**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

| **x**      | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|------------|---------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                              |
| ** ** | **For the  quarterly period ended: June 30, 2007**                                                      |
| ** ** | ** **                                                                                              |
| ** ** | **OR**                                                                                                  |
| ** ** | ** **                                                                                              |
| **o**      | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**Forthe transition periodfrom                  to**

**Commissionfile number 001-33437**

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**KKRFINANCIAL HOLDINGS LLC**

(Exact name of registrantas specified in its governing instruments)

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

 

**(415) 315-3620**

Registrant’s telephonenumber, including area code

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Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding12 months and (2) has been subject to such filing requirements forthe past 90 days. Yes x   No o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act. (Check one):

| Large accelerated  filer x | Accelerated filer o | Non-accelerated filer o |
|---------------------------------|--------------------------|------------------------------|

 

Indicate by check mark whether the Registrant is ashell company (as defined in Rule 12b-2 of the Securities Exchange Act of1934). Yes o   No x

Theregistrant’s number of common shares outstanding as of August 1, 2007 was80,498,990.

 

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**TABLE OF CONTENTS**
| **PART I .**          |   | 3                                                                                           |
|-----------------------|--------|---------------------------------------------------------------------------------------------|
| FINANCIAL INFORMATION |   | 3                                                                                           |
| Item 1.               |   | Financial  Statements                                                                       |   | 3 |
| Item 2.               |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   | 25 |
| Item 3.               |   | Quantitative  and Qualitative Disclosures about Market Risk                                 |   | 45 |
| Item 4.               |   | Controls and  Procedures                                                                    |   | 45 |
| **Part II.**     |   |                                                                                        |   | 45 |
| OTHER INFORMATION     |   | 45                                                                                          |
| Item 1.               |   | Legal Proceedings                                                                           |   | 45 |
| Item  1A.             |   | Risk  Factors                                                                               |   | 45 |
| Item 2.               |   | Unregistered  Sales of Equity Securities and Use of Proceeds                                |   | 45 |
| Item 3.               |   | Defaults Upon  Senior Securities                                                            |   | 45 |
| Item 4.               |   | Submission of  Matters to a Vote of Security Holders                                        |   | 45 |
| Item 5.               |   | Other Information                                                                           |   | 46 |
| Item  6.              |   | Exhibits                                                                                    |   | 46 |

 

2

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**PART I. FINANCIAL INFORMATION**

**Item 1. Financial Statements(Unaudited)**

**KKRFinancial Holdings LLC and SubsidiariesCondensed Consolidated Balance Sheets(Unaudited)(Amounts in thousands, except share information)**
| ** **                                                                                                                                                                                                         | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                         | ** ** | **2007**          | ** ** | **2006**              | ** ** |
| **Assets**                                                                                                                                                                                                         |       |              |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                         |       | $                 | 23,481     |                  | $          | 5,125 |   |
| Restricted cash and  cash equivalents                                                                                                                                                                              |       | 713,219           |       | 138,065               |       |
| Trading securities,  $6,530,082 and $0 pledged as collateral as of June 30, 2007 and December 31,  2006, respectively                                                                                              |       | 6,587,422         |       | —                |       |
| Securities  available-for-sale, $1,180,412 and $8,336,435 pledged as collateral as of  June 30, 2007 and December 31, 2006, respectively                                                                      |       | 1,438,966         |       | 8,500,636             |       |
| Loans ($4,565,474 and  $0 at fair value as of June 30, 2007 and December 31, 2006, respectively),  net of allowance for loan losses of $0 and $1,500 as of June 30, 2007 and  December 31, 2006, respectively |       | 9,817,232         |       | 8,442,021             |       |
| Derivative assets                                                                                                                                                                                                  |       | 80,786            |       | 63,433                |       |
| Interest receivable                                                                                                                                                                                                |       | 104,694           |       | 84,048                |       |
| Principal receivable                                                                                                                                                                                               |       | 26,315            |       | 4,540                 |       |
| Non-marketable equity  securities                                                                                                                                                                                  |       | 173,823           |       | 166,323               |       |
| Investment in  unconsolidated affiliate                                                                                                                                                                            |       | —            |       | 104,035               |       |
| Other assets                                                                                                                                                                                                       |       | 131,360           |       | 56,951                |       |
| **Total  assets**                                                                                                                                                                                                  |       | $                 | 19,097,298 |                  | $          | 17,565,177 |   |
| **Liabilities**                                                                                                                                                                                                    |       |              |       |                  |       |
| Repurchase agreements                                                                                                                                                                                              |       | $                 | 2,393,138  |                  | $          | 4,457,089 |   |
| Collateralized loan  obligation senior secured notes                                                                                                                                                               |       | 4,621,000         |       | 2,252,500             |       |
| Collateralized loan  obligation junior secured notes to affiliates                                                                                                                                                 |       | 431,293           |       | —                |       |
| Asset-backed secured  liquidity notes                                                                                                                                                                              |       | 8,942,827         |       | 8,705,601             |       |
| Secured revolving  credit facility                                                                                                                                                                                 |       | 156,531           |       | 34,710                |       |
| Secured demand loan                                                                                                                                                                                                |       | 41,658            |       | 41,658                |       |
| Junior subordinated  notes                                                                                                                                                                                         |       | 329,908           |       | 257,743               |       |
| Accounts payable,  accrued expenses and other liabilities                                                                                                                                                          |       | 376,205           |       | 45,237                |       |
| Accrued interest  payable                                                                                                                                                                                          |       | 41,973            |       | 36,991                |       |
| Accrued interest payable  to affiliates                                                                                                                                                                            |       | 8,256             |       | —                |       |
| Related party payable                                                                                                                                                                                              |       | 11,186            |       | 6,901                 |       |
| Income tax liability                                                                                                                                                                                               |       | 500               |       | 601                   |       |
| Securities sold, not  yet purchased                                                                                                                                                                                |       | 58,491            |       | —                |       |
| Derivative liabilities                                                                                                                                                                                             |       | 1,805             |       | 2,715                 |       |
| **Total  liabilities**                                                                                                                                                                                             |       | 17,414,771        |       | 15,841,746            |       |
| **Shareholders’ Equity**                                                                                                                                                                                      |       |              |       |                  |       |
| Preferred shares, no  par value, 50,000,000 shares authorized and none issued and outstanding at  June 30, 2007 and December 31, 2006                                                                         |       | —            |       | —                |       |
| Common shares, no par  value, 250,000,000 shares authorized and 80,464,713 shares issued and  outstanding at June 30, 2007 and December 31, 2006                                                              |       | —            |       | —                |       |
| Paid-in-capital                                                                                                                                                                                                    |       | 1,677,827         |       | 1,671,135             |       |
| Accumulated other  comprehensive income                                                                                                                                                                            |       | 65,768            |       | 70,520                |       |
| Accumulated deficit                                                                                                                                                                                                |       | (61,068           | )          | (18,224               | )          |
| **Total  shareholders’ equity**                                                                                                                                                                               |       | 1,682,527         |       | 1,723,431             |       |
| **Total liabilities and  shareholders’ equity**                                                                                                                                                               |       | $                 | 19,097,298 |                  | $          | 17,565,177 |   |

 

See notes to condensedconsolidated financial statements.

3

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**KKR Financial Holdings LLC andSubsidiariesCondensed Consolidated Statements of Operations(Unaudited)(Amounts in thousands, except per share information)**
| ** **                                                                         | ** ** | **For the three** | ** ** | **For the three** | ** ** | **For the six**   | ** ** | **For the six**   | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                         | ** ** | **months ended**       | ** ** | **months ended**       | ** ** | **months ended**       | ** ** | **months ended**       | ** ** |
| ** **                                                                         | ** ** | **June 30, 2007** | ** ** | **June 30, 2006** | ** ** | **June 30, 2007** | ** ** | **June 30, 2006** | ** ** |
| **Net  investment income:**                                                        | ** ** | ** **                  | ** ** | ** **                  | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Securities  interest income                                                        |       | $                           | 114,294    |                        | $          | 94,010                      |       | $                           | 229,902    |   | $ | 173,974 |   |
| Loan interest  income                                                              |       | 148,993                     |       | 130,098                     |       | 282,735                     |       | 255,204                     |       |
| Dividend income                                                                    |       | 884                         |       | 912                         |       | 1,858                       |       | 1,795                       |       |
| Other interest  income                                                             |       | 5,960                       |       | 1,807                       |       | 8,647                       |       | 3,652                       |       |
| Total investment  income                                                           |       | 270,131                     |       | 226,827                     |       | 523,142                     |       | 434,625                     |       |
| Interest expense                                                                   |       | (210,219                    | )          | (175,094                    | )          | (410,285                    | )          | (331,657                    | )          |
| Interest expense  to affiliates                                                    |       | (8,256                      | )          | —                      |       | (8,256                      | )          | —                      |       |
| Net investment  income                                                             |       | 51,656                      |       | 51,733                      |       | 104,601                     |       | 102,968                     |       |
| **Other  income:**                                                                 | ** ** | ** **                  | ** ** | ** **                  | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Net unrealized  loss on trading securities and loans carried at fair value         |       | (16,821                     | )          | —                      |       | (14,052                     | )          | —                      |       |
| Net realized and  unrealized gain on derivatives and foreign exchange              |       | 6,481                       |       | 3,299                       |       | 13,619                      |       | 3,309                       |       |
| Net realized  gain on investments                                                  |       | 26,752                      |       | 691                         |       | 33,696                      |       | 2,139                       |       |
| Fee and other  income                                                              |       | 2,540                       |       | 458                         |       | 4,588                       |       | 673                         |       |
| Total other  income                                                                |       | 18,952                      |       | 4,448                       |       | 37,851                      |       | 6,121                       |       |
| **Non-investment  expenses:**                                                      | ** ** | ** **                  | ** ** | ** **                  | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Related party  management compensation                                             |       | 15,114                      |       | 13,778                      |       | 34,413                      |       | 28,218                      |       |
| Professional  services                                                             |       | 806                         |       | 548                         |       | 1,347                       |       | 1,495                       |       |
| Loan servicing  expense                                                            |       | 3,126                       |       | 3,720                       |       | 6,389                       |       | 7,716                       |       |
| Insurance  expense                                                                 |       | 192                         |       | 274                         |       | 386                         |       | 498                         |       |
| Directors  expenses                                                                |       | 285                         |       | 375                         |       | 605                         |       | 748                         |       |
| General and  administrative expenses                                               |       | 3,756                       |       | 2,436                       |       | 9,764                       |       | 4,664                       |       |
| Total  non-investment expenses                                                     |       | 23,279                      |       | 21,131                      |       | 52,904                      |       | 43,339                      |       |
| Income before  equity in income of unconsolidated affiliate and income tax expense |       | 47,329                      |       | 35,050                      |       | 89,548                      |       | 65,750                      |       |
| Equity in income  of unconsolidated affiliate                                      |       | 5,725                       |       | —                      |       | 12,706                      |       | —                      |       |
| Income before  income tax expense                                                  |       | 53,054                      |       | 35,050                      |       | 102,254                     |       | 65,750                      |       |
| Income tax  expense                                                                |       | 83                          |       | 119                         |       | 859                         |       | 431                         |       |
| Net income                                                                         |       | $                           | 52,971     |                        | $          | 34,931                      |       | $                           | 101,395    |   | $ | 65,319 |   |
| Net income per  common share:                                                      |       |                        |       |                        |       |                        |       |                        |       |
| Basic                                                                              |       | $                           | 0.67       |                        | $          | 0.45                        |       | $                           | 1.29       |   | $ | 0.84 |   |
| Diluted                                                                            |       | $                           | 0.66       |                        | $          | 0.44                        |       | $                           | 1.26       |   | $ | 0.82 |   |
| Weighted-average  number of common shares outstanding:                             |       |                        |       |                        |       |                        |       |                        |       |
| Basic                                                                              |       | 78,770                      |       | 77,675                      |       | 78,769                      |       | 77,675                      |       |
| Diluted                                                                            |       | 80,462                      |       | 79,410                      |       | 80,334                      |       | 79,237                      |       |
| Distributions  declared per common share                                           |       | $                           | 0.56       |                        | $          | 0.45                        |       | $                           | 1.10       |   | $ | 0.85 |   |

 

See notes to condensedconsolidated financial statements.

4

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**KKR Financial Holdings LLC andSubsidiariesCondensed Consolidated Statement of Changes in Shareholders’ Equity(Unaudited)(Amounts in thousands)**
| ** **                                                              | ** ** | ** **       | ** ** | ** **  | ** ** | **Accumulated**   | ** ** | ** **      | ** ** | ** **        | ** ** | ** **             | ** ** |
|-------------------------------------------------------------------------|------------|------------------|------------|-------------|------------|-------------------|------------|-----------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                              | ** ** | ** **       | ** ** | ** **  | ** ** | **Other**         | ** ** | ** **      | ** ** | ** **        | ** ** | **Total**              | ** ** |
| ** **                                                              | ** ** | **Common ** | ** ** | **Paid-In** | ** ** | **Comprehensive** | ** ** | **Accumulated** | ** ** | **Comprehensive** | ** ** | **Shareholders’** | ** ** |
| ** **                                                              | ** ** | **Shares**       | ** ** | **Capital** | ** ** | **Income**        | ** ** | **Deficit**     | ** ** | **Income**        | ** ** | **Equity**             | ** ** |
| **Balance  at January 1, 2007**                                         |       | 80,465           |       | $           | 1,671,135  |              | $          | 70,520          |       | $                 | (18,224    | )                      |       |   | $ | 1,723,431 |   |
| Cumulative  effect of adjustment from adoption of SFAS No. 159          |       | —           |       | —      |       | —            |       | (55,728         | )          |              |       | (55,728                | )          |
| Net income                                                              |       | —           |       | —      |       | —            |       | 101,395         |       | $                 | 101,395    |                   | 101,395    |   |
| Net change in  unrealized gain on cash flow hedges                      |       | —           |       | —      |       | 10,078            |       | —          |       | 10,078            |       | 10,078                 |       |
| Net change in  unrealized gain or loss on securities available-for-sale |       | —           |       | —      |       | (14,830           | )          | —          |       | (14,830           | )          | (14,830                | )          |
| Comprehensive  income                                                   |       |             |       |        |       |              |       |            |       | $                 | 96,643     |                   |       |   |
| Cash  distributions on common shares                                    |       | —           |       | —      |       | —            |       | (88,511         | )          |              |       | (88,511                | )          |
| Amortization of  restricted common shares                               |       | —           |       | 6,254       |       | —            |       | —          |       |              |       | 6,254                  |       |
| Amortization of  common share options                                   |       | —           |       | 438         |       | —            |       | —          |       |              |       | 438                    |       |
| **Balance at June 30, 2007**                                            |       | 80,465           |       | $           | 1,677,827  |              | $          | 65,768          |       | $                 | (61,068    | )                      |       |   | $ | 1,682,527 |   |

 

See notes to condensedconsolidated financial statements.

5

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**KKRFinancial Holdings LLC and SubsidiariesCondensed****Consolidated Statements of Cash Flows(Unaudited)(Amounts in thousands)**
| ** **                                                                                             | ** ** | **Six months ended** | ** ** | **Six months ended** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                                                                             | ** ** | **June 30, 2007**    | ** ** | **June 30, 2006**    | ** ** |
| **Cash  flows from operating activities:**                                                             |       |                           |       |                           |       |
| Net income                                                                                             |       | $                              | 101,395    |                           | $          | 65,319 |   |
| Adjustments to  reconcile net income to cash provided by operating activities:                         |       |                           |       |                           |       |
| Net realized and unrealized gain on derivatives                                                        |       | (13,628                        | )          | (547                           | )          |
| Net realized and unrealized (gain) loss on foreign  exchange                                           |       | 9                              |       | (1,316                         | )          |
| Write-off of capitalized costs                                                                         |       | 2,247                          |       | —                         |       |
| Share-based compensation                                                                               |       | 6,692                          |       | 11,926                         |       |
| Net unrealized loss on trading securities and loans  carried at fair value                             |       | 14,052                         |       | 142                            |       |
| Net gain on sale of securities available-for-sale                                                      |       | (29,931                        | )          | (1,864                         | )          |
| Net gain on sale of loans                                                                              |       | (3,765                         | )          | (275                           | )          |
| Depreciation and net amortization                                                                      |       | 3,869                          |       | 912                            |       |
| Deferred income tax benefit                                                                            |       | —                         |       | (398                           | )          |
| Equity in income of unconsolidated affiliate                                                           |       | (12,706                        | )          | —                         |       |
| Changes in  assets and liabilities:                                                                    |       |                           |       |                           |       |
| Interest receivable                                                                                    |       | (2,068                         | )          | (15,876                        | )          |
| Other assets                                                                                           |       | (38,332                        | )          | (5,211                         | )          |
| Related party payable                                                                                  |       | 4,289                          |       | 1,603                          |       |
| Accounts payable, accrued expenses and other  liabilities                                              |       | (1,843                         | )          | 56,729                         |       |
| Accrued interest payable                                                                               |       | (35,983                        | )          | 5,872                          |       |
| Accrued interest payable to affiliates                                                                 |       | 8,256                          |       | —               |       |
| Income tax liability                                                                                   |       | (101                           | )          | —                         |       |
| Net cash provided by operating activities                                                              |       | 2,452                          |       | 117,016                        |       |
| **Cash  flows from investing activities:**                                                             |       |                           |       |                           |       |
| Principal  payments on trading securities                                                              |       | 951,765                        |       | —                         |       |
| Purchase of  securities available-for-sale                                                             |       | (222,824                       | )          | (2,206,292                     | )          |
| Principal  payments on securities available-for-sale                                                   |       | 107,583                        |       | 1,067,842                      |       |
| Proceeds from  sale of securities available-for-sale                                                   |       | 516,866                        |       | 45,556                         |       |
| Purchase of  loans                                                                                     |       | (1,525,730                     | )          | (1,309,627                     | )          |
| Principal  payments on loans                                                                           |       | 1,204,667                      |       | 1,458,291                      |       |
| Proceeds from  sale of loans                                                                           |       | 527,284                        |       | 164,936                        |       |
| Purchases of  non-marketable equity securities                                                         |       | (7,500                         | )          | (91,621                        | )          |
| Proceeds from  sales of securities sold, not yet purchased                                             |       | 75,691                         |       | —                         |       |
| Proceeds from  non-marketable equity securities                                                        |       | —                         |       | 4,692                          |       |
| Net settlement  from derivatives                                                                       |       | 4,140                          |       | 973                            |       |
| Net additions to  restricted cash and cash equivalents                                                 |       | (575,154                       | )          | (25,031                        | )          |
| Restricted cash  and cash equivalents acquired due to consolidation of KKR Financial CLO 2007-1,  Ltd. |       | 57,104                         |       | —                         |       |
| Additions of  leasehold improvements and equipment                                                     |       | (232                           | )          | (3,594                         | )          |
| Investment in  unconsolidated affiliate                                                                |       | (60,327                        | )          | —                         |       |
| Net cash provided by (used in) investing activities                                                    |       | 1,053,333                      |       | (893,875                       | )          |
| **Cash  flows from financing activities:**                                                             |       |                           |       |                           |       |
| Net change in  repurchase agreements                                                                   |       | (3,992,228                     | )          | (4,614,356                     | )          |
| Net change in  asset-backed secured liquidity notes                                                    |       | 237,226                        |       | 5,301,401                      |       |
| Proceeds from  borrowings:                                                                             |       |                           |       |                           |       |
| Collateralized loan obligation senior secured notes                                                    |       | 2,368,500                      |       | 25,000                         |       |
| Collateralized loan obligation junior secured notes  to affiliates                                     |       | 262,103                        |       | —                         |       |
| Secured revolving credit facility                                                                      |       | 553,035                        |       | 760,171                        |       |
| Secured demand loan                                                                                    |       | —                         |       | 2,372,236                      |       |
| Junior subordinated notes                                                                              |       | 70,000                         |       | 100,000                        |       |
| Other  capitalized costs                                                                               |       | (16,340                        | )          | (21,037                        | )          |
| Repayments of  borrowings:                                                                             |       |                           |       |                           |       |
| Secured demand loan                                                                                    |       | —                         |       | (2,371,088                     | )          |
| Secured revolving credit facility                                                                      |       | (431,214                       | )          | (701,577                       | )          |
| Distributions on  common shares                                                                        |       | (88,511                        | )          | (68,317                        | )          |
| Net cash (used in) provided by financing activities                                                    |       | (1,037,429                     | )          | 782,433                        |       |
| **Net increase  in cash and cash equivalents**                                                         |       | 18,356                         |       | 5,574                          |       |
| **Cash  and cash equivalents at beginning of period**                                                  |       | 5,125                          |       | 16,110                         |       |
| **Cash  and cash equivalents at end of period**                                                        |       | $                              | 23,481     |                           | $          | 21,684 |   |
| ** **                                                                                             |       |                           |       |                           |       |
| **Supplemental  cash flow information:**                                                               |       |                           |       |                           |       |
| Cash paid for  interest                                                                                |       | $                              | 424,725    |                           | $          | 432,010 |   |
| Cash paid for  taxes                                                                                   |       | $                              | 1,590      |                           | $          | 3,518 |   |
| **Non-cash  investing and financing activities:**                                                      |       |                           |       |                           |       |
| Net payable for  securities purchases                                                                  |       | $                              | 312,553    |                           | $          | 212,299 |   |
| Transfers of  loans held for investment to held for sale                                               |       | $                              | —     |                           | $          | 107,456 |   |
| Affiliate contributions  for collateralized loan obligation junior secured notes                       |       | $                              | 169,209    |                           | $          | — |   |

 

See notes to condensedconsolidated financial statements.

6

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**KKRFinancial Holdings LLC and Subsidiaries**

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

**Note 1. Organization**

KKR Financial Holdings LLC together with itssubsidiaries, the “Company” or “KKR Financial”, is a specialty finance companythat uses leverage with the objective of generating competitive risk-adjustedreturns. The Company seeks to achieve its investment objective by investing in(i) corporate loans and debt securities, (ii) marketable equity securities, and(iii) non-marketable equity securities. The Company also makes opportunisticinvestments in other asset classes from time to time, including investments inresidential and commercial mortgage loans and securities. The Company investsin both cash and derivative instruments.

KKR Financial Holdings LLC is a Delaware limitedliability company and was organized on January 17, 2007.  KKR Financial Holdings LLC is the successorto KKR Financial Corp., a Maryland Corporation. KKR Financial Corp. was originally incorporated in the State of Marylandon July 7, 2004 and elected to be treated as a real estate investment trust(“REIT”) for U.S. federal income tax purposes. On May 4, 2007, KKR Financial Holdings LLC completed a restructuringtransaction, pursuant to which KKR Financial Corp. (the “REIT Subsidiary”)became a subsidiary of KKR Financial Holdings LLC and each outstanding share ofKKR Financial Corp.’s common stock was converted into one of KKR Financial HoldingsLLC’s common shares, which are publicly traded on the New York StockExchange.  KKR Financial Holdings LLC willnot be treated as a REIT for U.S. federal income tax purposes; however, KKRFinancial Holdings LLC intends to be treated as a partnership, and not as anassociation or publicly traded partnership that is taxable as a corporation,for U.S. federal income tax purposes.

The restructuring transaction has been accounted foras a reorganization of entities under common control whereby the consolidatedassets and liabilities of the Company were recorded at the historical cost ofKKR Financial Corp. as reflected on KKR Financial Corp.’s consolidatedfinancial statements. The Company is considered as the successor of KKRFinancial Corp. for accounting purposes, and KKR Financial Corp.’s consolidatedfinancial statements for prior periods are the Company’s historical consolidatedfinancial statements presented herein.

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

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

**Basis of Presentation**

The accompanying condensed consolidated financialstatements have been prepared in conformity with accounting principlesgenerally accepted in the United States of America (“GAAP”). The condensedconsolidated financial statements include the accounts of the Company, its REITSubsidiary, its domestic and foreign taxable corporate subsidiaries,consolidated residential mortgage loan securitization trusts where the Companyis the primary beneficiary, and entities established to complete securedfinancing transactions that are considered to be variable interest entities andfor which the Company is the primary beneficiary.

These condensedconsolidated financial statements are unaudited and should be read inconjunction with the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2006.

**Use of Estimates**

The preparation of financial statements in conformitywith GAAP requires management to make estimates and assumptions that affect theamounts reported in the Company’s consolidated financial statements andaccompanying notes. Actual results could differ from management’s estimates.

**Consolidation**

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

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KKR Financial CLO 2005-1, Ltd. (“CLO 2005-1”),KKR Financial CLO 2005-2, Ltd. (“CLO 2005-2”), KKR FinancialCLO 2006-1, Ltd. (“CLO 2006-1”), and KKR Financial CLO 2007-1,Ltd. (“CLO 2007-1”), are entities established to complete secured financingtransactions. These entities are VIEs and are not considered to be qualifyingspecial-purpose entities (“QSPE”) as defined by Statement of FinancialAccounting Standards No. 140, *Accounting for Transfersand Servicing of Financial Assets and Extinguishments of Liabilities*(“SFASNo. 140”). The Company has determined it is the primary beneficiary ofthese entities and has included the accounts of these entities in theseconsolidated financial statements. Additionally, the Company is the primarybeneficiary of six residential mortgage loan securitization trusts that are notconsidered to be QSPEs under SFAS No. 140 and the Company has thereforeincluded the accounts of these entities in these consolidatedfinancial statements.

All inter-company balances and transactions havebeen eliminated in consolidation.

**Cash and CashEquivalents**

Cash and cash equivalents include cash on hand, cashheld in banks and highly liquid investments with original maturities of threemonths or less. Interest income earned on cash and cash equivalents is recordedin other interest income.

**Restricted Cashand Cash Equivalents**

Restricted cash and cash equivalents represent amountsthat are held by third parties under certain of the Company’s financing andderivative transactions. Interest income earned on restricted cash and cashequivalents is recorded in other interest income.

**Trading Securities**

Effective January 1, 2007, the Company classifies itsinvestments in residential mortgage-backed securities as trading securities(see “Recent Accounting Pronouncements”). These investments are carried at estimated fair value, with unrealizedgains and losses reported in income. Estimated fair values are based onestimates provided by independent pricing sources or dealers who make marketsin such securities. Upon the sale of a security, the realized net gain or lossis computed on a specific identification basis.  Unamortized premiums and discounts onsecurities that are highly rated are recognized over the contractual life,adjusted for estimated prepayments using the effective interest method. Forsecurities representing beneficial interests in securitizations that are nothighly rated (i.e., subordinate tranches of residential mortgage-backedsecurities), unamortized premiums and discounts are recognized over thecontractual life, adjusted for estimated prepayments and estimated creditlosses of the securities using the effective interest method.  Actual prepayment and credit loss experienceis reviewed quarterly and effective yields are recalculated when differencesarise between prepayments and credit losses originally anticipated compared toamounts actually received plus anticipated future prepayments.

**SecuritiesAvailable-for-Sale**

The Company classifies its investments in securitiesother than residential mortgage-backed securities as available-for-sale sincethe Company may sell them prior to maturity and does not hold them principallyfor the purpose of selling them in the near term. These investments are carriedat estimated fair value, with unrealized gains and losses reported inaccumulated other comprehensive income. Estimated fair values are based onquoted market prices, when available, or on estimates provided by independentpricing sources or dealers who make markets in such securities. Upon the saleof a security, the realized net gain or loss is computed on a specificidentification basis.

The Company monitors its available-for-sale securitiesportfolio for impairments. A loss is recognized when the Company determinesthat a decline in the estimated fair value of a security below its amortizedcost is other-than-temporary. The Company considers many factors in determiningwhether the impairment of a security is deemed to be other-than-temporary,including, but not limited to, the length of time the security has had adecline in estimated fair value below its amortized cost, the amount of theunrealized loss, the intent and ability of the Company to hold the security fora period of time sufficient for a recovery in value, recent events specific tothe issuer or industry, external credit ratings and recent changes in suchratings.

Unamortized premiums and 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.

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**Non-marketableEquity Securities**

Non-marketable equity securities consist primarily ofprivate equity investments. These investments are accounted for under the costmethod. The Company reviews these investments quarterly for possibleother-than-temporary impairment. The Company reduces the carrying value of theinvestment and recognizes a loss when the Company considers a decline inestimated fair value below the cost basis of the security to beother-than-temporary.

**SecuritiesSold, Not Yet Purchased**

**Securitiessold, not yet purchased are marketable equity securities that the Company hassold, but did not own prior to the sale. In order to facilitate a short sale,the Company has to borrow the securities from another party and deliver them tothe buyer.  The Company will be requiredto “cover” its short sale in the future through the purchase of the security inthe market at the prevailing market price and deliver it to the counterpartyfrom which it borrowed. The Company is exposed to a loss to the extent that thesecurity price increases during the time from when the Company borrowed thesecurity to when the Company purchases it in the market to cover the short sale.  Changes in the value of these securities arereflected in net unrealized gain or loss on trading securities and loanscarried at fair value.**

**Loans**

The Company purchases pools of residential mortgagewhole loans and participations in corporate leveraged loans and commercial realestate loans in the primary and secondary market. Loans are held for investmentand the Company initially records loans at their purchase prices. Effective January1, 2007, the Company accounts for residential mortgage loans at fair value withchanges in fair value recorded in income (see “Recent Accounting Pronouncements”).For non-residential mortgage loans, the Company accounts for these loans basedon their outstanding principal plus or minus unaccreted purchase discounts andunamortized purchase premiums. In certain instances, where the creditfundamentals underlying a particular loan have materially changed in such amanner that the Company’s expected return may decrease, the Company may electto sell a loan held for investment due to adverse changes in creditfundamentals. Once the determination has been made by the Company that it willno longer hold the loan for investment, the Company accounts for the loan atthe lower of amortized cost or estimated fair value.

Interest income on loans represents interest at statedcoupon rates adjusted for accretion of purchase discounts and the amortizationof purchase premiums. For corporate and commercial real estate loans,unamortized premiums and discounts are recognized in interest income over thecontractual life, adjusted for actual prepayments, of the loans using theeffective interest method. For residential mortgage loans, unamortized premiumsand discounts are recognized over the contractual life, adjusted for estimatedprepayments using the effective interest method.

**Allowance andProvision for Loan Losses**

The Company maintains an allowance for loan losses ata level that the Company believes is adequate based on an evaluation of knownand inherent risks related to its loan investments. When determining theadequacy of the allowance for loan losses the Company considers historical andindustry loss experience, economic conditions and trends, the estimated fairvalues of its loans, credit quality trends and other factors that the Companydetermines are relevant. Loans are generally evaluated for impairmentindividually, but loans purchased on a pooled basis with relatively smallerbalances and substantially similar characteristics may be evaluatedcollectively for impairment.

The Company’s investments in commercial real estateloans and corporate loans are not homogeneous and the Company individuallyreviews each of the loans for impairment and uses relevant information in itsanalysis, including current estimated fair values, current valuation multiples,estimated fair values and quality of collateral, projected operating cash flowsand projected liquidation cash flows. The Company considers a loan to beimpaired when, based on current information and events, the Company believes itis probable that it will be unable to collect all amounts due to it based onthe contractual terms of the loan. When a loan is impaired, the allowance forloan losses is increased by the amount of the excess of the amortized costbasis of the loan over its estimated fair value. Increases in the allowance forloan losses are recognized in the Company’s results of operations as aprovision for loan losses. When the Company makes a determination that some orall of a loan is uncollectible, the Company charges-off or writes-down the loanand the allowance for loan losses is reduced.

An impaired loan may be left on accrual status duringthe period the Company is pursuing repayment of the loan; however, the loan isplaced on non-accrual status at such time as: (i) management believes thatscheduled debt service payments may not be paid when contractually due;(ii) the loan becomes 90 days delinquent; (iii) management determinesthe borrower is incapable of, or has ceased efforts toward, curing the cause ofthe impairment; or (iv) the net realizable value of 

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the underlying collateralsecuring the loan decreases below the Company’s carrying value of such loan.While on non-accrual status, previously recognized accrued interest is reversedand interest income is recognized only upon actual receipt.

As disclosed under “Recent Accounting Pronouncements”upon adoption of SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities — Including an amendment of FASBStatement No. 115* (“SFAS No. 159”) as of January 1, 2007, theCompany accounts for its investments in residential mortgage loans at fairvalue and therefore does not record an allowance for loan losses for theseinvestments.

**LeaseholdImprovements and Equipment**

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

**Borrowings**

The Company finances the acquisition of itsinvestments, including loans, trading securities and securitiesavailable-for-sale, primarily through the use of secured borrowings in the formof securitization transactions structured as secured financings, repurchaseagreements, asset-backed secured liquidity notes, warehouse facilities, demandloans, and other secured and unsecured borrowings. The Company recognizesinterest expense on all borrowings on an accrual basis.

**Trust PreferredSecurities**

Trusts formed by the Company for the sole purpose ofissuing trust preferred securities are not consolidated by the Company inaccordance with FIN 46R as the Company has determined that it is not theprimary beneficiary of such trusts. The Company’s investment in the commonsecurities of such trusts is included in other assets on the Company’sconsolidated financial statements.

**DerivativeFinancial Instruments**

The Company recognizes all derivatives on itsconsolidated balance sheet at estimated fair value. On the date the Companyenters into a derivative contract, the Company designates and documents eachderivative contract as one of the following at the time the contract isexecuted: (i) a hedge of a recognized asset or liability (“fair value”hedge); (ii) a hedge of a forecasted transaction or of the variability ofcash flows to be received or paid related to a recognized asset or liability (“cashflow” hedge); (iii) a hedge of a net investment in a foreign operation; or(iv) a derivative instrument not designated as a hedging instrument (“free-standingderivative”). For a fair value hedge, the Company records changes in theestimated fair value of the derivative and, to the extent that it is effective,changes in the fair value of the hedged asset or liability attributable to thehedged risk, in current period earnings in the same financial statementcategory as the hedged item. For a cash flow hedge, the Company records changesin the estimated fair value of the derivative to the extent that it iseffective in other comprehensive income. The Company subsequently reclassifiesthese changes in estimated fair value to net income in the sameperiod(s) that the hedged transaction affects earnings in the samefinancial statement category as the hedged item. For free-standing derivatives,the Company reports changes in the fair values in current period other income.

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

**Foreign Currency**

The Company makes investments in non-U.S. dollardenominated securities and loans. As a result, the Company is subject to therisk of fluctuation in the exchange rate between the U.S. dollar and theforeign currency in which it makes an 

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investment. In order toreduce the currency risk, the Company may hedge the applicable foreigncurrency. All investments denominated in a foreign currency are converted tothe U.S. dollar using prevailing exchange rates on the balance sheet date.Income, expenses, gains and losses on investments denominated in a foreigncurrency are converted to the U.S. dollar using the prevailing exchange rateson the dates when they are recorded. Foreign exchange gains and losses arerecorded in other income.

**ManagerCompensation**

The Management Agreement provides for the payment of abase management fee to the Manager, as well as an incentive fee if the Company’sfinancial performance exceeds certain benchmarks. See Note 12 for thespecific terms of the computation and payment of the incentive fee. The basemanagement fee and the incentive fee are accrued and expensed during the periodfor which they are earned by the Manager.

**Share-BasedCompensation**

The Company accounts for share-basedcompensation issued to its directors and to its Manager using the fair valuebased methodology prescribed by SFAS No. 123(R), *Share-Based Payment* (“SFAS No. 123(R)”).Compensation cost related to restricted common shares issued to the Company’sdirectors is measured at its estimated fair value at the grant date, and isamortized and expensed ratably over the vesting period. Compensation costrelated to restricted common shares and common share options issued to the Manageris initially measured at estimated fair value at the grant date, and isremeasured on subsequent dates to the extent the awards are unvested. TheCompany has elected to use the graded vesting attribution method pursuant toSFAS No. 123(R) to amortize compensation expense for the restrictedcommon shares and common share options granted to the Manager.

**Income Taxes**

***The Company is no longer treated as a REIT for U.S. federalincome tax purposes; however, the Company intends to be treated as apartnership, and not as an association or publicly traded partnership that istaxable as a corporation, for U.S. federal income tax purposes. Therefore, theCompany is not subject to U.S. federal income tax at the entity level, but issubject to limited state income taxes. Holders of the Company’s shares will berequired to take into account their allocable share of each item of theCompany’s income, gain, loss, deduction, and credit for the taxable year of theCompany ending within or with their taxable year.***

The Company’s REIT Subsidiary has elected to be taxedas a REIT and is required to comply with the provisions of the Internal RevenueCode of 1986, as amended, (the “Code”), with respect thereto. Accordingly, theCompany’s REIT Subsidiary is not subject to federal income tax to the extentthat its distributions satisfy the REIT requirements and certain asset, incomeand ownership tests and recordkeeping requirements are fulfilled. Even thoughthe Company’s REIT Subsidiary qualifies for federal taxation as a REIT, it maybe subject to some amount of federal, state, local and foreign taxes based onthe REIT Subsidiary’s taxable income.

KKR TRS Holdings, Inc. (“TRS Inc.”), KKR TRS Holdings,Ltd. (“TRS Ltd.”), CLO 2005-1, CLO 2005-2, CLO 2006-1, andCLO 2007-1 are not consolidated for federal income tax return purposes. Forfinancial reporting purposes, current and deferred taxes are provided for onthe portion of earnings recognized by the Company with respect to its interestin TRS Inc., a domestic taxable corporate subsidiary, because it is taxedas a regular subchapter C corporation under the provisions of the Code.

Deferred income tax assets and liabilities arecomputed based on temporary differences between the GAAP consolidated financialstatements and the federal income tax basis of assets and liabilities as ofeach consolidated balance sheet date. TRS Ltd., CLO 2005-1, CLO 2005-2,CLO 2006-1, and CLO 2007-1, the Company’s foreign taxable corporatesubsidiaries, are organized as exempted companies incorporated with limitedliability under the laws of the Cayman Islands, and are generally exempt fromfederal and state income tax at the corporate entity level because theyrestrict their activities in the United States to trading in stock andsecurities for their own account. Therefore, despite their status as taxablecorporate subsidiaries, they generally will not be subject to corporate incometax on their earnings, and no provisions for income taxes for the quarter endedJune 30, 2007 were required; however, the Company will generally be required toinclude their current taxable income in the calculation of its taxable incomeallocable to shareholders.

**Earnings Per Share**

In accordance with SFAS No. 128, *Earnings per Share*, the Company presentsboth basic and diluted earnings per common share (“EPS”) in its consolidatedfinancial statements and footnotes thereto. Basic earnings per common share (“BasicEPS”) excludes dilution and is computed by dividing net income or lossallocable to common shareholders by the weighted-average number of commonshares, including vested restricted common shares, outstanding for the period.Diluted 

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earnings per share (“DilutedEPS”) reflects the potential dilution of common share options and unvestedrestricted common shares, if they are not anti-dilutive. See Note 3 for EPScomputations.

**Recent Accounting Pronouncements**

In February 2006, the FASB issued SFASNo. 155, *Accounting for Certain Hybrid FinancialInstruments* (“SFAS No. 155”). Key provisions of SFASNo. 155 include: (1) a broad fair value measurement option forcertain hybrid financial instruments that contain an embedded derivative thatwould otherwise require bifurcation; (2) clarification that only thesimplest separations of interest payments and principal payments qualify forthe exception afforded to interest-only strips and principal-only strips fromderivative accounting under paragraph 14 of SFAS No. 133*,* thereby narrowing such exception; (3) a requirementthat beneficial interests in securitized financial assets be analyzed todetermine whether they are free-standing derivatives or whether they are hybridinstruments that contain embedded derivatives requiring bifurcation;(4) clarification that concentrations of credit risk in the form of subordinationare not embedded derivatives; and (5) elimination of the prohibition on aQSPE holding passive derivative financial instruments that pertain tobeneficial interests that are or contain a derivative financial instrument. Ingeneral, these changes will reduce the operational complexity associated withbifurcating embedded derivatives, and increase the number of beneficialinterests in securitization transactions, including interest-only strips andprincipal-only strips, required to be accounted for in accordance with SFASNo. 133. The Company adopted SFAS No. 155 as of the beginning of 2007 andthe adoption of SFAS No. 155 did not have a material impact on the Company’sconsolidated financial statements.

In June 2006, the FASB issued InterpretationNo. 48, *Accounting for Uncertainty in IncomeTaxes—an interpretation of FASB Statement No. 109* (“FIN 48”).FIN 48 clarifies the accounting for uncertainty in income taxes recognized inan enterprise’s financial statements in accordance with FASB StatementNo. 109, *Accounting for Income Taxes*. FIN48 prescribes a recognition threshold and measurement attribute for thefinancial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. The Company adopted FIN 48 as of thebeginning of 2007 and the adoption of FIN 48 did not have a materialimpact on its consolidated financial statements.

In September 2006, the FASB issued SFASNo. 157, *Fair Value Measurements*(“SFASNo. 157”). This statement defines fair value, establishes a framework formeasuring fair value in GAAP and expands disclosures about fair valuemeasurements. SFAS No. 157 does not require any new fair valuemeasurements. The Company adopted SFAS No. 157 as of the beginning of 2007and the adoption of SFAS No. 157 did not have a material impact on themanner in which the Company measures the fair value of its financialinstruments, but did result in certain additional disclosures, which arecontained in Note 13.

In February 2007, FASB issued SFAS No. 159, *The Fair Value Option for Financial Assets and FinancialLiabilities—Including an amendment of FASB Statement No. 115*(“SFASNo. 159”). This statement permits entities to choose to measure manyfinancial instruments and certain other items at fair value (i.e., the fairvalue option). The election to use the fair value option is available when anentity first recognizes a financial asset or financial liability or uponentering into a firm commitment. Subsequent changes in fair value must be recorded in earnings.  Additionally, SFAS No. 159 allows for aone-time election for existing positions upon adoption, with the transitionadjustment recorded to beginning retained earnings.

The Company adopted SFAS No.159 as of the beginning of 2007 and elected to apply the fair value option forits investments in residential mortgage loans and residential mortgage-backedsecurities. Additionally, the Company intends to consistently apply theelection of the fair value option to any future residential mortgage investments.The Company has elected the fair value option for its residential mortgageinvestments for the purpose of enhancing the transparency of its financialcondition as fair value is consistent with how the Company manages the risks ofresidential mortgage investments. The transition adjustment to beginningaccumulated deficit that was recorded as of January 1, 2007 due to the adoptionof SFAS No. 159 was a loss of $55.7 million. The following table presents information about the eligible instrumentsfor which the Company elected the fair value option and for which transitionadjustments were recorded as of January 1, 2007 (amounts in thousands):
| ** **                                                  | ** ** | ** **                      | ** ** | ** **                             | ** ** | **Carrying Value at**  | ** ** |
|-------------------------------------------------------------|------------|---------------------------------|------------|----------------------------------------|------------|----------------------------------|------------|
| ** **                                                  | ** ** | ** **                      | ** ** | **Transition Adjustment to** | ** ** | **January 1, 2007**    | ** ** |
| ** **                                                  | ** ** | **Carrying Value at** | ** ** | **Accumulated Deficit**           | ** ** | **(After Adoption of** | ** ** |
| ** **                                                  | ** ** | **January 1, 2007**   | ** ** | **Gain/(Loss)**                        | ** ** | **SFAS No. 159)**      | ** ** |
| Residential  mortgage loans                                 |       | $                               | 5,109,261  |                                   | $          | (35,653                          | )          | $ | 5,073,608 |   |
| Allowance for  loan losses                                  |       | (1,500                          | )          | 1,500                                  |       | —                           |       |
| Residential  mortgage-backed securities (1)                 |       | 7,536,196                       |       | (21,575                                | )          | 7,536,196                        |       |
| Cumulative effect of  the adoption of the fair value option |       |                            |       | $                                      | (55,728    | )                                |       |   |
|                                                             |            |                                 |            |                                        |            |                                  |            |  |  |  |

 

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(1)             Priorto January 1, 2007, residential mortgage-backed securities were classified asavailable-for-sale and carried at fair value. Accordingly, the election of the fair value option for mortgage-backedsecurities did not change their carrying value and resulted in areclassification from accumulated other comprehensive income to beginningaccumulated deficit.

In June 2007, the American Institute of CertifiedPublic Accountants (“AICPA”) issued Statement of Position (“SOP”) 07-1, *Clarification of the Scope of the Audit and Accounting Guide,**Investment Companies**and Accounting for Parent Companies and Equity Method Investors forInvestments in Investment Companies.* This SOP provides guidance fordetermining whether an entity is within the scope of the AICPA Audit andAccounting Guide *Investment Companies* (the“Guide”).  Entities that are within thescope of the Guide are required, among other things, to carry their investmentsat fair value, with changes in fair value included in earnings. The provisionsof this SOP are effective on January 1, 2008. The Company is currentlyevaluating this new guidance and has not determined whether it will be requiredto apply the provisions of the Guide in presenting its financial statements.

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**Note 3. Earnings per Share**

The Companycalculates basic net income per common share by dividing net income for theperiod by the weighted-average number of its common shares outstandingfor the period. Diluted net income per common share takes into account theeffect of dilutive instruments, such as common share options and unvestedrestricted common shares, but uses the average share price for the period indetermining the number of incremental shares that are to be added to theweighted-average number of common shares outstanding. The following tablepresents a reconciliation of basic and diluted net income per common share forthe three and six months ended June 30, 2007 and June 30, 2006 (amounts inthousands, except per share information):
| ** **                                                                | ** ** | **Three months ended** | ** ** | **Three months ended ** | ** ** | **Six months ended ** | ** ** | **Six months ended ** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                | ** ** | **June 30, 2007**      | ** ** | **June 30, 2006**            | ** ** | **June 30, 2007**          | ** ** | **June 30, 2006**          | ** ** |
| **Basic:**                                                                | ** ** | ** **                       | ** ** | ** **                             | ** ** | ** **                           | ** ** | ** **                           | ** ** |
| Net income                                                                |       | $                                | 52,971     |                                   | $          | 34,931                               |       | $                                    | 101,395    |   | $ | 65,319 |   |
| Weighted-average  number of common shares outstanding                     |       | 78,770                           |       | 77,675                                 |       | 78,769                               |       | 77,675                               |       |
| Basic net income  per common share                                        |       | $                                | 0.67       |                                   | $          | 0.45                                 |       | $                                    | 1.29       |   | $ | 0.84 |   |
| **Diluted:**                                                              | ** ** | ** **                       | ** ** | ** **                             | ** ** | ** **                           | ** ** | ** **                           | ** ** |
| Net income                                                                |       | $                                | 52,971     |                                   | $          | 34,931                               |       | $                                    | 101,395    |   | $ | 65,319 |   |
| Weighted-average  number of common shares outstanding                     |       | 78,770                           |       | 77,675                                 |       | 78,769                               |       | 77,675                               |       |
| Plus:  Incremental shares from assumed conversion of dilutive instruments |       | 1,692                            |       | 1,735                                  |       | 1,565                                |       | 1,562                                |       |
| Adjusted  weighted-average number of common shares outstanding            |       | 80,462                           |       | 79,410                                 |       | 80,334                               |       | 79,237                               |       |
| Diluted net income per  common share                                      |       | $                                | 0.66       |                                   | $          | 0.44                                 |       | $                                    | 1.26       |   | $ | 0.82 |   |

 

**Note 4. Trading Securities**

Upon adoption of SFAS No. 159 as of January 1, 2007,the Company elected the fair value option for its investments in residential mortgage-backedsecurities.  As of December 31, 2006, theCompany’s investments in residential mortgage-backed securities were classifiedas securities available-for-sale; however, in accordance with SFAS No.159, theelection of the fair value option for the Company’s residential mortgage-backedsecurities results in these investments being classified as trading securitiesas of January 1, 2007. As of June 30, 2007, trading securities totaled $6.6billion.

Note 8 to these condensed consolidated financial statementsdescribes the Company’s borrowings under which the Company has pledged tradingsecurities for borrowings under repurchase agreements and asset-backed securedliquidity notes.  As of June 30, 2007,$6.5****billion of trading securities werepledged as collateral for both borrowings under repurchase agreements and ascollateral for asset-backed secured liquidity notes.

As of June 30, 2007, the Company had securities sold,not yet purchased with a par value of $58.9 million and an unrealized gain of$0.4 million which is included in net unrealized loss on trading securities andloans carried at fair value on the Company’s consolidated statement ofoperations. Securities sold, not yet purchased consist of marketable equitysecurities that the Company has sold short.

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

The following tablesummarizes the Company’s securities classified as available-for-sale as of June30, 2007, which are carried at estimated fair value (amounts in thousands):
| ** **                             | ** ** | **Amortized** | ** ** | **Gross Unrealized** | ** ** | **Gross Unrealized** | ** ** | **Estimated**       | ** ** |
|----------------------------------------|------------|---------------|------------|---------------------------|------------|---------------------------|------------|---------------------|------------|
| **Description**                        | ** ** | **Cost**      | ** ** | **Gains**                 | ** ** | **Losses**                | ** ** | **Fair Value** | ** ** |
| Commercial  mortgage-backed securities |       | $             | 32,000     |                      | $          | —                    |       | $                   | (391       | ) | $ | 31,609 |   |
| Corporate  securities                  |       | 1,336,871     |       | 24,700                    |       | (22,495                   | )          | 1,339,076           |       |
| Common and  preferred stock            |       | 65,694        |       | 3,000                     |       | (413                      | )          | 68,281              |       |
| Total                                  |       | $             | 1,434,565  |                      | $          | 27,700                    |       | $                   | (23,299    | ) | $ | 1,438,966 |   |

 

The following table showsthe gross unrealized losses and fair value of the Company’s available-for-salesecurities, aggregated by length of time that the individual securities havebeen in a continuous unrealized loss position, as of June 30, 2007 (amounts inthousands):
| ** **                             | ** ** | **Less than 12 months** | ** ** | **12 Months or More** | ** ** | **Total**           | ** ** |
|----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|---------------------|------------|
| **Description**                        | ** ** | **Fair Value**                    | ** ** | **Unrealized Losses**           | ** ** | **Fair Value** | ** ** | **Unrealized Losses** | ** ** | **Fair Value** | ** ** | **Unrealized Losses** | ** ** |
| Commercial  mortgage-backed securities |       | $                                      | 31,609     |                                 | $          | (391                | )          | $ | — |   | $ | — |   | $ | 31,609 |   | $ | (391 | ) |
| Corporate  securities                  |       | 1,319,486                              |       | (19,077                              | )          | 19,590              |       | (3,418 | ) | 1,339,076 |   | (22,495 | ) |
| Common and  preferred stock            |       | 68,281                                 |       | (413                                 | )          | —              |       | — |   | 68,281 |   | (413 | ) |
| Total                                  |       | $                                      | 1,419,376  |                                 | $          | (19,881             | )          | $ | 19,590 |   | $ | (3,418 | ) | $ | 1,438,966 |   | $ | (23,299 | ) |

 

The unrealized losses in the above table are temporaryimpairments due to market factors and are not reflective of creditdeterioration. The Company has performed credit analyses in relation to theseinvestments and has determined that the carrying value of these investments isfully recoverable over their expected holding period. As the Company has the intentand ability to hold these investments until recovery, the unrealized losses arenot considered to be other-than-temporary impairments.

The following tablesummarizes the Company’s securities classified as available-for-sale as ofDecember 31, 2006, which are carried at estimated fair value (amounts inthousands):
| ** **                              | ** ** | **Amortized** | ** ** | **Gross Unrealized** | ** ** | **Gross Unrealized** | ** ** | **Fair Value Hedge** | ** ** | **Estimated**       | ** ** |
|-----------------------------------------|------------|---------------|------------|---------------------------|------------|---------------------------|------------|--------------------------------|------------|---------------------|------------|
| **Description**                         | ** ** | **Cost**      | ** ** | **Gains**                 | ** ** | **Losses**                | ** ** | **Adjustment**                 | ** ** | **Fair Value** | ** ** |
| Residential  mortgage-backed securities |       | $             | 7,557,771  |                      | $          | 16,130                    |       | $                              | (37,705    | )                   | $          | — |   | $ | 7,536,196 |   |
| Commercial  mortgage-backed securities  |       | 32,000        |       | 36                        |       | —                    |       | (13                            | )          | 32,023              |       |
| Asset-backed  securities                |       | 31,071        |       | 203                       |       | (37                       | )          | —                         |       | 31,237              |       |
| Corporate  securities                   |       | 799,900       |       | 36,697                    |       | (4,385                    | )          | —                         |       | 832,212             |       |
| Common and  preferred stock             |       | 68,113        |       | 1,314                     |       | (459                      | )          | —                         |       | 68,968              |       |
| Total                                   |       | $             | 8,488,855  |                      | $          | 54,380                    |       | $                              | (42,586    | )                   | $          | (13 | ) | $ | 8,500,636 |   |

 

14

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The following table shows the gross unrealized lossesand fair value of the Company’s available-for-sale securities, aggregated bylength of time that the individual securities have been in a continuousunrealized loss position, as of December 31, 2006 (amounts in thousands):
| ** **                               | ** ** | **Less than 12 months** | ** ** | **12 Months or More** | ** ** | **Total**           | ** ** |
|------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|---------------------|------------|
| **Description**                          | ** ** | **Fair Value**                    | ** ** | **Unrealized Losses**           | ** ** | **Fair Value** | ** ** | **Unrealized Losses** | ** ** | **Fair Value** | ** ** | **Unrealized Losses** | ** ** |
| Residential  mortgage- backed securities |       | $                                      | —     |                                 | $          | —              |       | $ | 1,853,323 |   | $ | (37,705 | ) | $ | 1,853,323 |   | $ | (37,705 | ) |
| Asset-backed  securities                 |       | 7,462                                  |       | (37                                  | )          | —              |       | — |   | 7,462 |   | (37 | ) |
| Corporate  securities                    |       | 61,848                                 |       | (4,106                               | )          | 18,907              |       | (279 | ) | 80,755 |   | (4,385 | ) |
| Common and  preferred stock              |       | 33,063                                 |       | (459                                 | )          | —              |       | — |   | 33,063 |   | (459 | ) |
| Total                                    |       | $                                      | 102,373    |                                 | $          | (4,602              | )          | $ | 1,872,230 |   | $ | (37,984 | ) | $ | 1,974,603 |   | $ | (42,586 | ) |

 

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

During the three and six months ended June 30, 2007,the Company’s gross realized gains from the sales of available-for-salesecurities were $27.4 million and $32.1 million, respectively. The Company hadgross realized losses of $1.5 million and $2.2 million from the sales ofavailable-for-sale securities during the three and six months ended June 30,2007. During the three and six months ended June 30, 2006, the Company’s grossrealized gains from the sales of available-for-sale securities were $1.4million and $2.2 million, respectively. The Company had gross realized lossesof $0.1 million from the sales of available-for-sale securities during thethree months and six months ended June 30, 2006.

Note 8 to these condensed consolidated financialstatements describes the Company’s borrowings under which the Company haspledged securities available-for-sale for borrowings under repurchaseagreements, asset-backed secured liquidity notes, and all other securedfinancing transactions. The following table summarizes the estimated fair valueof securities available-for-sale pledged as collateral under repurchaseagreements, asset-backed secured liquidity notes, and all other securedfinancing transactions as of June 30, 2007 (amounts in thousands):
| ** **                                                                                                             | ** ** | **Commercial**      | ** ** | ** **        | ** ** | ** **               | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|-------------------|------------|--------------------------|------------|
| ** **                                                                                                             | ** ** | **Mortgage-Backed** | ** ** | **Corporate**     | ** ** | **Common and**      | ** ** |
| ** **                                                                                                             | ** ** | **Securities**      | ** ** | **Securities(1)** | ** ** | **Preferred Stock** | ** ** |
| Pledged as  collateral for borrowings under repurchase agreements                                                      |       | $                   | 31,609     |              | $          | 66,789                   |       | $ | — |   |
| Pledged as  collateral for borrowings under secured revolving credit facility                                          |       | —              |       | 55,913            |       | —                   |       |
| Pledged as  collateral for borrowings under secured demand loan                                                        |       | —              |       | —            |       | 46,202                   |       |
| Pledged as  collateral for collateralized loan obligation senior secured notes and junior  secured notes to affiliates |       | —              |       | 979,899           |       | —                   |       |
| Total                                                                                                                  |       | $                   | 31,609     |              | $          | 1,102,601                |       | $ | 46,202 |   |

 

----

(1)             Includesasset-backed securities.

15

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The following table summarizes the estimated fairvalue of securities available-for-sale pledged as collateral under repurchaseagreements, asset-backed secured liquidity notes, and all other securedfinancing transactions as of December 31, 2006 (amounts in thousands):
| ** **                                                                     | ** ** | **Residential** | ** ** | **Commercial** | ** ** | ** **        | ** ** | ** **               | ** ** |
|--------------------------------------------------------------------------------|------------|-----------------|------------|----------------|------------|-------------------|------------|--------------------------|------------|
| ** **                                                                     | ** ** | **Mortgage-**   | ** ** | **Mortgage-**  | ** ** | ** **        | ** ** | ** **               | ** ** |
| ** **                                                                     | ** ** | **Backed**      | ** ** | **Backed**     | ** ** | **Corporate**     | ** ** | **Common and**      | ** ** |
| ** **                                                                     | ** ** | **Securities**  | ** ** | **Securities** | ** ** | **Securities(1)** | ** ** | **Preferred Stock** | ** ** |
| Pledged as collateral  for borrowings under repurchase agreements              |       | $               | 1,378,199  |           | $          | 32,023            |       | $                        | 310,856    |   | $ | — |   |
| Pledged as collateral  for asset-backed secured liquidity notes                |       | 6,126,699       |       | —         |       | —            |       | —                   |       |
| Pledged as collateral  for borrowings under secured revolving credit facility  |       | —          |       | —         |       | 33,186            |       | —                   |       |
| Pledged as collateral  for borrowings under secured demand loan                |       | —          |       | —         |       | —            |       | 47,056                   |       |
| Pledged as collateral  for collateralized loan obligation senior secured notes |       | —          |       | —         |       | 408,416           |       | —                   |       |
| Total                                                                          |       | $               | 7,504,898  |           | $          | 32,023            |       | $                        | 752,458    |   | $ | 47,056 |   |

 

----

(1)             Includesasset-backed securities.

**Note 6.Loans**

Upon adoption of SFAS No. 159 as of January 1, 2007,the Company elected the fair value option for its investments in residentialmortgage loans.  Prior to such election, theloans were carried at net unamortized cost less an allowance for loan losses.As described in Note 2, the Company recorded a transition adjustment to adjustthe carrying value of its portfolio of residential mortgage loans to fair valueand reverse its allowance for loan losses for its residential mortgage loanportfolio as of January 1, 2007.  Thefollowing table summarizes the Company’s loans as of June 30, 2007 and December31, 2006 (amounts in thousands):
| ** **                                                | ** ** | **As of**              | ** ** | **As of**                  | ** ** |
|-----------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                                                | ** ** | **June 30, 2007** | ** ** | **December 31, 2006** | ** ** |
| Residential mortgage  loans, at fair value                |       | $                           | 4,565,474  |                            | $          | — |   |
| Residential mortgage  loans, at net amortized cost        |       | —                      |       | 5,109,261                       |       |
| Corporate loans, at net  amortized cost                   |       | 5,137,004                   |       | 3,225,567                       |       |
| Commercial real estate  loans, at net amortized cost      |       | 114,754                     |       | 108,693                         |       |
| Allowance for loan  losses for residential mortgage loans |       | —                      |       | (1,500                          | )          |
| Total                                                     |       | $                           | 9,817,232  |                            | $          | 8,442,021 |   |

 

16

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The following table summarizes the components of thecarrying value of the Company’s loans recorded at net amortized cost as of June30, 2007 (amounts in thousands):
| ** **                    | ** ** | ** **    | ** ** | **Unamortized** | ** ** | **Net**                 | ** ** |
|-------------------------------|------------|---------------|------------|-----------------|------------|-------------------------|------------|
| ** **                    | ** ** | **Principal** | ** ** | **Discount**    | ** ** | **Amortized Cost** | ** ** |
| Corporate loans               |       | $             | 5,148,483  |            | $          | (11,479                 | )          | $ | 5,137,004 |   |
| Commercial real  estate loans |       | 114,854       |       | (100            | )          | 114,754                 |       |
| Total                         |       | $             | 5,263,337  |            | $          | (11,579                 | )          | $ | 5,251,758 |   |

 

The following table summarizes the components of thecarrying value of the Company’s loans as of December 31, 2006 (amounts inthousands):
| ** **                                                | ** ** | ** **    | ** ** | **Unamortized**        | ** ** | **Net**                 | ** ** |
|-----------------------------------------------------------|------------|---------------|------------|------------------------|------------|-------------------------|------------|
| ** **                                                | ** ** | **Principal** | ** ** | **Premium/(Discount)** | ** ** | **Amortized Cost** | ** ** |
| Residential  mortgage loans                               |       | $             | 5,092,419  |                   | $          | 16,842                  |       | $ | 5,109,261 |   |
| Corporate loans                                           |       | 3,232,414     |       | (6,847                 | )          | 3,225,567               |       |
| Commercial real  estate loans                             |       | 108,790       |       | (97                    | )          | 108,693                 |       |
| Allowance for  loan losses for residential mortgage loans |       | (1,500        | )          | —                 |       | (1,500                  | )          |
| Total loans, net  of allowance for loan losses            |       | $             | 8,432,123  |                   | $          | 9,898                   |       | $ | 8,442,021 |   |

 

Note 8 to these condensed consolidated financialstatements describes the Company’s borrowings under which the Company haspledged loans for borrowings under repurchase agreements, asset-backed securedliquidity notes, and all other secured financing transactions. The followingtable summarizes the carrying value of loans pledged as collateral underrepurchase agreements, asset-backed secured liquidity notes, and all othersecured financing transactions as of June 30, 2007 (amounts in thousands):
| ** **                                                                                                             | ** ** | **Residential**         | ** ** | ** **               | ** ** | **Commercial Real** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|--------------------------|------------|--------------------------|------------|
| **(amounts in thousands)**                                                                                   | ** ** | **Mortgage Loans** | ** ** | **Corporate Loans** | ** ** | **Estate Loans**    | ** ** |
| Pledged as  collateral for borrowings under repurchase agreements                                                      |       | $                       | 1,180,403  |                     | $          | —                   |       | $ | — |   |
| Pledged as  collateral for asset-backed secured liquidity notes                                                        |       | 3,246,847               |       | —                   |       | —                   |       |
| Pledged as  collateral for borrowings under secured revolving credit facility                                          |       | —                  |       | 119,111                  |       | —                   |       |
| Pledged as  collateral for collateralized loan obligation senior secured notes and junior  secured notes to affiliates |       | —                  |       | 5,017,893                |       | 114,754                  |       |
| Total                                                                                                                  |       | $                       | 4,427,250  |                     | $          | 5,137,004                |       | $ | 114,754 |   |

 

The following table summarizes the carrying value ofloans pledged as collateral under repurchase agreements, asset-backed securedliquidity notes, and all other secured financing transactions as ofDecember 31, 2006 (amounts in thousands):
| ** **                                                                     | ** ** | **Residential**         | ** ** | ** **               | ** ** | **Commercial Real** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------|------------|--------------------------|------------|--------------------------|------------|
| ** **                                                                     | ** ** | **Mortgage Loans** | ** ** | **Corporate Loans** | ** ** | **Estate Loans**    | ** ** |
| Pledged as  collateral for borrowings under repurchase agreements              |       | $                       | 2,136,419  |                     | $          | 596,976                  |       | $ | 15,000 |   |
| Pledged as  collateral for asset-backed secured liquidity notes                |       | 2,905,586               |       | —                   |       | —                   |       |
| Pledged as  collateral for borrowings under secured revolving credit facility  |       | —                  |       | 174,893                  |       | —                   |       |
| Pledged as  collateral for collateralized loan obligation senior secured notes |       | —                  |       | 2,452,066                |       | 93,693                   |       |
| Total                                                                          |       | $                       | 5,042,005  |                     | $          | 3,223,935                |       | $ | 108,693 |   |

 

The following table summarizes the delinquencystatistics of residential mortgage loans as of June 30, 2007 (dollar amounts inthousands):
| Delinquency Status | ** ** | **Number of Loans** | ** ** | **Principal Amount** | ** ** |
|-------------------------|------------|-------------------------------|------------|---------------------------|------------|
| 30 to 59 days           |       | 72                            |       | $                         | 23,109     |   |
| 60 to 89 days           |       | 11                            |       | 3,441                     |       |
| 90 days or more         |       | 19                            |       | 5,029                     |       |
| In foreclosure          |       | 31                            |       | 10,488                    |       |
| Total                   |       | 133                           |       | $                         | 42,067     |   |

 

17

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The following table summarizes the delinquencystatistics of residential mortgage loans as of December 31, 2006 (dollaramounts in thousands):
| Delinquency Status | ** ** | **Number of Loans** | ** ** | **Principal Amount** | ** ** |
|-------------------------|------------|-------------------------------|------------|---------------------------|------------|
| 30 to 59 days           |       | 90                            |       | $                         | 35,968     |   |
| 60 to 89 days           |       | 10                            |       | 3,040                     |       |
| 90 days or more         |       | 15                            |       | 2,855                     |       |
| In foreclosure          |       | 18                            |       | 5,442                     |       |
| Total                   |       | 133                           |       | $                         | 47,305     |   |

 

As of June 30, 2007, the aggregate fair value ofresidential mortgage loans that are 90 days or more past due or inforeclosure approximated the unpaid principal balance of these loans. As ofJune 30, 2007, the uncollected principal amount of the Company’s residentialmortgage loans exceeded their fair value by $38.2 million. As of June 30, 2007,twelve****of the residential mortgage loansowned by the Company with an outstanding balance of $3.0 million (not includedin the table above) were real estate owned (“REO”) as a result of foreclosureon delinquent loans.****As ofDecember 31, 2006, six of the residential mortgage loans owned by theCompany with an outstanding balance of $1.3 million (not included in the tableabove) were REO as a result of foreclosure on delinquent loans. As of June 30,2007 and December 31, 2006, the estimated fair value of the underlying propertyfor these loans approximated the loan balance and the loans have beenreclassified from loans to other assets on the Company’s balance sheet at thelower of cost or estimated fair value less costs of disposal.

As of June 30, 2007, the Company had 50 loans thatwere either 90 days or greater past due or in foreclosure and placed onnon-accrual status. As of June 30, 2007, the Company had not recognizedapproximately $0.3 million in interest income for loans that were eitherin non-accrual status or classified as REO**.**

The following table summarizes the changes in theallowance for loan losses for the Company’s residential mortgage loan portfolioduring the six months ended June 30, 2007 (amounts in thousands):
| Balance, beginning of period                                  |   | $      | 1,500  |   |
|---------------------------------------------------------------|--------|--------|--------|--------|
| Transition to  SFAS No. 159 adjustment to accumulated deficit |   | (1,500 | )      |
| Balance, end of period                                        |   | $      | — |   |

 

**CorporateLoans**

As of June 30, 2007 and December 31, 2006, nocorporate loans were delinquent and as of June 30, 2007 and December 31,2006, the Company had not recorded an allowance for loan losses for itscorporate loan portfolio. In reviewing the Company’s portfolio of corporateloans, the Company determined that no loans were impaired as of June 30, 2007or December 31, 2006.

**Note 7.Investment in Unconsolidated Affiliate**

During the third quarter of 2006 the Company investedin KKR Financial Holdings I, L.P. (“KFH”), a limited partnership where theCompany held a 49.9% limited partnership interest. The remaining 50.1% of KFHwas owned by three private investment funds (collectively, the “KKR StrategicCapital Funds”) and the general partner of the KKR Strategic CapitalFunds. The KKR Strategic Capital Funds are managed by an affiliate of theManager and the KFH general partner is 100% owned by the Manager. KFH wasformed to hold the subordinated interests in three special purpose entitiesformed during the third quarter of 2006 for the purpose of completing securedfinancing transactions in the form of collateralized loan obligation issuancesto finance certain investments in corporate loans and securities.  These three special purpose entities wereconsolidated by KFH since KFH was determined to be the primary beneficiary ofthese entities under FIN 46R.

During the second quarter of 2007, the three specialpurpose entities which KFH had previously consolidated were combined in onesecured financing transaction, CLO 2007-1 (see description under Borrowings inNote 8). Because the Company holds the majority of the subordinated interestsin CLO 2007-1, the Company has determined that it is the primary beneficiary ofCLO 2007-1 and therefore consolidates the accounts of CLO 2007-1 into thesefinancial statements.

18

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**Note 8.Borrowings**

The Company leverages its portfolio of securities andloans through the use of repurchase agreements, asset-backed secured liquiditynotes, warehouse facilities, demand loans, and securitization transactionsstructured as secured financings. Each of the borrowing facilities used by theCompany bears interest at floating rates based on a spread above LIBOR orasset-backed secured liquidity note interest rates.

Certaininformation with respect to the Company’s borrowings as of June 30, 2007 issummarized in the following table (dollar amounts in thousands):
| ** **                                        | ** ** | ** **      | ** ** | ** **    | ** ** | **Weighted**       | ** ** | ** **                      | ** ** |
|---------------------------------------------------|------------|-----------------|------------|---------------|------------|--------------------|------------|---------------------------------|------------|
| ** **                                        | ** ** | ** **      | ** ** | **Weighted**  | ** ** | **Average**        | ** ** | ** **                      | ** ** |
| ** **                                        | ** ** | ** **      | ** ** | **Average**   | ** ** | **Remaining**      | ** ** | ** **                      | ** ** |
| ** **                                        | ** ** | **Outstanding** | ** ** | **Borrowing** | ** ** | **Maturity**       | ** ** | **Fair Value**             | ** ** |
| ** **                                        | ** ** | **Borrowings**  | ** ** | **Rate**      | ** ** | **(in days)** | ** ** | **of Collateral (1)** | ** ** |
| Repurchase  agreements                            |       | $               | 2,393,138  |          | 5.53       | %                  | 27         |                            | $          | 1,782,000 |   |
| Demand loan                                       |       | 41,658          |       | 5.88          |       | 2                  |       | 46,202                          |       |
| Secured  revolving credit facility                |       | 156,531         |       | 6.07          |       | 9                  |       | 176,007                         |       |
| Asset-backed  secured liquidity notes             |       | 8,942,827       |       | 5.39          |       | 21                 |       | 9,273,731                       |       |
| CLO 2005-1  senior secured notes                  |       | 773,000         |       | 5.64          |       | 3,588              |       | 958,044                         |       |
| CLO 2005-2  senior secured notes                  |       | 752,000         |       | 5.63          |       | 3,802              |       | 912,170                         |       |
| CLO 2006-1  senior secured notes                  |       | 727,500         |       | 5.72          |       | 4,074              |       | 975,275                         |       |
| CLO 2007-1  senior secured notes                  |       | 2,368,500       |       | 5.89          |       | 5,068              |       | 2,776,669                       |       |
| CLO 2007-1  junior secured notes to affiliates(2) |       | 431,293         |       | —        |       | 5,068              |       | 505,619                         |       |
| Junior  subordinated notes                        |       | 329,908         |       | 7.74          |       | 10,708             |       | —                          |       |
| Total                                             |       | $               | 16,916,355 |          |       |               |       |                            | $          | 17,405,717 |   |

 

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(1)             Collateralfor borrowings consists of trading securities, securities available-for-sale,and loans.

(2)    CLO 2007-1junior secured notes to affiliates consist of $244.7 million of mezzanine noteswith a weighted average borrowing rate of 10.21% and $186.6 million ofsubordinated notes that do not have a contractual coupon rate, but insteadreceive a pro rata amount of the net distributions from CLO 2007-1.

Certaininformation with respect to the Company’s borrowings as of December 31,2006 is summarized in the following table (dollar amounts in thousands):
| ** **                            | ** ** | ** **      | ** ** | ** **    | ** ** | **Weighted**       | ** ** | ** **                      | ** ** |
|---------------------------------------|------------|-----------------|------------|---------------|------------|--------------------|------------|---------------------------------|------------|
| ** **                            | ** ** | ** **      | ** ** | **Weighted**  | ** ** | **Average**        | ** ** | ** **                      | ** ** |
| ** **                            | ** ** | ** **      | ** ** | **Average**   | ** ** | **Remaining**      | ** ** | ** **                      | ** ** |
| ** **                            | ** ** | **Outstanding** | ** ** | **Borrowing** | ** ** | **Maturity**       | ** ** | **Fair Value**             | ** ** |
| ** **                            | ** ** | **Borrowings**  | ** ** | **Rate**      | ** ** | **(in days)** | ** ** | **of Collateral (1)** | ** ** |
| Repurchase  agreements                |       | $               | 3,824,728  |          | 5.44       | %                  | 19         |                            | $          | 3,728,241 |   |
| Demand loan                           |       | 41,658          |       | 5.88          |       | 1                  |       | 47,056                          |       |
| Secured  revolving credit facility    |       | 34,710          |       | 6.07          |       | 18                 |       | 208,536                         |       |
| Asset-backed  secured liquidity notes |       | 8,705,601       |       | 5.38          |       | 14                 |       | 9,015,211                       |       |
| CLO 2005-1  senior secured notes      |       | 773,000         |       | 5.78          |       | 3,769              |       | 984,837                         |       |
| CLO 2005-2  senior secured notes      |       | 752,000         |       | 5.65          |       | 3,983              |       | 982,976                         |       |
| CLO 2006-1  senior secured notes      |       | 727,500         |       | 5.73          |       | 4,255              |       | 1,001,405                       |       |
| CDO 2005-1  repurchase agreements     |       | 1,074           |       | 6.45          |       | 18                 |       | 1,434                           |       |
| CLO 2006-2  repurchase agreements     |       | 631,287         |       | 5.95          |       | 1                  |       | 734,348                         |       |
| Junior  subordinated notes            |       | 257,743         |       | 7.71          |       | 10,811             |       | —                          |       |
| Total                                 |       | $               | 15,749,301 |          |       |               |       |                            | $          | 16,704,044 |   |

 

----

(1)             Collateralfor borrowings consists of trading securities, securities available-for-sale,and loans.

On May 22, 2007,the Company closed CLO 2007-1, a $3.5 billion secured financingtransaction.  The Company issued $2.4billion of senior secured notes at par to unaffiliated investors with aweighted average coupon of three-month LIBOR plus 0.53% and issued $244.7 millionof mezzanine notes and $186.6 million of subordinated notes to the KKRStrategic Capital Funds.  During thequarter ended June 30, 2007, the Company recorded interest expense of $8.3million for the notes issued to the KKR Strategic Capital Funds and as of June30, 2007 the Company had accrued interest payable to the KKR Strategic CapitalFunds totaling $8.3 million.

DuringJune 2007, the Company issued $72.2 million of junior subordinated notes to KKRFinancial Capital Trust VI (the “Trust”), an entity the Company formed forissuing trust preferred securities and through which the Company received $70.0million in gross proceeds through the Trust’s issuance of trust preferredsecurities to unaffiliated investors in June 2007.  Interest is payable quarterly at a floatingrate equal to three-month LIBOR plus 2.50%.

19

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**Note 9.Derivative Financial Instruments**

The Company enters into derivative transactions inorder to hedge its interest rate risk exposure to the effects of interest ratechanges. Additionally, the Company enters into derivative transactions in thecourse of its investing. The counterparties to the Company’s derivativeagreements are major financial institutions with which the Company and itsaffiliates 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 and FairValue Hedges**

The Company uses interest rate derivatives consistingof swaps and corridors to hedge a portion of the interest rate risk associatedwith its borrowings under repurchase agreements, asset-backed secured liquiditynotes and CLO senior secured notes. The Company designates these financialinstruments as cash flow hedges. The Company also uses interest rate swaps tohedge all or a portion of the interest rate risk associated with certain fixedinterest rate investments. The Company designates these financial instrumentsas fair value hedges.

**Free-StandingDerivatives**

The Company has entered into free-standing derivativesin conjunction with its investment and risk management activities, but theCompany has not designated the derivative contracts as hedging instruments foraccounting purposes. Such derivative contracts may include credit defaultswaps, foreign exchange contracts, and interest rate derivatives. Free-standingderivatives also include investment financing arrangements (total rate of returnswaps) whereby the Company receives the sum of all interest, fees and anypositive change in fair value amounts from a reference asset with a specifiednotional amount and pays interest, fees and any negative change in fair valueamounts from such reference asset.

Thetable below summarizes the estimated net fair value of the derivativeinstruments as of June 30, 2007 and December 31, 2006 (amounts inthousands):
|                                 | ** ** | **As of**              | ** ** | **As of**                  | ** ** |
|---------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                      | ** ** | **June 30, 2007** | ** ** | **December 31, 2006** | ** ** |
| ** **                      | ** ** | **Notional**                | ** ** | **Fair Value**             | ** ** | **Notional** | ** ** | **Fair Value** | ** ** |
| **Cash  Flow Hedges:**          |       |                        |       |                            |       |   |   |   |   |
| Interest rate corridors         |       | $                           | 744,936    |                            | $          | 11,822 |   | $ | 702,369 |   | $ | 13,591 |   |
| Interest rate swaps             |       | 4,216,027                   |       | 55,419                          |       | 4,567,828 |   | 45,314 |   |
| **Fair  Value Hedges:**         |       |                        |       |                            |       |   |   |   |   |
| Interest rate swaps             |       | 32,000                      |       | 442                             |       | 32,000 |   | 13 |   |
| **Free-Standing  Derivatives:** |       |                        |       |                            |       |   |   |   |   |
| Interest rate swaptions         |       | 31,000                      |       | 75                              |       | 31,000 |   | 75 |   |
| Credit default swaps - long     |       | 16,000                      |       | 173                             |       | 3,000 |   | 179 |   |
| Credit default swaps - short    |       | 290,000                     |       | 518                             |       | 275,000 |   | (797 | ) |
| Total rate of return swaps      |       | 497,941                     |       | 10,246                          |       | 222,647 |   | 2,343 |   |
| Common stock warrants           |       | —                      |       | 286                             |       | — |   | — |   |
| Net fair value                  |       | $                           | 5,827,904  |                            | $          | 78,981 |   | $ | 5,833,844 |   | $ | 60,718 |   |

 

During the three and six months ended June 30, 2007and June 30, 2006, the Company recognized an immaterial amount of ineffectivenessin income from its cash flow and fair value hedges.

**Note 10. Accumulated Other Comprehensive Income**

Thecomponents of accumulated other comprehensive income were as follows (amountsin thousands):
|                                                                                                     | ** ** | **As of**              | ** ** | **As of**                  | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                                                                                          | ** ** | **June 30, 2007** | ** ** | **December 31, 2006** | ** ** |
| Net unrealized  gains on available-for-sale securities                                              |       | $                           | 4,844      |                            | $          | 11,776 |   |
| Net unrealized  gains on available-for-sale securities from investment in unconsolidated  affiliate |       | —                      |       | 7,898                           |       |
| Net unrealized  gains on cash flow hedges                                                           |       | 60,924                      |       | 50,846                          |       |
| Accumulated other  comprehensive income                                                             |       | $                           | 65,768     |                            | $          | 70,520 |   |

 

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Thechanges in the components of other comprehensive income were as follows(amounts in thousands):
| ** **                                                                                                                               | ** ** | **Three months**        | ** ** | **Three months**        | ** ** | **Six months**          | ** ** | **Six months**          | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                               | ** ** | **ended June 30,** | ** ** | **ended June 30,** | ** ** | **ended June 30,** | ** ** | **ended June 30,** | ** ** |
| ** **                                                                                                                               | ** ** | **2007**                     | ** ** | **2006**                     | ** ** | **2007**                     | ** ** | **2006**                     | ** ** |
| Unrealized gains on  securities available-for-sale:                                                                                      |       |                         |       |                         |       |                         |       |                         |       |
| Unrealized  holding (losses) gains arising during period                                                                                 |       | $                            | (6,273     | )                            | $          | 542                          |       | $                            | 641        |   | $ | (3,514 | ) |
| Transition  adjustment to accumulated deficit in conjunction with fair value option  election for residential mortgage-backed securities |       | —                       |       | —                       |       | 21,575                       |       | —                       |       |
| Reclassification  adjustments for (gains) losses realized in net income                                                                  |       | (25,340                      | )          | 1,225                        |       | (29,148                      | )          | 1,864                        |       |
| Unrealized gains  (losses) on securities available-for-sale                                                                              |       | (31,613                      | )          | 1,767                        |       | (6,932                       | )          | (1,650                       | )          |
| Unrealized losses on  available-for-sale securities from investment in unconsolidated affiliate                                          |       | (8,810                       | )          | —                       |       | (7,898                       | )          | —                       |       |
| Unrealized gains on  cash flow hedges                                                                                                    |       | 28,251                       |       | 25,326                       |       | 10,078                       |       | 72,393                       |       |
| Other comprehensive income                                                                                                               |       | $                            | (12,172    | )                            | $          | 27,093                       |       | $                            | (4,752     | ) | $ | 70,743 |   |

 

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

TheCompany has adopted an amended and restated share incentive plan (the “2007Share Incentive Plan”) that provides for the grant of qualified incentivecommon share options that meet the requirements of Section 422 of theCode, non-qualified common share options, share appreciation rights, restrictedcommon shares and other share-based awards. The 2007 Share Incentive Plan wasadopted on May 4, 2007. The Compensation Committee of the Board of Directorsadministers the plan. Share options and other share-based awards may be grantedto the Manager, directors, officers and any key employees of the Manager and toany other individual or entity performing services for the Company.

Theexercise price for any share option granted under the 2007 Share Incentive Planmay not be less than 100% of the fair market value of the common shares at thetime the common share option is granted. Each option to acquire a common share mustterminate no more than ten years from the date it is granted. The 2007 ShareIncentive Plan, authorizes a total of 8,089,625 shares that may be used tosatisfy awards under the 2007 Share Incentive Plan. The Company made itsinitial grants on August 12, 2004 and August 19, 2004, the dates thatthe Company closed its initial private placement of common shares and the datethat the over-allotment option was exercised, respectively.

Thefollowing table summarizes restricted common share transactions:
|                                                                         | ** ** | **Manager** | ** ** | **Directors** | ** ** | **Total** | ** ** |
|-------------------------------------------------------------------------|------------|-------------|------------|---------------|------------|-----------|------------|
| **Unvested shares as of January 1, 2007** |       | 1,647,955   |       | 52,033        |       | 1,699,988 |       |
| Issued                                                                  |       | —      |       | —        |       | —    |       |
| Vested                                                                  |       | —      |       | (5,150        | )          | (5,150    | )          |
| Forfeited                                                               |       | —      |       | —        |       | —    |       |
| **Unvested shares as of June 30,  2007**                                |       | 1,647,955   |       | 46,883        |       | 1,694,838 |       |

 

Therestricted common shares granted to the directors were valued using the fairmarket value at the time of grant, which was $21.30 per share for therestricted common shares granted in 2006. Pursuant to SFAS No. 123(R), theCompany is required to value any unvested restricted common shares granted tothe Manager at the current market price. The Company valued the unvestedrestricted common shares at $24.91 and $20.81 per share at June 30, 2007 andJune 30, 2006, respectively.

Thefollowing table summarizes common share option transactions:
|                                        | ** ** | **Number**          | ** ** | **Weighted Average** | ** ** |
|----------------------------------------|------------|---------------------|------------|---------------------------|------------|
| ** **                             | ** ** | **of Options** | ** ** | **Exercise Price**   | ** ** |
| **Outstanding  as of January 1, 2007** |       | 1,932,279           |       | $                         | 20.00      |   |
| Granted                                |       | —              |       | —                    |       |
| Exercised                              |       | —              |       | —                    |       |
| Forfeited                              |       | —              |       | —                    |       |
| **Outstanding as of June 30, 2007**    |       | 1,932,279           |       | $                         | 20.00      |   |

 

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57,500and nil of the common share options outstanding were exercised at June 30, 2007and June 30, 2006, respectively. 1,269,020 and 663,260 common share optionswere exercisable on June 30, 2007 and June 30, 2006, respectively. The commonshare options are valued using the Black-Scholes model using the followingassumptions:
|                | ** ** | **As of**              | ** ** | **As of**              | ** ** |
|----------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **     | ** ** | **June 30, 2007** | ** ** | **June 30, 2006** | ** ** |
| Expected life  |       | 7.1 years                   |       | 8.1 years                   |       |
| Discount rate  |       | 5.00                        | %          | 5.19                        | %          |
| Volatility     |       | 22.34                       | %          | 16.00                       | %          |
| Dividend yield |       | 9.00                        | %          | 9.00                        | %          |

 

Theestimated fair value of the common share options was $2.79 and $0.91 at June30, 2007 and June 30, 2006, respectively. For the three and six months endedJune 30, 2007 and June 30, 2006, the components of share-based compensationexpense are as follows (amounts in thousands):
|                                                 | ** ** | **For the three** | ** ** | **For the three** | ** ** | **For the six**   | ** ** | **For the six**   | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                      | ** ** | **months ended**       | ** ** | **months ended**       | ** ** | **months ended**       | ** ** | **months ended**       | ** ** |
| ** **                                      | ** ** | **June 30, 2007** | ** ** | **June 30, 2006** | ** ** | **June 30, 2007** | ** ** | **June 30, 2006** | ** ** |
| Options granted  to Manager                     |       | $                           | (184       | )                           | $          | (497                        | )          | $                           | 438        |   | $ | (509 | ) |
| Restricted  shares granted to Manager           |       | 930                         |       | 5,465                       |       | 6,040                       |       | 12,086                      |       |
| Restricted shares  granted to certain directors |       | 108                         |       | 175                         |       | 214                         |       | 349                         |       |
| Total share-based  compensation expense         |       | $                           | 854        |                        | $          | 5,143                       |       | $                           | 6,692      |   | $ | 11,926 |   |

 

**Note 12.** **Management Agreement and Related Party Transactions**

The Manager manages the Company’s day-to-dayoperations, subject to the direction and oversight of the Company’s Board ofDirectors. The Management Agreement expires on December 31 of each year,but is automatically renewed for a one-year term each December 31 unlessterminated upon the affirmative vote of at least two-thirds of the Company’sindependent directors, or by a vote of the holders of a majority of the Company’soutstanding common shares, based upon (1) unsatisfactory performance by theManager that is materially detrimental to the Company or (2) a determinationthat the management fee payable by the Manager is not fair, subject to theManager’s right to prevent such a termination under this clause (2) byaccepting a mutually acceptable reduction of management fees.  The Manager must be provided 180 days priornotice of any such termination and will be paid a termination fee equal to fourtimes the sum of the average annual base management fee and the average annualincentive fee for the two 12-month periods immediately preceding the date oftermination, calculated as of the end of the most recently completed fiscalquarter prior to the date of termination.

The Management Agreement contains certain provisionsrequiring the Company to indemnify the Manager with respect to all losses ordamages arising from acts not constituting bad faith, willful misconduct, orgross negligence. The Company has evaluated the impact of these guarantees onits consolidated financial statements and determined that they are notmaterial.

For the three and six months ended June 30, 2007, theCompany incurred $7.1 million and $14.3 million in base management fees,respectively. In addition, the Company recognized share-basedcompensation expense related to common share options and restricted commonshares granted to the Manager of $0.7 million and $6.5 million,respectively, for the three and six months ended June 30, 2007 (seeNote 11). The Company also reimbursed the Manager $2.2 million and $3.9million for expenses for the three and six months ended June 30, 2007,respectively. For the three and six months ended June 30, 2006, the Companyincurred $7.2 million and $14.4 million in base management fees,respectively. In addition, the Company recognized share-basedcompensation expense related to common share options and restricted commonshares granted to the Manager of $5.0 million and $11.6 million,respectively, for the three and six months ended June 30, 2006 (seeNote 11). The Company also reimbursed the Manager $1.4 million and $2.8million for expenses for the three and six months ending June 30, 2006,respectively. Base management fees incurred and share-based compensationexpense relating to 

22

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common share options andrestricted common shares granted to the Manager are included in related partymanagement compensation on the condensed consolidated statements of operations.Expenses incurred by the Manager and reimbursed by the Company are reflected inthe respective consolidated statement of operations non-investment expensecategory based on the nature of the expense.

Incentive fees of $6.2 million and $12.6 million wereearned by the Manager during the three and six months ended June 30, 2007,respectively.  The Manager earned $1.6million and $2.3 million in incentive fees for the three and six months endedJune 30, 2006, respectively.

An affiliate of the Company’s Manager has entered intoseparate management agreements with the respective investment vehicles for CLO2005-1, CLO 2005-2, CLO 2006-1, and CLO 2007-1 and is entitledto receive fees for the services performed as collateral manager. BeginningApril 15, 2007 the collateral manager ceased waiving fees for CLO 2005-1 forwhich the Company recorded an expense of $1.0 million during the quarter endedJune 30, 2007. As of June 30, 2007, the collateral manager has permanentlywaived approximately $11.6 million in fees. The collateral manager evaluates such waivers on a quarterly basis andthere are no assurances that the collateral manager will waive such managementfees subsequent to those dates.

**Note 13.   Fair Value Disclosures**

Effective January 1, 2007 the Company adopted SFASNo. 157, which requires additional disclosures about the Company’s assets andliabilities that are measured at fair value.

As defined in SFAS No. 157, fair value is the pricethat would be received to sell an asset or paid to transfer a liability in anorderly transaction between market participants at the measurement date.  Where available, fair value is based onobservable market prices or parameters or derived from such prices orparameters.  Where observable prices orinputs are not available, valuation models are applied.  These valuation techniques involve some levelof management estimation and judgment, the degree of which is dependent on theprice transparency for the instruments or market and the instruments’complexity for disclosure purposes. Beginning in January 2007, assets andliabilities recorded at fair value in the Consolidated Balance Sheet arecategorized based upon the level of judgment associated with the inputs usedthe measure their value. Hierarchical levels, as defined in SFAS No. 157 anddirectly related to the amount of subjectivity associated with the inputs tofair valuations of these assets and liabilities, are as follows:

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

The types of assets carried at Level 1 fair value generally are equitieslisted in active markets.

Level 2:  Inputs other than quotedprices included in Level 1 that are observable for the asset, either directly orindirectly. Level 2 inputs include quoted prices for similar assets in active markets,and inputs other than quoted prices that are observable for the asset orliability.

Fair valued assets and liabilities that are generally included in thiscategory are mortgage backed-securities and mortgage loans where the mortgageloans on the Company’s financial statements consist of mortgage-backedsecurities where the issuing trust has been consolidated on the Company’sconsolidated financial statements, certain corporate and commercial real estatedebt securities and loan investments, and certain financial instrumentsclassified as derivatives where the fair value is based on observable marketinputs.

Level 3: Inputs are unobservable inputs for the asset, and includesituations where there is little, if any, market activity for the asset orliability. In certain cases, the inputs used to measure fair value may fallinto different levels of the fair value hierarchy. In such cases, the level inthe fair value hierarchy within which the fair value measurement in itsentirety falls has been determined based on the lowest level input that issignificant to the fair value measurement in its entirety. The Company’sassessment of the significance of a particular input to the fair valuemeasurement in its entirety requires judgment, and considers factors specificto the asset.

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

The categorization of anasset or liability within the fair value hierarchy is based on the lowest levelof significant input to its valuation.

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The following table presents information about theCompany’s assets and liabilities (including derivatives that are presented net)measured at fair value on a recurring basis as of June 30, 2007, and indicatesthe fair value hierarchy of the valuation techniques utilized by the Company todetermine such fair value.
| ** **                           | ** ** | **Quoted Prices in**     | ** ** | ** **                 | ** ** | ** **                   | ** ** | ** **                  | ** ** |
|--------------------------------------|------------|------------------------------------|------------|----------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                           | ** ** | **Active Markets**            | ** ** | **Significant Other** | ** ** | **Significant**              | ** ** | ** **                  | ** ** |
| ** **                           | ** ** | **for Identical Assets** | ** ** | **Observable Inputs** | ** ** | **Unobservable Inputs** | ** ** | **Balance as of** | ** ** |
| **(amounts in thousands)** | ** ** | **(Level 1)**                 | ** ** | **(Level 2)**         | ** ** | **(Level 3)**           | ** ** | **June 30, 2007** | ** ** |
| Trading  securities                  |       | $                                  | —     |                       | $          | 6,587,422                    |       | $                           | —     |   | $ | 6,587,422 |   |
| Securities  available-for-sale       |       | 68,281                             |       | 1,313,685                  |       | 57,000                       |       | 1,438,966                   |       |
| Loans                                |       | —                             |       | 4,399,984                  |       | 165,490                      |       | 4,565,474                   |       |
| Derivatives, net                     |       | —                             |       | 77,664                     |       | 1,317                        |       | 78,981                      |       |
| Securities sold,  not yet purchased  |       | (58,491                            | )          | —                     |       | —                       |       | (58,491                     | )          |
| Total                                |       | $                                  | 9,790      |                       | $          | 12,378,755                   |       | $                           | 223,807    |   | $ | 12,612,352 |   |

 

The following table presents additional informationabout assets, including derivatives that are measured at fair value on arecurring basis for which the Company has utilized Level 3 inputs to determinefair value, for the three months ended June 30, 2007:
| ** **                                                                                                                                                                              | ** ** | **Fair Value Measurements Using** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                                                                                              | ** ** | **Significant Unobservable Inputs**    | ** ** |
| ** **                                                                                                                                                                              | ** ** | **(Level 3)**                               | ** ** |
| ** **                                                                                                                                                                              | ** ** | **Securities**                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                                                                                              | ** ** | **Available-For-**                               | ** ** | ** ** | ** ** | **Derivatives,** | ** ** |
| **(amounts in thousands)**                                                                                                                                                    | ** ** | **Sale**                                         | ** ** | **Loans** | ** ** | **net** | ** ** |
| Beginning  balance as of March 31, 2007                                                                                                                                                 |       | $                                                | 105,352    |   | $ | 168,188 |   | $ | 1,109 |   |
| Total gains or  losses (realized and unrealized):                                                                                                                                       |       |                                             |       |   |   |   |   |
| Included in  earnings                                                                                                                                                                   |       | —                                           |       | (14 | ) | 208 |   |
| Included in  other comprehensive income                                                                                                                                                 |       | —                                           |       | — |   | — |   |
| Purchases,  sales, other settlements and issuances, net                                                                                                                                 |       | (48,352                                          | )          | (2,684 | ) | — |   |
| Ending balance  as of June 30, 2007                                                                                                                                                     |       | $                                                | 57,000     |   | $ | 165,490 |   | $ | 1,317 |   |
|                                                                                                                                                                                    |       |                                             |       |   |   |   |   |
| The amount of total  gains or losses for the period included in earnings attributable to the  change in unrealized gains or losses relating to assets still held at the  reporting date |       | $                                                | —     |   | $ | (14 | ) | $ | 208 |   |

 

The following table presents additional informationabout assets, including derivatives that are measured at fair value on arecurring basis for which the Company has utilized Level 3 inputs to determinefair value, for the six months ended June 30, 2007:
| ** **                                                                                                                                                                              | ** ** | **Fair Value Measurements Using** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                                                                                              | ** ** | **Significant Unobservable Inputs**    | ** ** |
| ** **                                                                                                                                                                              | ** ** | **(Level 3)**                               | ** ** |
| ** **                                                                                                                                                                              | ** ** | **Securities**                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                                                                                              | ** ** | **Available-For-**                               | ** ** | ** ** | ** ** | **Derivatives,** | ** ** |
| **(amounts in thousands)**                                                                                                                                                    | ** ** | **Sale**                                         | ** ** | **Loans** | ** ** | **net** | ** ** |
| Beginning  balance as of December 31, 2006                                                                                                                                              |       | $                                                | 104,498    |   | $ | 153,192 |   | $ | — |   |
| Total gains or  losses (realized and unrealized):                                                                                                                                       |       |                                             |       |   |   |   |   |
| Included in  earnings                                                                                                                                                                   |       | —                                           |       | (133 | ) | 1,317 |   |
| Included in  other comprehensive income                                                                                                                                                 |       | —                                           |       | — |   | — |   |
| Purchases,  sales, other settlements and issuances, net                                                                                                                                 |       | (47,498                                          | )          | 12,431 |   | — |   |
| Ending balance  as of June 30, 2007                                                                                                                                                     |       | $                                                | 57,000     |   | $ | 165,490 |   | $ | 1,317 |   |
|                                                                                                                                                                                    |       |                                             |       |   |   |   |   |
| The amount of total  gains or losses for the period included in earnings attributable to the  change in unrealized gains or losses relating to assets still held at the  reporting date |       | $                                                | —     |   | $ | (133 | ) | $ | 1,317 |   |

 

As of June 30, 2007, the Company did not have anyassets or liabilities measured at fair value on a non-recurring basis.

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**Note 14.  Subsequent Events**

OnJuly 2, 2007, the compensation committee of the Board of Directors granted34,277 restricted common shares to the Company’s Directors pursuant to the 2007Share Incentive Plan.

OnJuly 23, 2007 the Company issued an aggregate of $300.0 million of 7.000%convertible senior notes maturing on July 15, 2012 (the “Notes”) to qualifiedinstitutional buyers.  The initialpurchaser of the Notes has an option to purchase an amount up to an additional$45.0 million of Notes.  The Notesrepresent senior unsecured obligations of the Company and bear interest at therate of 7.000% per year. Interest is payable semi-annually on January 15 andJuly 15 of each year, beginning January 15, 2008.

TheNotes are convertible into the Company’s common shares, initially at aconversion rate of 31.08 shares per $1,000 principal of Notes, which isequivalent to an initial conversion price of $32.175 per common share. On July23, 2007, the Company’s closing share price was $23.74. The Notes areconvertible prior to the maturity date at any time on or after June 15, 2012and also under the following circumstances: (a) a holder may surrender any ofits Notes for conversion during any calendar quarter beginning after September30, 2007 (and only during such calendar quarter) if, and only if, the closingsale price of the Company’s common shares for at least 20 trading days (whetheror not consecutive) in the period of 30 consecutive trading days ending on thelast trading day of the preceding calendar quarter is greater than 130% of theconversion price per common share in effect on the applicable trading day; (b)a holder may surrender any of its Notes for conversion during the fiveconsecutive trading-day period following any five consecutive trading-dayperiod in which the trading price of the Notes was less than 98% of the productof the closing sale price of the Company’s common shares multiplied by theapplicable conversion rate; (c) a holder may surrender for conversion any ofits Notes if those Notes have been called for redemption, at any time prior tothe redemption date, even if the Notes are not otherwise convertible at suchtime; and (d) a holder may surrender any of its Notes for conversion if theCompany engages in certain specified transactions, as defined in the indenturecovering the Notes.

OnJuly 25, 2007, the FASB authorized a proposed FASB Staff Position (the “proposedFSP”) that, if approved for issuance by the FASB, will affect the accountingfor the Company’s Notes. If approved for issuance by the FASB, the proposed FSPwill require that the initial debt proceeds be allocated between a liabilitycomponent and an equity component. The resulting debt discount would beamortized over the period the debt is expected to be outstanding as additionalinterest expense. The proposed FSP is expected to be effective for fiscal yearsbeginning after December 15, 2007 and would require retrospective application.

OnAugust 2, 2007, the Company’s Board of Directors declared a cash distributionfor the three months ended June 30, 2007 on the Company’s common shares of$0.56 per share, payable on August 30, 2007 to shareholders of record as of theclose of business on August 16, 2007.

**Item2.   Management’s Discussion and Analysis of Financial Condition andResults of Operations**

*Unlessotherwise expressly stated or the context suggests otherwise, the terms “we,” “us”and “our” refer, as of dates and for periods on and after May 4, 2007 to  KKR Financial Holdings LLC and itssubsidiaries and, as of dates and for periods prior to May 4, 2007, to ourpredecessor, KKR Financial Corp., and its subsidiaries; “Manager” means KKRFinancial Advisors LLC; “KKR” means Kohlberg Kravis Roberts & Co. L.P. andits affiliated companies (excluding portfolio companies that are minority ormajority owned or managed by funds associated with KKR); “Management Agreement”means the amended and restated management agreement between KKR FinancialHoldings LLC and the Manager. The following management’s discussion andanalysis (“MD&A”) is intended to assist the reader in understanding ourbusiness. The MD&A is provided as a supplement to, and should be read inconjunction with, our Condensed Consolidated Financial Statements andaccompanying notes included in this Quarterly Report on Form 10-Q and ourConsolidated Financial Statements and accompanying notes included in our AnnualReport on Form 10-K for the year ended December 31, 2006.*

**ForwardLooking Statements**

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

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**Executive Overview**

We are a specialty finance company that uses leveragewith the objective of generating competitive risk-adjusted returns. We seek toachieve our investment objective by investing in (i) corporate loans and debtsecurities, (ii) marketable equity securities and (iii) non-marketable equitysecurities. We also make opportunistic investments in other asset classes fromtime to time, including investments in residential and commercial mortgageloans and securities. We invest in both cash and derivative instruments.

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

Our income is generatedprimarily from (i) net interest income and dividend income, (ii) realizedand unrealized gains and losses on our derivative instruments that are notaccounted for as hedges, (iii) realized gains and losses from the sales ofinvestments, (iv) unrealized gains and losses on trading securities and loanscarried at fair value, and (v) fee income.

We are notcurrently reinvesting funds in residential real estate-relatedinvestments as those investments pay down in the ordinary coursebut may choose to do so if new residential real estate-related investments meetour return requirements.  In addition, weare considering other alternatives to reducing our residential realestate-related investments, including selling all or a portion ofits residential real estate-related investments through asset sales or salesor other dispositions of the common shares of KKR Financial Corp., ourreal-estate investment trust (“REIT”) subsidiary (“REIT Subsidiary”).

We are externally managed andadvised by our Manager, an affiliate of KKR, pursuant to the ManagementAgreement.

***Cash Distributions to Shareholders***

On August 2, 2007, our Board of Directors declared a cash distributionfor the quarter ended June 30, 2007 on our common shares of $0.56 per commonshare. The aggregate distribution amount of $45.1 million is payable on August30, 2007 to our common shareholders of record as of the close of business onAugust 16, 2007.

***Investment Portfolio***

As ofJune 30, 2007 our investment portfolio totaled $18.0 billion, representing anincrease of 5.3% from $17.1 billion as of December 31, 2006. As of June30, 2007, our investment portfolio primarily consisted of residential mortgageloans and securities totaling $11.2 billion, corporate loans and securitiestotaling $6.5 billion, commercial real estate loans and securities totaling$146.4 million, and marketable equity securities consisting of preferred andcommon stock totaling $68.3 million. In addition, we held investments innon-marketable equity securities totaling $173.8 million as of June 30, 2007.

***Financing Transactions***

On May 22, 2007,we closed KKR Financial CLO 2007-1, Ltd. (“CLO 2007-1”), a $3.5 billion securedfinancing transaction.  We issued $2.4billion of senior secured notes at par to unaffiliated investors with aweighted average coupon of three-month LIBOR plus 0.53% and issued $244.7 millionof mezzanine notes and $186.6 million of subordinated notes to three privateinvestment funds (collectively, the “KKR Strategic Capital Funds”) that aremanaged by an affiliate of our Manager.

DuringJune 2007, we issued $72.2 million of junior subordinated notes to KKRFinancial Capital Trust VI (“Trust VI”), an entity we formed for issuingtrust preferred securities and through which we received $70.0 million in grossproceeds through Trust VI’s issuance of trust preferred securities tounaffiliated investors in June 2007. Interest is payable quarterly at a floating rate equal to three-monthLIBOR plus 2.50%.

OnJuly 23, 2007 we issued an aggregate of $300.0 million of 7.000% convertiblenotes maturing on July 15, 2012 (the “Notes”) to qualified institutionalbuyers.  The initial purchaser of theNotes has an option to purchase up to an additional $45.0 million ofNotes.  The Notes represent seniorunsecured obligations of us and bear interest at the rate of 7.000% per year.Interest is payable semi-annually on January 15 and July 15 of each year,beginning January 15, 2008.

TheNotes are convertible into our common shares, initially at a conversion rate of31.08 shares per $1,000 principal of Notes, which is equivalent to an initialconversion price of $32.175 per common share. The Notes are convertible priorto the maturity date at any time on or after June 15, 2012 and also under thefollowing circumstances: (i) a holder may surrender any of its Notes forconversion during any calendar quarter beginning after 

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September 30, 2007 (andonly during such calendar quarter) if, and only if, the closing sale price ofour common shares for at least 20 trading days (whether or not consecutive) inthe period of 30 consecutive trading days ending on the last trading day of thepreceding calendar quarter is greater than 130% of the conversion price percommon share in effect on the applicable trading day; (ii) a holder maysurrender any of its Notes for conversion during the five consecutivetrading-day period following any five consecutive trading-day period in whichthe trading price of the Notes was less than 98% of the product of the closingsale price of our common shares multiplied by the applicable conversion rate; (iii)a holder may surrender for conversion any of its Notes if those Notes have beencalled for redemption, at any time prior to the redemption date, even if theNotes are not otherwise convertible at such time; and (iv) a holder maysurrender any of its Notes for conversion if we engage in certain specifiedtransactions, as defined in the indenture covering the Notes.

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**CriticalAccounting Policies**

Ourconsolidated financial statements are prepared by management in conformity withaccounting principles generally accepted in the United States of America (“GAAP”).Our significant accounting policies are fundamental to understanding ourfinancial condition and results of operations because some of these policiesrequire that we make significant estimates and assumptions that may affect thevalue of our assets or liabilities and financial results. We believe thatcertain of our policies are critical because they require us to make difficult,subjective, and complex judgments about matters that are inherently uncertain.We have reviewed these critical accounting policies with our Board of Directorsand our audit committee.

***RevenueRecognition***

We account for interest income on our investmentsusing the effective yield method. For investments purchased at par, theeffective yield is the contractual coupon rate on the investment. Unamortizedpremiums and discounts on non-residential mortgage-backed securities arerecognized in interest income over the contractual life, adjusted for actualprepayments, of the securities using the effective interest method. Forsecurities representing beneficial interests in securitizations that are nothighly rated (i.e., subordinate tranches of residential mortgage-backedsecurities), unamortized premiums and discounts are recognized over thecontractual life, adjusted for estimated prepayments and estimated creditlosses of the securities using the effective interest method. Actual prepaymentand credit loss experience is reviewed quarterly and effective yields arerecalculated when differences arise between prepayments and credit lossesoriginally anticipated compared to amounts actually received plus anticipatedfuture prepayments.

Interest income on loans includes interest at statedcoupon rates adjusted for accretion of purchase discounts and the amortizationof purchase premiums. For corporate and commercial real estate loans,unamortized premiums and discounts are recognized in interest income over thecontractual life, adjusted for actual prepayments, of the loans using theeffective interest method. For residential mortgage loans, unamortized premiumsand discounts are recognized over the contractual life, adjusted for estimatedprepayments using the effective interest method.

As of June 30, 2007, unamortized purchase premiums andunaccreted purchase discounts on our investment portfolio totaled $23.6 millionand $52.5 million, respectively.

Upon adoption ofSFAS No. 159, *The Fair Value Option for Financial Assetsand Financial Liabilities—Including an amendment of FASB Statement No. 115*(“SFAS No. 159”) as of January 1, 2007 as disclosed below under “RecentAccounting Pronouncements”, we carry our investments in residentialmortgage-backed securities and residential mortgage loans at fair value withchanges in fair value recorded in income.

***Share-BasedCompensation***

We account for share-based compensation issuedto members of our Board of Directors and our Manager using the fair value basedmethodology in accordance with SFAS No. 123(R). We do not have anyemployees, although we believe that members of our Board of Directors aredeemed to be employees for purposes of interpreting and applying accountingprinciples relating to share-based compensation. We record ascompensation costs the restricted common shares that we issued to members ofour Board of Directors at estimated fair value as of the grant date and weamortize the cost into expense over the three-year vesting period using thestraight-line method. We record compensation costs for restricted common sharesand common share options that we issued to our Manager at estimated fair valueas of the grant date and we remeasure the amount on subsequent reporting datesto the extent that the restricted common shares and/or common share optionshave not vested. Unvested restricted common shares are valued using observablesecondary market prices. Unvested common shares options are valued using theBlack-Scholes model and assumptions based on observable market data forcomparable companies. We amortize compensation expense related to therestricted common shares and common share options that we granted to ourManager using the graded vesting attribution method in accordance with SFAS No.123 (R).

Because we remeasure the amount of compensation costsassociated with the unvested restricted common shares and unvested common shareoptions that we issued to our Manager as of each reporting period, our share-basedcompensation expense reported in our consolidated financial statements willchange based on the estimated fair value of our common shares and this mayresult in earnings volatility. For the three and six months ended June 30,2007, share-based compensation totaled $0.9 million and $6.7 million,respectively. As of June 30, 2007, substantially all of the non-vested commonshare options and restricted common shares issued that are subject to SFASNo. 123(R) are subject to remeasurement. As of June 30, 2007, a$1 increase in the price of our common shares would have increased ourfuture share-based compensation expense by approximately $1.9 million and thisfuture share-based compensation expense would be recognized over the remaining 

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vesting periods of ouroutstanding restricted common shares and common share options. As of June 30,2007, future unamortized share-based compensation totaled $6.4 million, ofwhich $3.5 million and $2.9 million will be recognized in 2007 and 2008,respectively.

***Accounting forDerivative Instruments and Hedging Activities***

We recognize all derivatives on our consolidatedbalance sheet 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 and, to the extent that it is effective, changes in thefair value of the hedged asset or liability attributable to the hedged risk, inthe current period earnings in the same financial statement category as thehedged item. For a cash flow hedge, we record changes in the estimated fairvalue of the derivative to the extent that it is effective in othercomprehensive income. We subsequently reclassify these changes in estimatedfair value to net income in the same period(s) that the hedged transactionaffects earnings in the same financial statement category as the hedged item.For free-standing derivatives, we report changes in the fair values in currentperiod other income.

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

We are not required to account for our derivativecontracts using hedge accounting as described above. If we decide not todesignate the derivative contracts as hedges or if we fail to fulfill thecriteria necessary to qualify for hedge accounting, then the changes in theestimated fair values of our derivative contracts would immediately affectperiodic earnings, potentially resulting in the increased volatility of ourearnings. The qualification requirements for hedge accounting are complex andas a result we must evaluate, designate, and thoroughly document each hedgetransaction at inception and perform ineffectiveness analysis and preparerelated documentation at inception and on a recurring basis thereafter. As ofJune 30, 2007, the estimated fair value of our derivatives that are accountedfor as hedges totaled $67.7 million.

***Impairments***

We evaluate our investment portfolio for impairment asof each quarter end or more frequently if we become aware of any materialinformation that would lead us to believe that an investment may be impaired.We evaluate whether the investment is considered impaired and whether theimpairment is other-than-temporary. If we make a determination that theimpairment is other-than-temporary, we recognize an impairment loss equal to thedifference between the amortized cost basis and the estimated fair value of theinvestment. We consider many factors in determining whether the impairment ofan investment is other-than-temporary, including but not limited to the lengthof time the security has had a decline in estimated fair value below itsamortized cost, the amount of the loss, our intent and our financial ability tohold the investment for a period of time sufficient for a recovery in itsestimated fair value, recent events specific to the issuer or industry,external credit ratings and recent downgrades in such ratings.

**Recent AccountingPronouncements**

In February 2006, the FASB issued SFASNo. 155, *Accounting for Certain Hybrid FinancialInstruments* (“SFAS No. 155”). Key provisions of SFASNo. 155 include: (1) a broad fair value measurement option forcertain hybrid financial instruments that contain an embedded derivative thatwould otherwise require bifurcation; (2) clarification that only thesimplest separations of interest payments and principal payments qualify forthe exception afforded to interest-only strips and principal-only strips fromderivative accounting under paragraph 14 of SFAS No. 133*,* thereby narrowing such exception; (3) a requirementthat beneficial interests in securitized financial assets be analyzed todetermine whether they are freestanding derivatives or whether they are hybridinstruments that contain embedded derivatives requiring bifurcation;(4) clarification that concentrations of credit risk in the form ofsubordination are not embedded derivatives; and (5) elimination of theprohibition on a QSPE holding passive derivative financial instruments thatpertain to beneficial interests that are or contain a derivative financialinstrument. In general, these changes will reduce the operational complexity 

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associated withbifurcating embedded derivatives, and increase the number of beneficialinterests in securitization transactions, including interest-only strips andprincipal-only strips, required to be accounted for in accordance with SFASNo. 133. We adopted SFAS No. 155 as of the beginning of 2007 and theadoption of SFAS No. 155 did not have a material impact on our consolidatedfinancial statements.

In June 2006, the FASB issued InterpretationNo. 48, *Accounting for Uncertainty in IncomeTaxes—an interpretation of FASB Statement No. 109* (“FIN 48”).FIN 48 clarifies the accounting for uncertainty in income taxes recognized inan enterprise’s financial statements in accordance with FASB StatementNo. 109, *Accounting for Income Taxes*. FIN48 prescribes a recognition threshold and measurement attribute for thefinancial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. We adopted FIN 48 as of the beginning of 2007and the adoption of FIN 48 did not have a material impact on ourconsolidated financial statements.

In June 2007, theAmerican Institute of Certified Public Accountants  (AICPA) issued Statement of Position (SOP)07-1, *Clarification of the Scope of the Audit andAccounting Guide* Investment Companies *andAccounting for Parent Companies and Equity Method Investors for Investments inInvestment Companies.*This SOP provides guidance for determiningwhether an entity is within the scope of the AICPA Audit and Accounting Guide *Investment Companies*(the Guide).  Entities that are within the scope of theGuide are required, among other things, to carry their investments at fairvalue, with changes in fair value included in earnings. The provisions of thisSOP are effective on January 1, 2008. The Company is currently evaluating thisnew guidance and has not determined whether it will be required to apply theprovisions of the Guide in presenting its financial statements.

In September 2006, the FASB issued SFASNo. 157, *Fair Value Measurements*(“SFASNo. 157”). This statement defines fair value, establishes a framework formeasuring fair value in GAAP and expands disclosures about fair valuemeasurements. SFAS No. 157 does not require any new fair valuemeasurements. We adopted SFAS No. 157 as of the beginning of 2007 and theadoption of SFAS No. 157 did not have a material impact on the manner inwhich the Company measures the fair value of its financial instruments, but didresult in certain additional disclosures, which are contained in Note 13of our condensed consolidated financial statements.

In February 2007, FASB issued SFAS No. 159.This statement permits entities to choose to measure many financial instrumentsand certain other items at fair value (i.e., the fair value option). Theelection to use the fair value option is available when an entity firstrecognizes a financial asset or financial liability or upon entering into afirm commitment.  Subsequent changes infair value must be recorded in earnings. Additionally, SFAS No. 159 allows for a one-time election for existingpositions upon adoption, with the transition adjustment recorded to beginningretained earnings.

We adopted SFAS No. 159 as of the beginning of 2007and elected to apply the fair value option for our investments in residentialmortgage loans and residential mortgage-backed securities. Additionally, weintend to consistently apply the election of the fair value option to anyfuture residential mortgage investments. We have elected the fair value optionfor our residential mortgage investments for the purpose of enhancing thetransparency of our financial condition as fair value is consistent with how wemanages the risks of residential mortgage investments. The transitionadjustment to beginning accumulated deficit that was recorded as of January 1,2007 due to the adoption of SFAS No. 159 was a loss of $55.7 million.  The following table presents informationabout the eligible instruments for which the Company elected the fair valueoption and for which transition adjustments was recorded as of January 1, 2007(amounts in thousands):
| ** **                                                  | ** ** | **Carrying Value at  January 1, 2007** | ** ** | **Transition Adjustment to  Accumulated Deficit  Gain/(Loss)** | ** ** | **Carrying Value at  January 1, 2007  (After Adoption of  SFAS No. 159)** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|
| Residential  mortgage loans                                 |       | $                                                          | 5,109,261  |                                                                          | $          | (35,653                                                                                                           | )          | $ | 5,073,608 |   |
| Allowance for  loan losses                                  |       | (1,500                                                     | )          | 1,500                                                                         |       | —                                                                                                            |       |
| Residential  mortgage-backed securities (1)                 |       | 7,536,196                                                  |       | (21,575                                                                       | )          | 7,536,196                                                                                                         |       |
| Cumulative effect of  the adoption of the fair value option |       |                                                       |       | $                                                                             | (55,728    | )                                                                                                                 |       |   |
|                                                             |            |                                                            |            |                                                                               |            |                                                                                                                   |            |  |  |  |

 

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(1)             Priorto January 1, 2007, residential mortgage-backed securities were classified asavailable-for-sale and carried at fair value. Accordingly, the election of the fair value option for mortgage-backedsecurities did not change their carrying value and resulted in areclassification from accumulated other comprehensive income to beginningaccumulated deficit.

**Resultsof Operations**

**Three and six months ended June 30, 2007 compared to threeand six months ended June 30, 2006**

*Summary*

Ournet income for the three and six months ended June 30, 2007 totaled$53.0 million (or $0.66 per diluted share) and $101.4 million (or $1.26per diluted share), as compared to net income of $34.9 million (or $0.44 perdiluted share) and $65.3 million (or $0.82 per diluted share) for the three andsix months ended June 30, 2006.

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*Net Investment Income*

The following table presents the components of our netinvestment income for the three and six months ended June 30, 2007 and 2006:

**ComparativeNet Investment Income Components (Amounts in thousands)**
| ** **                                                                          | ** ** | **For the three  months ended  June 30, 2007** | ** ** | **For the three  months ended  June 30, 2006** | ** ** | **For the six  months ended  June 30, 2007** | ** ** | **For the six  months ended  June 30, 2006** | ** ** |
|-------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| Investment  Income:                                                                 |       |                                                                    |       |                                                                    |       |                                                                  |       |                                                                  |       |
| Residential mortgage loans and securities interest  income                          |       | $                                                                       | 154,309    |                                                                    | $          | 155,402                                                               |       | $                                                                     | 318,015    |   | $ | 301,532 |   |
| Corporate loans and securities interest income                                      |       | 105,280                                                                 |       | 61,511                                                                  |       | 187,665                                                               |       | 111,925                                                               |       |
| Commercial real estate loans and securities interest  income                        |       | 3,459                                                                   |       | 6,889                                                                   |       | 6,311                                                                 |       | 15,527                                                                |       |
| Other interest income                                                               |       | 5,960                                                                   |       | 1,807                                                                   |       | 8,647                                                                 |       | 3,652                                                                 |       |
| Common and preferred stock dividend income                                          |       | 884                                                                     |       | 912                                                                     |       | 1,858                                                                 |       | 1,795                                                                 |       |
| Net discount accretion                                                              |       | 239                                                                     |       | 306                                                                     |       | 646                                                                   |       | 194                                                                   |       |
| Total investment income                                                             |       | 270,131                                                                 |       | 226,827                                                                 |       | 523,142                                                               |       | 434,625                                                               |       |
| Interest  Expense:                                                                  |       |                                                                    |       |                                                                    |       |                                                                  |       |                                                                  |       |
| Repurchase agreements interest expense                                              |       | 44,052                                                                  |       | 97,704                                                                  |       | 99,264                                                                |       | 203,766                                                               |       |
| Collateralized loan obligation senior secured notes  interest expense               |       | 48,095                                                                  |       | 20,420                                                                  |       | 80,155                                                                |       | 38,385                                                                |       |
| Collateralized loan obligation junior secured notes  to affiliates interest expense |       | 8,255                                                                   |       | —                                                                  |       | 8,255                                                                 |       | —                                                                |       |
| Asset-backed secured liquidity notes interest  expense                              |       | 120,518                                                                 |       | 62,322                                                                  |       | 238,015                                                               |       | 93,798                                                                |       |
| Secured revolving credit facility interest expense                                  |       | 2,402                                                                   |       | 2,119                                                                   |       | 3,390                                                                 |       | 2,869                                                                 |       |
| Demand loan interest expense                                                        |       | 611                                                                     |       | 573                                                                     |       | 1,215                                                                 |       | 1,077                                                                 |       |
| Junior subordinated notes interest expense                                          |       | 5,036                                                                   |       | 1,336                                                                   |       | 10,021                                                                |       | 1,368                                                                 |       |
| Other interest expense                                                              |       | 552                                                                     |       | 633                                                                     |       | 1,186                                                                 |       | 1,574                                                                 |       |
| Interest rate swap and corridor interest expense,  net                              |       | (11,046                                                                 | )          | (10,013                                                                 | )          | (22,960                                                               | )          | (11,180                                                               | )          |
| Total interest expense                                                              |       | 218,475                                                                 |       | 175,094                                                                 |       | 418,541                                                               |       | 331,657                                                               |       |
| Net investment income                                                               |       | $                                                                       | 51,656     |                                                                    | $          | 51,733                                                                |       | $                                                                     | 104,601    |   | $ | 102,968 |   |

 

Aspresented in the table above, our net investment income decreased by $0.1million and increased by $1.6 million for the three and six months ended June30, 2007 compared to the three and six months ended June 30, 2006. Netinvestment income in the table above does not include equity in income ofunconsolidated affiliate of $5.7 million and $12.7 million for the three andsix months ended June 30, 2007, respectively. We did not have any equity inincome from unconsolidated affiliate for the three and six month periods endedJune 30, 2006.  Equity in income ofunconsolidated affiliate reflected our pro rata interest in the net income of alimited partnership that was formed to hold the subordinated interests in threeentities formed to execute secured financing transactions in the form of collateralizedloan obligations (“CLOs”).  On May 22,2007, we closed CLO 2007-1.  The threeentities previously held by our unconsolidated affiliate were included in CLO2007-1 and as we have retained the majority of the expected returns and lossesof CLO 2007-1 we consolidated this entity effective May 22, 2007. Accordingly,our investment portfolio of $18.0 billion as of June 30, 2007 includes theassets consolidated from this transaction and represents an increase of $2.1billion or approximately 13% from $15.9 billion as of June 30, 2006.  Net investment income plus equity in incomeof unconsolidated affiliate totals $57.4 million and $117.3 million for thethree and six months ended June 30, 2007, respectively, or an increase ofapproximately 11% and 14%, respectively, from net investment income for thethree and six months ended June 30, 2006.

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*Other Income*

Thefollowing table presents the components of our other income for the three andsix months ended June 30, 2007 and June 30, 2006:

**ComparativeOther Income Components (Amounts in thousands)**
| ** **                                                                 | ** ** | **For the three  months ended  June 30, 2007** | ** ** | **For the three  months ended  June 30, 2006** | ** ** | **For the six  months ended  June 30, 2007** | ** ** | **For the six  months ended  June 30, 2006** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| Net realized and  unrealized gain on derivatives and foreign exchange:     |       |                                                                    |       |                                                                    |       |                                                                  |       |                                                                  |       |
| Interest rate swaptions                                                    |       | $                                                                       | 16         |                                                                    | $          | 25                                                                    |       | $                                                                     | —     |   | $ | 58 |   |
| Interest rate swaps                                                        |       | —                                                                  |       | (9                                                                      | )          | —                                                                |       | 152                                                                   |       |
| Credit default swaps                                                       |       | 1,015                                                                   |       | 334                                                                     |       | 973                                                                   |       | 76                                                                    |       |
| Total rate of return swaps                                                 |       | 5,602                                                                   |       | 2,007                                                                   |       | 12,369                                                                |       | 1,707                                                                 |       |
| Common stock warrants                                                      |       | (144                                                                    | )          | —                                                                  |       | 286                                                                   |       | —                                                                |       |
| Foreign exchange translation                                               |       | (8                                                                      | )          | 942                                                                     |       | (9                                                                    | )          | 1,316                                                                 |       |
| Total realized and unrealized gain on derivatives  and foreign exchange    |       | 6,481                                                                   |       | 3,299                                                                   |       | 13,619                                                                |       | 3,309                                                                 |       |
| Net unrealized  loss on trading securities and loans carried at fair value |       | (16,821                                                                 | )          | —                                                                  |       | (14,052                                                               | )          | —                                                                |       |
| Net realized  gain on investments                                          |       | 26,752                                                                  |       | 691                                                                     |       | 33,696                                                                |       | 2,139                                                                 |       |
| Fee and other  income                                                      |       | 2,540                                                                   |       | 458                                                                     |       | 4,588                                                                 |       | 673                                                                   |       |
| Total other income                                                         |       | $                                                                       | 18,952     |                                                                    | $          | 4,448                                                                 |       | $                                                                     | 37,851     |   | $ | 6,121 |   |

 

Aspresented in the table above, other income totaled $19.0 million and $37.9million for the three and six months ended June 30, 2007, respectively, ascompared to $4.4 million and $6.1 million for the three and six months endedJune 30, 2006, respectively. The increase in total other income is primarilyattributable to increased net realized gains on the sale of investments andincreased use of total rate of return swaps to finance investments.  The overall increase in other income ispartially offset by the inclusion of the changes in the fair value ofresidential mortgage-backed securities and residential mortgage loans in incomedue to the adoption of SFAS No. 159.

*Non-Investment Expenses*

Thefollowing table presents the components of our non-investment expenses for thethree and six months ended June 30, 2007 and June 30, 2006:

**Comparative Non-Investment ExpenseComponents (Amounts in thousands)**
| ** **                              | ** ** | **For the three  months ended  June 30, 2007** | ** ** | **For the three  months ended  June 30, 2006** | ** ** | **For the six  months ended  June 30, 2007** | ** ** | **For the six  months ended  June 30, 2006** | ** ** |
|-----------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| Related party  management compensation: |       |                                                                    |       |                                                                    |       |                                                                  |       |                                                                  |       |
| Base management fees                    |       | $                                                                       | 7,077      |                                                                    | $          | 7,215                                                                 |       | $                                                                     | 14,273     |   | $ | 14,373 |   |
| Incentive fee                           |       | 6,249                                                                   |       | 1,595                                                                   |       | 12,620                                                                |       | 2,268                                                                 |       |
| Share-based compensation                |       | 746                                                                     |       | 4,968                                                                   |       | 6,478                                                                 |       | 11,577                                                                |       |
| CLO management fees                     |       | 1,042                                                                   |       | —                                                                  |       | 1,042                                                                 |       | —                                                                |       |
| Related party  management compensation  |       | 15,114                                                                  |       | 13,778                                                                  |       | 34,413                                                                |       | 28,218                                                                |       |
| Professional  services                  |       | 806                                                                     |       | 548                                                                     |       | 1,347                                                                 |       | 1,495                                                                 |       |
| Loan servicing  expense                 |       | 3,126                                                                   |       | 3,720                                                                   |       | 6,389                                                                 |       | 7,716                                                                 |       |
| Insurance  expense                      |       | 192                                                                     |       | 274                                                                     |       | 386                                                                   |       | 498                                                                   |       |
| Directors  expenses                     |       | 285                                                                     |       | 375                                                                     |       | 605                                                                   |       | 748                                                                   |       |
| General and  administrative expenses    |       | 3,756                                                                   |       | 2,436                                                                   |       | 9,764                                                                 |       | 4,664                                                                 |       |
| Total non-investment  expenses          |       | $                                                                       | 23,279     |                                                                    | $          | 21,131                                                                |       | $                                                                     | 52,904     |   | $ | 43,339 |   |

 

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As presented in the table above, our non-investmentexpenses increased by $2.1 million and $9.6 million for the three and sixmonths ended June 30, 2007, respectively, compared to the three months and sixmonths ended June 30, 2006. The significant components of non-investmentexpense are described below.

Management compensation to related parties consists ofbase management fees payable to our Manager pursuant to the ManagementAgreement, incentive management fees, and share-based compensation related torestricted common shares and common share options 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. Our Manager is also entitled to an incentive feeprovided that our quarterly “net income,” as defined in the ManagementAgreement, before the incentive fee exceeds a defined return hurdle.

General and administrative expenses consist ofexpenses incurred by our Manager on our behalf that are reimbursable to ourManager pursuant to the Management Agreement. Professional services expensesconsist of legal, accounting and other professional services. Loan servicingexpense consists of fixed servicing fees paid to third-party servicers. Theincrease in non-investment expense is primarily due to the increased incentivefee expense for the three and six months ending June 30, 2007 compared to thethree and six months ending June 30, 2006, which is directly related to ourincrease in net income (as defined in the Management Agreement) for the threeand six months ending June 30, 2007 compared to the three and six months endingJune 30, 2006, and our decision in the first quarter of 2007 to terminate anexisting $300.0 million credit facility entered into by KKR Financial CDO2005-1, Ltd., which resulted in the write-off of approximately $2.2 million ofcapitalized costs related to this facility.

*Income Tax Provision*

We are no longer treated asa REIT for U.S. federal income tax purposes; however, we intend to be treatedas a partnership, and not as an association or publicly traded partnership thatis taxable as a corporation, for U.S. federal income tax purposes. Therefore,we are not subject to U.S. federal income tax at the entity-level, but aresubject to limited state income taxes. Holders of our shares will be requiredto take into account their allocable share of each item of our income, gain,loss, deduction, and credit for our taxable year end ending within or withtheir taxable year.

KKR Financial Corp., our REIT subsidiary, elected tobe taxed as a REIT and we believe that it has complied with the provisions ofthe Code with respect thereto. Accordingly, our REIT subsidiary is not subjectto federal income tax to the extent that its distributions to us satisfy theREIT requirements and certain asset, income and ownership tests, andrecordkeeping requirements are fulfilled.

KKR TRS Holdings Inc. (“TRS Inc.”), our domestictaxable corporate subsidiary, is taxed as a regular subchapter C corporationunder the provisions of the Code. TRS Inc. was formed to make, from time totime, certain investments that would not be REIT qualifying investments if madedirectly by us, and to earn income that would not be REIT qualifying income ifearned directly by us. For the three and six months ending June 30, 2007, TRSInc. had pre-tax net income of $0.2 million and $2.1 million, respectively, andfor the three and six months ending June 30, 2007, the provision for incometaxes totaled $0.1 million and $0.9 million, respectively. As of June 30,2007, TRS Inc. had a net income tax receivable of $0.5 million.

KKR Financial CLO 2005-1, Ltd., KKR Financial CLO2005-2, Ltd., KKR Financial CLO 2006-1 Ltd., and CLO 2007-1 are foreign taxablecorporate subsidiaries that were established to facilitate securitizationtransactions, structured as secured financing transactions, and KKR TRSHoldings, Ltd., is a foreign taxable corporate subsidiary that was formed tomake from time to time, certain foreign investments. They are organized asexempted companies incorporated with limited liability under the laws of theCayman Islands, and are generally exempt from federal and state income tax atthe corporate entity level because they restrict their activities in the UnitedStates to trading in stock and securities for their own account. Therefore,despite their status as taxable corporate subsidiaries, they generally will notbe subject to corporate income tax on their earnings, and no provisions forincome taxes for the three and six months ending June 30, 2007 were recorded;however, we are generally required to include their current taxable income inour calculation of taxable income allocable to shareholders.

**Financial Condition**

**Summary**

Thetables below summarize the carrying value, amortized cost, and estimated fairvalue of our investment portfolio as of June 30, 2007 and December 31, 2006,classified by interest rate type. Carrying value is the value that investmentsare recorded on our consolidated balance sheets and is estimated fair value forsecurities and residential mortgage loans and amortized cost for corporate andcommercial real estate loans held for investment and the lower of amortizedcost or market value for loans held for sale. Estimated fair values set forthin the tables below are based on dealer quotes and/or nationally recognizedpricing services.

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Thetable below summarizes our investment portfolio as of June 30, 2007 classifiedby interest rate type:

**InvestmentPortfolio(Dollar amounts in thousands)**
| ** **                                                    | ** ** | **Carrying Value** | ** ** | **Amortized Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Portfolio Mix %  by Fair Value** | ** ** |
|---------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|--------------------------------|------------|--------------------------------------------------------|------------|
| **Floating  Rate:**                                           | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                             | ** ** |
| Residential  Adjustable Rate Mortgage (“ARM”) Loans |       | $                       | 1,172,530  |                    | $          | 1,190,441                      |       | $                                                      | 1,172,530  |   | 6.5 | % |
| Residential ARM  Securities                                   |       | 4,850,890               |       | 4,843,801               |       | 4,850,890                      |       | 26.9                                                   |       |
| Corporate Loans                                               |       | 5,071,211               |       | 5,071,211               |       | 5,085,623                      |       | 28.2                                                   |       |
| Corporate Debt  Securities                                    |       | 266,365                 |       | 262,450                 |       | 266,365                        |       | 1.5                                                    |       |
| Commercial Real  Estate Loans                                 |       | 114,754                 |       | 114,754                 |       | 115,357                        |       | 0.6                                                    |       |
| Total Floating Rate                                           |       | 11,475,750              |       | 11,482,657              |       | 11,490,765                     |       | 63.7                                                   |       |
| **Hybrid  Rate:**                                             | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                             | ** ** |
| Residential  Hybrid ARM Loans                                 |       | 3,392,944               |       | 3,427,884               |       | 3,392,944                      |       | 18.8                                                   |       |
| Residential  Hybrid ARM Securities                            |       | 1,736,532               |       | 1,762,488               |       | 1,736,532                      |       | 9.6                                                    |       |
| Total Hybrid Rate                                             |       | 5,129,476               |       | 5,190,372               |       | 5,129,476                      |       | 28.4                                                   |       |
| **Fixed  Rate:**                                              | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                             | ** ** |
| Corporate Loans                                               |       | 65,793                  |       | 65,793                  |       | 66,993                         |       | 0.4                                                    |       |
| Corporate Debt  Securities                                    |       | 1,072,711               |       | 1,074,421               |       | 1,072,711                      |       | 5.9                                                    |       |
| Commercial Real  Estate Debt Securities                       |       | 31,609                  |       | 32,000                  |       | 31,609                         |       | 0.1                                                    |       |
| Total Fixed Rate                                              |       | 1,170,113               |       | 1,172,214               |       | 1,171,313                      |       | 6.4                                                    |       |
| **Marketable  and Non-Marketable Equity Securities:**         | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                             | ** ** |
| Common and  Preferred Stock                                   |       | 68,281                  |       | 65,694                  |       | 68,281                         |       | 0.4                                                    |       |
| Non-Marketable  Equity Securities                             |       | 173,823                 |       | 173,823                 |       | 201,605                        |       | 1.1                                                    |       |
| Total Marketable  and Non-Marketable Equity Securities        |       | 242,104                 |       | 239,517                 |       | 269,886                        |       | 1.5                                                    |       |
| Total                                                         |       | $                       | 18,017,443 |                    | $          | 18,084,760                     |       | $                                                      | 18,061,440 |   | 100.0 | % |

 

The schedule above excludes equity securities sold,not yet purchased totaling $58.5 million as of June 30, 2007 and for which theCompany had an unrealized gain of $0.4 million.

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The table below summarizes our investment portfolio asof December 31, 2006, classified by interest rate type:

**Investment Portfolio(Dollar amounts in thousands)**
| ** **                                             | ** ** | **Carrying Value** | ** ** | **Amortized Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Portfolio Mix %  by Fair Value** | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|--------------------------------|------------|--------------------------------------------------------|------------|
| **Floating  Rate:**                                    | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                             | ** ** |
| Residential ARM  Loans                                 |       | $                       | 1,441,959  |                    | $          | 1,441,959                      |       | $                                                      | 1,433,151  |   | 8.4 | % |
| Residential ARM  Securities                            |       | 5,673,932               |       | 5,662,830               |       | 5,673,932                      |       | 33.2                                                   |       |
| Corporate Loans                                        |       | 3,200,567               |       | 3,200,567               |       | 3,221,334                      |       | 18.8                                                   |       |
| Corporate Debt  Securities                             |       | 357,696                 |       | 344,650                 |       | 357,696                        |       | 2.1                                                    |       |
| Commercial Real  Estate Loans                          |       | 108,693                 |       | 108,693                 |       | 109,192                        |       | 0.7                                                    |       |
| Total Floating Rate                                    |       | 10,782,847              |       | 10,758,699              |       | 10,795,305                     |       | 63.2                                                   |       |
| **Hybrid  Rate:**                                      | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                             | ** ** |
| Residential  Hybrid ARM Loans                          |       | 3,667,302               |       | 3,667,302               |       | 3,647,783                      |       | 21.3                                                   |       |
| Residential  Hybrid ARM Securities                     |       | 1,862,264               |       | 1,894,941               |       | 1,862,264                      |       | 10.9                                                   |       |
| Total Hybrid Rate                                      |       | 5,529,566               |       | 5,562,243               |       | 5,510,047                      |       | 32.2                                                   |       |
| **Fixed  Rate:**                                       | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                             | ** ** |
| Corporate Loans                                        |       | 25,000                  |       | 25,000                  |       | 25,000                         |       | 0.1                                                    |       |
| Corporate Debt  Securities                             |       | 505,753                 |       | 486,321                 |       | 505,753                        |       | 2.9                                                    |       |
| Commercial Real  Estate Debt Securities                |       | 32,023                  |       | 32,000                  |       | 32,023                         |       | 0.2                                                    |       |
| Total Fixed Rate                                       |       | 562,776                 |       | 543,321                 |       | 562,776                        |       | 3.2                                                    |       |
| **Marketable  and Non-Marketable Equity Securities:**  | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                             | ** ** |
| Common and  Preferred Stock                            |       | 68,968                  |       | 68,113                  |       | 68,968                         |       | 0.4                                                    |       |
| Non-Marketable  Equity Securities                      |       | 166,323                 |       | 166,323                 |       | 166,323                        |       | 1.0                                                    |       |
| Total Marketable and Non-Marketable Equity  Securities |       | 235,291                 |       | 234,436                 |       | 235,291                        |       | 1.4                                                    |       |
| Total                                                  |       | $                       | 17,110,480 |                    | $          | 17,098,699                     |       | $                                                      | 17,103,419 |   | 100.0 | % |

 

**Asset Quality**

*Asset Quality Review*

Weevaluate and monitor the asset quality of our investment portfolio byperforming detailed credit reviews and by monitoring key credit statistics andtrends. We monitor the credit rating of our investment portfolio through theuse of both Moody’s Investor Services, Inc. (“Moody’s”) and Standard &Poor’s Ratings Service (“Standard & Poor’s”) ratings, and Moody’sweighted average rating factor, or WARF. WARF is the quantitative equivalent ofMoody’s traditional rating categories (e.g., Ba1, Ba2, etc.) and is used byMoody’s in its credit enhancement calculations for securitization transactions.By monitoring both Moody’s and Standard & Poor’s ratings and Moody’sWARF we can monitor trends and changes in the credit ratings of our investmentportfolio. For residential mortgage loans and residential mortgage-backedsecurities we monitor the credit quality of the underlying borrowers bymonitoring trends and changes in the underlying borrowers’ FICO® scores.Borrowers with lower FICO® scores generally default more frequently thanborrowers with higher FICO® scores. For residential and commercial real estatemortgage loans and mortgage-backed securities we monitor trends and changes inloan to value, or LTV, ratios. Increases in LTV ratios are likely to result inhigher realized credit losses when borrowers default.

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*Investment Securities*

Thefollowing table summarizes the par value of our debt investment securitiesportfolio by investment class stratified by Moody’s and Standard &Poor’s ratings category as of June 30, 2007:

**InvestmentSecurities(Amounts in thousands)**
| **Ratings Category**    | ** ** | **Residential  ARM Securities** | ** ** | **Residential  Hybrid ARM  Securities** | ** ** | **Corporate  Debt  Securities** | ** ** | **Commercial  Real Estate Debt  Securities** | ** ** | **Total** | ** ** |
|------------------------------|------------|--------------------------------------|------------|----------------------------------------------|------------|---------------------------------|------------|--------------------------------------------------------|------------|-----------|------------|
| Aaa/AAA                      |       | $                                    | 4,809,925  |                                         | $          | 1,699,412                       |       | $                                                      | —     |      | $          | — |   | $ | 6,509,337 |   |
| Aa1/AA+ through  Aa3/AA-     |       | 12,816                               |       | 28,152                                       |       | —                          |       | —                                                 |       | 40,968    |       |
| A1/A+ through  A3/A-         |       | 9,240                                |       | 17,915                                       |       | —                          |       | —                                                 |       | 27,155    |       |
| Baa1/BBB+  through Baa3/BBB- |       | 6,557                                |       | 9,606                                        |       |                            |       | —                                                 |       | 16,163    |       |
| Ba1/BB+ through  Ba3/BB-     |       | 3,279                                |       | 3,839                                        |       | 222,500                         |       | 32,000                                                 |       | 261,618   |       |
| B1/B+ through  B3/B-         |       | 2,384                                |       | 2,559                                        |       | 393,065                         |       | —                                                 |       | 398,008   |       |
| Caa1/CCC+ and  lower         |       | —                               |       | —                                       |       | 701,000                         |       | —                                                 |       | 701,000   |       |
| Non-Rated                    |       | 5,185                                |       | 6,394                                        |       | 41,336                          |       | —                                                 |       | 52,915    |       |
| Total                        |       | $                                    | 4,849,386  |                                         | $          | 1,767,877                       |       | $                                                      | 1,357,901  |      | $          | 32,000 |   | $ | 8,007,164 |   |

 

The following table shows the par value of our debtinvestment securities portfolio by investment class stratified by Moody’s andStandard & Poor’s ratings category as of December 31, 2006:

**InvestmentSecurities(Amounts in thousands)**
| **Ratings Category**    | ** ** | **Residential  ARM Securities** | ** ** | **Residential  Hybrid ARM  Securities** | ** ** | **Corporate  Debt  Securities** | ** ** | **Commercial  Real Estate Debt  Securities** | ** ** | **Total** | ** ** |
|------------------------------|------------|--------------------------------------|------------|----------------------------------------------|------------|---------------------------------|------------|--------------------------------------------------------|------------|-----------|------------|
| Aaa/AAA                      |       | $                                    | 5,622,446  |                                         | $          | 1,831,413                       |       | $                                                      | —     |      | $          | — |   | $ | 7,453,859 |   |
| Aa1/AA+ through  Aa3/AA-     |       | 14,976                               |       | 28,336                                       |       | —                          |       | —                                                 |       | 43,312    |       |
| A1/A+ through  A3/A-         |       | 10,797                               |       | 18,032                                       |       | —                          |       | —                                                 |       | 28,829    |       |
| Baa1/BBB+  through Baa3/BBB- |       | 7,662                                |       | 9,648                                        |       | 21,071                          |       | 18,000                                                 |       | 56,381    |       |
| Ba1/BB+ through  Ba3/BB-     |       | 3,831                                |       | 3,864                                        |       | 160,500                         |       | 14,000                                                 |       | 182,195   |       |
| B1/B+ through  B3/B-         |       | 2,786                                |       | 2,576                                        |       | 370,315                         |       | —                                                 |       | 375,677   |       |
| Caa1/CCC+ and  lower         |       | —                               |       | —                                       |       | 208,505                         |       | —                                                 |       | 208,505   |       |
| Non-Rated                    |       | 6,227                                |       | 6,434                                        |       | 86,500                          |       | —                                                 |       | 99,161    |       |
| Total                        |       | $                                    | 5,668,725  |                                         | $          | 1,900,303                       |       | $                                                      | 846,891    |      | $          | 32,000 |   | $ | 8,447,919 |   |

 

*Loans*

Our residential mortgage loan portfolio totaled $4.6billion as of June 30, 2007 and $5.1 billion as of December 31, 2006. Asof June 30, 2007, we owned twelve real estate properties acquired throughforeclosure. The outstanding loan balance of $3.0 million with respect to thesetwelve properties (not included in the following table) was reclassified fromloans to other assets on our balance sheet. As the estimated fair value ofthese twelve properties approximates the outstanding loan balance we have notrecorded a charge against our allowance for loan losses.

Theweighted average original FICO® score and weighted average original LTV ratioof our residential mortgage loan portfolio were 735 and 68.4%, respectively, asof June 30, 2007. As of December 31, 2006, the weighted average originalFICO® score and weighted average LTV ratio of our residential mortgage loanportfolio were 739 and 68.6%, respectively. As of June 30, 2007 our residentialmortgage loan portfolio did not have any material concentrations in investorowned properties, multi-unit housing properties, condominium properties and/orcooperative properties. A material portion of our residential mortgage loansare non-conforming mortgage loans, not due to credit quality, but because themortgage loans have balances that exceed the maximum balances necessary toqualify as a conforming mortgage loan.

The following table summarizes the delinquencystatistics of residential mortgage loans as of June 30, 2007 (dollar amounts inthousands):
| Delinquency Status | ** ** | **Number of Loans** | ** ** | **Principal Amount** | ** ** |
|-------------------------|------------|-------------------------------|------------|---------------------------|------------|
| 30 to 59 days           |       | 72                            |       | $                         | 23,109     |   |
| 60 to 89 days           |       | 11                            |       | 3,441                     |       |
| 90 days or more         |       | 19                            |       | 5,029                     |       |
| In foreclosure          |       | 31                            |       | 10,488                    |       |
| Total                   |       | 133                           |       | $                         | 42,067     |   |

 

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Thefollowing table summarizes the delinquency statistics of residential mortgageloans as of December 31, 2006 (dollar amounts in thousands):
| Delinquency Status | ** ** | **Number of Loans** | ** ** | **Principal Amount** | ** ** |
|-------------------------|------------|-------------------------------|------------|---------------------------|------------|
| 30 to 59 days           |       | 90                            |       | $                         | 35,968     |   |
| 60 to 89 days           |       | 10                            |       | 3,040                     |       |
| 90 days or more         |       | 15                            |       | 2,855                     |       |
| In foreclosure          |       | 18                            |       | 5,442                     |       |
| Total                   |       | 133                           |       | $                         | 47,305     |   |

 

Upon adoption of SFAS No. 159 as of January 1, 2007,we elected the fair value option for our investments in residential mortgageloans.  Prior to such election, the loanswere carried at net unamortized cost less an allowance for loan losses. As ofJanuary 1, 2007, we recorded a transition adjustment to adjust the carryingvalue of our portfolio of residential mortgage loans to fair value and reverseour allowance for loan losses for our residential mortgage loan portfolio as ofJanuary 1, 2007.  The followingtable summarizes the changes in the allowance for loan losses for ourresidential mortgage loan portfolio during the six months ended June 30, 2007(amounts in thousands):
| Balance, beginning of period                                  |   | $      | 1,500  |   |
|---------------------------------------------------------------|--------|--------|--------|--------|
| Transition to  SFAS No. 159 adjustment to accumulated deficit |   | (1,500 | )      |
| Balance, end of period                                        |   | $      | — |   |

 

Ourcorporate loan portfolio totaled $5.1 billion as of June 30, 2007 and$3.2 billion as of December 31, 2006. Our corporate loan portfolioconsists of debt obligations of corporations, partnerships and other entitiesin the form of first and second lien loans, mezzanine loans and bridge loans.

Weperformed an allowance for loan losses analysis as of June 30, 2007 and December 31,2006, and we have made the determination that no allowance for loan losses wasrequired for our corporate loan portfolio as of June 30, 2007 orDecember 31, 2006.

The following table summarizes the par value of ourcorporate loan portfolio stratified by Moody’s and Standard & Poor’sratings category as of June 30, 2007 and December 31, 2006:

**Corporate Loans(Amounts in thousands)**
| Ratings Category        | ** ** | **As of  June 30, 2007** | ** ** | **As of  December 31, 2006** | ** ** |
|------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                      |       | $                                       | —     |                                        | $          | — |   |
| Aa1/AA+ through  Aa3/AA-     |       | —                                  |       | —                                      |       |
| A1/A+ through  A3/A-         |       | —                                  |       | —                                      |       |
| Baa1/BBB+  through Baa3/BBB- |       | 69,406                                  |       | 77,326                                      |       |
| Ba1/BB+ through  Ba3/BB-     |       | 2,601,349                               |       | 1,764,598                                   |       |
| B1/B+ through  B3/B-         |       | 2,144,248                               |       | 1,153,856                                   |       |
| Caa1/CCC+ and  lower         |       | 193,120                                 |       | 93,340                                      |       |
| Non-Rated                    |       | 140,360                                 |       | 143,294                                     |       |
| Total                        |       | $                                       | 5,148,483  |                                        | $          | 3,232,414 |   |

 

Ourcommercial real estate loan portfolio totaled $114.8 million and$108.7 million as of June 30, 2007 and December 31, 2006,respectively.

Weperformed an allowance for loan losses analysis as of June 30, 2007 and December 31,2006, and we have made the determination that no allowance for loan losses wasrequired for our commercial real estate loan portfolio as of June 30, 2007 orDecember 31, 2006.

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Thefollowing table summarizes the par value of our commercial real estate loanportfolio stratified by Moody’s and Standard & Poor’s ratings categoryas of June 30, 2007 and December 31, 2006:

**Commercial RealEstate Loans(Amounts in thousands)**
| **Ratings Category**    | ** ** | **As of  June 30, 2007** | ** ** | **As of  December 31, 2006** | ** ** |
|------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                      |       | $                                       | —     |                                        | $          | — |   |
| Aa1/AA+ through  Aa3/AA-     |       | —                                  |       | —                                      |       |
| A1/A+ through  A3/A-         |       | —                                  |       | —                                      |       |
| Baa1/BBB+  through Baa3/BBB- |       | —                                  |       | —                                      |       |
| Ba1/BB+ through  Ba3/BB-     |       | 25,000                                  |       | 2,908                                       |       |
| B1/B+ through  B3/B-         |       | 89,854                                  |       | 90,882                                      |       |
| Caa1/CCC+ and  lower         |       | —                                  |       | —                                      |       |
| Non-Rated                    |       | —                                  |       | 15,000                                      |       |
| Total                        |       | $                                       | 114,854    |                                        | $          | 108,790 |   |

 

**Asset Repricing Characteristics**

*Summary*

The table below summarizes the repricingcharacteristics of our investment portfolio as of June 30, 2007 andDecember 31, 2006, and is classified by interest rate type:

**InvestmentPortfolio(Dollar amounts in thousands)**
| ** **                              | ** ** | **As of June 30, 2007** | ** ** | **As of December 31, 2006** | ** ** |
|-----------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                              | ** ** | **Amortized Cost**                     | ** ** | **Portfolio Mix**                          | ** ** | **Amortized Cost** | ** ** | **Portfolio Mix** | ** ** |
| **Floating  Rate:**                     | ** ** | ** **                                  | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Residential ARM  Loans                  |       | $                                           | 1,190,441  |                                            | 6.7        | % | $ | 1,441,959 |   | 8.6 | % |
| Residential ARM  Securities             |       | 4,843,801                                   |       | 27.1                                            |       | 5,662,830 |   | 33.6 |   |
| Corporate Loans                         |       | 5,071,211                                   |       | 28.4                                            |       | 3,200,567 |   | 19.0 |   |
| Corporate Debt  Securities              |       | 262,450                                     |       | 1.5                                             |       | 344,650 |   | 2.0 |   |
| Commercial Real  Estate Loans           |       | 114,754                                     |       | 0.6                                             |       | 108,693 |   | 0.6 |   |
| Total Floating Rate                     |       | 11,482,657                                  |       | 64.3                                            |       | 10,758,699 |   | 63.8 |   |
| **Hybrid  Rate:**                       | ** ** | ** **                                  | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Residential  Hybrid ARM Loans           |       | 3,427,884                                   |       | 19.2                                            |       | 3,667,302 |   | 21.8 |   |
| Residential  Hybrid ARM Securities      |       | 1,762,488                                   |       | 9.9                                             |       | 1,894,941 |   | 11.2 |   |
| Total Hybrid Rate                       |       | 5,190,372                                   |       | 29.1                                            |       | 5,562,243 |   | 33.0 |   |
| **Fixed  Rate:**                        | ** ** | ** **                                  | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Corporate Loans                         |       | 65,793                                      |       | 0.4                                             |       | 25,000 |   | 0.1 |   |
| Corporate Debt  Securities              |       | 1,074,421                                   |       | 6.0                                             |       | 486,321 |   | 2.9 |   |
| Commercial Real  Estate Debt Securities |       | 32,000                                      |       | 0.2                                             |       | 32,000 |   | 0.2 |   |
| Total Fixed Rate                        |       | 1,172,214                                   |       | 6.6                                             |       | 543,321 |   | 3.2 |   |
| Total                                   |       | $                                           | 17,845,243 |                                            | 100.0      | % | $ | 16,864,263 |   | 100.0 | % |

 

The table above excludes marketable equity securitieswith a fair value of $68.3 million and amortized cost of $65.7 million, andnon-marketable equity securities with a fair value of $201.6 million andamortized cost of $173.8 million as of June 30, 2007. The table above also excludesmarketable equity securities with a fair value of $69.0 million and amortizedcost of $68.1 million, and non-marketable equity securities with a fair valueof $166.3 million and amortized cost of $166.3 million as of December 31,2006.

*Residential ARM Securities*

As of June 30, 2007 and December 31, 2006,substantially all of our residential ARM securities were comprised of one-monthLIBOR floating rate securities that reprice monthly and were subject to aweighted average maximum net interest rate of 11.77% and 11.83%, respectively,which was materially above the then current weighted average net coupon of6.53% and 6.46%, respectively. Our repricing risk on our portfolio ofresidential ARM securities increases materially if interest rates continue toincrease to a level where the weighted average coupon rate approaches theweighted average maximum net

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interest rate, because the weighted average coupon issubject to a maximum rate, or cap, which is approximately equal to the weightedaverage maximum interest rate of 11.77% and 11.83% at June 30, 2007 andDecember 31, 2006.

*Residential Hybrid ARM Securities*

As of June 30, 2007 and December 31, 2006, all ofour residential hybrid ARM securities had underlying mortgage loans that wereoriginated as 5/1 hybrid ARM loans. As of June 30, 2007 and December 31,2006, we owned 100% of the securities that represent 100% of the beneficialinterest in the 5/1 hybrid ARM loans underlying our portfolio of hybrid ARMsecurities. When the underlying residential hybrid mortgage loans convert fromfixed rate to floating rate, the underlying mortgage loans will have an interestrate based on six-month or one-year LIBOR or one-year constant maturitytreasury index, or CMT, depending upon if the underlying mortgage loan is aLIBOR- or CMT-based mortgage loan. On the date that the residential hybrid ARMloans convert from a fixed rate to a floating rate loan, which we refer to asthe roll date, our portfolio of residential hybrid ARM loans will have aweighted average coupon that is the sum of (i) the post-roll date index,and (ii) the weighted average post-roll date net margin. As of June 30,2007 and December 31, 2006, all of the mortgage loans underlying ourresidential hybrid ARM securities had a post-roll date index reset frequency ofone year with 34%  based on six-month orone-year LIBOR and 66% based on one-year CMT. Our repricing risk on ourportfolio of residential hybrid ARM loans increases materially if interestrates continue to increase to a level where, subsequent to the roll date, theweighted average net coupon rate approaches the weighted average post roll datemaximum net interest rate of 9.43% because the post roll date weighted averagenet coupon is subject to a maximum rate, or cap, which is approximately equalto the weighted average post roll date maximum net interest rate of 9.43%. Theweighted average coupon on the portfolio of residential hybrid securities was4.18% as of June 30, 2007 and December 31, 2006. As of June 30, 2007 andDecember 31, 2006, the weighted average months until roll date for themortgage loans underlying our residential hybrid ARM securities was 18 and 24,respectively.

*Residential ARM Loans*

As of June 30, 2007 and December 31, 2006, all ofour residential ARM loans were comprised of one-month LIBOR floating rate loansthat reprice monthly and were subject to a weighted average maximum netinterest rate of 11.93% and 11.92%, respectively, which was well above the thencurrent weighted average net coupon of 6.38% and 6.43%, respectively. Ourrepricing risk on our portfolio of residential ARM loans increases materiallyif interest rates continue to increase to a level where the weighted averagenet coupon rate approaches the weighted average maximum interest rate, becausethe weighted average coupon is subject to a cap which is approximately equal tothe weighted average maximum interest rate of 11.93% and 11.92%, respectively,as of June 30, 2007 and December 31, 2006.

*Residential Hybrid ARM Loans*

As of June 30, 2007 and December 31, 2006, all ofour residential hybrid ARM loans were originated as either 3/1 or 5/1 hybridARM loans. When the loans convert from fixed rate to floating rate, theunderlying mortgage loans will have an interest rate based on six-month orone-year LIBOR or one-year CMT. On the date that the residential hybrid ARMloans convert from a fixed rate to a floating rate loan, which we refer to asthe roll date, our portfolio of residential hybrid ARM loans will have aweighted average coupon that is the sum of (i) the post-roll date index,and (ii) the weighted average post-roll date net margin. As of June 30,2007 and December 31, 2006, all of our residential hybrid ARM loans had apost-roll date index reset frequency of one-year with 45% and 46%,respectively, based on six-month or one-year LIBOR and 55% and 54%,respectively, based on one-year CMT. Our repricing risk on our portfolio ofresidential hybrid ARM loans increases materially if interest rates continue toincrease to a level where, subsequent to the roll date, the weighted averagenet coupon rate approaches the weighted average post-roll date maximum net interestrate, because the post-roll date weighted average net coupon is subject to acap which is approximately equal to the weighted average post-roll date maximumnet interest rate of 10.13%. The weighted average net coupon on theportfolio of residential hybrid loans was 4.86% and 4.85% as of June 30, 2007and December 31, 2006, respectively. As of June 30, 2007 andDecember 31, 2006, the weighted average months until roll date for themortgage loans underlying our residential hybrid ARM securities was 28 and 33,respectively.

*Corporate Loans and Securities*

All of our floating rate corporate loans andsecurities have index reset frequencies of less than twelve months with themajority of the loans resetting at least quarterly. The weighted average couponon our floating rate corporate loans and securities was 8.02% and 8.00% as ofJune 30, 2007 and December 31, 2006, respectively. As of both June 30,2007 and December 31, 2006, the weighted average years to maturity of ourfloating rate corporate loans and securities was 5.7 years and 6.0 years,respectively.

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As of June 30, 2007, our fixed rate corporate debtsecurities had a weighted average coupon of 10.42% and a weighted average yearsto maturity of 7.2 years, as compared to 9.75% and 6.3 years, respectively,as of December 31, 2006.

*Commercial Real Estate Loans andSecurities*

All of our floating rate commercial real estate loanshave index reset frequencies of less than twelve months. The weighted averagecoupon on our floating rate commercial real estate loans was 8.11% and 8.42% asof June 30, 2007 and December 31, 2006, respectively.  As of June 30, 2007 and December 31,2006, the weighted average years to maturity of our floating rate commercialreal estate loans was 3.2 years and 2.5 years, respectively.

As of June 30, 2007 our fixed rate commercial realestate securities had a weighted average coupon of 7.12% and a weighted averageyears to maturity of 29.4 years, as compared to 7.12% and 29.9 years,respectively, as of December 31, 2006. As of December 31, 2006, we owned no fixed rate commercial real estateloans.

**Portfolio Purchases**

We purchased $2.6 billion and $2.9 billion paramount of investments during the three and six months ended June 30, 2007,compared to $1.7 billion and $3.6 billion for the three and six months endingJune 30, 2006, respectively.

The table below summarizes our investment portfoliopurchases for the periods indicated and includes the par amount, or faceamount, of the securities and loans that were purchased:

**InvestmentPortfolio Purchases(Dollar amounts in thousands)**
|                                    | ** ** | **Three months ended  June 30, 2007** | ** ** | **Three months ended  June 30, 2006** | ** ** | **Six months ended  June 30, 2007** | ** ** | **Six months ended  June 30, 2006** | ** ** |
|------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                         | ** ** | **Par Amount**                                       | ** ** | **%**                                                     | ** ** | **Par Amount**                                     | ** ** | **%**                                                   | ** ** | **Par Amount** | ** ** | **%** | ** ** | **Par Amount** | ** ** | **%** | ** ** |
| Securities:                        |       |                                                      |       |                                                      |       |                                                    |       |                                                    |       |   |   |   |   |   |   |   |   |
| Residential ARM  Securities        |       | $                                                         | —     |                                                      | —     | %                                                       | $          | 800,491                                                 |       | 45.9 | % | $ | — |   | — | % | $ | 1,864,267 |   | 51.3 | % |
| Corporate Debt  Securities         |       | 724,000                                                   |       | 28.3                                                      |       | 212,247                                                 |       | 12.2                                                    |       | 758,000 |   | 25.9 |   | 340,016 |   | 9.4 |   |
| Marketable  Securities             |       | 22,906                                                    |       | 0.9                                                       |       | 16,768                                                  |       | 1.0                                                     |       | 40,634 |   | 1.4 |   | 27,143 |   | 0.7 |   |
| Non-Marketable  Securities         |       | —                                                    |       | —                                                    |       | 40,685                                                  |       | 2.3                                                     |       | 7,500 |   | 0.3 |   | 91,621 |   | 2.5 |   |
| Total Securities Principal Balance |       | 746,906                                                   |       | 29.2                                                      |       | 1,070,191                                               |       | 61.4                                                    |       | 806,134 |   | 27.6 |   | 2,323,047 |   | 63.9 |   |
| Loans:                             |       |                                                      |       |                                                      |       |                                                    |       |                                                    |       |   |   |   |   |   |   |   |   |
| Residential ARM  Loans             |       | —                                                    |       | —                                                    |       | 26,054                                                  |       | 1.5                                                     |       | 17,706 |   | 0.6 |   | 125,552 |   | 3.5 |   |
| Corporate Loans                    |       | 1,814,145                                                 |       | 70.8                                                      |       | 647,619                                                 |       | 37.1                                                    |       | 2,101,831 |   | 71.8 |   | 1,186,502 |   | 32.6 |   |
| Total Loans Principal Balance      |       | 1,814,145                                                 |       | 70.8                                                      |       | 673,673                                                 |       | 38.6                                                    |       | 2,119,537 |   | 72.4 |   | 1,312,054 |   | 36.1 |   |
| Grand Total  Principal Balance     |       | $                                                         | 2,561,051  |                                                      | 100.0      | %                                                       | $          | 1,743,864                                               |       | 100.0 | % | $ | 2,925,671 |   | 100.0 | % | $ | 3,635,101 |   | 100.0 | % |

 

**Shareholders’ Equity**

Our shareholders’ equity at each of June 30, 2007 andDecember 31, 2006 totaled $1.7 billion. Included in our shareholders’equity as of June 30, 2007 and December 31, 2006 is accumulated othercomprehensive income totaling $65.8 million and $70.5 million,respectively.

Our average shareholders’ equity and return on averageshareholders’ equity for the three and six months ended June 30, 2007 were$1.7 billion and 12.4%, and $1.7 billion and 11.9%, respectively. Ouraverage shareholders’ equity and return on average shareholders’ equity for thethree and six months ended June 30, 2006 were $1.7 billion and 8.1%, and$1.7 billion and 7.8%, respectively. Return on average shareholders’ equity isdefined as net income divided by weighted average shareholders’ equity.

Our book value per common share as of June 30, 2007and December 31, 2006 was $20.91 and $21.42, respectively, and werecomputed based on 80,464,713 shares issued and outstanding as June 30, 2007 andDecember 31, 2006, respectively.

On August 2, 2007, our Board of Directors declared anaggregate cash distribution of $45.1 million for the quarter ended June 30,2007 to shareholders of record on August 16, 2007. The distribution is payableon August 30, 2007.  Net income for thequarter of $53.0 million exceeded the aggregate amount of the distribution of$45.1 million by $7.9 million.

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**Liquidity and Capital Resources**

We manage our liquidity with the intention ofproviding the continuing ability to fund our operations and fulfill ourcommitments on a timely and cost-effective basis. Based on changes in ourworking capital, for any given period the cash flows provided by operatingactivities may be less than the cumulative distributions paid on our shares forsuch period and such shortfall, if any, may be funded through the issuance ofunsecured indebtedness or through the borrowing of additional amounts throughthe pledging of certain of our assets. Our Board of Directors considers available liquidity when declaringdistributions to shareholders.

 We believe thatour liquidity level and access to additional funding is in excess of thatnecessary to enable us to meet our anticipated liquidity requirementsincluding, but not limited to, funding our purchases of investments, requiredcash payments and additional collateral under our borrowings and our derivativetransactions, required periodic cash payments related to our derivativetransactions, payment of fees and expenses related to our Management Agreement,payment of general corporate expenses and general corporate capitalexpenditures and distributions to our shareholders. As of June 30, 2007, weowed our Manager $11.2 million for the payment of management fees andreimbursable expenses pursuant to the Management Agreement.

An increase in prepayment rates on our investmentssubstantially above our expectations could, however, cause a temporaryliquidity shortfall due to the timing of the necessary margin calls on ourfinancing arrangements and the actual receipt of the cash related to principalpaydowns. In addition, any material event that impacts capital markets participantsmay also impair our ability to access additional liquidity. If our cashresources are at any time insufficient to satisfy our liquidity requirements,we may have to sell assets or issue debt or additional equity securities.

Our ability to meet our long-term liquidity andcapital resource requirements may be subject to our ability to obtainadditional debt financing and equity capital. We may increase our capitalresources through offerings of equity securities (possibly including commonshares and one or more classes of preferred shares), commercial paper,medium-term notes, securitization transactions structured as securedfinancings, and senior or subordinated notes. If we are unable to renew,replace or expand our sources of financing on acceptable terms, it may have anadverse effect on our business and results of operations and our ability tomake distributions to shareholders. Upon liquidation, holders of our debtsecurities and lenders with respect to other borrowings will receive, and any holdersof preferred shares that we may issue in the future may receive, a distributionof our available assets prior to holders of our common shares. The decisions byinvestors and lenders to enter into equity, and financing transactions with uswill depend upon a number of factors, including our historical and projectedfinancial performance, compliance with the terms of our current creditarrangements, industry and market trends, the availability of capital and ourinvestors’ and lenders’ policies and rates applicable thereto, and the relativeattractiveness of alternative investment or lending opportunities.

Any material event that impacts capital marketsparticipants may also impair our ability to access additional liquidity and wemay therefore be required to sell some or all of our portfolio investments inorder to maintain sufficient liquidity. Such sales may be at prices lower thanthe carrying value of our investments, which would result in our recognition ofsuch losses and reduced income.

We have entered into various financing and derivativetransactions in the normal course of business which contain terms andconditions that include bilateral margin posting requirements. During periodsof increased adverse market volatility we are exposed to the risk that we mayhave to post additional margin collateral, which may have a material adverseimpact on our available liquidity.  As aresult, our contingent liquidity reserves may not be sufficient in the event ofa material adverse change in the credit markets and related market price marketvolatility.  Foradditional information, we refer you to both the risk factors previouslydisclosed in the Company’s Form 10-K for the period ended December 31, 2006 andrisk factors discussed under the caption “Risk Factors” under Item 8.01 in theCurrent Report on Form 8-K filed by the Company with the SEC on June 1, 2007.

We are no longer treated as a REIT for U.S. federalincome tax purposes and, as a result, will not be subject to the REIT requirementto make distributions to our shareholders, although we currently intend todistribute approximately 75% to 95% of our taxable income to ourshareholders.  However, distributions byus must be approved by, and will be subject to the sole discretion of, ourBoard of Directors and will be subject to various considerations including, butnot limited to, our financial performance, liquidity requirements, distributionrestrictions contained in our current or future financing facilities, ourdistribution yield relative to our peers and other relevant factors identifiedby our Board of Directors.

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**Sources of Funds**

*SecuritizationTransactions*

*On May 22, 2007, we closed CLO2007-1, a $3.5 billion secured financing transaction.  We issued $2.4 billion of senior securednotes at par to unaffiliated investors with a weighted average coupon ofthree-month LIBOR plus 0.53% and issued $244.7 million of mezzanine notes and$186.6 million of subordinated notes to KKR Strategic Capital Funds that aremanaged by an affiliate of our Manager.*

*RepurchaseAgreements*

As of June 30,2007, we had $2.4 billion outstanding on repurchase facilities with fourcounterparties with a weighted average effective rate of 5.53% and a weightedaverage remaining term to maturity of 27 days. Because we borrow underrepurchase agreements based on the estimated fair value of our pledgedinvestments, and because changes in interest rates can negatively impact thevaluation of our pledged investments, our ongoing ability to borrow under ourrepurchase facilities may be limited and our lenders may initiate margin callsin the event interest rates change or the value of our pledged securitiesdeclines as a result of adverse changes in interest rates or credit spreads.

*SecuredCredit Facility*

DuringJune 2006 our $275.0 million secured revolving credit facility matured andwas replaced with a $375.0 million three year senior secured revolving creditfacility. During September 2006, the facility was amended to increase thetotal commitment amount to $800.0 million with the option to further increasethe commitment amount to $900.0 million at any time so long as no default orevent of default on the facility has occurred and subject to addition of newlenders, increases in the commitments of existing lenders, or a combinationthereof. The new senior secured revolving credit facility matures inJune 2009 and consists of two tranches. Outstanding borrowings under thesenior secured revolving credit facility bear interest at either (i) an alternatebase rate per annum equal to the greater of (a) the prime rate in effecton such day, and (b) the federal funds rate in effect on such day plus0.50%, or (ii) an interest rate per annum equal to the LIBOR rate for theapplicable interest period plus 0.50% for borrowings under tranche A of thefacility and 0.75% for borrowings under tranche B of the facility. As of June30, 2007, we had $156.5 million in borrowings outstanding under tranche B ofthis facility. In connection with our restructuring transaction, the facilitywas further amended in May 2007 to add us and certain of our wholly-ownedsubsidiaries as borrowers.

*JuniorSubordinated Notes*

During June 2007,we formed Trust VI for the sole purpose of issuing trust preferred securities.On June 29, 2007, Trust VI issued preferred securities to unaffiliatedinvestors for gross proceeds of $70.0 million and common securities to us for$2.2 million. The combined proceeds were invested by Trust VI in $72.2 millionof junior subordinated notes issued by us. The junior subordinated notes arethe sole assets of Trust VI and mature on July 30, 2037, but are callableon or after July 30, 2012. Interest is payable quarterly at a floatingrate equal to three-month LIBOR plus 2.50%.

*Convertible Debt*

On July 23, 2007 we issued an aggregate of $300.0million of 7.000% convertible notes maturing on July 15, 2012 to qualifiedinstitutional buyers.  The initial purchaser of the Notes has an option topurchase up to $45.0 million of Notes.  The Notes represent seniorunsecured obligations of us and bear interest at the rate of 7.000% per year.Interest is payable semi-annually on January 15 and July 15 of each year,beginning January 15, 2008.

The Notes are convertible into our common shares,initially at a conversion rate of 31.08 shares per $1,000 principal of Notes,which is equivalent to an initial conversion price of $32.175 per common share.The Notes are convertible prior to the maturity date at any time on or afterJune 15, 2012 and also under the following circumstances: (i) a holder maysurrender any of its Notes for conversion during any calendar quarter beginningafter September 30, 2007 (and only during such calendar quarter) if, and onlyif, the closing sale price of our common shares for at least 20 trading days(whether or not consecutive) in the period of 30 consecutive trading daysending on the last trading day of the preceding calendar quarter is greaterthan 130% of the conversion price per common share in effect on the applicabletrading day; (ii) a holder may surrender any of its Notes for conversion duringthe five consecutive trading-day period following any five consecutivetrading-day period in which the trading price of the Notes was less than 98% ofthe product of the closing sale price of our common shares multiplied by theapplicable conversion rate; (iii) a holder may surrender for conversion any ofits Notes if those Notes have been called for redemption, at any time prior tothe redemption date, even if the Notes are not otherwise convertible at suchtime; and (iv) a holder may surrender any of its Notes for conversion if weengage in certain specified transactions, as defined in the indenture coveringthe Notes.

*Capital Utilization and Leverage*

As of June 30, 2007 and December 31, 2006, we hadshareholders’ equity totaling $1.7 billion, and our leverage was 10.1 times and9.1 times, respectively.

*Off-Balance*Sheet Commitments

The Company participates in certain financingarrangements, including bridge facilities and delayed draw facilities, wherebythe Company is committed to provide funding at the discretion of the borrowerup to a specific predetermined amount. As of June 30, 2007, the Company hadunfunded financing commitments totaling $411.6 million.

**REIT Matters**

As of June 30, 2007, webelieve that our REIT Subsidiary qualified as a REIT under the provisions ofthe Code. The Code requires, among other things, that at the end of eachcalendar quarter at least 75% of our REIT Subsidiary’s total assets must be “realestate assets” as defined in the Code. The Code also requires that each year atleast 75% of our REIT Subsidiary’s gross income come from real estate sourcesand 95% of our REIT Subsidiary’s gross income come from real estate sources andcertain other passive sources itemized in the Code, such as dividends andinterest. As of June 30, 2007, we believe that our REIT Subsidiary was incompliance with such requirements. As of June 30, 2007, we also believe thatour REIT Subsidiary met all of the REIT requirements regarding the ownership ofits common shares and the distribution of its 

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taxableincome. However, the sections of the Code and the corresponding U.S. TreasuryRegulations that relate to qualification and taxation as a REIT are highlytechnical and complex, and our REIT Subsidiary’s qualification and taxation asa REIT depends upon its ability to meet various qualification tests imposedunder the Code (such as those described above), including through its actualannual operating results, asset composition, distribution levels and diversityof share ownership. Accordingly, no assurance can be given that our REIT Subsidiaryhas been organized and has operated, or will continue to be organized and operated,in a manner so as to qualify or remain qualified as a REIT.

To maintain our REIT Subsidiary’s status as a REIT forfederal income tax purposes, our REIT Subsidiary is required to distribute atleast 90% of its REIT taxable income for each year. In addition, for eachtaxable year, to avoid certain federal excise taxes, our REIT Subsidiary isrequired to declare and pay dividends amounting to certain designatedpercentages of our REIT Subsidiary’s taxable income by the end of such taxableyear. For the period covered by our calendar year 2006 federal tax return, webelieve that our REIT Subsidiary met all of the distribution requirements of aREIT.

**Exemption fromRegulation under the Investment Company Act**

We intend to conduct our operations so that were notrequired to register as an investment company under the Investment Company Act.Our subsidiaries that issue collateralized debt obligations (“CDOs”) generallywill rely on Rule 3a-7, an exemption from the Investment Company Act providedfor certain structured financing vehicles. Accordingly, each of our CDO subsidiaries that rely on Rule 3a-7 issubject to an indenture that contains specific guidelines and restrictions,including a prohibition on the CDO issuers from acquiring and disposing ofassets primarily for the purposes of recognizing gains or decreasing lossesresulting from market value changes. Certain sales and purchases of assets maybe made so long as the CDOs do not violate the guidelines contained in theindentures and are not based primarily on the changes in market value. We can,however, continue to sell assets without limitation if we believe the creditprofile of the obligor will deteriorate. The proceeds of permitted dispositions may be reinvested in collateralthat is consistent with the credit profile of the CDO under specific andpredetermined guidelines.

Our REIT Subsidiary that holds mortgage loans andother real estate assets relies on the exemption from registration provided bySection 3(c)(5)(C) of the Investment Company Act. In order to qualify for thisexemption, at least 55% of a subsidiary’s portfolio must be composed ofmortgages and other liens on and interests in real estate (collectively, “qualifyingassets”) and at least 80% of the subsidiary’s portfolio must be composed ofreal estate-related assets.  Qualifyingassets include mortgage loans, mortgage-backed securities that represent theentire ownership in a pool of mortgage loans and other interests in realestate.  Accordingly, these restrictionswill limit the ability of these subsidiaries to invest directly inmortgage-backed securities that represent less than the entire ownership in apool of mortgage loans.

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

**Quantitative and QualitativeDisclosures About Market Risk**

**Market Risks**

*Currency Risks*

From time to time, we may make investments that aredenominated in a foreign currency through which we may be subject to foreign currencyexchange risk.

*Inflation Risks*

Our investment portfolio comprises the majority of ourassets and our investments are financial in nature. Changes in interest ratesand credit spreads may have a material adverse impact on our financialcondition, results of operations and liquidity. Changes in interest rates donot necessarily correlate with inflation rates or changes in inflation rates.

*Interest Rate Risk*

We believe that our primary market risk is interestrate risk. Interest rate risk is defined as the sensitivity of our current andfuture earnings to interest rate volatility, variability of spreadrelationships, the difference in repricing intervals 

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between our assets and liabilities and the effect thatinterest rates may have on our cash flows and the prepayment rates experiencedon our investments that have imbedded borrower optionality. The objective ofinterest rate risk management is to achieve earnings, preserve capital andachieve liquidity by minimizing the negative impacts of changing interestrates, asset and liability mix, and prepayment activity.

We are exposed to basis risk between our investmentsand our borrowings. Our floating rate investments and our variable rateborrowings do not reset on the same day or with the same frequency and, as aresult, we are exposed to basis risk with respect to index reset frequency. Ourfloating rate investments may reprice on indices that are different than theindices that are used to price our variable rate borrowings and, as a result,we are exposed to basis risk with respect to repricing index. The basis risksnoted above, in addition to other forms of basis risk that exist between ourinvestments and borrowings, may be material and could negatively impact futurenet interest margins.

Interest rate risk impacts our interest income,interest expense, prepayments, and the fair value of our investments, interestrate derivatives, and liabilities. We manage interest rate risk and makeinterest rate risk decisions by evaluating our projected earnings underselected interest rate scenarios. We also use static measures of interest raterisk including duration. During periods of increasing interest rates we arebiased to purchase investments that are floating rate and we have had that biassince our inception. We manage our interest rate risk using various techniquesranging from the purchase of floating rate investments to the use of interestrate derivatives. We generally fund our variable rate investments with variablerate borrowings with similar interest rate reset frequencies. We generally fundour fixed rate and our hybrid investments with short-term variable rateborrowings and we may use interest rate derivatives to hedge the variability ofthe cash flows associated with our existing or forecasted variable rateborrowings. Hedging activities are complex and accounting for interest ratederivatives as fair value or cash flow hedges in accordance with SFASNo. 133 is difficult.

Prepayments will impact the average lives of our fixedrate and hybrid investments and, as a result, we are exposed to the risk thatthe amount of variable rate borrowings that we have swapped from floating rateto fixed rate is materially different than we expected because the average lifeof the fixed rate or hybrid investment has either extended or contracted. Ifthe difference is material, we may have to adjust the amount of our interestrate derivative position and such action could generate a loss if we terminatedany of the interest rate derivatives or it may negatively impact our futureearnings if we have to increase our interest rate derivative positions becausethe average lives of our investments have extended.

The periodic and lifetime interest rate caps containedin our residential ARM loans and securities may limit the repricing of ourresidential ARM loans and securities and, as a result, we are exposed to therisk that repricing of our investments is limited by the respective caps andour variable rate borrowings do not have any similar such caps. As a result ourincome on the investments that are subject to the periodic and lifetime capwould remain constant while our cost of financing using variable rate debtwould increase. The periodic and lifetime interest rate caps may negativelyimpact future net interest margins and the fair values of our residential ARMloan and security investments.

The following table summarizes the estimated net fairvalue of our derivative instruments held at June 30, 2007 and December 31,2006 (amounts in thousands):

**Derivative FairValue**
|                                 | ** ** | **As of  June 30, 2007** | ** ** | **As of  December 31, 2006** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **Notional**                            | ** ** | **Fair Value**                         | ** ** | **Notional** | ** ** | **Fair Value** | ** ** |
| **Cash  Flow Hedges:**          | ** ** | ** **                              | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest rate corridors         |       | $                                       | 744,936    |                                        | $          | 11,822 |   | $ | 702,369 |   | $ | 13,591 |   |
| Interest rate swaps             |       | 4,216,027                               |       | 55,419                                      |       | 4,567,828 |   | 45,314 |   |
| **Fair  Value Hedges:**         | ** ** | ** **                              | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest rate swaps             |       | 32,000                                  |       | 442                                         |       | 32,000 |   | 13 |   |
| **Free-Standing  Derivatives:** | ** ** | ** **                              | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest rate swaptions         |       | 31,000                                  |       | 75                                          |       | 31,000 |   | 75 |   |
| Credit default swaps—long  |       | 16,000                                  |       | 173                                         |       | 3,000 |   | 179 |   |
| Credit default swaps—short |       | 290,000                                 |       | 518                                         |       | 275,000 |   | (797 | ) |
| Total rate of return swaps      |       | 497,941                                 |       | 10,246                                      |       | 222,647 |   | 2,343 |   |
| Common stock warrants           |       | —                                  |       | 286                                         |       | — |   | — |   |
| Net fair value                  |       | $                                       | 5,827,904  |                                        | $          | 78,981 |   | $ | 5,833,844 |   | $ | 60,718 |   |

 

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*Risk Management*

We seek to manage our interest rate risk exposure toprotect our investment portfolio and related borrowings against the effects ofmajor interest rate changes. We generally seek to manage our interest rate riskby:

·   Changing the mix between our floating rateinvestments and our fixed rate investments;

·   Monitoring and adjusting, if necessary, the resetindex and interest rates related to our investments and our borrowings;

·   Attempting to structure our borrowing agreements tohave a range of different maturities, terms, amortizations and interest rateadjustment periods; and

·   Using interest rate derivativesto adjust the interest rate sensitivity of our investment portfolio and ourborrowings.

**Item3.**         Quantitativeand Qualitative Disclosures About Market Risk

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

**Item4.**         Controls andProcedures

The Company’s management evaluated, with theparticipation of the Company’s principal executive and principal financialofficer, the effectiveness of the Company’s disclosure controls and procedures(as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Actof 1934, as amended (the “Exchange Act”)) as of June 30, 2007. Based on theirevaluation, the Company’s principal executive and principal financial officerconcluded that the Company’s disclosure controls and procedures as of June 30,2007 were designed and were functioning effectively to provide reasonableassurance that the information required to be disclosed by the Company inreports filed under the Exchange Act is (i) recorded, processed,summarized, and reported within the time periods specified in the SEC’s rulesand forms, and (ii) accumulated and communicated to management, includingthe principal executive and principal financial officers, as appropriate, toallow timely decisions regarding disclosure.

There has been no change in the Company’s internalcontrol over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f)under the Exchange Act) that occurred during the Company’s three and six monthsending June 30, 2007, that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

**PART II.OTHER INFORMATION**

**Item1.**        *Legal Proceedings*

None.

**Item1A.**      *Risk Factors*

In addition to risk factors previously disclosed inthe Company’s Form 10-K for the period ended December 31, 2006, please see theadditional risk factors discussed under the caption “Risk Factors” under Item8.01 in the Current Report on Form 8-K filed by the Company with the SEC onJune 1, 2007, which is incorporated by reference hereto only with respect tothe risk factors discussed under the caption “Risk Factors.”

**Item 2 *.******        UnregisteredSales of Equity Securities and Use of Proceeds***

None.

**Item3.**         *Defaults Upon Senior Securities*

None.

**Item4.**         *Submission of Matters to a Vote of Security Holders*

Our 2007 annualmeeting of the shareholders was held on May 3, 2007. A total of 74,356,740of our shares were present or voted by proxy at the meeting. This representedmore than 92% of our outstanding common shares. The following matters werevoted upon and received the votes as set forth below:

1.             Shareholders voted toapprove the merger under the Agreement and Plan of Merger among KKR FinancialCorp., KKR Financial Merger Corp. and KKR Financial Holdings LLC.  The proposal received 60,625,735 votes for,143,164 against and 69,438 abstained.

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2.             Shareholders electedtwelve directors to one-year terms that will expire at the annual meeting ofthe shareholders in 2008. The vote tabulation for individual directors was: 
| DIRECTOR             | ** ** | **FOR**    | ** ** | **WITHHELD** | ** ** |
|----------------------|------------|------------|------------|--------------|------------|
|                 |       |       |       |         |       |
| William F.  Aldinger |       | 73,689,294 |       | 667,446      |       |
| Tracy L. Collins     |       | 74,127,779 |       | 228,961      |       |
| Kenneth M.  deRegt   |       | 74,137,023 |       | 219,717      |       |
| V. Paul Finigan      |       | 73,682,032 |       | 674,708      |       |
| Saturnino S.  Fanlo  |       | 74,127,193 |       | 229,547      |       |
| Paul M. Hazen        |       | 73,671,058 |       | 685,682      |       |
| R. Glenn Hubbard     |       | 73,051,635 |       | 1,305,105    |       |
| Ross J. Kari         |       | 51,685,950 |       | 22,670,790   |       |
| Ely L. Licht         |       | 72,783,771 |       | 1,572,969    |       |
| Deborah H.  McAneny  |       | 74,125,180 |       | 231,560      |       |
| Scott C. Nuttall     |       | 73,677,056 |       | 679,684      |       |
| Willy R. Strothotte  |       | 74,042,676 |       | 314,064      |       |

 

3.             The election ofDeloitte & Touche LLP as our independent registered public accountingfirm for the year ending December 31, 2007 was ratified with 73,976,560shares voting for, 272,178 shares voting against, 108,002 shares abstaining andno broker non-votes.

**Item5.**         *Other Information*

None.

**Item6.**         *Exhibits*
| 31.1 | Chief Executive Officer Certification                  |
|------|--------------------------------------------------------|
| 31.2 | Chief Financial Officer Certification                  |
| 32   | Certification Pursuant to 18 U.S.C.  Section 1350 |

 

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**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, KKR Financial Holdings LLC has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.
|                         |       | KKR Financial Holdings LLC                                            |
|-------------------------|------------|-----------------------------------------------------------------------|
|                    |       |                                                                  |
| **Signature**           | ** ** | **Title**                                                             |
| ** **              | ** ** | ** **                                                            |
| /s/ SATURNINO S. FANLO  |       | Chief Executive Officer (Principal Executive  Officer)                |
| **Saturnino S. Fanlo**  |       |                                                                  |
| ** **              | ** ** | ** **                                                            |
| /s/ JEFFREY B. VAN HORN |       | Chief Financial Officer (Principal Financial and  Accounting Officer) |
| **Jeffrey B. Van Horn** |       |                                                                  |
| ** **              | ** ** | ** **                                                            |
| Date: August 2,  2007   |       |                                                                  |

 

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