements requires management to makeestimates and assumptions that affect the amounts reported in our condensedconsolidated financial statements and accompanying notes. Significantestimates, assumptions and judgments are applied in situations including the determinationof our allowance for loan losses and the valuation of certain investments. Werevise our estimates when appropriate. However, actual results could materiallydiffer from management’s estimates.

 

**Item 3.  Quantitative and Qualitative Disclosuresabout Market Risk**

 

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

 

**Item 4.  Controls and Procedures**

 

TheCompany’s management evaluated, with the participation of the Company’sprincipal executive and principal financial officer, the effectiveness of theCompany’s disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) as of September 30, 2010. Based on their evaluation, the Company’sprincipal executive and principal financial officer concluded that the Company’sdisclosure controls and procedures as of September 30, 2010 were designedand were functioning effectively to provide reasonable assurance that theinformation required to be disclosed by the Company in reports filed under theExchange Act is (i) recorded, processed, summarized, and reported withinthe time periods specified in the SEC’s rules and forms, and(ii) accumulated and communicated to management, including the principalexecutive and principal financial officers, as appropriate, to allow timelydecisions regarding disclosure.

 

Therehas been no change in the Company’s internal control over financial reporting(as defined in Rules 13a-15(f) and 15d-15(f) under the ExchangeAct) that occurred during the three months ending September 30, 2010, thathas materially affected, or is reasonably likely to materially affect, theCompany’s internal control over financial reporting.

 

**PART II.OTHER INFORMATION**

 

**Item 1. LegalProceedings**

 

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

 

On August 7, 2008, the members of our board of directors andcertain of our former executive officers and we were named in a putative classaction complaint filed by Charter Township of Clinton Police and FireRetirement System in the United States District Court for the Southern Districtof New York, or the Charter Litigation. On March 13, 2009, the leadplaintiff filed an amended complaint, which deleted as defendants the membersof our board of directors and named as defendants only our former chiefexecutive officer Saturnino S. Fanlo, our former chief operating officer DavidA. Netjes, our former chief financial officer Jeffrey B. Van Horn and us. Theamended complaint alleges that our April 2, 2007 registration statementand prospectus and the financial

 

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statementsincorporated therein contained material omissions in violation ofSection 11 of the Securities Act, regarding the risks and potential lossesassociated with our real estate-related assets, our ability to finance our realestate-related assets and the adequacy of our loss reserves for our realestate-related assets. The amended complaint further alleges that, pursuant toSection 15 of the Securities Act, Messrs. Fanlo, Netjes and Van Horneach have legal responsibility for the alleged Section 11 violation. OnApril 27, 2009, the defendants filed a motion to dismiss the amendedcomplaint for failure to state a claim under the Securities Act. Oral argumenton the defendants’ motion to dismiss took place on October 5, 2010, andthe parties are awaiting a decision from the Court.

 

On August 15, 2008, the members of our board of directors and ourexecutive officers (collectively, the “Kostecka Individual Defendants”) werenamed in a shareholder derivative action brought by Raymond W. Kostecka, apurported shareholder, in the Superior Court of California, County of SanFrancisco (the “California Derivative Action”). We are named as a nominaldefendant. The complaint in the California Derivative Action asserts claimsagainst the Kostecka Individual Defendants for breaches of fiduciary duty,abuse of control, gross mismanagement, waste of corporate assets, and unjustenrichment in connection with the conduct at issue in the Charter Litigation,including the filing of our April 2, 2007 registration statement withalleged material misstatements and omissions. By order dated January 8,2009, the Court approved the parties’ stipulation to stay the proceedings inthe California Derivative Action until the Charter Litigation is dismissed onthe pleadings or we file an answer to the Charter Litigation.

 

On March 23, 2009, the members of ourboard of directors and certain of our executive officers (collectively, the “HaleyIndividual Defendants”) were named in a shareholder derivative action broughtby Paul B. Haley, a purported shareholder, in the United States District Courtfor the Southern District of New York (the “New York Derivative Action”). Weare named as a nominal defendant. The complaint in the New York DerivativeAction asserts claims against the Haley Individual Defendants for breaches offiduciary duty, breaches of the duty of full disclosure, and for contributionin connection with the conduct at issue in the Charter Litigation, includingthe filing of our April 2, 2007 registration statement with allegedmaterial misstatements and omissions. By order dated June 18, 2009, theCourt approved the parties’ stipulation to stay the proceedings in the New YorkDerivative Action until the Charter Litigation is dismissed on the pleadings orwe file an answer to the Charter Litigation.

 

**Item 1A. Risk Factors**

 

Otherthan the risk factors set forth below, there have been no material changes inour risk factors from those disclosed in our Annual Report on Form 10-Kfor the year ended December 31, 2009.

 

***We leverage our portfolioinvestments, which may adversely affect our return on our investments and mayreduce cash available for distribution.***

 

We leverage our portfolio investments throughborrowings, generally through the use of bank credit facilities, total rate ofreturn swaps, securitizations, including the issuance of CLOs, and otherborrowings. The percentage of leverage varies depending on our ability toobtain credit facilities and the lenders’ and rating agencies’ estimate of thestability of the portfolio investments’ cash flow. At the current time, theonly contractual limitation on our ability to leverage our portfolio is acovenant contained in our senior secured credit facility that our leverageratio cannot exceed 2.0 to 1.0, computed on a basis that generally excludes thedebt of variable interest entities that we consolidate under GAAP. Our returnon our investments and cash available for distribution to holders of our sharesmay be reduced to the extent that changes in market conditions cause the costof our financing to increase relative to the income that can be derived fromthe assets acquired and financed. Our debt service payments reduce cash flowavailable for distributions to holders of our shares.

 

***Maintenance of our Investment Company Act exemptionimposes limits on our operations, which may adversely affect our results ofoperations.***

 

Section 3(a)(1)(A) ofthe Investment Company Act defines an investment company as any issuer that is,holds itself out as being, or proposes to be, primarily engaged in the businessof investing, reinvesting or trading in securities andSection 3(a)(1)(C) of the Investment Company Act defines aninvestment company as any issuer that is engaged or proposes to engage in thebusiness of investing, reinvesting, owning, holding or trading in securitiesand owns or proposes to acquire “investment securities” (within the meaning ofthe Investment Company Act) having a value exceeding 40% of the value of theissuer’s total assets (exclusive of U.S. government securities and cash items)on an unconsolidated basis (the “40% test”). Excluded from the term “investmentsecurities” are, among others, securities issued by majority-owned subsidiariesunless the subsidiary is an investment company or relies on the exceptions fromthe definition of an investment company provided bySection 3(c)(1) or Section 3(c)(7) of the InvestmentCompany Act (a “fund”). The Investment Company Act defines a “majority-ownedsubsidiary” of a person as any company 50% or more of the outstanding votingsecurities (i.e., those securities presently entitling the holder thereofto vote for the election of directors of the company) of which are owned bythat person, or by another company that is, itself, a majority owned subsidiaryof that person.

 

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We are organized as a holding company. We conduct our operationsprimarily through our majority-owned subsidiaries. Each of our subsidiaries iseither outside of the definition of an investment company in Sections3(a)(1)(A) and 3(a)(1)(C), described above, or excepted from the definitionof an investment company under the Investment Company Act. We believe that weare not, and that we do not propose to be, primarily engaged in the business ofinvesting, reinvesting or trading in securities and we do not believe that wehave held ourselves out as such. We intend to continue to conduct ouroperations so that we are not required to register as an investment companyunder the Investment Company Act.

 

We monitor our holdings regularly to confirm our continued compliancewith the 40% test. In calculating our position under the 40% test, we areresponsible for determining whether any of our subsidiaries is majority-owned.We treat subsidiaries in which we own at least 50% of the outstanding votingsecurities, including those that issue CLOs, as majority-owned for purposes ofthe 40% test. Some of our subsidiaries may rely solely onSection 3(c)(1) or Section 3(c)(7) of the InvestmentCompany Act. In order for us to satisfy the 40% test, our ownership interestsin those subsidiaries or any of our subsidiaries that are not majority-owned,together with any other “investment securities” that we may own, may not have acombined value in excess of 40% of the value of our total assets on anunconsolidated basis and exclusive of U.S. government securities and cashitems. However, most of our subsidiaries either fall outside of the generaldefinitions of an investment company or rely on exceptions provided byprovisions of, and rules and regulations promulgated under, the InvestmentCompany Act (other than Section 3(c)(1) orSection 3(c)(7) of the Investment Company Act) and, therefore, arenot defined or regulated as investment companies. In order to conform to theseexceptions, these subsidiaries are limited with respect to the assets in whicheach of them can invest and/or the types of securities each of them may issue.We must, therefore, monitor each subsidiary’s compliance with its applicableexception and our freedom of action, and that of our subsidiaries, may belimited as a result. For example, our subsidiaries that issue CLOs generallyrely on Rule 3a-7 under Investment Company Act, while KKR FinancialHoldings II, LLC, or “KFH II,” our subsidiary that is taxed as a REIT forU.S. federal income tax purposes, generally relies on Section 3(c)(5)(C) ofthe Investment Company Act. Each of these exceptions requires, among otherthings that the subsidiary (i) not issue redeemable securities and(ii) engage in the business of holding certain types of assets, consistentwith the terms of the exception. Similarly, any subsidiaries engaged in theownership of oil and gas assets may, depending on the nature of the assets, beoutside the definition of an investment company or rely on exceptions providedby Section 3(c)(5)(C) or Section 3(c)(9) of the InvestmentCompany Act.  WhileSection 3(c)(9) of the Investment Company Act does not limit thenature of the securities issued, it does impose business engagementrequirements that limit the types of assets that may be held.

 

We do not treat our interests in majority-owned subsidiaries that areoutside of the general definition of an investment company or that rely onSection 3(c)(5)(C) or Section 3(c)(9) of, or Rule 3a-7under, the Investment Company Act as investment securities when calculating our40% test.

 

We sometimes refer to our subsidiaries that rely on Rule 3a-7under the Investment Company Act as “CLO subsidiaries.” Rule 3a-7 underthe Investment Company Act is available to certain structured financingvehicles that are engaged in the business of holding financial assets that, bytheir terms, convert into cash within a finite time period and that issue fixedincome securities entitling holders to receive payments that depend primarilyon the cash flows from these assets, provided that, among other things, thestructured finance vehicle does not engage in certain portfolio managementpractices resembling those employed by mutual funds. Accordingly, each of theseCLO subsidiaries is subject to an indenture (or similar transaction documents)that contains specific guidelines and restrictions limiting the discretion ofthe CLO subsidiary and its collateral manager. In particular, these guidelinesand restrictions prohibit the CLO subsidiary from acquiring and disposing ofassets primarily for the purpose of recognizing gains or decreasing lossesresulting from market value changes. Thus, a CLO subsidiary cannot acquire ordispose of assets primarily to enhance returns to the owner of the equity inthe CLO subsidiary; however, subject to this limitation, sales and purchases ofassets may be made so long as doing so does not violate guidelines contained inthe CLO subsidiary’s relevant transaction documents. A CLO subsidiary generallycan, for example, sell an asset if the collateral manager believes that its creditquality has declined since its acquisition or that the credit profile of theobligor will deteriorate and the proceeds of permitted dispositions may bereinvested in additional collateral, subject to fulfilling the requirements setforth in Rule 3a-7 under the Investment Company Act and the CLO subsidiary’srelevant transaction documents. As a result of these restrictions, our CLOsubsidiaries may suffer losses on their assets and we may suffer losses on ourinvestments in those CLO subsidiaries.

 

We sometimes refer to KFH II, our subsidiary that relies onSection 3(c)(5)(C) of the Investment Company Act, as our “REITsubsidiary.” Section 3(c)(5)(C) of the Investment Company Act isavailable to companies that are primarily engaged in the business of purchasingor otherwise acquiring mortgages and other liens on and interests in realestate. While the SEC has not promulgated rules to address precisely whatis required for a company to be considered to be “primarily engaged in thebusiness of purchasing or otherwise acquiring mortgages and other liens on andinterests in real estate,” the SEC’s Division of Investment Management, or the “Division,”has taken the position, through a series of no-action and interpretive letters,that a company may rely on Section 3(c)(5)(C) of the InvestmentCompany Act if, among other things, at least 55% of the company’s assetsconsist of mortgage loans, other assets that are considered the functionalequivalent of mortgage loans and certain other interests in real property (collectively,“qualifying real estate assets”), and at least 25% of the company’s assetsconsist of real estate-related assets (reduced by the excess of the company’squalifying real estate assets over the required 55%), leaving no more than 20%of the company’s assets to 

 

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beinvested in miscellaneous assets. The Division has also provided guidance as tothe types of assets that can be considered qualifying real estate assets.Because the Division’s interpretive letters are not binding except as theyrelate to the companies to whom they are addressed, if the Division were tochange its position as to, among other things, what assets might constitutequalifying real estate assets our REIT subsidiary might be required to changeits investment strategy to comply with the changed position. We cannot predictwhether such a change would be adverse.

 

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

 

Most non-agency mortgage-backed securities do not constitute qualifyingreal estate assets because they represent less than the entire beneficialinterest in the related pool of mortgage loans; however, based on Divisionguidance, where our REIT subsidiary’s investment in non-agency mortgage- backedsecurities is the “functional equivalent” of owning the underlying mortgageloans, our REIT subsidiary may treat those securities as qualifying real estateassets. Moreover, investments in mortgage-backed securities that do not constitutequalifying real estate assets will be classified as real estate- relatedassets. Therefore, based upon the specific terms and circumstances related toeach non-agency mortgage-backed security that our REIT subsidiary owns, ourREIT subsidiary will make a determination of whether that security should beclassified as a qualifying real estate asset or as a real estate- relatedasset; and there may be instances where a security is recharacterized frombeing a qualifying real estate asset to a real estate-related asset, orconversely, from being a real estate-related asset to being a qualifying realestate asset based upon the acquisition or disposition or redemption of relatedclasses of securities from the same securitization trust. If our REIT subsidiaryacquires securities that, collectively, receive all of the principal andinterest paid on the related pool of underlying mortgage loans (less fees, suchas servicing and trustee fees, and expenses of the securitization), and thatsubsidiary has foreclosure rights with respect to those mortgage loans, thenour REIT subsidiary will consider those securities, collectively, to bequalifying real estate assets. If another entity acquires any of the securitiesthat are expected to receive cash flow from the underlying mortgage loans, thenour REIT subsidiary will consider whether it has appropriate foreclosure rightswith respect to the underlying loans and whether its investment is a first lossposition in deciding whether these securities should be classified asqualifying real estate assets. If our REIT subsidiary owns more than onesubordinate class, then, to determine the classification of subordinate classesother than the first loss class, our REIT subsidiary will consider whether suchclasses are contiguous with the first loss class (with no other classesabsorbing losses after the first loss class and before any other subordinateclasses that our REIT subsidiary owns), whether our REIT subsidiary owns theentire amount of each such class and whether our REIT subsidiary would continueto have appropriate foreclosure rights in connection with each such class ifthe more subordinate classes were no longer outstanding. If the answers to anyof these questions is no, then our REIT subsidiary would expect not to classifythat particular class, or classes senior to that class, as qualifying realestate assets.

 

We have made or may make oil and gas investments that are held throughone or more subsidiaries and would refer to those subsidiaries as our “Oil andGas Subsidiaries”.  Depending upon thenature of the oil and gas assets held by an Oil and Gas Subsidiary, such Oiland Gas Subsidiary may rely on Section 3(c)(5)(C) orSection 3(c)(9) of the Investment Company Act or may fall outside ofthe general definition of an investment company.  An Oil and Gas Subsidiary that does notengage primarily, propose to engage primarily or hold itself out as engagingprimarily in the business of investing, reinvesting or trading in securitieswill be outside of the general definition of an investment company providedthat it passes the 40% test.  This may bethe case where an Oil and Gas Subsidiary holds a sufficient amount of oil andgas assets constituting real estate interests together with other assets thatare not investment securities such as equipment.  Oil and Gas Subsidiaries that hold oil andgas assets that constitute real property interests, but are unable to pass the40% test, may rely on Section 3(c)(5)(C), subject to the requirements andrestrictions described above. Alternately, an Oil and Gas Subsidiary may rely onSection 3(c)(9) of the Investment Company Act if substantially all ofits business consists of owning or holding oil, gas or other mineral royalties orleases, certain fractional interests, or certificates of interest orparticipations in or investment contracts relating to such royalties, leases orfractional interests.  These variousrestrictions imposed on our Oil and Gas Subsidiaries by the Investment CompanyAct may have the effect of limiting our freedom of action with respect to oiland gas assets (or other assets) that may be held or acquired by suchsubsidiary or the manner in which we may deal in such assets.

 

As noted above, if the combined values of the investment securitiesissued by our subsidiaries that must rely on Section 3(c)(1) orSection 3(c)(7) of the Investment Company Act, together with anyother investment securities we may own, exceeds 40% of the value of our totalassets (exclusive of U.S. government securities and cash items) on anunconsolidated basis, we may be deemed to be an investment company. If we failto maintain an exception, exemption or other exclusion from the InvestmentCompany Act, we could, among other things, be required either (i) tochange substantially the manner in which we conduct our 

 

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operationsto avoid being subject to the Investment Company Act or (ii) to registeras an investment company. Either of these would likely have a material adverseeffect on us, our ability to service our indebtedness and to make distributionson our shares, and on the market price of our shares and any other securitieswe may issue. If we were required to register as an investment company underthe Investment Company Act, we would become subject to substantial regulationwith respect to our capital structure (including our ability to use leverage),management, operations, transactions with certain affiliated persons (withinthe meaning of the Investment Company Act), portfolio composition (includingrestrictions with respect to diversification and industry concentration) andother matters. Additionally, our Manager would have the right to terminate ourmanagement agreement. Moreover, if we were required to register as aninvestment company, we would no longer be eligible to be treated as apartnership for United States federal income tax purposes. Instead, we would beclassified as a corporation for tax purposes and would be able to avoidcorporate taxation only to the extent that we were able to elect and qualify asa regulated investment company (“RIC”) under applicable tax rules. Because oureligibility for RIC status would depend on our assets and sources of income atthe time that we were required to register as an investment company, there canbe no assurance that we would be able to qualify as a RIC. If we were to losepartnership status and fail to qualify as a RIC, we would be taxed as a regularcorporation. See “Partnership Tax Matters—*QualifyingIncome Exception*”.

 

We have not requested approval or guidance from the SEC or its staffwith respect to our Investment Company Act determinations, including, inparticular: our treatment of any subsidiary as majority-owned; the complianceof any subsidiary with Section 3(c)(5)(C) orSection 3(c)(9) of, or Rule 3a-7 under, the Investment CompanyAct, including any subsidiary’s determinations with respect to the consistencyof its assets or operations with the requirements thereof; or whether ourinterests in one or more subsidiaries constitute investment securities forpurposes of the 40% test. If the SEC were to disagree with our treatment of oneor more subsidiaries as being excepted from the Investment Company Act pursuantto Rule 3a-7, Section 3(c)(5)(C) or Section 3(c)(9), withour determination that one or more of our other holdings do not constituteinvestment securities for purposes of the 40% test, or with our determinationsas to the nature of the business in which we engage or the manner in which wehold ourselves out, we and/or one or more of our subsidiaries would need toadjust our operating strategies or assets in order for us to continue to passthe 40% test or register as an investment company, either of which could have amaterial adverse effect on us. Moreover, we may be required to adjust ouroperating strategy and holdings, or to effect sales of our assets in a mannerthat, or at a time or price at which, we would not otherwise choose, if thereare changes in the laws or rules governing our Investment Company Actstatus or that of our subsidiaries, or if the SEC or its staff provides morespecific or different guidance regarding the application of relevant provisionsof, and rules under, the Investment Company Act. Such guidance couldprovide additional flexibility, or it could further inhibit our ability, or theability of a subsidiary, to pursue a chosen operating strategy, which couldhave a material adverse effect on us.

 

If the SEC or a court of competent jurisdiction were to find that wewere required, but failed, to register as an investment company in violation ofthe Investment Company Act, we would have to cease business activities, wewould breach representations and warranties and/or be in default as to certainof our contracts and obligations, civil or criminal actions could be broughtagainst us, our contracts would be unenforceable unless a court were to requireenforcement and a court could appoint a receiver to take control of us andliquidate our business, any or all of which would have a material adverseeffect on our business.

 

***There are various potential conflicts of interest inour relationship with our Manager and its affiliates, including KKR, which couldresult in decisions that are not in the best interests of holders of ourshares.***

 

Weare subject to potential conflicts of interest arising out of our relationshipwith our Manager and its affiliates. As of December 31, 2009, our Managerand its affiliates collectively owned approximately 8.5% of our outstandingcommon shares on a fully diluted basis. In addition, as of December 31,2009 our chairman, Paul M. Hazen, who serves as a member of our Manager’sinvestment committee beneficially owned approximately 0.8% of our outstandingcommon shares on a fully diluted basis, and two of our directors, Scott C.Nuttall, who is an executive at KKR and until February 2009 served as amember of our Manager’s investment committee and William C. Sonneborn, who isan executive at KKR and serves as a member of our Manager’s investmentcommittee, beneficially owned approximately 0.8% and 0.7% of our outstandingcommon shares on a fully diluted basis, respectively. For purposes of computingthe percentage of shares of our outstanding common shares beneficially owned asof December 31, 2009 by any person or persons on a fully diluted basis, wedefine beneficial ownership to include securities actually owned by a person orpersons and securities over which that person or persons have or share votingor dispositive control, and we have based that calculation on our common sharesand options to purchase our common shares outstanding as of December 31,2009 and have assumed the exercise of all options to purchase our common sharesbeneficially owned by such person or persons, as the case may be. Ourmanagement agreement with our Manager was negotiated between related parties,and its terms, including fees payable, may not be as favorable to us as if ithad been negotiated with an unaffiliated third party. Pursuant to themanagement agreement, our Manager will not assume any responsibility other thanto render the services called for thereunder and will not be responsible forany action of our board of directors in following or declining to follow itsadvice or recommendations. The management agreement provides that our Manager,its members, managers, officers and employees will not be liable to us, anysubsidiary of ours, our directors, holders of our shares or any subsidiary’sshareholders for acts or omissions pursuant to or in accordance with themanagement agreement, except by reason of acts constituting bad faith, willfulmisconduct, gross negligence, or reckless disregard of their duties under themanagement agreement. Pursuant to the management agreement, we have agreed toindemnify our Manager and its members, managers, officers and employees andeach person controlling our Manager with respect to all expenses, losses,damages, liabilities, demands, charges and claims arising from acts oromissions of such indemnified party not constituting bad faith, willfulmisconduct, gross negligence, or reckless disregard of duties, performed ingood faith in accordance with and pursuant to the management agreement.

 

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Asnoted above, our Manager will at times cause us to invest in loans andsecurities of companies affiliated with KKR, provided that such investmentsmeet our requirements, and the terms of which such investments are made may notbe as favorable as if they were negotiated with unaffiliated third parties. Inaddition, from time to time, the Manager may cause us to buy loans orsecurities from, or to sell loans or securities to, other clients of KKR or itsaffiliates. The Manager has implemented policies and procedures to mitigateconflicts of interest in such transactions.

 

The parent company of our Manager has furnishedinformation to the SEC in response to a request from the SEC for information inconnection with its examination of certain investment advisors in order toreview trading procedures and valuation practices in the collateral pools ofstructured credit products. The parent company of our Manager also providedinformation regarding the surrender by us for cancellation, without consideration,of certain notes that had been issued to us by collateral pools of CLOs. Theparent company of our Manager is fully cooperating with the SEC’s examination.

 

***We have made and may make investments, such asinvestments in natural resources, that would generate income that is treated aseffectively connected with respect to holders of our common shares that are not“United States persons.”***

 

We have made and may make investments, such asinvestments in natural resources, the income from which likely would be treatedas effectively connected with the conduct of a United States trade or businesswith respect to holders of our shares that are not “United States persons”within the meaning of Section 7701(a)(30) of the Code.  Furthermore, any notional principal contractsthat we enter into, if any, in connection with investments in natural resourceslikely would generate income that would be treated as effectively connectedincome with the conduct of a United States trade or business.  To the extent our income is treated aseffectively connected income, a holder who is a non-United States persongenerally would be required to (i) file a United States federalincome tax return for such year reporting its allocable share, if any, of ourincome or loss effectively connected with such trade or business and(ii) pay United States federal income tax at regular United States taxrates on any such income. Moreover, if such a holder is a corporation, it mightbe subject to a United States branch profits tax on its allocable share of oureffectively connected income. In addition, distributions to such a holder wouldbe subject to withholding at the highest applicable tax rate to the extent ofthe holder’s allocable share of our effectively connected income. Any amount sowithheld would be creditable against such holder’s United States federal incometax liability, and such holder could claim a refund to the extent that theamount withheld exceeded such person’s United States federal income taxliability for the taxable year. Finally, if we are engaged in a United Statestrade or business, a portion of any gain recognized by an investor who is anon-United States person on the sale or exchange of its shares may be treatedfor United States federal income tax purposes as effectively connected income,and hence such holder may be subject to United States federal income tax on thesale or exchange.

 

***Holders of our shares may besubject to foreign, state and local taxes and return filing requirements as aresult of investing in our shares.***

 

In addition to United States federal income taxes, holders of ourcommon shares will likely be subject to other taxes, including foreign, stateand local taxes, unincorporated business taxes and estate, inheritance orintangible taxes that are imposed by the various jurisdictions in which weconduct business or own property.  Forexample, we will likely be treated as doing business in any foreign, state orlocal jurisdiction in which our natural resources investments are located.  As a result, our holders will likely berequired to file foreign, state and local income tax returns and pay foreign,state and local income taxes in some or all of these variousjurisdictions.  Further, holders may besubject to penalties for failure to comply with those requirements.

 

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

 

On July 15, 2010, ournon-employee directors deferred an immaterial amount of cash compensation inexchange for 4,908 phantom shares pursuant to the KKR Financial Holdings LLCNon-Employee Directors’ Deferred Compensation and Share Award Plan. Inaddition, on August 9, 2010, our non-employee directors received a totalof 26,965 phantom shares in lieu of restricted shares pursuant to the KKRFinancial Holdings LLC Non-Employee Directors’ Deferred Compensation and ShareAward Plan. Each phantom share is the economic equivalent of one of our commonshares. The phantom shares become payable, in cash or common shares, at theelection of the Company, upon the earlier of (i) the first day of January followingthe applicable non-employee director’s termination of service as a director or (ii) anelection date pre-selected by the applicable non-employee director, and in anyevent in cash or common shares, at the election of the applicable non-employeedirector, upon the occurrence of a change in control of the Company. The grantsmade to our non-employee directors were exempt from the registrationrequirements of the Securities Act pursuant to Section 4(2) thereof.

 

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OnAugust 9, 2010, the Compensation Committee of our board of directorsgranted to our non-employee directors an aggregate of 52,808 restricted commonshares pursuant to our 2007 Share Incentive Plan. Each of these grants vests inone-third increments on the first three anniversaries of the date of grant. Thegrants made to our non-employee directors were exempt from the registrationrequirements of the Securities Act pursuant to Section 4(2) thereof.For further discussion of the 2007 Share Incentive Plan, see “Item 1. FinancialStatements—Note 12. Share Options and Restricted Shares” of this QuarterlyReport on Form 10-Q.

 

**Item 3. DefaultsUpon Senior Securities**

 

None.

 

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

 

None.

 

**Item 5. OtherInformation**

 

OnNovember 3, 2010, our board of directors appointed Chief OperatingOfficer Michael R. McFerran to the additional post of Chief Financial Officer.Mr. McFerran will succeed Jeffrey B. Van Horn, who has been named KohlbergKravis Roberts & Co. L.P.’s Global Director of Tax as well as ourExecutive Vice President, Director of Tax. The board of directors alsoappointed Nicole J. Macarchuk as our General Counsel. All appointments wereeffective on November 3, 2010.

 

Mr. McFerran has beenour Chief Operating Officer since December 2008. Mr. McFerran hasbeen employed by our Manager since June 2005 and is our Manager’s ChiefFinancial Officer. Prior to joining our Manager, Mr. McFerran spent themajority of his career at Ernst & Young in their financial servicespractice, where he specialized in providing assurance and consulting servicesto a diverse mix of financial services firms. Additionally, prior to joiningKKR, Mr. McFerran held Vice President positions at both XL Capital Ltd.and American Express. Mr. McFerran holds an M.B.A. from the Haas School ofBusiness at U.C. Berkeley and is a Certified Public Accountant.

 

We expect that in February 2011,certain restricted common shares held by Mr. McFerran and certain otherexecutive officers of the Company will vest in accordance with their terms,resulting in federal and state tax withholding obligations.  The Company may engage in transactions withMr. McFerran and such other executive officers in order to facilitate thepayment of such withholding obligations, including purchasing, at thethen-current market price, a number of such restricted common shares sufficientto satisfy the withholding obligations of such individuals.

 

Ms. Macarchuk joins ourManager as a Director and is our Manager’s General Counsel. Prior to joining,Ms. Macarchuk served as General Counsel and Managing Director at Och-ZiffCapital Management Group.  She holds aJ.D. from Fordham University Law School and a B.A. from Fordham University.

 

**Item 6. Exhibits**

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

 

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**SIGNATURES**

 

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

 
|                         |       | KKR Financial Holdings LLC                                            |
|------------------------------|------------|-----------------------------------------------------------------------|
| ** **                   | ** ** | ** **                                                            |
| **Signature**                | ** ** | **Title**                                                             |
|                         |       |                                                                  |
|                         |       |                                                                  |
| /s/  WILLIAM C. SONNEBORN    |       | Chief  Executive Officer (Principal Executive Officer)                |
| **William C. Sonneborn**     |       |                                                                  |
|                         |       |                                                                  |
|                         |       |                                                                  |
| /s/  MICHAEL R. MCFERRAN     |       | Chief  Financial Officer (Principal Financial and Accounting Officer) |
| **Michael R. McFerran**      |       |
|                         |       |                                                                  |
| Date:  November 4, 2010 |       |                                                                  |

 

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