Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 
| **(Mark One)**                                                                                                                                    |
|---------------------------------------------------------------------------------------------------------------------------------------------------|
| **x**                                                                                                                                             | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
| ** **                                                                                                                                        |
| **For the quarterly period ended September 30,  2008**                                                                                       |
| ** **                                                                                                                                        |
| **or**                                                                                                                                            |
| ** **                                                                                                                                        |
| **o**                                                                                                                                             | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
| ** **                                                                                                                                        |
| **For the transition period  from         to         ** |

 

**Commissionfile number: 001-33437**

 

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**KKR FINANCIAL HOLDINGS LLC**

(Exact name ofregistrant as specified in its charter)

 

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

 

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

 

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

 

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

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

 

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

 

The number of shares of the registrant’scommon shares outstanding as of October 21, 2008 was 150,881,500.

 

 

 

Table of Contents

** **

**TABLEOF CONTENTS**

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

 

2

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Table of Contents

 

**PART I. FINANCIAL INFORMATION**

 

**Item1. Financial Statements**

 

**KKR Financial Holdings LLC and Subsidiaries**

**CondensedConsolidated Balance Sheets**

**(Unaudited)**

**(Amounts in thousands, except shareinformation)**

 
| ** **                                                                                                                                                                                  | ** ** | **As of  September**** 30****, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|---------------------------------------------|------------|
| **Assets**                                                                                                                                                                                  |       |                                                 |       |                                        |       |
| Cash and cash equivalents                                                                                                                                                                   |       | $                                                    | 196,526    |                                        | $          | 524,080 |   |
| Restricted cash and cash equivalents                                                                                                                                                        |       | 855,791                                              |       | 1,067,797                                   |       |
| Securities available-for-sale, $1,008,104  and $1,346,247 pledged as collateral as of September 30, 2008 and December 31, 2007, respectively                                           |       | 1,023,276                                            |       | 1,359,541                                   |       |
| Corporate loans, net of allowance for loan  losses of $35,000 and $25,000 as of September  30, 2008 and December 31, 2007, respectively                                                |       | 8,458,531                                            |       | 8,634,208                                   |       |
| Residential mortgage-backed securities, at  estimated fair value, $71,509 and $117,833 pledged as collateral as of September  30, 2008 and December 31, 2007, respectively             |       | 112,980                                              |       | 131,688                                     |       |
| Residential mortgage loans, at estimated  fair value                                                                                                                                        |       | 3,054,756                                            |       | 3,921,323                                   |       |
| Corporate loans held for sale                                                                                                                                                               |       | 28,201                                               |       | —                                      |       |
| Derivative assets                                                                                                                                                                           |       | 51,235                                               |       | 18,737                                      |       |
| Interest and principal receivable                                                                                                                                                           |       | 115,005                                              |       | 162,465                                     |       |
| Non-marketable equity securities                                                                                                                                                            |       | 17,505                                               |       | 20,084                                      |       |
| Reverse repurchase agreements                                                                                                                                                               |       | 27,645                                               |       | 69,840                                      |       |
| Other assets                                                                                                                                                                                |       | 75,998                                               |       | 86,504                                      |       |
| Assets of discontinued operations                                                                                                                                                           |       | —                                               |       | 3,049,758                                   |       |
| **Total assets**                                                                                                                                                                            |       | $                                                    | 14,017,449 |                                        | $          | 19,046,025 |   |
| **Liabilities**                                                                                                                                                                             |       |                                                 |       |                                        |       |
| Repurchase agreements                                                                                                                                                                       |       | $                                                    | —     |                                        | $          | 2,808,066 |   |
| Collateralized loan obligation senior  secured notes                                                                                                                                        |       | 7,549,672                                            |       | 5,948,610                                   |       |
| Collateralized loan obligation junior  secured notes to affiliates                                                                                                                          |       | 525,420                                              |       | 525,420                                     |       |
| Secured revolving credit facility                                                                                                                                                           |       | 378,306                                              |       | 167,024                                     |       |
| Secured demand loan                                                                                                                                                                         |       | —                                               |       | 24,151                                      |       |
| Convertible senior notes                                                                                                                                                                    |       | 300,000                                              |       | 300,000                                     |       |
| Junior subordinated notes                                                                                                                                                                   |       | 288,671                                              |       | 329,908                                     |       |
| Subordinated notes to affiliates                                                                                                                                                            |       | 84,000                                               |       | 152,574                                     |       |
| Residential mortgage-backed securities  issued, at estimated fair value                                                                                                                     |       | 2,868,232                                            |       | 3,169,353                                   |       |
| Accounts payable, accrued expenses and  other liabilities                                                                                                                                   |       | 27,821                                               |       | 7,390                                       |       |
| Accrued interest payable                                                                                                                                                                    |       | 56,901                                               |       | 114,035                                     |       |
| Accrued interest payable to affiliates                                                                                                                                                      |       | 36,317                                               |       | 44,121                                      |       |
| Related party payable                                                                                                                                                                       |       | 5,071                                                |       | 9,694                                       |       |
| Securities sold, not yet purchased                                                                                                                                                          |       | 83,507                                               |       | 100,394                                     |       |
| Derivative liabilities                                                                                                                                                                      |       | 82,968                                               |       | 56,663                                      |       |
| Liabilities of discontinued operations                                                                                                                                                      |       | —                                               |       | 3,644,083                                   |       |
| **Total liabilities**                                                                                                                                                                       |       | 12,286,886                                           |       | 17,401,486                                  |       |
| **Shareholders’ Equity**                                                                                                                                                               |       |                                                 |       |                                        |       |
| Preferred shares, no par value, 50,000,000  shares authorized and none issued and outstanding at September 30, 2008 and December 31, 2007                                              |       | —                                               |       | —                                      |       |
| Common shares, no par value, 250,000,000  shares authorized, and 150,881,500 and 115,248,990 shares issued and  outstanding at September 30,  2008 and December 31, 2007, respectively |       | —                                               |       | —                                      |       |
| Paid-in-capital                                                                                                                                                                             |       | 2,551,634                                            |       | 2,167,156                                   |       |
| Accumulated other comprehensive loss                                                                                                                                                        |       | (377,924                                             | )          | (157,245                                    | )          |
| Accumulated deficit                                                                                                                                                                         |       | (443,147                                             | )          | (365,372                                    | )          |
| **Total shareholders’ equity**                                                                                                                                                         |       | 1,730,563                                            |       | 1,644,539                                   |       |
| **Total liabilities and shareholders’ equity**                                                                                                                                         |       | $                                                    | 14,017,449 |                                        | $          | 19,046,025 |   |

 

See notes tocondensed consolidated financial statements.

 

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Table of Contents

 

**KKRFinancial Holdings LLC and Subsidiaries**

**CondensedConsolidated Statements of Operations**

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

** **
| ** **                                                                                                                                                                                          | ** ** | **For the three** | ** ** | **For the three** | ** ** | **For the nine**  | ** ** | **For the nine**  | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                          | ** ** | **months ended**       | ** ** | **months ended**       | ** ** | **months ended**       | ** ** | **months ended**       | ** ** |
| ** **                                                                                                                                                                                          | ** ** | **September 30, 2008** | ** ** | **September 30, 2007** | ** ** | **September 30, 2008** | ** ** | **September 30, 2007** | ** ** |
| **Net investment income:**                                                                                                                                                                          |       |                        |       |                        |       |                        |       |                        |       |
| Securities interest income                                                                                                                                                                          |       | $                           | 34,507     |                        | $          | 37,725                      |       | $                           | 109,104    |   | $ | 87,661 |   |
| Loan interest income                                                                                                                                                                                |       | 187,756                     |       | 190,471                     |       | 588,843                     |       | 468,283                     |       |
| Dividend income                                                                                                                                                                                     |       | 358                         |       | 782                         |       | 2,266                       |       | 2,722                       |       |
| Other interest income                                                                                                                                                                               |       | 4,431                       |       | 11,850                      |       | 20,505                      |       | 20,100                      |       |
| Total investment income                                                                                                                                                                             |       | 227,052                     |       | 240,828                     |       | 720,718                     |       | 578,766                     |       |
| Interest expense                                                                                                                                                                                    |       | (118,105                    | )          | (145,058                    | )          | (400,207                    | )          | (381,107                    | )          |
| Interest expense to affiliates                                                                                                                                                                      |       | (18,794                     | )          | (21,148                     | )          | (66,319                     | )          | (29,404                     | )          |
| Provision for loan losses                                                                                                                                                                           |       | —                      |       | (25,000                     | )     | (10,000                     | )          | (25,000                     | )          |
| Net investment income                                                                                                                                                                               |       | 90,153                      |       | 49,622                      |       | 244,192                     |       | 143,255                     |       |
| **Other (loss) income:**                                                                                                                                                                            |       |                        |       |                        |       |                        |       |                        |       |
| Net realized and unrealized loss on  derivatives and foreign exchange                                                                                                                               |       | (15,534                     | )          | (16,042                     | )     | (68,468                     | )          | (2,422                      | )          |
| Net realized and unrealized (loss) gain on  investments                                                                                                                                             |       | (28,278                     | )          | 53,400                      |       | (59,254                     | )          | 87,164                      |       |
| Net realized and unrealized gain (loss) on residential  mortgage-backed securities, residential mortgage loans, and residential  mortgage-backed securities issued, carried at estimated fair value |       | 121                         |       | (39,286                     | )     | (14,651                     | )          | (40,978                     | )          |
| Net realized and unrealized gain on securities  sold, not yet purchased                                                                                                                             |       | 14,242                      |       | 2,220                       |       | 22,892                      |       | 2,795                       |       |
| Gain on extinguishment of debt                                                                                                                                                                      |       | 3,056                       |       | —                      |       | 20,281                      |       | —                      |       |
| Other income                                                                                                                                                                                        |       | 2,470                       |       | 2,760                       |       | 7,939                       |       | 7,347                       |       |
| Total other (loss) income                                                                                                                                                                           |       | (23,923                     | )          | 3,052                       |       | (91,261                     | )          | 53,906                      |       |
| **Non-investment expenses:**                                                                                                                                                                        |       |                        |       |                        |       |                        |       |                        |       |
| Related party management compensation                                                                                                                                                               |       | 9,811                       |       | 4,925                       |       | 29,357                      |       | 39,338                      |       |
| General, administrative and directors  expenses                                                                                                                                                     |       | 3,820                       |       | 3,842                       |       | 14,094                      |       | 14,095                      |       |
| Professional services                                                                                                                                                                               |       | 1,335                       |       | 2,194                       |       | 4,263                       |       | 3,495                       |       |
| Loan servicing                                                                                                                                                                                      |       | 2,274                       |       | 2,729                       |       | 7,234                       |       | 8,751                       |       |
| Total non-investment expenses                                                                                                                                                                       |       | 17,240                      |       | 13,690                      |       | 54,948                      |       | 65,679                      |       |
| Income from continuing operations before  equity in income of unconsolidated affiliate and income tax expense                                                                                       |       | 48,990                      |       | 38,984                      |       | 97,983                      |       | 131,482                     |       |
| Equity in income of unconsolidated  affiliate                                                                                                                                                       |       | —                      |       | —                      |       | —                      |       | 12,706                      |       |
| Income from continuing operations before  income tax expense                                                                                                                                        |       | 48,990                      |       | 38,984                      |       | 97,983                      |       | 144,188                     |       |
| Income tax expense                                                                                                                                                                                  |       | —                      |       | (386                        | )          | (116                        | )          | (1,245                      | )          |
| Income from continuing operations                                                                                                                                                                   |       | 48,990                      |       | 38,598                      |       | 97,867                      |       | 142,943                     |       |
| Income (loss) from discontinued operations                                                                                                                                                          |       | —                      |       | (300,105                    | )          | 2,668                       |       | (303,055                    | )          |
| Net income (loss)                                                                                                                                                                                   |       | $                           | 48,990     |                        | $          | (261,507                    | )     | $                           | 100,535    |   | $ | (160,112 | ) |
|                                                                                                                                                                                                |       |                        |       |                        |       |                        |       |                        |       |
| Net income per common share:                                                                                                                                                                        |       |                        |       |                        |       |                        |       |                        |       |
| Basic                                                                                                                                                                                               |       |                        |       |                        |       |                        |       |                        |       |
| Income per share from continuing operations                                                                                                                                                         |       | $                           | 0.33       |                        | $          | 0.44                        |       | $                           | 0.72       |   | $ | 1.75 |   |
| Income (loss) per share from discontinued  operations                                                                                                                                               |       |                        | —     |                        |       | (3.43                       | )          |                        | 0.02       |   |   | (3.71 | ) |
| Net income (loss) per share                                                                                                                                                                         |       | $                           | 0.33       |                        | $          | (2.99                       | )          | $                           | 0.74       |   | $ | (1.96 | ) |
| Diluted                                                                                                                                                                                             |       |                        |       |                        |       |                        |       |                        |       |
| Income per share from continuing operations                                                                                                                                                         |       | $                           | 0.33       |                        | $          | 0.44                        |       | $                           | 0.71       |   | $ | 1.73 |   |
| Income (loss) per share from discontinued  operations                                                                                                                                               |       |                        | —     |                        |       | (3.42                       | )          |                        | 0.02       |   |   | (3.66 | ) |
| Net income (loss) per share                                                                                                                                                                         |       | $                           | 0.33       |                        | $          | (2.98                       | )          | $                           | 0.73       |   | $ | (1.93 | ) |
|                                                                                                                                                                                                |       |                        |       |                        |       |                        |       |                        |       |
| Weighted-average number of common shares  outstanding:                                                                                                                                              |       |                        |       |                        |       |                        |       |                        |       |
| Basic                                                                                                                                                                                               |       | 149,612                     |       | 87,443                      |       | 136,777                     |       | 81,692                      |       |
| Diluted                                                                                                                                                                                             |       | 149,883                     |       | 87,696                      |       | 137,319                     |       | 82,747                      |       |
|                                                                                                                                                                                                |       |                        |       |                        |       |                        |       |                        |       |
| Distributions declared per common share                                                                                                                                                             |       | $                           | 0.40       |                        | $          | 0.56                        |       | $                           | 1.30       |   | $ | 1.66 |   |

 

See notes tocondensed consolidated financial statements.

 

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**KKRFinancial Holdings LLC and Subsidiaries**

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

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

** **
| ** **                                                      | ** ** | **Common  Shares** | ** ** | **Paid-In  Capital** | ** ** | **Accumulated Other  Comprehensive  Loss** | ** ** | **Accumulated  Deficit** | ** ** | **Comprehensive  Loss** | ** ** | **Total  Shareholders’  Equity** | ** ** |
|-----------------------------------------------------------------|------------|--------------------|------------|----------------------|------------|-------------------------------------------------|------------|--------------------------|------------|-------------------------|------------|---------------------------------------|------------|
| **Balance at January 1, 2008**                             |       | 115,249            |       | $                    | 2,167,156  |                                            | $          | (157,245                 | )          | $                       | (365,372   | )                                     |       |   | $ | 1,644,539 |   |
| Net income                                                      |       | —             |       | —               |       | —                                          |       | 100,535                  |       | $                       | 100,535    |                                  | 100,535    |   |
| Net change in unrealized loss on cash flow  hedges              |       | —             |       | —               |       | (4,101                                          | )     | —                   |       | (4,101                  | )     | (4,101                                | )          |
| Net change in unrealized loss on securities  available-for-sale |       | —             |       | —               |       | (216,578                                        | )          |                     |       | (216,578                | )          | (216,578                              | )          |
| Comprehensive loss                                              |       |               |       |                 |       |                                            |       |                     |       | $                       | (120,144   | )                                |       |   |
| Cash distributions on common shares                             |       | —             |       | —               |       | —                                          |       | (178,310                 | )          |                    |       | (178,310                              | )          |
| Cancellation of restricted common shares                        |       | (3                 | )          | —               |       | —                                          |       | —                   |       |                    |       | —                                |       |
| Grant of restricted common shares                               |       | 1,135              |       | —               |       | —                                          |       | —                   |       |                    |       | —                                |       |
| Proceeds from issuance of common shares,  net of offering costs |       | 34,500             |       | 383,519              |       | —                                          |       | —                   |       |                    |       | 383,519                               |       |
| Amortization of restricted common shares                        |       | —             |       | 959                  |       | —                                          |       | —                   |       |                    |       | 959                                   |       |
| **Balance at September 30, 2008**                               |       | 150,881            |       | $                    | 2,551,634  |                                            | $          | (377,924                 | )          | $                       | (443,147   | )                                     |       |   | $ | 1,730,563 |   |

 

See notes to condensedconsolidated financial statements.

 

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**KKR Financial Holdings LLC and Subsidiaries**

**Condensed****Consolidated Statements of Cash Flows**

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

** **
| ** **                                                                                                                                  | ** ** | **For the nine  months ended  September 30, 2008** | ** ** | **For the nine  months ended  September 30, 2007** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| **Cash flows from operating activities:**                                                                                                   |       |                                                                   |       |                                                                   |       |
| Net income  (loss)                                                                                                                          |       | $                                                                      | 100,535    |                                                                   |       | (160,112 |  ) |
| Adjustments to reconcile net income (loss)  to net cash provided by operating activities:                                                   |       |                                                                   |       |                                                                   |       |
| Net realized and unrealized loss (gain) on  derivatives, foreign exchange, and securities sold, not yet purchased                           |       | 45,576                                                                 |       | (24,722                                                                | )          |
| Gain on extinguishment of debt                                                                                                              |       | (20,281                                                                | )          | —                                                                 |       |
| Write-off of unamortized debt issuance  costs                                                                                               |       | 1,224                                                                  |       | 2,247                                                                  |       |
| Lower of cost or estimated fair value  adjustment on corporate loans held for sale and provision for loan losses                            |       | 12,353                                                                 |       | 25,000                                                                 |       |
| Impairment of securities available-for-sale                                                                                                 |       | 20,254                                                                 |       | —                                                                 |       |
| Share-based compensation                                                                                                                    |       | 959                                                                    |       | 2,289                                                                  |       |
| Net unrealized (gain) loss on residential mortgage-backed  securities, residential mortgage loans, and liabilities at estimated fair  value |       | (7,568                                                                 | )          | 183,011                                                                |       |
| Net realized loss (gain) on sales of  investments                                                                                           |       | 39,735                                                                 |       | (43,565                                                                | )          |
| Depreciation and net amortization                                                                                                           |       | (26,043                                                                | )          | 3,948                                                                  |       |
| Equity in income of unconsolidated  affiliate                                                                                               |       | —                                                                 |       | (12,706                                                                | )          |
| Changes in assets and liabilities:                                                                                                          |       |                                                                   |       |                                                                   |       |
| Interest receivable                                                                                                                         |       | 32,617                                                                 |       | (31,785                                                                | )          |
| Other assets                                                                                                                                |       | (11,897                                                                | )          | (16,237                                                                | )          |
| Related party payable                                                                                                                       |       | (4,623                                                                 | )          | (1,923                                                                 | )          |
| Accounts payable, accrued expenses and  other liabilities                                                                                   |       | (27,965                                                                | )          | 116,136                                                                |       |
| Accrued interest payable                                                                                                                    |       | (57,656                                                                | )          | 29,404                                                                 |       |
| Accrued interest payable to affiliates                                                                                                      |       | 17,556                                                                 |       | 29,004                                                                 |       |
| Income tax liability                                                                                                                        |       | 12                                                                     |       | —                                                                 |       |
| Net cash provided by operating activities                                                                                                   |       | 114,788                                                                |       | 99,989                                                                 |       |
| **Cash flows from investing activities:**                                                                                                   |       |                                                                   |       |                                                                   |       |
| Principal payments from investments                                                                                                         |       | 1,307,765                                                              |       | 2,973,566                                                              |       |
| Proceeds from sale of investments                                                                                                           |       | 1,415,574                                                              |       | 3,125,000                                                              |       |
| Purchases of investments                                                                                                                    |       | (1,818,037                                                             | )          | (4,342,073                                                             | )          |
| Net proceeds, purchases, and settlements of  derivatives                                                                                    |       | (52,811                                                                | )     | 40,570                                                                 |       |
| Net change in reverse repurchase agreements                                                                                                 |       | 42,195                                                                 |       | (34,660                                                                | )          |
| Net additions (reductions) to restricted  cash and cash equivalents                                                                         |       | 212,359                                                                |       | (502,324                                                               | )          |
| Restricted cash and cash equivalents  acquired due to consolidation of KKR Financial CLO 2007-1, Ltd.                                       |       | —                                                                 |       | 57,104                                                                 |       |
| Additions of leasehold improvements and  equipment                                                                                          |       | —                                                                 |       | (244                                                                   | )          |
| Investment in unconsolidated affiliate                                                                                                      |       | —                                                                 |       | (60,327                                                                | )          |
| Net cash provided by investing activities                                                                                                   |       | 1,107,045                                                              |       | 1,256,612                                                              |       |
| **Cash flows from financing activities:**                                                                                                   |       |                                                                   |       |                                                                   |       |
| Net change in repurchase agreements,  secured revolving credit facility, and secured demand loan                                            |       | (2,620,935                                                             | )          | (3,675,629                                                             | )          |
| Net change in asset-backed secured  liquidity notes                                                                                         |       | (136,596                                                               | )          | (3,736,390                                                             | )          |
| Proceeds from issuance of residential  mortgage-backed securities issued                                                                    |       | —                                                                 |       | 3,319,547                                                              |       |
| Repayment of residential mortgage-backed  securities issued                                                                                 |       | (531,601                                                               | )          | (99,323                                                                | )          |
| Issuance of collateralized loan obligation  senior secured notes                                                                            |       | 1,600,000                                                              |       | 2,426,778                                                              |       |
| Net change in collateralized loan  obligation junior secured notes to affiliates                                                            |       | —                                                                 |       | 262,103                                                                |       |
| Issuance of convertible senior notes                                                                                                        |       | —                                                                 |       | 300,000                                                                |       |
| Net change in junior subordinated notes                                                                                                     |       | (20,956                                                                | )          | 70,000                                                                 |       |
| Net change  in subordinated notes to affiliates                                                                                             |       | (43,880                                                                | )          | 131,417                                                                |       |
| Net proceeds from common share offering                                                                                                     |       | 383,519                                                                |       | 437,675                                                                |       |
| Distributions on common shares                                                                                                              |       | (178,310                                                               | )          | (133,590                                                               | )          |
| Other capitalized costs                                                                                                                     |       | (628                                                                   | )          | (19,911                                                                | )          |
| Net cash used in financing activities                                                                                                       |       | (1,549,387                                                             | )          | (717,323                                                               | )          |
| **Net (decrease) increase in cash and cash  equivalents**                                                                                   |       | (327,554                                                               | )          | 639,278                                                                |       |
| **Cash and cash equivalents at beginning of  period**                                                                                       |       | 524,080                                                                |       | 5,125                                                                  |       |
| **Cash and cash equivalents at end of period**                                                                                              |       | $                                                                      | 196,526    |                                                                   | $          | 644,403 |   |
| **Supplemental cash flow information:**                                                                                                     |       |                                                                   |       |                                                                   |       |
| Cash paid for interest                                                                                                                      |       | $                                                                      | 547,266    |                                                                   | $          | 656,197 |   |
| Cash paid for income taxes                                                                                                                  |       | $                                                                      | 100        |                                                                   | $          | 1,775 |   |
| **Non-cash investing and financing  activities:**                                                                                           |       |                                                                   |       |                                                                   |       |
| Net payable for securities purchased                                                                                                        |       | $                                                                      | —     |                                                                   | $          | (180,689 | ) |
| Conversion from corporate loans to  corporate securities                                                                                    |       | $                                                                      | 331,725    |                                                                   | $          | — |   |
| Distributions of securities to the  asset-backed secured liquidity noteholders                                                              |       | $                                                                      | 3,623,049  |                                                                   | $          | — |   |
| Affiliate contributions for collateralized  loan obligation junior secured notes                                                            |       | $                                                                      | —     |                                                                   | $          | 169,209 |   |
|                                                                                                                                             |            |                                                                        |            |                                                                        |            |  |  |  |

 

See notes tocondensed consolidated financial statements.

 

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**KKR Financial Holdings LLC and Subsidiaries**

 

**Notesto Condensed Consolidated Financial Statements (Unaudited)**

 

**Note 1. Organization**

 

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

 

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

 

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

 

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

 

**Basis of Presentation**

 

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

 

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

 

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**Use of Estimates**

 

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

 

**Consolidation**

 

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

 

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

 

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

 

**Fair Value of Financial Instruments**

 

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

 

As defined in SFAS No. 157, fair valueis the price that would be received to sell an asset or paid to transfer aliability in an orderly transaction between market participants at themeasurement date. Where available, fair value is based on observable marketprices or parameters, or derived from such prices or parameters. Where observableprices or inputs are not available, valuation models are applied. Thesevaluation techniques involve some level of management estimation and judgment,the degree of which is dependent on the price transparency for the instrumentsor market and the instruments’ complexity for disclosure purposes. Beginning inJanuary 2007, assets and liabilities recorded at fair value in theconsolidated balance sheets are categorized based upon the level of judgmentassociated with the inputs used to measure their value. Hierarchical levels, asdefined in SFAS No. 157 and directly related to the amount of subjectivityassociated with the inputs to fair valuations of these assets and liabilities,are as follows:

 

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

 

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

 

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

 

Fair value assets and liabilities that aregenerally included in this category are certain corporate debt securities,corporate loans held for sale and certain financial instruments classified asderivatives where the fair value is based on observable market inputs.

 

Level 3: Inputs are unobservable inputsfor the asset or liability, and include situations where there is little, ifany, market activity for the asset or liability. In certain cases, the inputsused to measure fair value may fall into different levels of the fair value hierarchy.In such cases, the level in the fair value hierarchy within which the fairvalue measurement in its entirety falls has been determined based on the lowestlevel input that is

 

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significant to the fair value measurement inits entirety. The Company’s assessment of the significance of a particularinput to the fair value measurement in its entirety requires judgment and theconsideration of factors specific to the asset.

 

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

 

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

 

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

 

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

 

Depending on the relative liquidity in themarkets for certain assets, the Company may transfer assets to level 3 if itdetermines that observable quoted prices, obtained directly or indirectly, arenot available. Assets and liabilities that are valued using level 3 of the fairvalue hierarchy primarily consist of certain corporate debt securities, residentialmortgage-backed securities, residential mortgage loans, residential mortgage-backedsecurities issued and certain over-the-counter (“OTC”) derivative contracts.The valuation techniques used for these are described below.

 

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

 

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

 

*OTC Derivative Contracts:*OTC derivative contracts include forward, swap and option contracts related tointerest rates, foreign currencies, credit standing of reference entities, andequity prices. The fair value of OTC derivative contracts can be modeled usinga series of techniques, including closed-form analytic formulae, such as the Black-Scholesoption-pricing model, and simulation models or a combination thereof. Manypricing models do not entail material subjectivity because the methodologiesemployed do not necessitate significant judgment, and the pricing inputs areobserved from actively quoted markets, as is the case for generic interest rateswap and option contracts.

 

**Cash and Cash Equivalents**

 

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

 

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**Restricted Cash and Cash Equivalents**

 

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

 

**Residential Mortgage-Backed Securities**

 

EffectiveJanuary 1, 2007, the Company adopted SFAS No. 159, *The Fair Value Option for Financial Assets and FinancialLiabilities-Including an Amendment of Statement 115*(“SFAS No. 159”)*,* and elected the option of carrying its residential**mortgage-backedsecurities at estimated fair value, with unrealized gains and losses reportedin income. 

 

**Securities Available-for-Sale**

 

The Company classifies its investments incorporate debt securities and marketable equity securities asavailable-for-sale as the Company may sell them prior to maturity and does nothold them principally for the purpose of selling them in the near term. Theseinvestments are carried at estimated fair value, with unrealized gains andlosses reported in accumulated other comprehensive income (loss). Estimatedfair values are based on quoted market prices, when available, or on estimatesprovided by independent pricing sources or dealers who make markets in suchsecurities. Upon the sale of a security, the realized net gain or loss iscomputed on a weighted-average cost basis. Purchases and sales of securitiesare recorded on the trade date.

 

The Company monitors its available-for-salesecurities portfolio for impairments. A loss is recognized when it isdetermined that a decline in the estimated fair value of a security below itsamortized cost is other-than-temporary. The Company considers many factors indetermining whether the impairment of a security is deemed to beother-than-temporary, including, but not limited to, the length of time thesecurity has had a decline in estimated fair value below its amortized cost, theamount of the unrealized loss, the intent and ability of the Company to holdthe security for a period of time sufficient for a recovery in value, recentevents specific to the issuer or industry, external credit ratings and recentchanges in such ratings.

 

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

 

**Non-marketable Equity Securities**

 

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

 

**Securities Sold, Not Yet Purchased**

 

Securities sold, not yet purchased consist ofequity and debt securities that the Company has sold short. In order tofacilitate a short sale, the Company borrows the securities from another partyand delivers the securities to the buyer. The Company will be required to“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 shortsale. Changes in the value of these securities are reflected in net realizedand unrealized gain on securities sold, not yet purchased on the Company’scondensed consolidated statements of operations.

 

**Corporate Loans**

 

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

 

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

 

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**Residential Mortgage Loans**

 

EffectiveJanuary 1, 2007, the Company adopted SFAS No. 159 and elected theoption to carry its residential mortgage loans at estimated fair value, withunrealized gains and losses reported in income. 

 

**Corporate Loans Held for Sale**

 

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

 

**Allowance for Loan Losses**

 

The Company’s allowance for estimated loanlosses represents its estimate of probable credit losses inherent in the loanportfolio as of the balance sheet date. When determining the adequacy of theallowance for loan losses, the Company considers historical and industry lossexperience, economic conditions and trends, the estimated fair values of itsloans, credit quality trends and other factors that it determines are relevant.Additions to the allowance for loan losses are charged to current periodearnings through the provision for loan losses. The Company’s allowance forloan losses consists of two components, an allocated component and anunallocated component. Amounts determined to be uncollectible are chargeddirectly to the allowance for loan losses.

 

The allocated component of the Company’sallowance for loan losses consists of individual loans that are impaired andfor which the estimated allowance for loan losses is determined in accordancewith SFAS No. 114, *Accounting byCreditors for Impairment of a Loan.* The Company considers a loan tobe impaired when, based on current information and events, it believes it isprobable that it will be unable to collect all amounts due to it based on thecontractual terms of the loan. An impaired loan may be left on accrual statusduring the period the Company is pursuing repayment of the loan; however, theloan is placed on non-accrual status at such time as: (i) managementbelieves that scheduled debt service payments may not be paid whencontractually due; (ii) the loan becomes 90 days delinquent;(iii) management determines the borrower is incapable of, or has ceasedefforts toward, curing the cause of the impairment; or (iv) the netrealizable value of the underlying collateral securing the loan decreases belowthe Company’s carrying value of such loan. While on non-accrual status,previously recognized accrued interest is reversed if it is determined thatsuch amounts are not collectible and interest income is recognized only uponactual receipt.

 

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

 

**Leasehold Improvements and Equipment**

 

Leasehold improvements and equipment arecarried at cost less depreciation and amortization and are reviewed forimpairment whenever events or changes in circumstances indicate that thecarrying amount of the assets might not be recoverable. Equipment isdepreciated using the straight-line method over the estimated useful lives ofthe respective assets of three years. Leasehold improvements are amortized on astraight-line basis over the shorter of their estimated useful lives or leaseterms. Leasehold improvements and equipment, net of accumulated depreciationand amortization, are included in other assets.

 

**Borrowings**

 

The Company finances the acquisition of itsinvestments, including loans, residential mortgage-backed securities, andsecurities available-for-sale, primarily through the use of secured borrowingsin the form of securitization transactions structured as secured financings,repurchase agreements and other secured and unsecured borrowings. The Companyrecognizes interest expense on all borrowings on an accrual basis.

 

**Residential Mortgage-Backed Securities Issued**

** **

EffectiveJanuary 1, 2007, the Company adopted SFAS No. 159 and elected theoption to carry its residential mortgage-backed securities issued at estimatedfair value, with unrealized gains and losses reported in income. 

 

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**Trust Preferred Securities**

 

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

 

**Derivative Financial Instruments**

 

The Company recognizes all derivatives atestimated fair value. On the date the Company enters into a derivativecontract, the Company designates and documents each derivative contract as oneof the following at the time the contract is executed: (i) a hedge of arecognized asset or liability (“fair value” hedge); (ii) a hedge of aforecasted transaction or of the variability of cash flows to be received orpaid related to a recognized asset or liability (“cash flow” hedge);(iii) a hedge of a net investment in a foreign operation; or (iv) aderivative instrument not designated as a hedging instrument (“free-standingderivative”). For a fair value hedge, the Company records changes in theestimated fair value of the derivative and, to the extent that it is effective,changes in the fair value of the hedged asset or liability attributable to thehedged risk, in the current period earnings in the same financial statementcategory as the hedged item. For a cash flow hedge, the Company records changesin the estimated fair value of the derivative to the extent that it iseffective in other comprehensive (loss) income. The Company subsequentlyreclassifies these changes in estimated fair value to net income in the sameperiod(s) that the hedged transaction affects earnings in the samefinancial statement category as the hedged item. For free-standing derivatives,the Company reports changes in the fair values in current period other income.

 

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

 

**Foreign Currency**

 

The Company makes investments in non-U.S. 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 investment. In order to reduce thecurrency risk, the Company may hedge the applicable foreign currency. Allinvestments denominated in a foreign currency are converted to the U.S. dollarusing prevailing exchange rates on the balance sheet date. Income, expenses,gains and losses on investments denominated in a foreign currency are convertedto the U.S. dollar using the prevailing exchange rates on the dates when theyare recorded. Foreign exchange gains and losses are recorded in the condensedconsolidated statements of operations.

 

**Manager Compensation**

 

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

 

**Share-Based Compensation**

 

The Company accounts for share-basedcompensation issued to its directors and to its Manager using the fair valuebased methodology prescribed by SFAS No. 123(R), *Share-Based Payment* (“SFASNo. 123(R)”). Compensation cost related to restricted common shares issuedto the Company’s directors is measured at its estimated fair value at the grantdate, and is amortized and expensed over the vesting period on a straight-linebasis. Compensation cost related to restricted common shares and common shareoptions issued to the Manager is initially measured at estimated fair value atthe grant date, and is remeasured on subsequent dates to the extent the awardsare unvested. The Company has elected to use the graded vesting 

 

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attribution and straight-line method pursuant to SFASNo. 123(R) to amortize compensation expense for the restricted commonshares and common share options granted to the Manager.

 

**Income Taxes**

 

The Company is no longer treated as a REITfor U.S. federal income tax purposes; however, the Company intends to continueto operate so as to qualify as a partnership, and not as an association orpublicly traded partnership that is taxable as a corporation, for U.S. federalincome tax purposes. Therefore, the Company is not subject to U.S. federalincome tax at the entity level, but is subject to limited state income taxes.Holders of the Company’s shares will be required to take into account theirallocable share of each item of the Company’s income, gain, loss, deduction,and credit for the taxable year of the Company ending within or with theirtaxable year.

 

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

 

KKR TRS Holdings, Ltd. (“TRS Ltd.”)and KKR Financial Holdings, Ltd. (“KFH Ltd.”) are not consolidated for U.S. federalincome tax purposes. For financial reporting purposes, current and deferredtaxes are provided for on the portion of earnings recognized by the Companywith respect to its interest in KFN PEI VII, LLC (“PEI VII”), a domestictaxable corporate subsidiary, because it is taxed as a regularsubchapter C corporation under the provisions of the Code. Deferred incometax assets and liabilities are computed based on temporary differences betweenthe GAAP consolidated financial statements and the U.S. federal income taxbasis of assets and liabilities as of each consolidated balance sheet date. CLO2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1 and CLO 2007-A are foreignsubsidiaries treated as disregarded entities or partnerships for U.S. federalincome tax purposes that were established to facilitate securitizationtransactions, structured as secured financing transactions, and TRS Ltd.and KFH Ltd. are foreign taxable corporate subsidiaries that were formed tomake certain foreign and domestic investments from time to time. TRS Ltd. andKFH Ltd. are organized as exempted companies incorporated with limitedliability under the laws of the Cayman Islands, and are generally exempt fromU.S. federal and state income tax at the corporate entity level because theyrestrict their activities in the U.S. to trading in stock and securities fortheir own account. However, the Company will generally be required to includetheir current taxable income in its calculation of its taxable income allocableto shareholders.

 

**Earnings Per Share**

 

In accordance with SFAS No. 128, *Earnings per Share* (“SFAS No. 128”),the Company presents both basic and diluted earnings per common share (“EPS”)in its condensed consolidated financial statements and footnotes thereto. Basicearnings per common share (“Basic EPS”) excludes dilution and is computed bydividing net income or loss by the weighted-average number of common shares,including vested restricted common shares, outstanding for the period. Dilutedearnings per share (“Diluted EPS”) reflects the potential dilution of commonshare options and unvested restricted common shares using the treasury method,and the potential dilution of convertible senior notes using the if-convertedmethod, if they are not anti-dilutive. See Note 4 for earnings per commonshare computations.

 

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

 

**Recent Accounting Pronouncements**

 

In February 2008, the FASBissued FASB Staff Position (“FSP”) SFAS No. 140-3, *Accountingfor Transfers of Financial Assets and Repurchase Financing Transactions*(“FSPSFAS No. 140-3”). FSP SFAS No. 140-3 assumes that an initial transferof a financial asset and a repurchase financing are considered part of the samearrangement, or a linked transaction. However, if certain criteria are met, theinitial transfer and repurchase financing shall not be evaluated as a linkedtransaction and shall be evaluated separately under SFAS No. 140. FSP SFASNo. 140-3 is effective for the Company for 

 

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repurchase financings in whichthe initial transfer is entered into after December 31, 2008and early adoption is not permitted. TheCompany does not expect the adoption of FSP SFAS No. 140-3 to have a materialimpact on its financial statements.

 

In March 2008, the FASBissued SFAS No. 161, *Disclosures aboutDerivative Instruments and Hedging Activities, an Amendment of FASB StatementNo. 133*(“SFAS No. 161”). SFAS No. 161 requiresenhanced qualitative disclosures about objectives and strategies for usingderivatives, quantitative disclosures about fair value amounts of gains andlosses on derivative instruments, and disclosures about credit-risk-relatedcontingent features in derivative agreements. The additional disclosures required by SFAS No. 161 must beincluded in the Company’s financial statements beginning with the first quarterof 2009.

 

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

 

In May 2008, FASB issued SFASNo. 163, *Accounting for Financial Guarantee InsuranceContracts – an interpretation of FASB Statement No. 60*(“SFASNo. 163”). SFAS No. 163 requires recognition of an insurance claimliability prior to an event of default (insured event) when there is evidencethat credit deterioration has occurred in an insured financial obligation. SFASNo. 163 is effective for financial statements issued for fiscal yearsbeginning after December 15, 2008 and all interim periods within thosefiscal years, and early application is not permitted. The Company does notexpect the adoption of SFAS No. 163 to have a material impact on itsfinancial statements.

 

In October 2008, FASB issued FSP SFAS No.157-3, *Determining the Fair Value of a Financial Assetwhen the Market for that Asset is Not Active* (“FSP SFAS No. 157-3”).FSP SFAS No. 157-3 is intended to enhance the comparability and consistency infair value measurements of financial assets that trade in inactive markets andincludes illustrative examples addressing how assumptions should be consideredwhen measuring fair value when relevant observable inputs do not exist, as wellas how market quotes and available observable inputs in an inactive market shouldbe considered when assessing and measuring fair value. FSP SFAS No. 157-3 iseffective upon issuance and includes prior periods for which financialstatements have not been issued. The Company has taken FSP SFAS No. 157-3 intoconsideration when measuring the fair value of its assets and liabilities. 

 

**Note 3. Discontinued Operations**

 

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

 

As ofJune 30, 2008, the Company substantially completed its plan to exit itsresidential mortgage investment operations through the sale of certain of itsresidential mortgage-backed securities in the third quarter of 2007 and theagreement with the Noteholders related to the Facilities described above. Inaddition, on June 30, 2008, the Company completed the sale of a controllinginterest in the REIT Subsidiary to Rock Capital 2 LLC, which did not result ina gain or loss. Accordingly, the REIT Subsidiary is presented asdiscontinued operations for financial statement purposes for all periodspresented.

 

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The Company no longer deemsa sale or transfer of its remaining residential mortgage portfolio to beprobable in the near term. As such, the Company’s remaining residentialmortgage investment operations, which were previously presented as discontinuedoperations, are presented as continuing operations and the associated priorperiod amounts presented in the Company’s condensed consolidated financialstatements relating to the Company’s existing residential mortgage assets andliabilities as of September 30, 2008 have been reclassified for comparativepresentation.

 

As of September 30, 2008, the Company’s remaining residential mortgageportfolio consisted of $310.4 million of RMBS, of which $277.2 million wasrated investment grade or higher and $33.2 million was rated below investmentgrade. Of the $310.4 million of RMBS, $197.4 million represented interests inresidential mortgage securitization trusts that were not structured as QSPEs.  TheCompany consolidates these trusts because it is the primary beneficiary ofthese entities and therefore reported total assets of $3.1 billion and totalliabilities of $2.9 billion for these trusts in continuing operations as of September30, 2008.

 

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

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

 

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

 

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

 
| ** **                                 | ** ** | **Three months ended** | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** | **Nine months ended** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                 | ** ** | **September 30, 2008**      | ** ** | **September 30, 2007**      | ** ** | **September 30, 2008**     | ** ** | **September 30, 2007**     | ** ** |
| Net investment (loss) income               |       | $                                | —     |                             | $          | (14,480                         | )     | $                               | 16,795     |   | $ | (3,512 | ) |
| Other loss                                 |       | —                           |       | (148,250                         | )          | (5,361                          | )          | (161,252                        | )          |
| Non-investment expenses                    |       | —                           |       | (137,375                         | )          | (8,766                          | )          | (138,291                        | )          |
| (Loss) income from discontinued operations |       | $                                | —     |                             | $          | (300,105                        | )          | $                               | 2,668      |   | $ | (303,055 | ) |

** **

**Note 4. Earnings per Share**

 

The Company calculates basic net income percommon share by dividing net income for the period by the weighted-average numberof its common shares outstanding for the period. Diluted net income per commonshare is calculated by dividing net income by the weighted-average number ofcommon shares plus potentially dilutive common shares outstanding during theperiod. Potentially dilutive common shares include the assumed exercise ofoutstanding common share options and assumed vesting of outstanding restrictedcommon shares using the treasury stock method, as well as the assumedconversion of convertible senior notes using the if-converted method, if theyare not anti-dilutive.

 

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

 
| ** **                                                                               | ** ** | **Three months ended **

**September 30,** | ** ** | **Nine months ended **

**September 30,** | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                               | ** ** | **2008**                                                  | ** ** | **2007**                                                 | ** ** | **2008** | ** ** | **2007** | ** ** |
| Income from continuing operations                                                        |       | $                                                         | 48,990     |                                                     | $          | 38,598 |   | $ | 97,867 |   | $ | 142,943 |   |
| (Loss) income from discontinued operations                                               |       | —                                                    |       | (300,105                                                 | )          | 2,668 |   | (303,055 | ) |
| Net income (loss)                                                                        |       | $                                                         | 48,990     |                                                     | $          | (261,507 | )  | $ | 100,535 |   | $ | (160,112 | ) |
|                                                                                     |       |                                                      |       |                                                     |       |   |   |   |   |
| **Basic:**                                                                               |       |                                                      |       |                                                     |       |   |   |   |   |
| Basic weighted-average shares outstanding                                                |       | 149,612                                                   |       | 87,443                                                   |       | 136,777 |   | 81,692 |   |
| Income per share from continuing operations                                              |       | $                                                         | 0.33       |                                                     | $          | 0.44 |   | $ | 0.72 |   | $ | 1.75 |   |
| (Loss) income per share from discontinued  operations                                    |       |                                                      | —     |                                                     |       | (3.43 | ) |   | 0.02 |   |   | (3.71 | ) |
| Net income (loss) per share                                                              |       | $                                                         | 0.33       |                                                     | $          | (2.99 | ) | $ | 0.74 |   | $ | (1.96 | ) |
|                                                                                     |       |                                                      |       |                                                     |       |   |   |   |   |
| **Diluted:**                                                                             |       |                                                      |       |                                                     |       |   |   |   |   |
| Basic weighted-average shares outstanding                                                |       | 149,612                                                   |       | 87,443                                                   |       | 136,777 |   | 81,692 |   |
| Dilutive effect of share options and  restricted common shares using the treasury method |       | 271                                                       |       | 253                                                      |       | 542 |   | 1,055 |   |
| Diluted weighted-average shares outstanding  (1)                                         |       | 149,883                                                   |       | 87,696                                                   |       | 137,319 |   | 82,747 |   |
| Income per share from continuing operations                                              |       | $                                                         | 0.33       |                                                     | $          | 0.44 |   | $ | 0.71 |   | $ | 1.73 |   |
| (Loss) income per share from discontinued  operations                                    |       |                                                      | —     |                                                     |       | (3.42 | ) |   | 0.02 |   |   | (3.66 | ) |
| Net income (loss) per share                                                              |       | $                                                         | 0.33       |                                                     | $          | (2.98 | ) | $ | 0.73 |   | $ | (1.93 | ) |
|                                                                                          |            |                                                           |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

** **

**Note 5. Securities Sold, Not YetPurchased**

 

Securities sold, not yet purchased consist ofequity and debt securities that the Company has sold short. As of September 30,2008, the Company had securities sold, not yet purchased with a cost basis of$101.3 million and accumulated net unrealized gain of $17.8 million.As of December 31, 2007, the Company had securities sold, not yetpurchased with a cost basis of $103.1 million and accumulated netunrealized gain of $2.7 million.

 

For the three and nine months ended September30, 2008, the Company had net realized gains on securities sold, not yetpurchased of $0.7 million and $7.8 million, respectively, and netunrealized gains on securities sold, not yet purchased of $13.5 millionand $15.1 million, respectively. For the three and nine months ended September30, 2007, the Company had net realized gains on securities sold, not yetpurchased of $5.2 million and $5.3 million, and net unrealized losses onsecurities sold, not yet purchased of $2.9 million and $2.5 million,respectively.

 

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

 

The following table summarizes the Company’ssecurities classified as available-for-sale as of September 30, 2008, which arecarried at estimated fair value (amounts in thousands):

 
| **Description**              | ** ** | **Amortized Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated Fair   Value** | ** ** |
|------------------------------|------------|-------------------------|------------|------------------------------|------------|-------------------------------|------------|--------------------------------------|------------|
| Corporate debt securities    |       | $                       | 1,359,501  |                         | $          | 2,296                         |       | $                                    | (344,098   | ) | $ | 1,017,699 |   |
| Marketable equity securities |       | 17,322                  |       | 115                          |       | (11,860                       | )          | 5,577                                |       |
| Total                        |       | $                       | 1,376,823  |                         | $          | 2,411                         |       | $                                    | (355,958   | ) | $ | 1,023,276 |   |

 

The following table shows the grossunrealized losses and estimated fair value of the Company’s available-for-salesecurities, aggregated by length of time that the individual securities havebeen in a continuous unrealized loss position, as of September 30, 2008(amounts in thousands):

 
| ** **                   | ** ** | **Less Than 12 months** | ** ** | **12 Months or More** | ** ** | **Total**                      | ** ** |
|------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|--------------------------------|------------|
| **Description**              | ** ** | **Estimated Fair   Value**   | ** ** | **Unrealized  Losses**               | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| Corporate debt securities    |       | $                                      | 512,393    |                                 | $          | (63,530                        | )          | $ | 407,058 |   | $ | (280,568 | ) | $ | 919,451 |   | $ | (344,098 | ) |
| Marketable equity securities |       | 1,282                                  |       | (1,379                               | )          | 3,711                          |       | (10,481 | ) | 4,993 |   | (11,860 | ) |
| Total                        |       | $                                      | 513,675    |                                 | $          | (64,909                        | )          | $ | 410,769 |   | $ | (291,049 | ) | $ | 924,444 |   | $ | (355,958 | ) |

 

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Theunrealized losses in the above table exclude investments in common andpreferred stock that are deemed to be other-than-temporarily impaired by $20.3million. This amount consists of impairment charges that the Company recognizedduring the third quarter of 2008 totaling $10.6 million for certain publiclytraded preferred and common stock investments. The remainder of the $20.3million relates to an impairment charge recorded during the second quarter of2008 totaling $9.7 million for a preferred stock investment. The chargesrelating to the impairment of these securities were recognized in net realizedand unrealized (loss) gain on investments in the condensed consolidatedstatements of operations. 

 

Whenevaluating whether an impairment is other-than-temporary, the Company performsan analysis of the anticipated future cash flows and the Company’s ability andintent to hold the investment for a sufficient amount of time to recover theunrealized losses. Additionally, the Company considers the current eventsspecific to the issuer or industry including widening credit spreads andexternal credit ratings, as well as interest rate volatility.

 

The unrealized losses in the above table areconsidered to be temporary impairments due to market factors and are notreflective of credit deterioration. The Company has performed credit analysesin relation to these investments and believes the carrying value of theseinvestments to be fully recoverable over their expected holding period. Becausethe Company has the intent and ability to hold these investments untilrecovery, the unrealized losses are not considered to be other-than-temporaryimpairments.

 

The following table summarizes the Company’ssecurities classified as available-for-sale as of December 31, 2007, whichare carried at estimated fair value (amounts in thousands):

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

 

The following table shows the grossunrealized losses and estimated fair value of the Company’s available-for-salesecurities, aggregated by length of time that the individual securities havebeen in a continuous unrealized loss position, as of December 31, 2007(amounts in thousands):

 
| ** **                   | ** ** | **Less Than 12 months** | ** ** | **12 Months or More** | ** ** | **Total**                      | ** ** |
|------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|--------------------------------|------------|
| **Description**              | ** ** | **Estimated  Fair Value**         | ** ** | **Unrealized  Losses**               | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| Corporate debt securities    |       | $                                      | 1,075,296  |                                 | $          | (134,969                       | )          | $ | — |   | $ | — |   | $ | 1,075,296 |   | $ | (134,969 | ) |
| Marketable equity securities |       | 35,402                                 |       | (7,664                               | )          | 9,321                          |       | (3,112 | ) | 44,723 |   | (10,776 | ) |
| Total                        |       | $                                      | 1,110,698  |                                 | $          | (142,633                       | )          | $ | 9,321 |   | $ | (3,112 | ) | $ | 1,120,019 |   | $ | (145,745 | ) |

 

The unrealized losses in the above tableexclude one investment in a corporate security that was deemed to be another-than-temporary impairment of $5.9 million. The decline in fair valuewas deemed to be other-than-temporary in the fourth quarter of 2007 based onthe Company’s intent to sell the security during 2008. This corporate securitywas sold during the first quarter 2008 at approximately the same value it wascarried at as of December 31, 2007. 

 

All other unrealized losses in the tableabove are considered to be temporary impairments due to market factors and arenot reflective of credit deterioration. The Company has performed creditanalyses in relation to these investments and believes the carrying value ofthese investments to be fully recoverable over their expected holding period.Because the Company has the intent and ability to hold these investments untilrecovery, the related unrealized losses are not considered to beother-than-temporary impairments.

 

During the three and nine months endedSeptember 30, 2008, the Company had gross realized gains from the sales ofsecurities available-for-sale of $0.6 million and $5.2 million, respectively,and gross realized losses from the sales of securities available-for-sale of$7.7 million and $22.4 million, respectively. During the three andnine months ended September 30, 2007, the Company had gross realized gains fromthe sales of securities available-for-sale of $3.8 million and $35.7 million,respectively, and gross realized losses from the sales of securitiesavailable-for-sale of $2.6 million and $4.8 million, 

 

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respectively. Note 10 to these condensed consolidated financialstatements describes the Company’s borrowings under which the Company haspledged securities available-for-sale. The following table summarizes theestimated fair value of securities available-for-sale pledged as collateral forborrowings as of September 30, 2008 (amounts in thousands):

 
| ** **                                                                                                            | ** ** | **Corporate Debt  Securities** | ** ** | **Marketable  Equity  Securities** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------------|------------|
| Pledged as collateral for borrowings under  secured revolving credit facility                                         |       | $                              | 222,733    |                               | $          | — |   |
| Pledged as collateral for collateralized  loan obligation senior secured notes and junior secured notes to affiliates |       | 705,464                        |       | —                             |       |
| Pledged as collateral for subordinated  notes to affiliates                                                           |       | 79,907                         |       | —                             |       |
| Total                                                                                                                 |       | $                              | 1,008,104  |                               | $          | — |   |

 

The following table summarizes the estimatedfair value of securities pledged as collateral for borrowings as ofDecember 31, 2007 (amounts in thousands):

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

 

**Note 7. Corporate Loans and Allowancefor Loan Losses**

 

The following table summarizes the Company’scorporate loans as of September 30, 2008 and December 31, 2007 (amounts inthousands):

 
| ** **                             | ** ** | **As of September 30, 2008** | ** ** | **As of December 31, 2007** | ** ** |
|----------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------------|------------|
| Corporate loans, at net amortized cost |       | $                                           | 8,493,531  |                                            | $          | 8,659,208 |   |
| Less: allowance for loan losses        |       | (35,000                                     | )          | (25,000                                         | )          |
| Total                                  |       | $                                           | 8,458,531  |                                            | $          | 8,634,208 |   |

 

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

 
| ** **                              | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| **Description**                         | ** ** | **Principal**               | ** ** | **Net  Unamortized  Discount**  | ** ** | **Estimated  Fair  Value  Adjustment** | ** ** | **Net Carrying  Value** | ** ** | **Principal** | ** ** | **Net  Unamortized  Discount** | ** ** | **Net Carrying  Value** | ** ** |
| Corporate loans held for investment (1) |       | $                           | 8,752,586  |                            | $          | (259,055 | ) | $ | — |   | $ | 8,493,531 |   | $ | 8,766,169 |   | $ | (106,961 | ) | $ | 8,659,208 |   |
| Corporate loans held for sale           |       | 31,151                      |       | (597                            | )          | (2,353 | ) | 28,201 |   | — |   | — |   | — |   |
| Total loans                             |       | $                           | 8,783,737  |                            | $          | (259,652 | ) | $ | (2,353 | ) | $ | 8,521,732 |   | $ | 8,766,169 |   | $ | (106,961 | ) | $ | 8,659,208 |   |

 

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(1)               Excludes allowancefor loan losses of $35.0 million and $25.0 million as of September 30, 2008 andDecember 31, 2007, respectively.

 

As of September 30, 2008, approximately $28.2million of corporate loans were classified as held for sale.  The Company recorded a $2.4 million charge toearnings in net realized and unrealized (loss) gain on investments related tothese loans to adjust their carrying value to the lower of cost or estimatedfair value. The Company had no corporate loans held for sale as ofDecember 31, 2007.  Note 10 tothese condensed consolidated financial statements describes the Company’sborrowings under 

 

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which the Company has pledged loans for borrowings. The following tablesummarizes the carrying value of corporate loans, at net amortized cost,pledged as collateral for borrowings as of September 30, 2008 andDecember 31, 2007 (amounts in thousands):

 
| ** **                                                                                                            | ** ** | **As of September 30, 2008** | ** ** | **As of December 31, 2007** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------------|------------|
| Pledged as collateral for borrowings under  repurchase agreements                                                     |       | $                                           | —     |                                            | $          | 1,994,999 |   |
| Pledged as collateral for borrowings under  secured revolving credit facility                                         |       | 41,480                                      |       | 48,142                                          |       |
| Pledged as collateral for collateralized  loan obligation senior secured notes and junior secured notes to affiliates |       | 6,568,571                                   |       | 6,276,882                                       |       |
| Pledged as collateral for subordinated  notes to affiliates                                                           |       | 493,959                                     |       | 27,886                                          |       |
| Total                                                                                                                 |       | $                                           | 7,104,010  |                                            | $          | 8,347,909 |   |

 

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

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

 

The $35.0 million allowance for loan lossesis unallocated as of September 30, 2008 because the Company has not deemed anyindividual loans as being impaired as of that date. A provision for loan lossesof $10.0 million and $25.0 million was recorded during the nine months endedSeptember 30, 2008 and 2007, respectively. 

 

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

 

Uponadoption of SFAS No. 159 as of January 1, 2007, the Company electedthe option of carrying its investments in RMBS at estimated fair value. As of September 30, 2008 and December 31, 2007, RMBS totaled $113.0million and $131.7 million, respectively.

 

Note10 to these condensed consolidated financial statements describes the Company’sborrowings under which the Company has pledged RMBS. The followingtable summarizes the estimated fair value of RMBS pledged as collateral under repurchase agreements and asecured revolving credit facility as of September 30, 2008 andDecember 31, 2007 (amounts in thousands):

 
| ** **                                                                    | ** ** | **As of**

**September 30, 2008** | ** ** | **As of December 31, 2007** | ** ** |
|-------------------------------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| Pledged as collateral for borrowings under  repurchase agreements             |       | $                                      | —     |                                  | $          | 112,465 |   |
| Pledged as collateral for borrowings under  secured revolving credit facility |       | 71,509                                 |       | 5,368                                 |       |
| Total                                                                         |       | $                                      | 71,509     |                                  | $          | 117,833 |   |

 

**Note 9. Residential Mortgage Loans**

 

The following table summarizes the Company’sresidential mortgage loans as of September 30, 2008 and December 31, 2007(amounts in thousands):

** **
| ** **                                               | ** ** | **As of**

**September 30, 2008** | ** ** | **As of December 31, 2007** | ** ** |
|----------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| Residential mortgage loans, at estimated  fair value (1) |       | $                                      | 3,054,756  |                                  | $          | 3,921,323 |   |
|                                                          |            |                                        |            |                                       |            |  |  |

 

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(1)               Excludes realestate owned (“REO”) by the Company as a result of foreclosure on delinquentloans of $10.9 million and $7.2 million as of September 30, 2008 andDecember 31, 2007, respectively. REO is recorded within other assets onthe Company’s condensed consolidated balance sheets.

 

The following table summarizes the estimatedfair value of residential mortgage loans pledged as collateral for borrowingsas of September 30, 2008 and December 31, 2007 (amounts in thousands):

 
| ** **                                                                    | ** ** | **As of September 30, 2008** | ** ** | **As of December 31, 2007** | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------------------|------------|---------------------------------------|------------|
| Pledged as collateral for borrowings under  repurchase agreements             |       | $                                 | —     |                                  | $          | 163,586 |   |
| Pledged as collateral for borrowings under  secured revolving credit facility |       | 151,454                           |       | 25,162                                |       |
| Total                                                                         |       | $                                 | 151,454    |                                  | $          | 188,748 |   |

 

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

 
| ** **                  | ** ** | **As of September 30, 2008** | ** ** | **As of December 31, 2007** | ** ** |
|-----------------------------|------------|-----------------------------------|------------|---------------------------------------|------------|
| **Delinquency Status** | ** ** | **Number of  Loans**         | ** ** | **Principal  Amount**                 | ** ** | **Number of  Loans** | ** ** | **Principal  Amount** | ** ** |
| 30 to 59 days          |       | 76                                |       | $                                     | 28,793     |   | 96 |   | $ | 30,163 |   |
| 60 to 89 days          |       | 22                                |       | 7,440                                 |       | 18 |   | 6,151 |   |
| 90 days or more        |       | 60                                |       | 22,361                                |       | 43 |   | 14,045 |   |
| In foreclosure              |       | 58                                |       | 20,665                                |       | 38 |   | 11,800 |   |
| Total                       |       | 216                               |       | $                                     | 79,259     |   | 195 |   | $ | 62,159 |   |

 

As of September 30, 2008,the loss exposure or uncollected principal amount related to the Company’sdelinquent residential mortgage loans in the table above exceeded their fairvalue by $3.3 million. As of September 30, 2008, 31 of the residential mortgageloans owned by the Company with an outstanding balance of $10.9 million (notincluded in the table above) were REO as a result of foreclosure on delinquentloans. As of December 31, 2007, 25 of the residential mortgage loans ownedby the Company with an outstanding balance of $7.2 million (not included in thetable above) were REO as a result of foreclosure on delinquent loans.

 

**Note 10. Borrowings**

 

Certain information with respect to theCompany’s borrowings as of September 30, 2008 is summarized in the followingtable (dollar amounts in thousands):

 
| ** **                                        | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted-  Average  Borrowing  Rate** | ** ** | **Weighted-  Average  Remaining  Maturity (in  days)** | ** ** | **Estimated  Fair Value  of Collateral(1)** | ** ** |
|---------------------------------------------------|------------|-----------------------------|------------|-----------------------------------------|------------|-------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Secured revolving credit facility(2)              |       | $                           | 378,306    |                                    | 4.92       | %                                                           | 266        |                                                  | $          | 487,176 |   |
| CLO 2005-1 senior secured notes                   |       | 831,876                     |       | 3.12                                    |       | 3,130                                                       |       | 770,546                                               |       |
| CLO 2005-2 senior secured notes                   |       | 808,496                     |       | 3.12                                    |       | 3,344                                                       |       | 809,387                                               |       |
| CLO 2006-1 senior secured notes                   |       | 727,500                     |       | 3.17                                    |       | 3,616                                                       |       | 811,823                                               |       |
| CLO 2007-1 senior secured notes                   |       | 2,368,500                   |       | 3.33                                    |       | 4,610                                                       |       | 2,225,518                                             |       |
| CLO 2007-1 junior secured notes to  affiliates(3) |       | 431,292                     |       | —                                  |       | 4,610                                                       |       | 405,256                                               |       |
| CLO 2007-A senior secured notes                   |       | 1,213,300                   |       | 3.66                                    |       | 3,302                                                       |       | 1,161,480                                             |       |
| CLO 2007-A junior secured notes to  affiliates(4) |       | 94,128                      |       | —                                  |       | 3,302                                                       |       | 90,108                                                |       |
| Wayzata senior secured notes                      |       | 1,600,000                   |       | 3.60                                    |       | 1,507                                                       |       | 1,495,281                                             |       |
| Convertible senior notes                          |       | 300,000                     |       | 7.00                                    |       | 1,384                                                       |       | —                                                |       |
| Junior subordinated notes                         |       | 288,671                     |       | 6.53                                    |       | 10,210                                                      |       | —                                                |       |
| Subordinated notes to affiliates(5)               |       | 84,000                      |       | —                                  |       |                                                        |       | 78,502                                                |       |
| Total                                             |       | $                           | 9,126,069  |                                    |       |                                                        |       |                                                  | $          | 8,335,077 |   |

 

----

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

 

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

 

(3)                                CLO2007-1 junior secured notes to affiliates consists of(x) $244.7 million of mezzanine notes with a weighted-averageborrowing rate of 7.66% and (y) $186.6 million of subordinated notesthat do not have a contractual coupon rate, but instead receive a pro rataamount of the net distributions from CLO 2007-1.

 

(4)                                CLO2007-A junior secured notes to affiliates consists of(x) $79.0 million of mezzanine notes with a weighted-averageborrowing rate of 8.94% and (y) $15.1 million of subordinated notesthat do not have a contractual coupon rate, but instead receive a pro rataamount of the net distributions from CLO 2007-A.

 

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

 

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In the third quarter of 2008, the Companyretired $5.0 million of junior subordinated notes, which resulted in a gain onextinguishment of $3.1 million, partially offset by a $0.2 million write-off ofunamortized debt issuance costs and $0.1 million of other associated costs. 

 

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

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

 

----

(1)                                  Collateralfor borrowings consists of residentialmortgage-backed securities, securities available-for-sale and corporate andresidential mortgage loans.

 

 (2)                               Includes repurchaseagreements of $544.5 million collateralized by retained rated mezzaninenotes and unrated subordinated notes issued by the Company’s CLO subsidiaries.

 

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

 

(4)                                  CLO2007-1 junior secured notes to affiliates consists of(x) $244.7 million of mezzanine notes with a weighted-averageborrowing rate of 9.72% and (y) $186.6 million of subordinated notesthat do not have a contractual coupon rate, but instead receive a pro rataamount of the net distributions from CLO 2007-1.

 

(5)                                  CLO2007-A junior secured notes to affiliates consists of(x) $79.0 million of mezzanine notes with a weighted-averageborrowing rate of 10.87% and (y) $15.1 million of subordinated notesthat do not have a contractual coupon rate, but instead receive a pro rataamount of the net distributions from CLO 2007-A.

 

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

 

**Note 11. Derivative FinancialInstruments**

 

The Company enters into derivativetransactions in order to hedge its interest rate risk exposure to the effectsof interest rate changes. Additionally, the Company enters into derivativetransactions in the course of its investing. The Company’s derivativetransactions are with various counterparties, none of which are concentrated tothe extent of detrimentally affecting the Company’s financial condition orresults of operations. 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 Fair Value Hedges**

 

The Company uses interest rate derivativesconsisting of swaps to hedge a portion of the interest rate risk associatedwith its borrowings under CLO senior secured notes. The Company designatesthese financial instruments as cash flow hedges. 

 

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The Company also uses interest rate swaps to hedge all or a portion ofthe interest rate risk associated with certain fixed interest rate investments.The Company designates these financial instruments as fair value hedges.

 

**Free-Standing Derivatives**

 

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

 

The table below summarizes the aggregatenotional amount and estimated net fair value of the derivative instruments asof September 30, 2008 and December 31, 2007 (amounts in thousands):

 
| ** **                      | ** ** | **As of   September 30, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|---------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **Notional**                                  | ** ** | **Estimated  Fair Value**              | ** ** | **Notional** | ** ** | **Estimated  Fair Value** | ** ** |
| **Cash Flow Hedges:**           |       |                                          |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | $                                             | 383,333    |                                        | $          | (24,168 | ) | $ | 383,333 |   | $ | (19,018 | ) |
| **Fair Value Hedges:**          |       |                                          |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | 32,000                                        |       | (1,777                                      | )          | 32,000 |   | (1,212 | ) |
| **Free-Standing Derivatives:**  |       |                                          |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | 181,073                                       |       | (13                                         | )     | 690,799 |   | (7,959 | ) |
| Credit default swaps—long  |       | 53,500                                        |       | (1,063                                      | )          | 66,000 |   | (1,154 | ) |
| Credit default swaps—short |       | 300,070                                       |       | 48,168                                      |       | 268,000 |   | 12,613 |   |
| Total rate of return swaps      |       | 416,597                                       |       | (51,864                                     | )          | 442,204 |   | (21,998 | ) |
| Foreign exchange contracts      |       | 64,380                                        |       | (1,093                                      | )          | 9,711 |   | 3 |   |
| Common stock warrants           |       | —                                        |       | 77                                          |       | — |   | 799 |   |
| Total                           |       | $                                             | 1,430,953  |                                        | $          | (31,733 | ) | $ | 1,892,047 |   | $ | (37,926 | ) |

 

For all hedges where hedge accounting isbeing applied, effectiveness testing and other procedures to ensure the ongoingvalidity of the hedges are performed at least quarterly. During the three andnine months ended September 30, 2008 and September 30, 2007, the Companyrecognized an immaterial amount of ineffectiveness in income on the condensedconsolidated statements of operations.

 

**Note 12. Accumulated Other ComprehensiveLoss**

 

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

 
| ** **                                                                                                                               | ** ** | **As of September 30, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------------|------------|
| Net unrealized losses on available-for-sale  securities                                                                                  |       | $                                      | (354,805   | )                                           | $          | (159,802 | ) |
| Net unrealized losses on cash flow hedges                                                                                                |       | (23,119                                | )          | (19,018                                     | )          |
| Transition adjustment to accumulated  deficit in conjunction with fair value option election for residential mortgage-backed  securities |       | —                                 |       | 21,575                                      |       |
| Accumulated other comprehensive loss                                                                                                     |       | $                                      | (377,924   | )                                           | $          | (157,245 | ) |

 

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The components of other comprehensive losswere as follows (amounts in thousands):

 
| ** **                                                                                                                                | ** ** | **Three months**       | ** ** | **Three months**       | ** ** | **Nine months**        | ** ** | **Nine months**        | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                | ** ** | **ended**                   | ** ** | **ended**                   | ** ** | **ended**                   | ** ** | **ended**                   | ** ** |
| ** **                                                                                                                                | ** ** | **September 30, 2008** | ** ** | **September 30, 2007** | ** ** | **September 30, 2008** | ** ** | **September 30, 2007** | ** ** |
| Unrealized losses on securities  available-for-sale:                                                                                      |       |                        |       |                        |       |                        |       |                        |       |
| Unrealized holding losses arising during  period                                                                                          |       | $                           | (188,065   | )                      | $          | (73,218                     | )          | $                           | (254,042   | ) | $ | (72,577 | ) |
| Translation adjustment to accumulated  deficit in conjunction with fair value option election for residential  mortgage-backed securities |       | —                      |       | —                      |       | —                      |       | 21,575                      |       |
| Reclassification adjustments for losses  (gains) realized in net income (1)                                                               |       | 17,667                      |       | (1,309                      | )          | 37,464                      |       | (30,457                     | )          |
| Unrealized losses on available-for-sale  securities from investment in unconsolidated affiliate                                           |       | —                      |       | —                      |       | —                      |       | (7,898                      | )          |
| Unrealized losses on securities  available-for-sale                                                                                       |       | (170,398                    | )     | (74,527                     | )          | (216,578                    | )          | (89,357                     | )          |
| Unrealized losses on cash flow hedges:                                                                                                    |       |                        |       |                        |       |                        |       |                        |       |
| Unrealized holding losses arising during  period                                                                                          |       | (4,940                      | )          | (35,469                     | )          | (4,101                      | )          | (25,391                     | )          |
| Reclassification adjustments for gains  realized in discontinued operations                                                               |       | —                      |       | (28,569                     | )          | —                      |       | (28,569                     | )          |
| Unrealized losses on cash flow hedges  arising during period                                                                              |       | (4,940                      | )          | (64,038                     | )          | (4,101                      | )          | (53,960                     | )          |
| Other comprehensive loss                                                                                                                  |       | $                           | (175,338   | )                           | $          | (138,565                    | )          | $                           | (220,679   | ) | $ | (143,317 | ) |

 

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(1) Amounts for the three and nine months ended September 30, 2008 include animpairment of $20.3 million for investments in common and preferred stocksecurities which were determined to be other-than-temporary.

 

**Note 13. Share Options and RestrictedShares**

 

The Company has adopted an amended andrestated share incentive plan (the “2007 Share Incentive Plan”) that providesfor the grant of qualified incentive common share options that meet therequirements of Section 422 of the Code, non-qualified common shareoptions, share appreciation rights, restricted common shares and othershare-based awards. The 2007 Share Incentive Plan was adopted on May 4,2007. Prior to the 2007 Share Incentive Plan, the Company had adopted the 2004Stock Incentive Plan that provided for the grant of qualified incentive commonstock options that met the requirements of Section 422 of the Code,non-qualified common stock options, stock appreciation rights, restrictedcommon stock and other share-based awards. The 2004 Stock Incentive Plan wasamended on May 26, 2005. The Compensation Committee of the board ofdirectors administers the plan. Share options and other share-based awards maybe granted to the Manager, directors, officers and any key employees of theManager and to any other individual or entity performing services for theCompany.

 

The exercise price for any share optiongranted under the 2007 Share Incentive Plan may not be less than 100% of thefair market value of the common shares at the time the common share option isgranted. Each option to acquire a common share must terminate no more than tenyears from the date it is granted. As of September 30, 2008, the 2007 ShareIncentive Plan authorizes a total of 8,339,625 shares that may be used tosatisfy awards under the 2007 Share Incentive Plan. On February 19, 2008,the Compensation Committee of the board of directors granted the Manager1,097,000 restricted common shares that vest on February 19, 2011. Thefollowing table summarizes restricted common share transactions:

 
| ** **                                     | ** ** | **Manager** | ** ** | **Directors** | ** ** | **Total** | ** ** |
|------------------------------------------------|------------|-------------|------------|---------------|------------|-----------|------------|
| **Unvested shares as of January 1, 2008** |       | 625,000     |       | 72,657        |       | 697,657   |       |
| Issued                                         |       | 1,097,000   |       | 38,349        |       | 1,135,349 |       |
| Vested                                         |       | (625,000    | )     | (41,885       | )          | (666,885  | )          |
| Cancelled                                      |       | —      |       | (2,839        | )          | (2,839    | )          |
| Forfeited                                      |       | —      |       | —        |       | —    |       |
| **Unvested shares as of September 30, 2008**   |       | 1,097,000   |       | 66,282        |       | 1,163,282 |       |

 

Pursuant to SFAS No. 123(R), the Companyis required to value any unvested restricted common shares granted to theManager at the current market price. The Company valued the unvested restrictedcommon shares granted to the Manager at $6.36 and $16.85 per share at September30, 2008 and September 30, 2007, respectively. There were $6.2 million and$3.7 million of total unrecognized compensation costs related to unvestedrestricted common shares granted as of September 30, 2008 and September 30,2007, respectively.

 

The following table summarizes common shareoption transactions:

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

 

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As of September 30, 2008 andDecember 31, 2007, 1,932,279 common share options were exercisable. As ofSeptember 30, 2008 and December 31, 2007, the common share options werefully vested and expire in August 2014. For the three and nine monthsended September 30, 2008 and 2007, the components of share-based compensationexpense are as follows (amounts in thousands):

 
| ** **                                      | ** ** | **For the three** | ** ** | **For the three** | ** ** | **For the nine**  | ** ** | **For the nine**  | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                      | ** ** | **months ended**       | ** ** | **months ended**       | ** ** | **months ended**       | ** ** | **months ended**       | ** ** |
| ** **                                      | ** ** | **September 30, 2008** | ** ** | **September 30, 2007** | ** ** | **September 30, 2008** | ** ** | **September 30, 2007** | ** ** |
| Options granted to Manager                      |       | $                           | —     |                        | $          | (192                        | )          | $                           | —     |   | $ | 246 |   |
| Restricted shares granted to Manager            |       | (195                        | )          | (4,389                      | )          | 462                         |       | 1,651                       |       |
| Restricted shares granted to certain  directors |       | 142                         |       | 178                         |       | 497                         |       | 392                         |       |
| Total share-based compensation expense          |       | $                           | (53        | )                           | $          | (4,403                      | )          | $                           | 959        |   | $ | 2,289 |   |

 

**Note 14. Management Agreement andRelated 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 theCompany’s outstanding common shares, based upon (1) unsatisfactoryperformance by the Manager that is materially detrimental to the Company or(2) a determination that the management fee payable by the Manager is notfair, subject to the Manager’s right to prevent such a termination under thisclause (2) by agreeing to a mutually acceptable reduction ofmanagement fees. The Manager must be provided 180 days prior notice of anysuch termination and will be paid a termination fee equal to four times the sumof the average annual base management fee and the average annual incentive feefor the two 12-month periods immediately preceding the date of termination,calculated as of the end of the most recently completed fiscal quarter prior tothe date of termination.

 

The Management Agreement contains certainprovisions requiring the Company to indemnify the Manager with respect to alllosses or damages arising from acts not constituting bad faith, willfulmisconduct, or gross negligence. The Company has evaluated the impact of theseguarantees on its condensed consolidated financial statements and determinedthat they are not material.

 

For the three and nine months ended September 30, 2008, theCompany incurred $8.7 million and $25.1 million, respectively, in basemanagement fees. In addition, the Company recognized share-based compensationexpense related to common share options and restricted common shares granted tothe Manager of $(0.2) million and $0.5 million, respectively, for thethree and nine months ended September 30, 2008 (see Note 13). TheCompany also reimbursed the Manager $2.5 million and $7.6 million,respectively, for expenses for the three and nine months endedSeptember 30, 2008. For the three and nine months ended September 30, 2007, the Company incurred $8.2 million and$22.5 million, respectively, in base management fees. In addition, the Companyrecognized share-based compensation expense related to common share options andrestricted common shares granted to the Manager of $(4.6) million and$1.9 million, respectively, for thethree and nine months ended September 30, 2007 (see Note 13). The Company also reimbursed the Manager $1.9million and $5.8 million, respectively, for expenses for the three and nine months ended September 30, 2007. Base management fees incurredand share-based compensation expense relating to common share options andrestricted common shares granted to the Manager are included in related partymanagement compensation on the consolidated statements of operations. Expensesincurred by the Manager and reimbursed by the Company are reflected in therespective condensed consolidated statements of operations, non-investmentexpense category based on the nature of the expense.

 

The Manager is waiving the receipt of basemanagement fees earned related to the $230.4 million common share offeringand $270.0 million common share rights offering that occurred during thethird quarter of 2007 until such time as the Company’s common share closingprice on the NYSE is $20.00 or more for five consecutive trading days.Accordingly, the Manager permanently waived the receipt of approximately$2.2 million and $6.6 million of base management fees earned during thethree and nine months ended September 30, 2008, respectively.

 

No incentive fees were earned by the Managerduring the three and nine months ended September 30, 2008 and for thethree months ended September 30, 2007, but $12.6 million was earned by theManager during the nine months ended September 30, 2007. An affiliate ofthe Manager has entered into separate management agreements with the respectiveinvestment vehicles for CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO2007-A and Wayzata and is entitled to receive fees for the services performedas collateral manager. The collateral manager has permanently waived fees ofapproximately $62.1 million and $18.6 million as of September 30,2008 and September 30, 2007, respectively. Beginning 

 

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April 15, 2007, an affiliate of the Manager ceased waiving feesfor CLO 2005-1 for the services performed as collateral manager. The Companyrecorded an expense of $1.3 million and $3.8 million for collateralmanagement fees for CLO 2005-1 for the three and nine months ended September30, 2008, respectively. The collateral manager evaluates such waivers on aquarterly basis and there are no assurances that the collateral manager willwaive such management fees subsequent to September 30, 2008.

 

The Company has invested in corporate loans and debt securities of entitiesthat are affiliates of KKR. As of September 30, 2008, the aggregate paramount of these affiliated investments totaled $3.7 billion, or approximately35% of the total investment portfolio, and consisted of 23 issuers. The total$3.7 billion in investments were comprised of $2.8 billion of corporate loans,$720.6 million of corporate debt securities available for sale, and $270.3million notional amount of corporate loans financed under total rate of returnswaps (included in derivative assets and liabilities on the condensedconsolidated balance sheet).

 

**Note 15. Fair Value Disclosure**

 

The following table presents informationabout the Company’s assets and liabilities (including derivatives that arepresented net) measured at fair value as of September 30, 2008, andindicates the fair value hierarchy of the valuation techniques utilized by theCompany to determine such fair value (amounts in thousands):

 
| ** **                                     | ** ** | **Quoted Prices in  Active Markets  for Identical Assets  (Level 1)** | ** ** | **Significant Other  Observable Inputs  (Level 2)** | ** ** | **Significant  Unobservable Inputs  (Level 3)** | ** ** | **Balance as of  September 30, 2008** | ** ** |
|------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|------------------------------------------------------|------------|
| **Assets:**                                    |       |                                                                                                |       |                                                               |       |                                                      |       |                                                 |       |
| Securities available-for-sale                  |       | $                                                                                                   | 5,577      |                                                               | $          | 900,256                                                   |       | $                                                    | 117,443    |   | $ | 1,023,276 |   |
| Residential mortgage-backed securities         |       | —                                                                                              |       | —                                                             |       | 112,980                                                   |       | 112,980                                              |       |
| Residential mortgage loans                     |       | —                                                                                              |       | —                                                             |       | 3,054,756                                                 |       | 3,054,756                                            |       |
| REO                                            |       | —                                                                                              |       | —                                                             |       | 10,857                                                    |       | 10,857                                               |       |
| Corporate loans held for sale                  |       | —                                                                                              |       | 28,201                                                             |       | —                                                    |       | 28,201                                               |       |
| Total                                          |       | $                                                                                                   | 5,577      |                                                               | $          | 928,457                                                   |       | $                                                    | 3,296,036  |   | $ | 4,230,070 |   |
| **Liabilities:**                               |       |                                                                                                |       |                                                               |       |                                                      |       |                                                 |       |
| Derivatives, net                               |       | $                                                                                                   | —     |                                                               | $          | 21,163                                                    |       | $                                                    | (52,896    | )  | $ | (31,733 | ) |
| Residential mortgage-backed securities  issued |       | —                                                                                              |       | —                                                             |       | (2,868,232                                                | )          | (2,868,232                                           | )          |
| Securities sold, not yet purchased             |       | (58,937                                                                                             | )          | (24,570                                                            | )     | —                                                    |       | (83,507                                              | )          |
| Total                                          |       | $                                                                                                   | (58,937    | )                                                                  | $          | (3,407                                                    | )          | $                                                    | (2,921,128 | ) | $ | (2,983,472 | ) |

 

The following table presents informationabout the Company’s assets and liabilities (including derivatives that arepresented net) measured at fair value as of December 31, 2007, andindicates the fair value hierarchy of the valuation techniques utilized by theCompany to determine such fair value (amounts in thousands):

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

 

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The following table presents additionalinformation about assets, including derivatives, that are measured at fairvalue for which the Company has utilized level 3 inputs to determine fairvalue, for the three months ended September 30, 2008 and 2007 (amounts inthousands):

 
| ** **                                                                                                                                                                                 | ** ** | **Three months ended September 30, 2008** | ** ** | **Three months ended  September  30, 2007** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                 | ** ** | **Securities   Available-  For-Sale**                         | ** ** | **Residential  Mortgage-  Backed  Securities**             | ** ** | **Residential  Mortgage   Loans** | ** ** | **REO** | ** ** | **Derivatives,  net** | ** ** | **Residential  Mortgage-  Backed  Securities  Issued** | ** ** | **Securities   Available-  For-Sale** | ** ** | **Derivatives,  net** | ** ** |
| Beginning balance as of July 1                                                                                                                                                        |       | $                                                                  | 45,343     |                                                       | $          | 115,652 |   | $ | 3,394,996 |   | $ | 8,919 |   | $ | 3,471 |   | $ | (3,204,392 | ) | $ | 57,000 |   | $ | 1,317 |   |
| Total gains or losses (realized and  unrealized):                                                                                                                                          |       |                                                               |       |                                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Included in earnings                                                                                                                                                                       |       | —                                                             |       | 1,621                                                      |       | (168,058 | )  | — |   | (16,625 | )  | 168,059 |   | — |   | 145 |   |
| Included in other comprehensive loss                                                                                                                                                       |       | (1,532                                                             | )          | —                                                     |       | — |   | — |   | — |   | — |   | (538 |  ) | — |   |
| Net transfers in and/or out of level 3                                                                                                                                                |       | 73,959                                                             |       | —                                                     |       | (1,938 | )  | 1,938 |   | (39,067 | )  | — |   | 44,576 |   | — |   |
| Purchases, sales, other settlements and  issuances, net                                                                                                                                    |       | (327                                                               | )     | (4,293                                                     | )          | (170,244 | ) | — |   | (675 | ) | 168,101 |   | — |   | (1,031) |   |
| Ending balance as of September 30                                                                                                                                                          |       | $                                                                  | 117,443    |                                                       | $          | 112,980 |   | $ | 3,054,756 |   | $ | 10,857 |   | $ | (52,896 | )  | $ | (2,868,232 | ) | $ | 101,038 |   | $ | 431 |   |
| The amount of total gains or losses for the  period included in earnings attributable to the change in unrealized gains or  losses relating to assets still held at the reporting date (1) |       | $                                                                  | —     |                                                       | $          | 1,055 |   | $ | (167,404 | ) | $ | — |   | $ | (16,625 | ) | $ | 168,059 |   | $ | — |   | $ | 145 |   |

 

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

 

The following table presents additionalinformation about assets, including derivatives that are measured at fair valuefor which the Company has utilized level 3 inputs to determine fair value,for the nine months ended September 30, 2008 and 2007 (amounts in thousands):

 
| ** **                                                                                                                                                                                 | ** ** | **Nine months ended September 30, 2008** | ** ** | **Nine months ended  September 30,  2007** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                                                                                                 | ** ** | **Securities  Available-  For-Sale**                         | ** ** | **Residential  Mortgage-  Backed  Securities**       | ** ** | **Residential  Mortgage  Loans** | ** ** | **REO** | ** ** | **Derivatives,  net** | ** ** | **Residential  Mortgage-  Backed  Securities   Issued** | ** ** | **Securities   Available-  For-Sale** | ** ** | **Derivatives,  net** | ** ** |
| Beginning balance as of January 1                                                                                                                                                     |       | $                                                            | 99,498     |                                                 | $          | — |   | $ | — |   | $ | — |   | $ | 802 |   | $ | — |   | $ | 104,498 |   | $ | — |   |
| Total gains or losses (realized and  unrealized):                                                                                                                                          |       |                                                         |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Included in earnings                                                                                                                                                                       |       | —                                                       |       | (5,515                                               | )          | (307,122 | ) | — |   | (16,158 | ) | 315,311 |   | — |   | 431 |   |
| Included in other comprehensive loss                                                                                                                                                       |       | (5,622                                                       | )          | —                                               |       | — |   | — |   | — |   | — |   | (36 | ) | — |   |
| Net transfers in and/or out of level 3                                                                                                                                                |       | 41,234                                                       |       | 131,688                                              |       | 3,917,666 |   | 10,857 |   | (36,256 | )  | (3,169,353 | ) | 44,074 |   | — |   |
| Purchases, sales, other settlements and  issuances, net                                                                                                                                    |       | (17,667                                                      | )          | (13,193                                              | )          | (555,788 | ) | — |   | (1,284 | ) | (14,190 | ) | (47,498 | ) | — |   |
| Ending balance as of September 30                                                                                                                                                          |       | $                                                            | 117,443    |                                                 | $          | 112,980 |   | $ | 3,054,756 |   | $ | 10,857 |   | $ | (52,896 | )  | $ | (2,868,232 | ) | $ | 101,038 |   | $ | 431 |   |
| The amount of total gains or losses for the  period included in earnings attributable to the change in unrealized gains or  losses relating to assets still held at the reporting date (1) |       | $                                                            | —     |                                                 | $          | (8,195 | ) | $ | (318,679 | ) | $ | — |   | $ | (16,158 | ) | $ | 315,311 |   | $ | — |   | $ | 431 |   |

 

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

 

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**Note 16. Contingencies**

** **

Inthe normal course of business, the Company has been named as a defendant inlegal actions. The Company has denied, or believes it has a meritorious defenseand will deny liability in the significant cases pending against the Companydiscussed below. Based on current discussion and consultation with counsel, theCompany’s management believes that the resolution of these matters will nothave a material impact on the financial condition or cash flow of the Company.

 

OnAugust 7, 2008, the members of the Company’s board of directors and certain ofthe Company’s executive officers (the “Individual Defendants”) and the Company(collectively, “Defendants”) were named in a putative class action complaint(the “Complaint”) filed by Charter Township of Clinton Police and FireRetirement System in the United States District Court for the Southern Districtof New York (the “Charter Litigation”). The Complaint alleges that theCompany’s April 2, 2007 registration statement and prospectus (the “April 2,2007 Registration Statement”) contained material misstatements and omissions inviolation of Section 11 of the Securities Act of 1933, as amended (the"1933 Act"),  regarding therisks associated with the Company’s real estate related assets, the state ofthe Company’s capital in light of its real estate related assets, and theadequacy of the Company’s loss reserves for its real estate related assets (the“alleged Section 11 violation”). The Complaint further alleges that pursuant toSection 15 of the 1933 Act, the Individual Defendants have legal responsibilityfor the alleged Section 11 violation.

 

Theparties have stipulated that Defendants shall not be required to answer orotherwise respond to the Complaint. Pursuant to section 27(a) of the 1933 Act,the court is required to appoint a Lead Plaintiff by November 5, 2008. Theparties have stipulated that the Lead Plaintiff shall file and serve aconsolidated amended complaint or designate a previously-filed complaint as theoperative complaint (the “Operative Complaint”) no later than 45 days after anorder appointing it is entered by the Court. The parties have further stipulated that Defendants shall file ananswer, motion to dismiss, or other response to the Operative Complaint nolater than 45 days after it is served.

 

OnAugust 15, 2008, the members of the Company’s board of directors and theCompany’s executive officers (the “Director and Officer Defendants”) were namedin a shareholder derivative action (the “Derivative Action”) brought by RaymondW. Kostecka, a purported shareholder of the Company, in the Superior Court ofCalifornia, County of San Francisco. The Company is named as a nominaldefendant.  The complaint in theDerivative Action asserts claims against the Director and Officer Defendantsfor breaches of fiduciary duty, abuse of control, gross mismanagement, waste ofcorporate assets, and unjust enrichment in connection with the conduct at issuein the Charter Litigation, including the filing of the April 2, 2007Registration Statement with alleged material misstatements and omissions.

 

Theparties have submitted a stipulation requesting that the proceedings in the DerivativeAction be stayed until the Charter Litigation is dismissed on the pleadings orthe Company files an answer to the Charter Litigation.  

 

**Note17. Subsequent Events**

** **

On November 6,2008, the Company’s board of directors elected to not pay a dividend for thethird quarter of 2008. 

 

On November10, 2008, the Company entered into an agreement to replace its existingrevolving credit facility with a new $300.0 million senior secured asset-basedrevolving credit facility. The new facility matures on November 10, 2010. Thefacility bears interest at a rate of 30-day London interbank offered rate(“LIBOR”) plus 3.00% per annum and the commitment of the initial lenders in thefacility is reduced to $150.0 million on the one-year anniversary of the facility.The Company can satisfy the $150.0 million commitment reduction by eitherpaying down the facility or syndicating the facility to other lenders prior toNovember 10, 2009. Under the terms of the credit agreement, the Company will berestricted from making cash distributions to its shareholders in excess of theamount estimated by the Company to be necessary for its shareholders to satisfytheir federal and state tax liabilities with respect to their allocable shareof the Company's taxable income. This restriction will terminate as of November10, 2009 as long as the Company satisfies certain borrowing base conditionscontained in the credit agreement. As of November 7, 2008, the Company had $368.3million outstanding under its existing revolving credit facility. 

 

On November10, 2008, the Company entered into an agreement for a two-year $100.0 millionstandby unsecured revolving credit agreement with the Company’s externalmanager, KKR Financial Advisors LLC, and Kohlberg Kravis Roberts & Co.(Fixed Income) LLC, the parent of the Company’s external manager. The borrowingfacility matures in December 2010 and bears interest at a rate equal to LIBORfor an interest period of 1, 2 or 3 months (at the Company’s option) plus15.00% per annum.  Under the terms of theagreement, the Company can elect to capitalize a portion of accrued interest onany loan under the agreement by adding up to 80% of the interest due andpayable at a particular time in respect of such loan to the outstandingprincipal amount of the loan.

 

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** **

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

 

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

 

**Forward Looking Statements**

 

Certaininformation contained in this Quarterly Report on Form 10-Q constitutes “forward-looking”statements within the meaning of Section 27A of the Securities Act of1933, as amended, and Section 21E of the Securities Exchange Act of 1934,as amended, that are based on our current expectations, estimates andprojections. Pursuant to those sections, we may obtain a “safe harbor” forforward-looking statements by identifying those and by accompanying thosestatements with cautionary statements, which identify factors that could causeactual results to differ from those expressed in the forward-lookingstatements. Statements that are not historical facts, including statementsabout our beliefs and expectations, are forward-looking statements. The words “believe,”“anticipate,” “intend,” “aim,” “expect,” “strive,” “plan,” “estimate,” and “project,”and similar words identify forward-looking statements. Such statements are notguarantees of future performance, events or results and involve potential risksand uncertainties. Accordingly, actual results and the timing of certain eventscould differ materially from those addressed in forward-looking statements dueto a number of factors including, but not limited to, changes in interest ratesand market values, changes in prepayment rates, general economic conditions,and other factors not presently identified. Other factors that may impact ouractual results are discussed in our Annual Report on Form 10-K under thesection titled “Risk Factors.”  We do not undertake, and specificallydisclaim, any obligation to publicly release the result of any revisions thatmay be made to any forward-looking statements to reflect the occurrence ofanticipated or unanticipated events or circumstances after the date of suchstatements.

 

**Executive Overview**

 

We are a specialty finance company that usesleverage with the objective of generating competitive risk-adjusted returns. Weinvest in financial assets primarily consisting of corporate loans and securities,including senior secured and unsecured loans, mezzanine loans, high yieldcorporate bonds, distressed and stressed debt securities, marketable andnon-marketable equity securities, and credit default and total rate of returnswaps. We also make opportunistic investments in other asset classes from timeto time.

 

Our objective is to provide competitivereturns to our investors through a combination of distributions and capitalappreciation. As part of our investment strategy, we seek to investopportunistically in those asset classes that can generate competitiveleveraged risk-adjusted returns, subject to maintaining our exemption fromregulation under the Investment Company Act of 1940, as amended (the “InvestmentCompany Act”).

 

Our income is generated primarily from(i) net interest income and dividend income, (ii) realized andunrealized gains and losses on our derivatives that are not accounted for ashedges, (iii) realized gains and losses from the sales of investments,(iv) realized and unrealized gains and losses on securities sold, not yetpurchased, and (v) fee income.

 

We are a Delaware limited liability companyand were organized on January 17, 2007. We are the successor to KKR FinancialCorp. (the “REIT Subsidiary”), a Maryland corporation. The REIT Subsidiary wasoriginally incorporated in the State of Maryland on July 7, 2004 andelected to be treated as a real estate investment trust (“REIT”) for U.S.federal income tax purposes. On May 4, 2007, we completed a restructuringtransaction (the “Restructuring Transaction”), pursuant to which the REITSubsidiary became our subsidiary and each outstanding share of the REITSubsidiary’s common stock was converted into one of our common shares, whichare publicly traded on the New York Stock Exchange (“NYSE”) under the symbol “KFN”.Although we have not elected to be treated as a REIT for U.S. federal incometax purposes, we intend to continue to operate so as to qualify as a partnership,and not as an association or publicly traded partnership taxable as acorporation, for U.S. federal income tax purposes.

 

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OnJune 30, 2008, we completed the sale of a controlling interest in the REITsubsidiary to Rock Capital 2 LLC, which did not result in a gain or loss.

 

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

 

***Impact of Credit Market Events***

*** ***

During the third quarter of 2008, the globalcredit markets continued to experience unprecedented challenges and thelandscape of the U.S. financial services industry changed dramatically. DuringSeptember 2008, the U.S. federal government assumed a conservatorship role forboth Federal Home Loan Mortgage Corporation and Federal National MortgageAssociation, Lehman Brothers Holdings Inc. filed for bankruptcy, and the U.S.federal government provided a loan to American International Group Inc. (“AIG”)in exchange for an equity interest in AIG. During the same period, events inthe credit markets forced numerous other major U.S. financial institutions toannounce plans to consolidate and/or restructure their existing operations.

 

During the third quarter of 2008, illiquidityand wider credit spreads in the credit markets caused a material decline inasset prices, particularly in equities, corporate loans and high yieldsecurities.  These market conditions havecontinued subsequent to quarter end. Current market events may impact ourbusiness in many ways, including the following:

 
|   | · | Price declines in the  investments we hold reduce the proceeds we receive for any investments that  we decide to sell and in most cases would result in the realization of losses  on such sales. Realization of losses on such sales, depending on their  magnitude and timing, could cause us to not be in compliance at future  measurement dates with covenants in our secured revolving credit facility and  total rate of return swaps.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|   | · | Declines in market values  have required and may continue to require us to post substantial additional  cash collateral under market value based borrowing transactions and/or  derivative contracts. Specifically, derivative transactions, including total  rate of return swaps, our secured revolving credit facility, and Wayzata  Funding LLC (“Wayzata”) have certain provisions that require the posting of  additional cash margin due to the decline in the value of assets financed  through those facilities. The posting of additional cash margin adversely  impacts our cash flows available for operations, new investments and dividend  distributions. In addition, Wayzata’s market value features result in cash  being effectively trapped in the facility and not being paid to the junior  noteholders, including us, if the net asset value of Wayzata does not meet  certain limits. We believe that based on current asset prices, the net asset  value of Wayzata would result in cash being trapped and that during the  fourth quarter of 2008 Wayzata will cease being cash flow generative to us. We  cannot predict at this time how long the cessation of cash flows will last. The  posting of additional cash margin and trapping of any cash could also have  adverse consequences regarding our ability to retain assets to which such  margin provisions pertain. Our  borrowing arrangements are described in further detail under Sources of Funds  in this Management’s Discussion and Analysis of Financial Condition and  Results of Operations. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|   | · | Declines in the market  values and downgrades in the ratings of investments financed through our five  cash flow collateralized loan obligation (“CLO”) transactions may result in  the unrestricted cash flows we receive from the CLOs being used to deleverage  the facilities. While failing over-collateralization tests in these cash flow  CLOs does not affect our investment portfolio or results of operations, it  would adversely impact our cash flows available for operations, new  investments and dividend distributions. We currently believe that during the  fourth quarter of 2008, certain of our CLO facilities will temporarily cease  to be cash flow generative to us, and we cannot predict at this time  how long the cessation of cash flows will last. These provisions are described in further detail under Sources of  Funds in this Management’s Discussion and Analysis of Financial Condition and  Results of Operations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|   | · | Current  illiquidity in the financial markets may impact our ability to obtain new  financing facilities or replace existing financing facilities on favorable  terms.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |

 

In light of the foregoing developmentsrelated to current credit market conditions and their attendant risks, we havetaken or intend to take the following steps:

 
|   | · | We have elected not to pay a dividend for the third  quarter of 2008 in order to retain liquidity and provide maximum flexibility  with respect to uses of liquidity in the current environment.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   | · | On November 10, 2008, we entered into an agreement to replace our existing  revolving credit facility with a new $300.0 million senior secured  asset-based revolving credit facility. The new facility extends our revolving  credit maturity and provides for less restrictive financial covenants that  will enhance our flexibility to make appropriate portfolio management  decisions on behalf of our shareholders. The new facility matures on November  10, 2010. The facility bears interest at a rate of 30-day London interbank  offered rate (“LIBOR”) plus 3.00% per annum and the commitment of the initial  lenders in the facility is reduced to $150.0 million on the one-year  anniversary of the facility. We can satisfy the $150.0 million commitment  reduction by either paying down the facility or syndicating the facility to  other lenders prior to November 10, 2009. Under the terms of the credit  agreement, we will be restricted from making cash distributions to our  shareholders in excess of the amount estimated by us to be necessary for our  shareholders to satisfy their federal and state tax liabilities with respect to  their allocable share of our taxable income. This restriction will terminate  as of November 10, 2009 as long as we satisfy certain borrowing base  conditions contained in the credit agreement. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   | · | On November 10, 2008, we entered into an agreement for a two-year  $100.0 million standby unsecured revolving credit agreement with our Manager,  KKR Financial Advisors LLC, and Kohlberg Kravis Roberts & Co. (Fixed  Income) LLC, the parent of our Manager. We entered into this $100.0 million  standby unsecured revolving credit agreement in order to enhance our  flexibility in bridging the difference in the balance outstanding under our  current credit facility with the borrowing capacity under the new facility. The  borrowing facility matures in December 2010 and bears interest at a rate  equal to LIBOR for an interest period of 1, 2 or 3 months (at our option)  plus 15.00% per annum. Under the terms of the agreement, we can elect to  capitalize a portion of accrued interest on any loan under the agreement by  adding up to 80% of the interest due and payable at a particular time in  respect of such loan to the outstanding principal amount of the loan.                                                                                                                                                                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   | · | We are evaluating whether and how to reduce our exposure and  contracts that require posting of additional collateral when market values  decline. Any such future reduction in exposure may result in losses on  investments, losses on our investments in Wayzata, and reduction or  elimination of borrowings under facilities whose terms would not be  replicable in today’s financial environment.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |

 

***DiscontinuedOperations***

 

InAugust 2007, our board of directors approved a plan to exit ourresidential mortgage investment operations and sell the REIT Subsidiary. As ofJanuary 1, 2008, the REIT Subsidiary’s assets and liabilities consistedsolely of those held by our 

 

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twoasset-backed commercial paper conduits (the “Facilities”).  During March 2008, we entered into anagreement with the holders of the secured liquidity notes (“SLNs”) issued bythe Facilities (the “Noteholders”) in order to terminate the Facilities.  With respect to the agreement with theNoteholders, all of the residential mortgage-backed securities (“RMBS”) fundedby the SLNs have been returned to the Noteholders in satisfaction of the SLNsand we have paid the Noteholders approximately $42.0 million in conjunctionwith this resolution. We had previously accrued $36.5 million for contingenciesrelated to resolution of the Facilities and as a consequence of thistransaction, we recorded an incremental charge during the quarter endedMarch 31, 2008 for $5.5 million. The agreement with the Noteholdersresulted in approximated $3.6 billion par amount of RMBS being returned to theNoteholders in satisfaction of approximately $3.5 billion par amount of SLNsheld by the Noteholders. Accordingly, we removed the RMBS and SLNs that relatedto the Facilities from our condensed consolidated financial statements as ofMarch 31, 2008. Under the agreement with the Noteholders, both we and ouraffiliates have been released from any future obligations or liabilities to theNoteholders.

 

As of June 30, 2008, we substantially completed our plan to exitour residential mortgage investment operations through the sale of certain ofour residential mortgage-backed securities in the third quarter of 2007 and theagreement with the Noteholders related to the Facilities described above. Inaddition, on June 30, 2008, we completed the sale of a controllinginterest in the REIT Subsidiary to Rock Capital 2 LLC, which did not result ina gain or loss. Accordingly, the REIT Subsidiary is presented as discontinuedoperations for financial statement purposes for all periods presented.

 

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

 

***Extinguishment ofDebt***

 

During the third quarter of 2008, we retired$5.0 million of junior subordinated notes, which resulted in a gain onextinguishment of $3.1 million, partially offset by a $0.2 millionwrite-off of unamortized debt issuance costs and $0.1 million of otherassociated costs. During the nine months ended September 30, 2008, we retired$40.0 million of junior subordinated notes, which resulted in a gain onextinguishment of $20.3 million, partially offset by a $1.3 million write-offof unamortized debt issuance costs and $0.8 million of other associated costs.

 

***Common ShareOffering***

 

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

 

***Investment Portfolio***

 

As of September 30, 2008, our investments incorporate loans and debt securities totaled $9.5 billion, which represents a4.3% decrease from $10.0 billion as of December 31, 2007. Additionally,our investments in RMBS totaled $310.4 million as of September 30, 2008, whichrepresents a decrease of 8.1% from $337.6 million as of December 31, 2007.  As described under Discontinued Operationsabove, we consolidate both the assets and liabilities of certain residentialmortgage-backed securitization trusts in accordance with accounting principlesgenerally accepted in the United States of America (“GAAP”) and as a result,$197.4 million of our $310.4 million of RMBS investments are included in theconsolidation of these entities and the $197.4 million represents the netdifference between residential mortgage loans of $3.1 billion and residentialmortgage-backed securities issued of $2.9 billion, plus $10.9 million of realestate owned (included in other assets on our condensed consolidated balancesheet).

 

**Critical Accounting Policies**

 

Our condensed consolidated financialstatements are prepared by management in conformity with GAAP. Our significantaccounting policies are fundamental to understanding our financial conditionand results of operations because some of these policies require that we makesignificant estimates and assumptions that may affect the value of our assetsor liabilities and financial results. We believe that certain of our policiesare critical because they require us to make difficult, subjective, and complexjudgments about matters that are inherently uncertain. We have reviewed thesecritical accounting policies with our board of directors and the auditcommittee of our board of directors.

 

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***Fair Value of Financial Instruments***

 

Effective January 1, 2007, we adoptedStatement of Financial Accounting Standards (“SFAS”) No. 157, *Fair Value Measurements* (“SFASNo. 157”), which requires additional disclosures about our assets andliabilities that are measured at fair value.

 

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

 

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

 

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

 

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

 

Fair value assets and liabilities that aregenerally included in this category are certain corporate debt securities,corporate loans held for sale and certain financial instruments classified asderivatives where the fair value is based on observable market inputs.

 

Level 3: Inputs are unobservable inputsfor the asset or liability, and include situations where there is little, ifany, market activity for the asset or liability. In certain cases, the inputsused to measure fair value may fall into different levels of the fair valuehierarchy. In such cases, the level in the fair value hierarchy within whichthe fair value measurement in its entirety falls has been determined based onthe lowest level input that is significant to the fair value measurement in itsentirety. Our assessment of the significance of a particular input to the fairvalue measurement in its entirety requires judgment and the consideration offactors specific to the asset.

 

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

 

The availability of observable inputs canvary depending on the financial asset or liability and is affected by a widevariety of factors, including, for example, the type of product, whether theproduct is new, whether the product is traded on an active exchange or in the secondarymarket, and the current market conditions. To the extent that valuation isbased on models or inputs that are less observable or unobservable in themarket, the determination of fair value requires more judgment. Accordingly,the degree of judgment exercised by us in determining fair value is greatestfor instruments categorized in level 3. In certain cases, the inputs usedto measure fair value may fall into different levels of the fair valuehierarchy. In such cases, for disclosure purposes the level in the fair valuehierarchy within which the fair value measurement in its entirety falls isdetermined based on the lowest level input that is significant to the fairvalue measurement in its entirety.

 

Fair value is a market-based measureconsidered from the perspective of a market participant who holds the asset orowes the liability rather than an entity-specific measure. Therefore, even whenmarket assumptions are not readily available, our own assumptions are set toreflect those that market participants would use in pricing the asset orliability at the measurement date.

 

Many financial assets and liabilities havebid and ask prices that can be observed in the marketplace. Bid prices reflectthe highest price that we and others are willing to pay for an asset. Askprices represent the lowest price that we and others are willing to accept foran asset. For financial assets and liabilities whose inputs are based onbid-ask prices, we do not require that 

 

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fair value always be a predetermined point in the bid-ask range. Ourpolicy is to allow for mid-market pricing and adjusting to the point within thebid-ask range that meets our best estimate of fair value.

 

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

 

*Residential Mortgage-Backed Securities,Residential Mortgage Loans, and Residential Mortgage-Backed Securities Issued:*Residential mortgage-backed securities, residential mortgage loans, andresidential mortgage-backed securities issued are initially valued attransaction price and are subsequently valued using market data for similarinstruments (e.g., recent transactions, nationally recognized pricing services,or broker quotes), comparisons to benchmark derivative indices or movements inunderlying credit spreads.

 

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

 

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

 

***Share-Based Compensation***

 

We account for share-based compensationissued to members of our board of directors and our Manager using the fairvalue based methodology in accordance with SFAS No. 123(R), *Share-based Compensation* (“SFASNo. 123(R)”). We do not have any employees, although we believe thatmembers of our board of directors are deemed to be employees for purposes ofinterpreting and applying accounting principles relating to share-basedcompensation. We record as compensation costs the restricted common shares thatwe issued to members of our board of directors at estimated fair value as ofthe grant date and we amortize the cost into expense over the three-yearvesting period using the straight-line method. We record compensation costs forrestricted common shares and common share options that we issued to our Managerat estimated fair value as of the grant date and we remeasure the amount onsubsequent reporting dates to the extent the awards have not vested. Unvestedrestricted common shares are valued using observable secondary market prices.Unvested common share options are valued using the Black-Scholes model andassumptions based on observable market data for comparable companies. Weamortize compensation expense related to the restricted common share and commonshare options that we granted to our Manager using the graded vestingattribution and straight-line method in accordance with SFAS No. 123(R).As of September 30,2008, the common share options were fully vested.

 

Because we remeasure the amount ofcompensation costs associated with the unvested restricted common shares andunvested common share options that we issued to our Manager as of eachreporting period, our share-based compensation expense reported in ourcondensed consolidated financial statements will change based on the estimatedfair value of our common shares and this may result in earnings volatility. Forthe three and nine months ended September 30, 2008, share-based compensation totaled$(0.2) million and $0.5 million, respectively. As of September 30, 2008, substantially allof the non-vested restricted common shares issued that are subject to SFASNo. 123(R) are subject to remeasurement. As of September 30, 2008, a $1 increase inthe price of our common shares would have increased our future share-basedcompensation expense by approximately $1.1 million and this futureshare-based compensation expense would be recognized over the remaining vestingperiods of our outstanding restricted common shares. As of September 30, 2008, future unamortizedshare-based compensation totaled $6.2 million, of which $0.7 million,$2.7 million, and $2.8 million will be recognized in 2008, 2009, andbeyond, respectively.

 

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

 

We recognize all derivatives on our condensedconsolidated balance sheets at estimated fair value. On the date we enter intoa derivative contract, we designate and document each derivative contract asone of the following at the time the contract is executed: (i) a hedge of arecognized asset or liability (“fair value” hedge); (ii) a hedge of aforecasted transaction or of the variability of cash flows to be received orpaid related to a recognized asset or liability (“cash flow” hedge);(iii) a hedge of a net investment in a foreign operation; or (iv) aderivative instrument not designated as a hedging instrument (“free-standing 

 

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derivative”). For a fair value hedge, we record changes in theestimated fair value of the derivative and, to the extent that it is effective,changes in the fair value of the hedged asset or liability attributable to thehedged risk, in the current period earnings in the same financial statementcategory as the hedged item. For a cash flow hedge, we record changes in theestimated fair value of the derivative to the extent that it is effective inother comprehensive income. We subsequently reclassify these changes inestimated fair value to net income in the same period(s) that the hedgedtransaction affects earnings in the same financial statement category as thehedged item. For free-standing derivatives, we report changes in the fairvalues in current period other (loss) 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 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 ourderivative contracts using hedge accounting as described above. If we decidenot to designate the derivative contracts as hedges or if we fail to fulfillthe criteria necessary to qualify for hedge accounting, then the changes in theestimated fair values of our derivative contracts would affect periodicearnings immediately 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 ofSeptember 30, 2008, the estimated fair value of our net derivative liabilitiestotaled $31.7 million.

 

***Impairments***

 

We evaluate our investment portfolio for impairment as of each quarterend or more frequently if we become aware of any material information thatwould lead us to believe that an investment may be impaired. We evaluatewhether the investment is considered impaired and whether the impairment isother-than-temporary. If we make a determination that the impairment isother-than-temporary, we recognize an impairment loss equal to the differencebetween the amortized cost basis and the estimated fair value of theinvestment. Evaluating whether the impairment of an investment isother-than-temporary requires significant judgment and requires us to makecertain estimates and assumptions. We consider many factors in determiningwhether the impairment of an investment is other-than-temporary, including butnot limited to the length of time the security has had a decline in estimatedfair value below its amortized cost, the amount of the loss, our intent andfinancial ability to hold the investment for a period of time sufficient for arecovery in its estimated fair value, recent events specific to the issuer orindustry, external credit ratings and recent downgrades in such ratings. As of September 30, 2008, we had aggregateunrealized losses on our securities classified as available-for-sale ofapproximately $356.0 million, which if not recovered may result in therecognition of future losses. As ofSeptember 30, 2008, there were impairments of $20.3 million which were determinedto be other-than-temporary which were recorded as a loss in the condensedconsolidated statements of operations.

 

***Allowance for Loan Losses***

 

Our allowance for estimated loan lossesrepresents our estimate of probable credit losses inherent in the loanportfolio as of the balance sheet date. When determining the adequacy of theallowance for loan losses, we consider historical and industry loss experience,economic conditions and trends, the estimated fair values of our loans, creditquality trends and other factors that we determine are relevant. Additions tothe allowance for loan losses are charged to current period earnings throughthe provision for loan losses. Amounts determined to be uncollectible arecharged directly to the allowance for loan losses. Our allowance for loanlosses consists of two components, an allocated component and an unallocatedcomponent.

 

The allocated component of our allowance forloan losses consists of individual loans that are impaired and for which theestimated allowance for loan losses is determined in accordance with SFASNo. 114, *Accounting by Creditors forImpairment of a Loan.* We consider a loan to be impaired when, basedon current information and events, we believe it is probable that we will beunable to collect all amounts due to us based on the contractual terms of theloan. An impaired loan may be left on accrual status during the period we arepursuing repayment of the loan; however, the loan is placed on non-accrualstatus at such time as: (i) we believe that scheduled debt servicepayments may not be paid when contractually due; (ii) the loan becomes90 days delinquent; (iii) we determine the borrower is incapable of, orhas ceased efforts toward, curing the cause of the impairment; or (iv) thenet realizable value of the underlying collateral securing the loan decreasesbelow our carrying value of such loan. While on non-accrual status, previouslyrecognized accrued interest is reversed if it is determined that such amountsare not collectible and interest income is recognized only upon actual receipt.

 

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The unallocated component of our allowancefor loan losses is determined in accordance with SFAS No. 5, *Accounting for Contingencies*. Thiscomponent of the allowance for loan losses represents our estimate of lossesinherent, but unidentified, in our portfolio as of the balance sheet date. Theunallocated component of the allowance for loan losses is estimated based upona review of our loan portfolio’s risk characteristics, risk grouping of loansin the portfolio based upon estimated probability of default and severity ofloss based on loan type, and consideration of general economic conditions andtrends. As of September30, 2008, our allowance for loan losses totaled $35.0 million.

 

**Recent Accounting Pronouncements**

 

In February 2008, the FASBissued FSP FAS 140-3, *Accounting for Transfersof Financial Assets and Repurchase Financing Transactions*(“FSP SFASNo. 140-3”). FSP SFAS No. 140-3 assumes that an initial transfer of afinancial asset and a repurchase financing are considered part of the samearrangement, or a linked transaction. However, if certain criteria are met, theinitial transfer and repurchase financing shall not be evaluated as a linkedtransaction and shall be evaluated separately under SFAS No. 140, *Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities* (“SFAS No. 140”). FSP SFASNo. 140-3 is effective for us for repurchase financings in which theinitial transfer is entered into after December 31, 2008 andearly adoption is not permitted. We donot expect the adoption of FSP SFAS No. 140-3 to have a material impact onour condensed consolidatedfinancial statements.

 

In March 2008, the FASBissued SFAS No. 161, *Disclosures aboutDerivative Instruments and Hedging Activities, an Amendment of FASB StatementNo. 133*(“SFAS No. 161”). SFAS No. 161 requiresenhanced qualitative disclosures about objectives and strategies for usingderivatives, quantitative disclosures about fair value amounts of gains andlosses on derivative instruments, and disclosures about credit-risk-relatedcontingent features in derivative agreements. The additional disclosuresrequired by SFAS No. 161 must be included in our financial statementsbeginning with the first quarter of 2009.

 

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

 

In May 2008, FASB issued SFASNo. 163, *Accounting for Financial Guarantee InsuranceContracts — an interpretation of FASB Statement No. 60*(“SFASNo. 163”). SFAS No. 163 requires recognition of an insurance claimliability prior to an event of default (insured event) when there is evidencethat credit deterioration has occurred in an insured financial obligation. SFASNo. 163 is effective for financial statements issued for fiscal yearsbeginning after December 15, 2008 and all interim periods within thosefiscal years, and early application is not permitted. We do not expect theadoption of SFAS No. 163 to have a material impact on our financialstatements.

 

In October 2008, FASB issued FSP SFAS No.157-3, *Determining the Fair Value of a Financial Assetwhen the Market for that Asset is Not Active* (“FSP SFAS No. 157-3”).FSP SFAS No. 157-3 is intended to enhance the comparability and consistency infair value measurements of financial assets that trade in inactive markets andincludes illustrative examples addressing how assumptions should be consideredwhen measuring fair value when relevant observable inputs do not exist, as wellas how market quotes and available observable inputs in an inactive marketshould be considered when assessing the measuring fair value. FSP SFAS No.157-3 is effective upon issuance including prior periods for which financialstatements have not been issued. We have taken FSP SFAS No. 157-3 intoconsideration when measuring the fair value of our assets and liabilities. 

 

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**Results of Operations**

 

**Three and nine months ended September 30,2008 compared to three and nine months ended September 30, 2007**

 

*Summary*

 

Our net income for the three and nine monthsended September 30,2008 totaled $49.0 million (or $0.33 per diluted common share) and $100.5million (or $0.73 per diluted common share), respectively, as compared to netloss of $261.5 million (or $2.98 per diluted common share) and $160.1million (or $1.93 per diluted common share) for the three and nine months endedSeptember 30, 2007, respectively.Income from continuing operations for the three and nine months ended September 30, 2008 totaled$49.0 million (or $0.33 per diluted common share) and $97.9 million (or$0.71 per diluted common share), respectively, as compared to$38.6 million (or $0.44 per diluted common share) and $142.9 million (or$1.73 per diluted common share) for the three and nine months ended September 30, 2007, respectively.

 

*Net Investment Income*

 

The following table presents the componentsof our net investment income for the three and nine months ended September 30, 2008 and 2007:

 

**Comparative Net Investment Income Components**

**(Amountsin thousands)**

 
| ** **                                                 | ** ** | **For the three  months ended  September 30, 2008** | ** ** | **For the three  months ended  September 30, 2007** | ** ** | **For the nine  months ended  September 30, 2008** | ** ** | **For the nine  months ended  September 30, 2007** | ** ** |
|------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| Investment Income:                                         |       |                                                                    |       |                                                                    |       |                                                                   |       |                                                                   |       |
| Corporate loans and securities interest income             |       | $                                                                       | 165,878    |                                                                    | $          | 164,287                                                                |       | $                                                                      | 529,068    |   | $ | 358,178 |   |
| Residential mortgage loans and securities  interest income |       | 41,871                                                                  |       | 61,413                                                                  |       | 134,718                                                                |       | 194,106                                                                |       |
| Other interest income                                      |       | 4,431                                                                   |       | 11,850                                                                  |       | 20,505                                                                 |       | 20,100                                                                 |       |
| Dividend income                                            |       | 358                                                                     |       | 782                                                                     |       | 2,266                                                                  |       | 2,722                                                                  |       |
| Net discount accretion                                     |       | 14,514                                                                  |       | 2,496                                                                   |       | 34,161                                                                 |       | 3,660                                                                  |       |
| Total investment income                                    |       | 227,052                                                                 |       | 240,828                                                                 |       | 720,718                                                                |       | 578,766                                                                |       |
| Interest Expense:                                          |       |                                                                    |       |                                                                    |       |                                                                   |       |                                                                   |       |
| Repurchase agreements                                      |       | 970                                                                     |       | 22,888                                                                  |       | 34,407                                                                 |       | 63,503                                                                 |       |
| Collateralized loan obligation senior  secured notes       |       | 68,246                                                                  |       | 69,250                                                                  |       | 214,653                                                                |       | 149,404                                                                |       |
| Secured revolving credit facility                          |       | 3,496                                                                   |       | 3,190                                                                   |       | 9,269                                                                  |       | 6,580                                                                  |       |
| Secured demand loan                                        |       | —                                                                  |       | 513                                                                     |       | 348                                                                    |       | 1,728                                                                  |       |
| Convertible senior notes                                   |       | 5,440                                                                   |       | 4,183                                                                   |       | 16,450                                                                 |       | 4,183                                                                  |       |
| Junior subordinated notes                                  |       | 4,941                                                                   |       | 6,481                                                                   |       | 17,045                                                                 |       | 16,502                                                                 |       |
| Residential mortgage-backed securities  issued             |       | 31,506                                                                  |       | 38,072                                                                  |       | 99,938                                                                 |       | 137,650                                                                |       |
| Other interest expense                                     |       | 1,665                                                                   |       | 766                                                                     |       | 2,687                                                                  |       | 2,033                                                                  |       |
| Interest rate swap                                         |       | 1,841                                                                   |       | (285                                                                    | )          | 5,410                                                                  |       | (476                                                                   | )          |
| Total interest expense                                     |       | 118,105                                                                 |       | 145,058                                                                 |       | 400,207                                                                |       | 381,107                                                                |       |
| Interest expense to affiliates                             |       | 18,794                                                                  |       | 21,148                                                                  |       | 66,319                                                                 |       | 29,404                                                                 |       |
| Provision for loan losses                                  |       | —                                                                  |       | 25,000                                                                  |       | 10,000                                                                 |       | 25,000                                                                 |       |
| Net investment income                                      |       | $                                                                       | 90,153     |                                                                    | $          | 49,622                                                                 |       | $                                                                      | 244,192    |   | $ | 143,255 |   |

 

As presented in the table above, netinvestment income increased $40.5 million, or 81.7%, and $100.9 million,or 70.5%, from the three and nine months ended September 30, 2007,respectively, compared to the three and nine months ended September 30, 2008.For the three months ended September 30, 2008, the increase is primarily attributableto lower interest expense on residential mortgage-backed securities issued andno provision for loan loss recorded for the quarter ended September 30, 2008. Inaddition, net discount accretion increased by $12.0 million due to ourportfolio of corporate loans and debt securities having a lowerweighted-average purchase price as compared to prior year. For the nine monthsended September 30, 2008, the increase is primarily attributable to theinterest income earned on additional investments in our investment portfolioduring 2008, as well as greater discount accretion on corporate loans and debtsecurities. As of September 30, 2008, we held $9.5 billion of investmentsin corporate loans and debt securities, excluding the allowance for loan lossesof $35.0 million. In comparison, as of September 30, 2007, investments incorporate loans and debt securities totaled $8.5 billion, excluding theallowance for loan losses of $25.0 million.

 

Net investment income in the table above doesnot include equity in income of unconsolidated affiliate of nil for the threeand nine months ended September 30, 2008 and nil and $12.7 million for thethree and nine months ended September 30, 2007, respectively. Equity in incomeof unconsolidated affiliate reflects our pro rata interest in the net income ofa limited partnership that was formed to hold the subordinated interests inthree entities formed to execute secured financing transactions in the form ofCLOs.

 

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*Other (Loss) Income*

 

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

 

**Comparative Other (Loss) Income Components**

**(Amounts in thousands)**

 
| ** **                                                                                                                                                                              | ** ** | **For the three  months ended  September 30, 2008** | ** ** | **For the three  months ended  September 30, 2007** | ** ** | **For the nine  months ended  September 30, 2008** | ** ** | **For the nine  months ended  September 30, 2007** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| Net realized  and unrealized loss on derivatives and foreign exchange:                                                                                                                  |       |                                                                    |       |                                                                    |       |                                                                   |       |                                                                   |       |
| Interest  rate swaptions                                                                                                                                                                |       | $                                                                       | —     |                                                                    | $          | 15                                                                     |       | $                                                                      | —     |   | $ | 15 |   |
| Interest  rate swaps                                                                                                                                                                    |       | (706                                                                    | )          | (822                                                                    | )     | 2,820                                                                  |       | (822                                                                   | )     |
| Credit  default swaps                                                                                                                                                                   |       | 9,543                                                                   |       | 1,424                                                                   |       | 19,877                                                                 |       | 2,397                                                                  |       |
| Total rate  of return swaps                                                                                                                                                             |       | (20,019                                                                 | )          | (16,834                                                                 | )     | (86,464                                                                | )          | (4,465                                                                 | )     |
| Common stock  warrants                                                                                                                                                                  |       | (15                                                                     | )          | 145                                                                     |       | (722                                                                   | )          | 432                                                                    |       |
| Foreign  contract                                                                                                                                                                       |       | —                                                                  |       | —                                                                  |       | —                                                                 |       | —                                                                 |       |
| Foreign  exchange translation                                                                                                                                                           |       | (4,337                                                                  | )     | 30                                                                      |       | (3,979                                                                 | )     | 21                                                                     |       |
| Total  realized and unrealized loss on derivatives and foreign exchange                                                                                                                 |       | (15,534                                                                 | )          | (16,042                                                                 | )     | (68,468                                                                | )          | (2,422                                                                 | )     |
| Net realized  loss on residential loans carried at estimated fair value                                                                                                                 |       | (1,589                                                                  | )          | (141                                                                    | )     | (3,088                                                                 | )          | (342                                                                   | )     |
| Net  unrealized gain (loss) on residential mortgage-backed securities, residential  mortgage loans, and residential mortgage-backed securities issued, carried at  estimated fair value |       | 1,710                                                                   |       | (39,145                                                                 | )     | (11,563                                                                | )          | (40,636                                                                | )          |
| Net realized  (loss) gain on investments                                                                                                                                                |       | (17,996                                                                 | )          | 53,400                                                                  |       | (36,647                                                                | )          | 87,164                                                                 |       |
| Impairment  of securities available-for-sale                                                                                                                                            |       | (10,566                                                                 | )          | —                                                                  |       | (20,254                                                                | )          | —                                                                 |       |
| Lower of  cost or estimated fair value adjustment to loans held for sale                                                                                                                |       | 284                                                                     |       | —                                                                  |       | (2,353                                                                 | )          | —                                                                 |       |
| Gain on  extinguishment of debt                                                                                                                                                         |       | 3,056                                                                   |       | —                                                                  |       | 20,281                                                                 |       | —                                                                 |       |
| Net realized  and unrealized gain on securities sold, not yet purchased                                                                                                                 |       | 14,242                                                                  |       | 2,220                                                                   |       | 22,892                                                                 |       | 2,795                                                                  |       |
| Other income                                                                                                                                                                            |       | 2,470                                                                   |       | 2,760                                                                   |       | 7,939                                                                  |       | 7,347                                                                  |       |
| Total other  (loss) income                                                                                                                                                              |       | $                                                                       | (23,923    | )                                                                       | $          | 3,052                                                                  |       | $                                                                      | (91,261    | ) | $ | 53,906 |   |

 

As presented in the table above, total otherloss totaled $23.9 million and $91.3 million for the three and nine monthsended September 30, 2008, respectively, as compared to other income of$3.1 million and $53.9 million for the three and nine months endedSeptember 30, 2007, respectively. The change in total other (loss) income forthe three months ended September 30, 2008 is primarily attributable to a$15.5 million net realized and unrealized loss on derivatives and foreignexchange of which $20.0 million was related to total rate of return swaps,an $18.0 million realized loss on sales of investments, and $10.6 million of lossesdue to the impairment of securities available-for-sale, all partially offset bya $3.1 million gain on the extinguishment of junior subordinated notes, a $1.7million net unrealized gain on the estimated fair value of our residentialmortgage positions, and a $14.2 million net realized and unrealized gain onsecurities sold, not yet purchased. The change in total other (loss) income forthe nine months ended September 30, 2008 is primarily attributable to a$68.5 million net realized and unrealized loss on derivatives and foreignexchange of which $86.5 million was related to total rate of return swaps,a $36.6 million realized loss on sales of investments, and $20.3 million of lossesdue to the impairment of securities available-for-sale, all partially offset bya $20.3 million gain on the extinguishment of junior subordinated notes, and a$22.9 million net realized and unrealized gain on securities sold, not yetpurchased.

 

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*Non-Investment Expenses*

 

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

 

**Comparative Non-Investment Expense Components**

**(Amountsin thousands)**

 
| ** **                             | ** ** | **For the three  months ended  September 30, 2008** | ** ** | **For the three  months ended  September 30, 2007** | ** ** | **For the nine  months ended  September 30, 2008** | ** ** | **For the nine  months ended  September 30, 2007** | ** ** |
|----------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| Related party management compensation: |       |                                                                    |       |                                                                    |       |                                                                   |       |                                                                   |       |
| Base management fees                   |       | $                                                                       | 8,729      |                                                                    | $          | 8,229                                                                  |       | $                                                                      | 25,089     |   | $ | 22,502 |   |
| Incentive fee                          |       | —                                                                  |       | —                                                                  |       | —                                                                 |       | 12,620                                                                 |       |
| Share-based compensation               |       | (195                                                                    | )     | (4,581                                                                  | )     | 462                                                                    |       | 1,897                                                                  |       |
| CLO management fees                    |       | 1,277                                                                   |       | 1,277                                                                   |       | 3,806                                                                  |       | 2,319                                                                  |       |
| Related party management compensation  |       | 9,811                                                                   |       | 4,925                                                                   |       | 29,357                                                                 |       | 39,338                                                                 |       |
| Professional services                  |       | 1,335                                                                   |       | 2,194                                                                   |       | 4,263                                                                  |       | 3,495                                                                  |       |
| Loan servicing expense                 |       | 2,274                                                                   |       | 2,729                                                                   |       | 7,234                                                                  |       | 8,751                                                                  |       |
| Insurance expense                      |       | 302                                                                     |       | 161                                                                     |       | 621                                                                    |       | 547                                                                    |       |
| Directors expenses                     |       | 208                                                                     |       | 380                                                                     |       | 924                                                                    |       | 984                                                                    |       |
| General and administrative expenses    |       | 3,310                                                                   |       | 3,301                                                                   |       | 12,549                                                                 |       | 12,564                                                                 |       |
| Total non-investment expenses          |       | $                                                                       | 17,240     |                                                                    | $          | 13,690                                                                 |       | $                                                                      | 54,948     |   | $ | 65,679 |   |

 

As presented in the table above, ournon-investment expenses increased by $3.6 million for the three months endedSeptember 30, 2008 compared to September 30, 2007, but decreased by$10.7 million for the nine months ended September 30, 2008 compared toSeptember 30, 2007. The significant components of non-investment expense aredescribed below.

 

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

 

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

 

*Income Tax Provision*

 

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

 

KKR Financial Holdings II, LLC (“KFH II”), ourwholly-owned subsidiary which holds certain real estate mortgage-backedsecurities, elected to be taxed as a REIT and we believe that it has compliedwith the provisions of the Internal Revenue Code of 1986, as amended, (the“Code”), with respect thereto. KFH II is not subject to U.S. federal income taxto the extent that it currently distributes its income and satisfies certainasset, income and ownership tests, and recordkeeping requirements.

 

KKR FinancialCLO 2005-1, Ltd. (“CLO 2005-1”), KKR FinancialCLO 2005-2, Ltd. (“CLO 2005-2”), KKR FinancialCLO 2006-1, Ltd. (“CLO 2006-1”), KKR Financial CLO 2007-1, Ltd. (“CLO2007-1”), and KKR Financial CLO 2007-A, Ltd. (“CLO 2007-A”) are foreignsubsidiaries treated as disregarded entities or partnerships for U.S. federalincome tax purposes that were established to facilitate securitizationtransactions, structured as secured financing transactions, and KKR TRSHoldings, Ltd. (“TRS Ltd.”) and KKR Financial Holdings, Ltd. (“KFH Ltd.”)are foreign taxable corporate subsidiaries that were formed to make certainforeign and domestic investments from time to time. TRS Ltd. and KFH Ltd. areorganized as exempted companies incorporated with limited liability under thelaws of the Cayman Islands, and are generally not subject to U.S. federal andstate 

 

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income tax at the corporate entity level because they restrict theiractivities in the U.S. to trading in stock and securities for their ownaccount. Therefore, they generally will not be subject to corporate income taxin our financial statements on their earnings, and no provisions for incometaxes for the three months and nine months ended September 30, 2008 and 2007were recorded; however, we are generally required to include their currenttaxable income in our calculation of taxable income allocable to shareholders.

 

**Investment Portfolio**

 

***Corporate Investment Summary***

 

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

 

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

 

**Corporate Investment Portfolio**

**(Dollaramounts in thousands)**

 
| ** **                                             | ** ** | **Carrying   Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Portfolio Mix   % by Fair Value** | ** ** |
|--------------------------------------------------------|------------|---------------------------|------------|---------------------|------------|--------------------------------|------------|--------------------------------------------------------------|------------|
| **Floating Rate:**                                     |       |                      |       |                |       |                           |       |                                                         |       |
| Corporate Loans                                        |       | $                         | 8,388,705  |                | $          | 8,388,705                      |       | $                                                            | 7,100,663  |   | 85.9 | % |
| Corporate Debt Securities                              |       | 166,272                   |       | 234,400             |       | 166,272                        |       | 2.0                                                          |       |
| Total Floating Rate                                    |       | 8,554,977                 |       | 8,623,105           |       | 7,266,935                      |       | 87.9                                                         |       |
| **Fixed Rate:**                                        |       |                      |       |                |       |                           |       |                                                         |       |
| Corporate Loans                                        |       | 133,027                   |       | 133,027             |       | 122,572                        |       | 1.5                                                          |       |
| Corporate Debt Securities                              |       | 851,427                   |       | 1,125,101           |       | 851,427                        |       | 10.3                                                         |       |
| Total Fixed Rate                                       |       | 984,454                   |       | 1,258,128           |       | 973,999                        |       | 11.8                                                         |       |
| **Marketable and Non-Marketable Equity  Securities:**  |       |                      |       |                |       |                           |       |                                                         |       |
| Marketable Equity Securities                           |       | 5,577                     |       | 17,322              |       | 5,577                          |       | 0.1                                                          |       |
| Non-Marketable Equity Securities                       |       | 17,505                    |       | 17,505              |       | 17,505                         |       | 0.2                                                          |       |
| Total Marketable and Non-Marketable Equity  Securities |       | 23,082                    |       | 34,827              |       | 23,082                         |       | 0.3                                                          |       |
| Total(1)                                               |       | $                         | 9,562,513  |                | $          | 9,916,060                      |       | $                                                            | 8,264,016  |   | 100.0 | % |

 

----

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

 

The schedule above excludes equity securitiessold, not yet purchased, with a cost of $101.3 million and for which wehad accumulated net unrealized gains of $17.8 million as of September 30,2008.

 

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

** **

**Corporate Investment Portfolio**

**(Dollaramounts in thousands)**

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

 

----

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

 

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

 

*Corporate Loans*

 

Our corporate loan portfolio totaled $8.5billion as of September 30, 2008 and $8.7 billion as of December 31,2007. Our corporate loan portfolio consists of debt obligations ofcorporations, partnerships and other entities in the form of first and secondlien loans, mezzanine loans and bridge loans. As of September 30, 2008, $8.4billion, or 98.4%, of our corporate loan portfolio was floating rate and $0.1billion, or 1.6%, was fixed rate.  As ofDecember 31, 2007, $8.6 billion, or 99.2%, of our corporate loan portfoliowas floating rate and $0.1 billion, or 0.8%, was fixed rate.

 

All of our floating rate corporate loans have index reset frequenciesof less than twelve months with the majority resetting at least quarterly. Theweighted-average coupon on our floating rate corporate loans was 6.13% and7.85% as of September 30, 2008 and December 31, 2007, respectively, andthe weighted-average coupon spread to LIBOR of our floating rate corporate loanportfolio was 2.92% and 2.87% as of September 30, 2008 and December 31,2007, respectively. The weighted-average years to maturity of our floating ratecorporate loans was 5.2 years and 5.7 years as of September 30, 2008 andDecember 31, 2007, respectively.

 

As of September 30, 2008, our fixed ratecorporate loans had a weighted-average coupon of 14.07% and a weighted-averageyears to maturity of 5.9 years, as compared to 11.01% and 5.8 years,respectively, as of December 31, 2007.

 

As of September 30, 2008 andDecember 31, 2007, there were no corporate loan balances placed onnon-accrual status. We evaluate and monitor the asset quality of our investmentportfolio by performing detailed credit reviews and by monitoring key creditstatistics and trends. The key credit statistics and trends we monitor toevaluate the quality of our investments include credit ratings of both ourinvestments and the issuer, financial performance of the issuer includingearnings trends, free cash flows of the issuer, debt service coverage ratios ofthe issuer, financial leverage of the issuer, and industry trends that have ormay impact the issuer’s current or future financial performance and debtservice ability. As of September 30, 2008, none of our corporate loaninvestments were delinquent on principal or interest payments and none of theinvestments were in default status. Our allowance for loan losses totaled $35.0million and $25.0 million as of September 30, 2008 and December 31, 2007,respectively. There were no charge-offs and a $10.0 million provision foradditional losses was recorded during the nine months ended September 30, 2008.

 

We recorded a $2.4 million charge to earningsduring the quarter ended September 30, 2008 for the lower of cost or estimatedfair value adjustment for corporate loans held for sale which had an estimatedfair value of $28.2 million as of September 30, 2008. We had no corporate loansheld for sale as of December 31, 2007.

 

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

 

**Corporate Loans**

**(Amountsin thousands)**

 
| **Ratings Category**        | ** ** | **As of  September 30, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|----------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                          |       | $                                       | —     |                                        | $          | — |   |
| Aa1/AA+ through Aa3/AA–     |       | —                                  |       | —                                      |       |
| A1/A+ through A3/A–         |       | —                                  |       | —                                      |       |
| Baa1/BBB+ through Baa3/BBB– |       | —                                  |       | 10,353                                      |       |
| Ba1/BB+ through Ba3/BB–     |       | 3,820,459                               |       | 4,595,862                                   |       |
| B1/B+ through B3/B–         |       | 4,257,648                               |       | 3,391,638                                   |       |
| Caa1/CCC+ and lower              |       | 672,966                                 |       | 405,584                                     |       |
| Non-rated                        |       | 32,664                                  |       | 362,731                                     |       |
| Total                            |       | $                                       | 8,783,737  |                                        | $          | 8,766,168 |   |

 

*Corporate Debt Securities*

 

Our corporate debt securities portfoliototaled $1.0 billion as of September 30, 2008 and $1.3 billion as of December 31,2007. Our corporate debt securities portfolio consists of debt obligations ofcorporations, partnerships and other entities in the form of senior secured andsubordinated notes. As of September 30, 2008, $0.9 billion, or 83.7%, of ourcorporate debt securities portfolio was fixed rate and $0.2 billion, or 16.3%,was floating rate.  As of December 31,2007, $1.1 billion, or 84.7%, of our corporate debt securities portfolio wasfixed rate and $0.2 billion, or 15.3%, was floating rate.

 

As of September 30, 2008, our fixed ratecorporate debt securities had a weighted-average coupon of 10.28% and aweighted-average years to maturity of 7.0 years, as compared to 10.42% and 7.5years, respectively, as of December 31, 2007.

 

All of our floating rate corporate debtsecurities have index reset frequencies of less than twelve months.  The weighted-average coupon on our floatingrate corporate debt securities was 6.12% and 8.39% as of September 30, 2008 andDecember 31, 2007, respectively, and the weighted-average coupon spread toLIBOR of our floating rate corporate debt securities was 3.27% and 3.28% as of September30, 2008 and December 31, 2007, respectively. The weighted-average yearsto maturity of our floating rate corporate debt securities was 5.0 years and5.4 years as of September 30, 2008 and December 31, 2007, respectively.

 

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

 

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

 

**Corporate Debt Securities**

**(Amountsin thousands)**

 
| **Ratings Category**        | ** ** | **As of  September 30, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|----------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                          |       | $                                       | —     |                                        | $          | — |   |
| Aa1/AA+ through Aa3/AA–     |       | 20,000                                  |       | —                                      |       |
| A1/A+ through A3/A–         |       | 20,000                                  |       | —                                      |       |
| Baa1/BBB+ through Baa3/BBB– |       | —                                  |       | —                                      |       |
| Ba1/BB+ through Ba3/BB–     |       | 32,000                                  |       | 236,553                                     |       |
| B1/B+ through B3/B–         |       | 628,006                                 |       | 431,478                                     |       |
| Caa1/CCC+ and lower              |       | 695,970                                 |       | 772,315                                     |       |
| Non-Rated                        |       | 6,815                                   |       | 30,000                                      |       |
| Total                            |       | $                                       | 1,402,791  |                                        | $          | 1,470,346 |   |

 

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***Residential Mortgage InvestmentSummary***

 

Our residential mortgage investment portfolioconsists of investments in RMBS with an estimated fair value of $310.4 millionas of September 30, 2008. The $310.4 million of RMBS is comprised of $277.2million of RMBS that are rated investment grade or higher and $33.2 million ofRMBS that are rated below investment grade. Of the $310.4 million of RMBSinvestments we hold, $197.4 million are in six residential mortgage-backedsecuritization trusts that are not structured as qualifying special-purposeentities as defined by SFAS No. 140. Accordingly, as we own the first losssecurities in these trusts, we are deemed to be the primary beneficiary ofthese entities and as such, consolidate these trusts in accordance with GAAP.This results in us reflecting the financial position and results of thesetrusts in our condensed consolidated financial statements. Consolidation ofthese six entities does not impact our net assets or net income; however, itdoes result in us showing the consolidated assets, liabilities, revenues andexpenses on our condensed consolidated financial statements. On our condensedconsolidated balance sheet as of September 30, 2008, the $310.4 million of RMBSis computed as our investments in RMBS of $113.0 million, plus $197.4 million,which represents the difference between residential mortgage loans of $3.1billion less residential mortgage-backed securities issued of $2.9 billion plus$10.9 million of real estate owned that is included in other assets on ourcondensed consolidated balance sheet. The $310.4 million of RMBS as ofSeptember 30, 2008 represents a decrease of 8.1% from $337.6 million as ofDecember 31, 2007. 

 

As our condensed consolidated financial statements included in thisForm 10-Q are presented to reflect the consolidation of the aforementionedresidential mortgage securitization trusts, the information contained in thisManagement’s Discussion and Analysis of Financial Condition and Results ofOperations reflects our residential mortgage portfolio presented on aconsolidated basis consistent with the disclosures in our condensedconsolidated financial statements. 

 

The tables below summarize the carryingvalue, amortized cost, and estimated fair value of our residential mortgageinvestments as of September 30, 2008 and December 31, 2007, classified byinterest rate type. Carrying value is the value that investments are recordedon our condensed consolidated balance sheets and is estimated fair value forresidential mortgage-backed securities and residential mortgage loans.Estimated fair values set forth in the tables below are based on dealer quotes,nationally recognized pricing services and/or management’s judgment whenrelevant observable inputs do not exist.

 

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

 

**Residential Mortgage Investment Portfolio**

**(Dollaramounts in thousands)**

 
| ** **                                                    | ** ** | **Carrying  Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Portfolio Mix   % by Fair Value** | ** ** |
|---------------------------------------------------------------|------------|---------------------|------------|---------------------|------------|--------------------------------|------------|--------------------------------------------------------------|------------|
| **Floating Rate:**                                            |       |                |       |                |       |                           |       |                                                         |       |
| Residential Adjustable Rate Mortgage  (“ARM”) Loans |       | $                   | 469,576    |                | $          | 598,838                        |       | $                                                            | 469,576    |   | 14.8 | % |
| Residential ARM Securities                                    |       | 38,217              |       | 49,970              |       | 38,217                         |       | 1.2                                                          |       |
| Total Floating Rate                                           |       | 507,793             |       | 648,808             |       | 507,793                        |       | 16.0                                                         |       |
| **Hybrid Rate:**                                              |       |                |       |                |       |                           |       |                                                         |       |
| Residential Hybrid ARM Loans                                  |       | 2,596,038           |       | 2,893,815           |       | 2,596,038                      |       | 81.6                                                         |       |
| Residential Hybrid ARM Securities                             |       | 74,762              |       | 80,838              |       | 74,762                         |       | 2.4                                                          |       |
| Total Hybrid Rate                                             |       | 2,670,800           |       | 2,974,653           |       | 2,670,800                      |       | 84.0                                                         |       |
| Total                                                         |       | $                   | 3,178,593  |                | $          | 3,623,461                      |       | $                                                            | 3,178,593  |   | 100.0 | % |

 

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

 

**Residential Mortgage Investment Portfolio**

**(Dollar amounts in thousands)**

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

 

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*ResidentialARM Securities*

 

Our residential ARM securities portfoliototaled $38.2 million as of September 30, 2008 and $52.0 million as of December 31,2007.  As of September 30, 2008 and December 31,2007, substantially all of our residential ARM securities were comprised ofone-month LIBOR floating rate securities that reprice monthly and were subjectto a weighted-average maximum net interest rate of 11.33% and 11.76%,respectively, which was materially above the then current weighted-average netcoupon of 5.83% and 6.52%, respectively.

 

**Residential ARM Securities**

**(Amountsin thousands)**

 
| **Ratings Category**        | ** ** | **As of  September 30, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|----------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                          |       | $                                       | 27,937     |                                        | $          | 34,960 |   |
| Aa1/AA+ through Aa3/AA–     |       | —                                  |       | —                                      |       |
| A1/A+ through A3/A–         |       | 5,341                                   |       | 7,326                                       |       |
| Baa1/BBB+ through Baa3/BBB– |       | 3,356                                   |       | 4,466                                       |       |
| Ba1/BB+ through Ba3/BB–     |       | 1,191                                   |       | 2,049                                       |       |
| B1/B+ through B3/B–         |       | 275                                     |       | 1,196                                       |       |
| Caa1/CCC+ and lower              |       | —                                  |       | —                                      |       |
| Non-Rated                        |       | 117                                     |       | 1,967                                       |       |
| Total                            |       | $                                       | 38,217     |                                        | $          | 51,964 |   |

 

*ResidentialHybrid ARM Securities*

 

Our residentialhybrid ARM securities portfolio totaled $74.8 million as of September 30, 2008and $79.7 million as of December 31, 2007. As of September 30, 2008and December 31, 2007, all of our residential hybrid ARM securities hadunderlying mortgage loans that were originated as 5/1 hybrid ARM loans. Theweighted-average coupon on the portfolio of residential hybrid securities was 4.35%and 4.18% as of September 30, 2008 and December 31, 2007, respectively. Asof September 30, 2008 and December 31, 2007, our weighted-average monthsuntil roll date for the mortgage loans underlying our residential hybrid ARMsecurities was 7 and 12, respectively.

 

**Residential Hybrid ARM Securities**

**(Amounts in thousands)**

 

| **Ratings Category**        | ** ** | **As of  September 30, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|----------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                          |       | $                                       | 18,542     |                                        | $          | 23,083 |   |
| Aa1/AA+ through Aa3/AA–     |       | 26,129                                  |       | 26,756                                      |       |
| A1/A+ through A3/A–         |       | 15,434                                  |       | 14,898                                      |       |
| Baa1/BBB+ through Baa3/BBB– |       | 6,102                                   |       | 9,002                                       |       |
| Ba1/BB+ through Ba3/BB–     |       | 3,021                                   |       | 2,915                                       |       |
| B1/B+ through B3/B–         |       | 1,856                                   |       | 1,356                                       |       |
| Caa1/CCC+ and lower              |       | —                                  |       | —                                      |       |
| Non-Rated                        |       | 3,678                                   |       | 1,714                                       |       |
| Total                            |       | $                                       | 74,762     |                                        | $          | 79,724 |   |

 

*Residential ARM Loans*

 

Our residential ARM loans portfolio totaled $469.6 million as of September30, 2008 and $628.7 million as of December 31, 2007. As of September30, 2008 and December 31, 2007, all of our residential ARM loans werecomprised of one-month LIBOR floating rate loans that reprice monthly and weresubject to a weighted-average maximum net interest rate of 11.93% which waswell above the then current weighted-average net coupon of 3.68% and 6.19%,respectively.

 

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*Residential Hybrid ARM Loans*

 

Our residential hybrid ARM loans portfolio totaled $2.6 billion as of September30, 2008 and $3.3 billion as of December 31, 2007. As of September 30,2008 and December 31, 2007, all of our residential hybrid ARM loans wereoriginated as either 3/1 or 5/1 hybrid ARM loans. The weighted-average netcoupon on the portfolio of residential hybrid loans was 4.87% and 4.88% as of September30, 2008 and December 31, 2007, respectively. As of September 30, 2008 andDecember 31, 2007, the weighted-average months until roll date for themortgage loans underlying our residential hybrid ARM securities was 15 and 22,respectively.

 

**Portfolio Purchases**

 

We purchased $0.5 billion and $1.8 billion par amount ofinvestments during the three and nine months ended September 30, 2008, compared to $2.2 billion and $5.1 billion forthe three and nine months ended September30, 2007, respectively.

 

The table below summarizes our investment portfolio purchases for theperiods indicated and includes the par amount of the corporate debt securitiesand loans that were purchased:

 

**Investment Portfolio Purchases**

**(Dollar amounts in thousands)**

 
| ** **                         | ** ** | **Three months ended  September 30, 2008** | ** ** | **Three months ended  September 30, 2007** | ** ** | **Nine months ended  September 30, 2008** | ** ** | **Nine months ended  September 30, 2007** | ** ** |
|------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                         | ** ** | **Par Amount**                                       | ** ** | **%**                                                     | ** ** | **Par Amount**                                      | ** ** | **%**                                                    | ** ** | **Par Amount** | ** ** | **%** | ** ** | **Par Amount** | ** ** | **%** | ** ** |
| Securities:                        |       |                                                      |       |                                                      |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |
| Corporate Debt Securities          |       | $                                                         | 50,000     |                                                      | 10.5       | %                                                        | $          | 184,500                                                  |       | 8.4 | % | $ | 176,747 |   | 9.9 | % | $ | 942,500 |   | 18.4 | % |
| Marketable Equity Securities       |       | —                                                    |       | —                                                    |       | 2,225                                                    |       | 0.1                                                      |       | 6,496 |   | 0.4 |   | 42,859 |   | 0.8 |   |
| Non-Marketable Equity Securities   |       | —                                                    |       | —                                                    |       | 5,690                                                    |       | 0.2                                                      |       | — |   | — |   | 13,190 |   | 0.3 |   |
| Total Securities Principal Balance |       | 50,000                                                    |       | 10.5                                                      |       | 192,415                                                  |       | 8.7                                                      |       | 183,243 |   | 10.3 |   | 998,549 |   | 19.5 |   |
| Loans:                             |       |                                                      |       |                                                      |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |
| Corporate Loans                    |       | 426,320                                                   |       | 89.5                                                      |       | 2,013,571                                                |       | 91.3                                                     |       | 1,597,573 |   | 89.7 |   | 4,115,402 |   | 80.5 |   |
| Grand Total Principal Balance      |       | $                                                         | 476,320    |                                                      | 100.0      | %                                                        | $          | 2,205,986                                                |       | 100.0 | % | $ | 1,780,816 |   | 100.0 | % | $ | 5,113,951 |   | 100.0 | % |

 

The schedule above excludes equity securities sold, not yet purchased,with a cost of $101.3 million and $67.2 million as of September 30, 2008 and2007, respectively. 

** **

**Discontinued Operations**

 

Summarized financial information for discontinued operations is asfollows (amounts in thousands):

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

 

(Loss) income from discontinued operations is as follows (amounts inthousands):

 
| ** **                                 | ** ** | **Three months ended** | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** | **Nine months ended** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                 | ** ** | **September 30, 2008**      | ** ** | **September 30, 2007**      | ** ** | **September 30, 2008**     | ** ** | **September 30, 2007**     | ** ** |
| (Loss) income from discontinued operations |       | $                                | —     |                             | $          | (300,105                        | )          | $                               | 2,668      |   | $ | (303,055 | ) |
|                                            |            |                                  |            |                                  |            |                                 |            |                                 |            |  |  |  |  |

 

**Shareholders’ Equity**

 

Our shareholders’ equity at September30, 2008 and December 31, 2007 totaled $1.7 billion and$1.6 billion, respectively. Included in our shareholders’ equity as of September 30, 2008 and December 31,2007, was accumulated other comprehensive loss totaling $377.9 million and$157.2 million, respectively.

 

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Our average shareholders’ equity and return on average shareholders’equity for the three and nine months ended September30, 2008 was $1.8 billion and 10.7% and $1.8 billion and 7.6%,respectively. Our average shareholders’ equity and return on averageshareholders’ equity for the three and nine months ended September 30, 2007 was$1.6 billion and (64.7)% and $1.7 billion and (12.8)%, respectively. Return onaverage shareholders’ equity is defined as net income divided byweighted-average shareholders’ equity. Our book value per share as of September 30, 2008 and December 31,2007 was $11.47 and $14.27, respectively, and is computed based on 150,881,500and 115,248,990 shares issued and outstanding as of September 30, 2008 and December 31, 2007, respectively.

 

**Liquidity and Capital Resources**

 

We manage our liquidity with the intention of maintaining thecontinuing ability to fund our operations and fulfill our commitments on atimely and cost-effective basis. Based on changes in our working capital, forany given period the cash flows provided by operating activities may be lessthan the cumulative distributions paid on our shares for such period and suchshortfall, if any, may be funded through the issuance of unsecured indebtednessor through the borrowing of additional amounts through the pledging of certainof our assets. Our board of directors considers available liquidity whendeclaring distributions to shareholders. As of September 30, 2008, we had unrestricted cash and cash equivalentstotaling $196.5 million and as of the date we filed this Form 10-Q, we hadcash and cash equivalents of approximately $120.0 million.

 

We believe that our liquidity leveland access to additional financing are in excess of that necessary tosufficiently 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 capital expenditures,and implementing our long-term business strategy, although there can be noassurance in this regard.

 

Our ability to meet our long-term liquidity and capital resourcerequirements may be subject to our ability to obtain additional debt financingand equity capital. We may increase our capital resources through offerings ofequity securities (possibly including common shares and one or more classes ofpreferred shares), medium-term notes, securitization transactions structured assecured financings, and senior or subordinated notes. If we are unable torenew, replace or expand our sources of financing on acceptable terms, it mayhave an adverse effect on our business and results of operations and ourability to make distributions to shareholders. Upon liquidation, holders of ourdebt securities and lenders with respect to other borrowings will receive, andany holders of preferred shares that we may issue in the future may receive, adistribution of our available assets prior to holders of our common shares. Thedecisions by investors and lenders to enter into equity, and financingtransactions with us will depend upon a number of factors, including ourhistorical and projected financial performance, compliance with the terms ofour current credit arrangements, industry and market trends, the availabilityof capital and our investors’ and lenders’ policies and rates applicablethereto, and the relative attractiveness of alternative investment or lendingopportunities.

 

Additional factors that may impact our liquidity and capital resourcesin light of the current economic environment are described under Impact ofCredit Market Events in the Executive Overview section of this Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

 

**Sources of Funds**

* *

*Common Share Offering*

 

OnApril 8, 2008, we completed a public offering of 34.5 million commonshares at a price of $11.85 per common share. Net proceeds from the transactionbefore expenses totaled $384.3 million.

 

*Cash Flow CLO Transactions*

* *

As of September 30, 2008, we had five cashflow CLO transactions outstanding, consisting of CLO 2005-1, CLO 2005-2, CLO2006-1, CLO 2007-1 and CLO 2007-A. In aggregate, these transaction issued anaggregate of $8.0 billion of secured notes. An affiliate of our Manager owns a37% interest in CLO 2007-1 and CLO 2007-A. The par amount of the interests inthe cash flow CLOs held by the affiliate of our Manager is $525.4 million,which is reflected as collateralized loan obligation junior secured notes toaffiliates on our condensed consolidated balance sheet. In accordance withGAAP, we consolidate each of these CLO transactions. We utilize cash flow CLOsto fund our investments in corporate loans and corporate debt securities.

 

The indentures governing our CLO transactions include numerouscompliance tests, the majority of which relate to the CLO’s portfolio profile.In the event that a portfolio profile test is not met, the indenture placesrestrictions on the ability of the CLO’s manager to reinvest availableprincipal proceeds generated by the collateral in the CLOs until the specifictest has been cured.

 

In addition to the portfolio profile tests, the indentures for the CLOtransactions include over-collateralization tests which set the ratio of thecollateral value of the assets in the CLO to the tranches of debt for which thetest is being measured, as well as interest coverage tests.  For purposes of the calculation, collateralvalue is the par value of the assets unless an asset is in default, is adiscounted obligation, or is a CCC-rated asset in excess of the percentage ofCCC-rated asset limit specified for each CLO transaction. If an asset is indefault, the indenture for each CLO transaction defines the value used todetermine the collateral value, which value is 

 

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generally thelower of market value of the asset or the recovery value proscribed for theasset based on its type and rating by Standard & Poor’s or Moody’s.

 

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

 

The indenture for each CLO transaction specifies a CCC-threshold forthe percentage of total assets in the CLO that can be rated CCC. All assets inexcess of the CCC threshold specified for the respective CLO are included inthe over-collateralization test at market value and not par.  

 

Defaults of assets in CLOs, ratings downgrade of assets in CLOs to CCC,price declines of CCC assets in excess of the proscribed CCC threshold amount,and price declines in assets classified as discount obligations may reduce theover-collateralization ratio such that a CLO is not in compliance. If a CLO isnot in compliance with an over-collateralization test, cash flows normallypayable to the holders of junior classes of notes will be used by the CLO toamortize the most senior class of notes until such point as theover-collateralization test is brought back into compliance. Recent declines inasset prices, particularly in the corporate loan and high yield securitiesasset classes, have been of a historic magnitude and have therefore increasedthe risk of failing the over-collateralization tests on all CLO transactions.Accordingly, we expect that one or more CLO transactions will be out ofcompliance with the over-collateralization tests for periods of time. Whilebeing out of compliance with an over-collateralization test would not impactour investment portfolio or results of operations, it would impact ourunrestricted cash flows available for operations, new investments and dividenddistributions. As of the date we filed this Form 10-Q, we believe that based oncurrent asset prices that we would be failing one or more of theover-collateralization tests for CLO 2006-1, CLO 2007-1 and CLO 2007-A.

 

*Wayzata*

* *

Wayzata is a $2.0 billion market value CLO transaction. Through thetransaction, $1.6 billion of senior notes were issued to an unaffiliated thirdparty and $336.0 million and $84.0 million of junior notes are held by us andan affiliate of our Manager, respectively. As we own the majority of the juniornotes, we consolidate Wayzata on our condensed consolidated financialstatements. Similar to our cash flow CLOs, we utilize Wayzata to fund ourinvestments in corporate loans and corporate debt securities. 

 

Wayzata’s market value structure provides for an approximately 5%decline in Wayzata’s net asset value to occur prior to any requirement to addadditional junior notes to the facility. In the event that the market value ofthe assets financed in the facility decline by greater than the aforementioned 5%trigger amount, the facility will go into default unless junior notes areissued in an amount equal to or greater than the aggregate amount of thedecline in the net asset value of the assets financed in the facility. If thefacility were to go into default without remedy, then the holders of the seniornotes would foreclose on the collateral of the facility. As of September 30,2008, Wayzata’s net asset value had not declined below the trigger amount;however, due to the recent market declines in asset prices, there is noguarantee Wayzata’s net asset value may not decline by greater than theapproximately 5% trigger amount. In addition, Wayzata’s market value featuresresult in cash being effectively trapped in the facility and not being paid tothe junior noteholders, including us, if the net asset value of Wayzata doesnot meet certain limits. We believe that based on current asset prices, the netasset value of Wayzata would result in cash being trapped and that during thefourth quarter of 2008, Wayzata will cease being cash flow generative to us,and we cannot predict at this time how long the cessation of cash flows willlast. While maintaining a net asset value of Wayzata below the amount requiredto receive cash distributions will not impact our investment portfolio orresults of operations, it will impact our unrestricted cash flows available foroperations, new investments and dividend distributions.

 

 

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*Senior Secured Asset-Based Revolving CreditFacility*

 

On November 10,2008, we and certain of our subsidiaries (collectively, the “Borrowers”)entered into a Credit Agreement (the “Credit Agreement”) with Bank of America,N.A. and Citicorp North America, Inc., as lenders.  The Credit Agreement provides for a two-year$300.0 million senior secured asset-based revolving credit facility (the“Facility”). The Facility is subject, among other things, to the terms of aborrowing base derived from the value of eligible specified financialassets.  The borrowing base is subject tocertain reserves and caps customary for financings of this type.  Prior to the one-year anniversary of theclosing of the credit agreement (the “Adjustment Date”), the Borrowers (i) mayborrow, prepay and reborrow amounts in excess of the borrowing baseavailability and (ii) must prepay loans with net cash proceeds fromcertain types of asset sales to the extent aggregate amounts outstanding underthe Facility exceed the borrowing base then in effect.  On and after the Adjustment Date, if at anytime the aggregate amounts outstanding under the Facility exceed the borrowingbase then in effect, a prepayment of an amount sufficient to eliminate suchexcess is required to be made.

 

The Borrowershave the right to prepay loans under the Facility in whole or in part at anytime. All amounts borrowed under the Credit Agreement must be repaid on orbefore November 10, 2010.  Initialborrowings under the Credit Agreement are subject to, among other things, thesubstantially concurrent repayment by the Borrowers of all amounts due andowing under the existing credit facility and such facility’s effectivetermination.

 

Loans underthe Credit Agreement bear interest, at the Borrower’s option, at a rate equalto LIBOR plus 3.00% per annum or an alternate base rate.  Ongoing extensions of credit under the CreditAgreement are subject to customary conditions, including, after the AdjustmentDate, sufficient availability under the borrowing base.  The Credit Agreement also contains covenantsthat require the Borrowers to satisfy a net worth financial test and maintain acertain leverage ratio.  In addition, theCredit Agreement contains customary negative covenants applicable to theBorrowers and their subsidiaries, including negative covenants that restrict theability of such entities to, among other things, (i) incur additionalindebtedness or engage in certain other types of financing transactions, (ii) allowcertain liens to attach to such entities’ assets, and (iii) pay dividendsor make certain other restricted payments. The Credit Agreement also includes other covenants, representations,warranties, indemnities and events of default, that are customary forfacilities of this type, including events of default relating to a change ofcontrol.

 

*StandbyRevolving Credit Facility*

 

On November 10,2008, the Borrowers entered into an agreement for a two-year $100.0 millionstandby unsecured revolving credit agreement (the “Standby Agreement”) with ourexternal manager, KKR Financial Advisors LLC, and Kohlberg Kravis Roberts &Co. (Fixed Income) LLC, the parent of our external manager. The borrowingfacility matures in December 2010 and bears interest at a rate equal toLIBOR for an interest period of 1, 2 or 3 months (at our option) plus 15.00%per annum. Under the terms of the agreement, we can elect to capitalize aportion of accrued interest on any loan under the agreement by adding up to 80%of the interest due and payable at a particular time in respect of such loan tothe outstanding principal amount of the loan. The Borrowers have the right to prepay loans under the Standby Agreementin whole or in part at any time. The Standby Agreement includes covenants,representations, warranties, indemnities and events of default that arecustomary for facilities of this type.

 

*Junior SubordinatedNotes*

 

During the third quarter of 2008, we retired $5.0 million of juniorsubordinated notes, which resulted in a gain on extinguishment of $3.1 million,partially offset by a $0.2 million write-off of unamortized debt issuance costsand $0.1 million of other associated costs. During the nine months ended September 30,2008, we retired $40.0 million of junior subordinated notes, which resulted ina gain on extinguishment of $20.3 million, partially offset by a $1.3 millionwrite-off of unamortized debt issuance costs and $0.8 million of otherassociated costs.

 

*Capital Utilization and Leverage*

 

As of September 30,2008 and December 31, 2007, we had shareholders’ equity totaling $1.7billion and $1.6 billion, respectively and our leverage was 5.3 times and6.2 times equity, respectively.

 

*Off-Balance Sheet Commitments*

 

As of September 30, 2008,we had committed to purchase corporate loans with aggregate commitmentstotaling $231.1 million. This amount reflects unsettled trades as ofSeptember 30, 2008.

 

We participate in certain financing arrangements, including revolversand delayed draw facilities, whereby we are committed to provide funding at thediscretion of the borrower up to a specific predetermined amount. As of September 30, 2008, we had unfundedfinancing commitments totaling $170.6 million.

 

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

** **

***Qualifying Income Exception***

*** ***

We intend to continue to operate so as toqualify as a partnership, and not as an association or a publicly tradedpartnership taxable as a corporation, for U.S. federal income tax purposes. Ingeneral, if a partnership is “publicly traded” (as defined in the Code), itwill be treated as a corporation for U.S. federal income purposes. A publiclytraded partnership will, however, be taxed as a partnership, and not as acorporation, for U.S. federal income tax purposes, so long as it is notrequired to register under the Investment Company Act and at least 90% of itsgross income for each taxable year constitutes “qualifying income” within themeaning of Section 7704(d) of the Code. We refer to this exception as the“qualifying income exception.” Qualifying income generally includes rents,dividends, interest (to the extent such interest is neither derived from the“conduct of a financial or insurance business” nor based, directly orindirectly, upon “income or profits” of any person), and capital gains from thesale or other disposition of stocks, bonds and real property. Qualifying incomealso includes other income derived from the business of investing in, amongother things, stocks and securities.

 

If we fail to satisfy the “qualifying incomeexception” described above, items of income, gain, loss, deduction and creditwould not pass through to holders of our shares and such holders would betreated for U.S. federal (and certain state and local) income tax purposes asshareholders in a corporation. In such case, we would be required to pay incometax at regular corporate rates on all of our income. In addition, we wouldlikely be liable for state and local income and/or franchise taxes on all ofour income. Distributions to holders of our shares would constitute ordinarydividend income taxable to such holders to the extent of our earnings andprofits, and these distributions would not be deductible by us. If we were taxableas a corporation, it could result in a material reduction in cash flow andafter-tax return for holders of our shares and thus could result in asubstantial reduction in the value of our shares and any other securities wemay issue.

 

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

*** ***

We intend to continue to operate so as toqualify, for U.S. federal income tax purposes, as a partnership and not asan association or a publicly traded partnership taxable as a corporation.Holders of our shares are subject to U.S. federal income taxation and, insome cases, state, local and foreign income taxation, on their allocable shareof our taxable income, regardless of whether or when they receive cashdistributions. In addition, certain of our investments, including investments inforeign CLO issuers and debt securities, may produce taxable income withoutcorresponding distributions of cash to us or produce taxable income prior to orfollowing the receipt of cash relating to such income. Consequently, in sometaxable years, holders of 

 

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our shares may recognize taxable income in excess of our cashdistributions, and if we did not pay dividends, would not receive cashdistributions, but would have a tax liability attributable to their allocationof our taxable income.

 

**Exemption from Regulation under theInvestment Company Act**

 

We intend to conduct our operations so that we are not required toregister as an investment company under the Investment Company Act.Section 3(a)(l)(C) of the Investment Company Act defines aninvestment company as any issuer that is engaged or proposes to engage in thebusiness of investing, reinvesting, owning, holding or trading in securitiesand owns or proposes to acquire “investment securities” having a valueexceeding 40% of the value of the issuer’s total assets (exclusive of U.S.government securities and cash items) on an unconsolidated basis (the “40%test”). Excluded from the term “investment securities,” among other things, aresecurities issued by majority-owned subsidiaries that are not themselvesinvestment companies and are not relying on the exceptions from the definitionof an investment company provided by Section 3(c)(l) orSection 3(c)(7) of the Investment Company Act.

 

We are organized as a holding company that conducts its operationsprimarily through majority-owned subsidiaries. As a result, the securitiesissued to us by our subsidiaries that are excepted from the definition of an“investment company” by Section 3(c)(l) or 3(c)(7) of theInvestment Company Act, together with any other “investment securities” we mayown, may not have a combined value in excess of 40% of the value of our totalassets (exclusive of U.S. government securities and cash items) on anunconsolidated basis. This requirement limits the types of businesses in whichwe may engage through our subsidiaries.

 

The determination of whether an entity is a majority-owned subsidiary ofours is made by us. The Investment Company Act defines a “majority-ownedsubsidiary of a person” as a company owning 50% or more of the outstandingvoting securities of which are owned by such person, or by another companywhich is a majority-owned subsidiary of such person. The Investment Company Actfurther defines “voting securities” as any security presently entitling theowner or holder thereof to vote for the election of directors of a company. Wetreat companies, including our subsidiaries that issue CLOs, in which we own atleast a majority of the outstanding voting securities as majority-ownedsubsidiaries for purposes of the 40% test.

 

Most of our subsidiaries are limited by the provisions of theInvestment Company Act and the rules and regulations promulgated thereunderwith respect to the assets in which each can invest without being regulated asan investment company. Our subsidiaries that issue CLOs generally will rely onRule 3a-7, an exception from the definition of an investment company underthe Investment Company Act available to certain structured financing vehicles.These structured financings may not engage in portfolio management practicesresembling those employed by mutual funds. Accordingly, each of our CLOsubsidiaries that relies on Rule 3a-7 is subject to specific guidelinesand restrictions limiting the discretion of the CLO issuer and our collateralmanager. In particular, our guidelines, which are included in the CLOindentures, prohibit the CLO issuer from acquiring and disposing of assetsprimarily for the purposes of recognizing gains or decreasing losses resultingfrom market value changes. The CLO issuer cannot acquire or dispose of assetsprimarily to enhance returns to the owner of the equity in the CLO.  Sales and purchases of assets may be made solong as the CLO issuer does not violate guidelines contained in the indentures.The proceeds of permitted dispositions may be reinvested by our CLOs inadditional collateral, subject to fulfilling the requirements set forth in theapplicable indentures. As a result of these restrictions, our CLO subsidiariesmay suffer losses on their assets and we may suffer losses on our investmentsin our CLO subsidiaries. We do not treat our ownership interests in ourmajority-owned CLO subsidiaries that rely on Rule 3a-7 under the InvestmentCompany Act as investment securities for purposes of the 40% test.

 

Some of our subsidiaries are currently relying on the exceptionprovided by Section 3(c)(7) of the Investment Company Act, and therefore, ourownership interests in these subsidiaries are deemed to be investmentsecurities for purposes of the 40% test. We must monitor our holdings in thesesubsidiaries and any future subsidiaries relying on the exceptions provided bySection 3(c)(1) or 3(c)(7) to ensure that the value of our investment in suchsubsidiaries, together with any other investment securities we may own, doesnot exceed 40% of the value of our total assets (exclusive of U.S. governmentsecurities and cash items) on an unconsolidated basis.

 

If the combined values of the investment securities issued by oursubsidiaries that must rely on Section 3(c)(1) or 3(c)(7) of the InvestmentCompany Act, together, with any other investment securities we may own, exceeds40% of the value of our total assets (exclusive of U.S. government securitiesand cash items) on an unconsolidated basis, we may be deemed to be aninvestment company. If we fail to maintain an exemption, exception or otherexclusion from registration as an investment company, we could, among otherthings, be required either (a) to change substantially the manner in which weconduct our operations to avoid being required to register as aninvestment  company or (b) to register asan investment company, either of which could have a material adverse effect onus and our ability to service our indebtedness and to make distributions on ourshares and on the market price of our shares and any other securities we mayissue.  If we were required to registeras an investment company under the Investment Company Act, we would becomesubject to substantial regulation with respect to our capital structure(including our ability to use leverage), management, operations, transactionswith affiliated persons (as defined 

 

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in theInvestment Company Act), portfolio composition, including restrictions withrespect to diversification and industry concentration, and other matters, andour Manager would have the right to terminate our management agreement.

 

We have not requested the SEC to approve our treatment of any companyas a majority-owned subsidiary for purposes of the Investment Company Act, ourtreatment of any CLO issuer as a subsidiary meeting the requirements of Rule3a-7 or our determination of whether or not any investment constitutes aninvestment security for purposes of the Investment Company Act. If the SEC wereto disagree with our treatment of one or more CLO issuers as subsidiaries ableto rely on Rule 3a-7, or with our determination that one or more of ourinvestments otherwise do not constitute investment securities for purposes ofthe 40% test, we would need to adjust our investment strategy and ourinvestments in order to continue to pass the 40% test. Any such adjustment inour investment strategy or investments could have a material adverse effect onus. Moreover, to the extent that the SEC provides more specific or differentguidance regarding the application of Section 3 (a)(1)(C), Rule 3a-7,or other provisions of the Investment Company Act to our business or structure,we may be required to adjust our investment strategy and investmentsaccordingly. Any additional guidance from the SEC could provide additionalflexibility to us, or it could further inhibit our ability to pursue theinvestment strategy we have chosen, which could have a material adverse effecton us.

 

**Quantitative and Qualitative DisclosuresAbout Market Risk**

 

*Currency Risks*

 

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

 

*Liquidity Risk*

 

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

 

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

 

Our ability to meet our long-term liquidity and capital resourcerequirements may be subject to our ability to obtain additional debt financingand equity capital. We may increase our capital resources through offerings ofequity securities (possibly including common shares and one or more classes ofpreferred shares) and senior or subordinated notes. If we are unable to renew,replace or expand our sources of financing on acceptable terms, it may have anadverse effect on our business and results of operations and our ability tomake distributions to shareholders. Upon liquidation, holders of our debtsecurities and lenders with respect to other borrowings will receive, and anyholders of preferred shares that we may issue in the future may receive, adistribution of our available assets prior to holders of our common shares. Thedecisions by investors and lenders to enter into equity and financingtransactions with us will depend upon a number of factors, including ourhistorical and projected financial performance, compliance with the terms of ourcurrent credit arrangements, industry and market trends, the availability ofcapital and our investors’ and lenders’ policies and rates applicable thereto,and the relative attractiveness of alternative investment or lendingopportunities.

 

Liquidityis of critical importance to companies in the financial services sector. Mostfailures of financial institutions in recent times have occurred in large partdue to insufficient liquidity resulting from adverse circumstances. As such, wehave established a formal liquidity contingency plan which provides guidelinesfor liquidity management. We determine our current liquidity position andforecast liquidity based on anticipated changes in the balance sheet. In orderto maintain adequate liquidity and funding, we also stress test our liquidityposition under several different stress scenarios. A stress test aims atcapturing the impact of extreme (but rare) market rate changes on the marketvalue of equity and net interest income. This scenario is applied on a dailybasis to our balance sheet and the resulting loss in cash is evaluated. Besidesproviding a measure of the potential loss under the extreme scenario, thistechnique enables us to identify the nature of the changes in market riskfactors to which it is the most sensitive, allowing us to take appropriateaction to address those risk factors. 

 

*Credit Spread Exposure*

 

Ourinvestments are subject to spread risk. Our investments in floating rate loansand securities are valued based on a market credit spread over LIBOR and areaffected similarly by changes in LIBOR spreads. Our investments in fixed rateloans 

 

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and securities are valuedbased on a market credit spread over the rate payable on fixed rate U.S.Treasuries of like maturity. Increased credit spreads, or credit spreadwidening, will have an adverse impact on the value of our investments whiledecreased credit spreads, or credit spread tightening, will have a positiveimpact on the value of our investments.

 

*Derivative Risk*

 

Derivative transactionsincluding engaging in swaps and foreign currency transactions are subject tocertain risks. There is no guarantee that a company can eliminate its exposureunder an outstanding swap agreement by entering into an offsetting swapagreement with the same or another party. Also, there is a possibility ofdefault of the other party to the transaction or illiquidity of the derivativeinstrument. Furthermore, the ability to successfully use derivativetransactions depends on the ability to predict market movements which cannot beguaranteed. As such, participation in derivative instruments may result ingreater losses as we would have to sell or purchase an investment atinopportune times for prices other than current market prices or may force usto hold an asset we might otherwise have sold. In addition, as certainderivative instruments are unregulated, they are difficult to value and aretherefore susceptible to liquidity and credit risks. 

 

Collateral postingrequirements are individually negotiated between counterparties and there is noregulatory requirement concerning the amount of collateral that a counterpartymust post to secure its obligations under certain derivative instruments.Because they are unregulated, there is no requirement that parties to acontract be informed in advance when a credit default swap is sold. As aresult, investors may have difficulty identifying the party responsible forpayment of their claims. If a counterparty’s credit becomes significantlyimpaired, multiple requests for collateral posting in a short period of timecould increase the risk that we may not receive adequate collateral. Amountspaid by us as premiums and cash or other assets held in margin accounts withrespect to derivative instruments are not available for investment purposes. 

* *

*Counterparty Risk*

* *

We have credit risks thatare generally related to the counterparties with which we do business. If acounterparty becomes bankrupt, or otherwise fails to perform its obligationsunder a derivative contract due to financial difficulties, we may experiencesignificant delays in obtaining any recovery under the derivative contract in abankruptcy or other reorganization proceeding. These risks of non-performancemay differ from risks associated with exchange-traded transactions which aretypically backed by guarantees and have daily marks-to-market and settlementpositions. Transactions entered into directly between parties do not benefitfrom such protections and thus, are subject to counterparty default. It may bethe case where any cash or collateral we pledged to the counterparty may beunrecoverable and we may be forced to unwind our derivative agreements at aloss. We may obtain only a limited recovery or may obtain no recovery in suchcircumstances, thereby reducing liquidity and earnings.

* *

*Interest Rate Risk*

 

Interestrate risk is defined as the sensitivity of our current and future earnings tointerest rate volatility, variability of spread relationships, the differencein repricing intervals between our assets and liabilities and the effect thatinterest rates may have on our cash flows and the prepayment ratesexperienced on our investments that have imbedded borrower optionality. Theobjective of interest rate risk management is to achieve earnings, preservecapital and achieve liquidity by minimizing the negative impacts of changinginterest rates, asset and liability mix, and prepayment activity.

 

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

 

Interest rate risk impacts our interest income, interest expense,prepayments, and the fair value of our investments, interest rate derivatives,and liabilities. During periods of increasing interest rates we are biased topurchase investments that are floating rate and we have had that bias since ourinception. We manage our interest rate risk using various techniques rangingfrom the purchase of floating rate investments to the use of interest ratederivatives. We generally fund our variable rate investments with variable rateborrowings with similar interest rate reset frequencies. We generally fund ourfixed rate and our hybrid investments with short-term variable rate borrowingsand we may use interest rate derivatives to hedge the variability of the cashflows associated with our existing or forecasted variable rate borrowings.

 

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The following table summarizes the estimated net fair value of ourderivative instruments held at September30, 2008 and December 31, 2007 (amounts in thousands):

 

**Derivative Fair Value**

 
| ** **                      | ** ** | **As of  September 30, 2008** | ** ** | **As of  December 31, 2007** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **Notional**                            | ** ** | **Estimated  Fair Value**              | ** ** | **Notional** | ** ** | **Estimated  Fair Value** | ** ** |
| **Cash Flow Hedges:**           |       |                                    |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | $                                       | 383,333    |                                        | $          | (24,168 | ) | $ | 383,333 |   | $ | (19,018 | ) |
| **Fair Value Hedges:**          |       |                                    |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | 32,000                                  |       | (1,777                                      | )          | 32,000 |   | (1,212 | ) |
| **Free-Standing Derivatives:**  |       |                                    |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | 181,073                                 |       | (13                                         | )     | 690,799 |   | (7,959 | ) |
| Credit default swaps—long  |       | 53,500                                  |       | (1,063                                      | )          | 66,000 |   | (1,154 | ) |
| Credit default swaps—short |       | 300,070                                 |       | 48,168                                      |       | 268,000 |   | 12,613 |   |
| Total rate of return swaps      |       | 416,597                                 |       | (51,864                                     | )          | 442,204 |   | (21,998 | ) |
| Foreign exchange contracts      |       | 64,380                                  |       | (1,093                                      | )          | 9,711 |   | 3 |   |
| Common stock warrants           |       | —                                  |       | 77                                          |       | — |   | 799 |   |
| Total                           |       | $                                       | 1,430,953  |                                        | $          | (31,733 | ) | $ | 1,892,047 |   | $ | (37,926 | ) |

** **

**Item 3.**                          Quantitative and Qualitative Disclosures AboutMarket Risk

** **

See discussion of quantitative and qualitative disclosures about marketrisk in “Quantitative and Qualitative Disclosures About Market Risk” section ofManagement’s Discussion and Analysis of Financial Condition and Results ofOperations.

 

**Item 4.**                          Controls and Procedures

** **

The Company’s managementevaluated, with the participation of the Company’s principal executive andprincipal financial officer, the effectiveness of the Company’s disclosurecontrols and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the“Exchange Act”)) as of September 30, 2008. Based on their evaluation, the Company’sprincipal executive and principal financial officer concluded that theCompany’s disclosure controls and procedures as of September 30, 2008 were designed and were functioning effectivelyto provide reasonable assurance that the information required to be disclosedby the Company in reports filed under the Exchange Act is (i) recorded,processed, summarized, and reported within the time periods specified in theSEC’s rules and forms, and (ii) accumulated and communicated tomanagement, including the principal executive and principal financial officers,as appropriate, to allow timely decisions regarding disclosure.

 

There has been no change in theCompany’s internal control over financial reporting (as defined inRules 13a-15(f) and 15d-15(f) under the Exchange Act) thatoccurred during the Company’s three and nine months ending September 30, 2008,that has materially affected, or is reasonably likely to materially affect, theCompany’s internal control over financial reporting.

 

**PART II.OTHER INFORMATION**

 

**Item 1.**                          *Legal Proceedings*

** **

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

 

OnAugust 7, 2008, the members of the Company’s board of directors and certain ofthe Company’s executive officers (the “Individual Defendants”) and the Company(collectively, “Defendants”) were named in a putative class action complaint (the“Complaint”) filed by Charter Township of Clinton Police and Fire RetirementSystem in the United States District Court for the Southern District of NewYork (the “Charter Litigation”). The Complaint alleges that the Company’s April2, 2007 

 

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registrationstatement and prospectus (the “April 2, 2007 Registration Statement”) containedmaterial misstatements and omissions in violation of Section 11 of theSecurities Act of 1933, as amended (the "1933 Act"),  regarding the risks associated with theCompany’s real estate related assets, the state of the Company’s capital inlight of its real estate related assets, and the adequacy of the Company’s lossreserves for its real estate related assets (the “alleged Section 11violation”). The Complaint further alleges that pursuant to Section 15 of the1933 Act, the Individual Defendants have legal responsibility for the allegedSection 11 violation.

 

Theparties have stipulated that Defendants shall not be required to answer orotherwise respond to the Complaint. Pursuant to section 27(a) of the 1933 Act,the court is required to appoint a Lead Plaintiff by November 5, 2008. Theparties have stipulated that the Lead Plaintiff shall file and serve aconsolidated amended complaint or designate a previously-filed complaint as theoperative complaint (the “Operative Complaint”) no later than 45 days after anorder appointing it is entered by the Court. The parties have further stipulated that Defendants shall file ananswer, motion to dismiss, or other response to the Operative Complaint nolater than 45 days after it is served.

 

OnAugust 15, 2008, the members of the Company’s board of directors and theCompany’s executive officers (the “Director and Officer Defendants”) were namedin a shareholder derivative action (the “Derivative Action”) brought by RaymondW. Kostecka, a purported shareholder of the Company, in the Superior Court ofCalifornia, County of San Francisco. The Company is named as a nominaldefendant. The complaint in the Derivative Action asserts claims against theDirector and Officer Defendants for breaches of fiduciary duty, abuse ofcontrol, gross mismanagement, waste of corporate assets, and unjust enrichmentin connection with the conduct at issue in the Charter Litigation, includingthe filing of the April 2, 2007 Registration Statement with alleged materialmisstatements and omissions.

 

Theparties have submitted a stipulation requesting that the proceedings in theDerivative Action be stayed until the Charter Litigation is dismissed on thepleadings or the Company files an answer to the Charter Litigation.  

 

**Item 1A.**                 *Risk Factors*

** **

There havebeen no material changes in our risk factors from those disclosed in our AnnualReport on Form 10-K for the year ended December 31, 2007.

 

**Item2 *.******                       Unregistered Sales of Equity Securities and Useof Proceeds***

 

None.

 

**Item 3.**                          *Defaults Upon SeniorSecurities*

** **

None.

 

**Item 4.**                          *Submission of Matters to a Voteof Security Holders*

 

None.

 

**Item 5.**                          *Other Information*

** **

None.

 

**Item 6.**                          *Exhibits*

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

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,KKR Financial Holdings LLC has duly caused this report to be signed on itsbehalf 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: November 10,  2008 |       |                                                                 |

 

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