**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

**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 March 31, 2009**                                                                                                                                                       |
| **or**                                                                                                                                                                                                       |
| **o**                                                                                                                                                                                                        | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
| **For the transition period from              to              ** |

 

**Commission file number: 001-33437**

 

----

 

**KKRFINANCIAL HOLDINGS LLC**

(Exact name ofregistrant as specified in its charter)

 

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

 

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

 

----

 

Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. x Yes  o No

 

Indicate bycheck mark whether the registrant has submitted electronically and posted on itscorporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of thischapter) during the preceding 12 months (or for such shorter period that theregistrant was required to submit and post such files). Yes o  No o

 

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

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

 

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

 

The number ofshares of the registrant’s common shares outstanding as of May 4, 2009 was150,889,325.

 

 

 

----

 

**TABLE OF CONTENTS**

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

 

2

----

 

**PART I. FINANCIAL INFORMATION**

 

**Item1. Financial Statements**

 

**KKR Financial Holdings LLC and Subsidiaries**

**CondensedConsolidated Balance Sheets**

**(Unaudited)**

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

 
| ** **                                                                                                                                                                                  | ** ** | **March 31,  2009** | ** ** | **December 31,  2008** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                  |       |                     |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                   |       | $                        | 55,363     |                        | $          | 41,430 |   |
| Restricted cash and cash equivalents                                                                                                                                                        |       | 378,832                  |       | 1,233,585                   |       |
| Securities available-for-sale, $479,120 and  $553,441 pledged as collateral as of March 31, 2009 and  December 31, 2008, respectively                                             |       | 482,210                  |       | 555,965                     |       |
| Corporate loans, net of allowance for loan  losses of $507,762 and $480,775 as of March 31, 2009 and  December 31, 2008, respectively                                             |       | 7,114,124                |       | 7,246,797                   |       |
| Residential mortgage-backed securities, at  estimated fair value, $87,883 and $102,814 pledged as collateral as of  March 31, 2009 and December 31, 2008, respectively       |       | 87,883                   |       | 102,814                     |       |
| Residential mortgage loans, at estimated  fair value                                                                                                                                        |       | 2,260,759                |       | 2,620,021                   |       |
| Corporate loans held for sale                                                                                                                                                               |       | 259,901                  |       | 324,649                     |       |
| Derivative assets                                                                                                                                                                           |       | 9,557                    |       | 73,869                      |       |
| Interest and principal receivable                                                                                                                                                           |       | 77,406                   |       | 116,788                     |       |
| Reverse repurchase agreements                                                                                                                                                               |       | 80,156                   |       | 88,252                      |       |
| Other assets                                                                                                                                                                                |       | 104,027                  |       | 110,912                     |       |
| **Total assets**                                                                                                                                                                            |       | $                        | 10,910,218 |                        | $          | 12,515,082 |   |
| **Liabilities**                                                                                                                                                                             |       |                     |       |                        |       |
| Collateralized loan obligation senior  secured notes                                                                                                                                        |       | $                        | 6,383,928  |                        | $          | 7,487,611 |   |
| Collateralized loan obligation junior  secured notes to affiliates                                                                                                                          |       | 627,301                  |       | 655,313                     |       |
| Secured revolving credit facility                                                                                                                                                           |       | 267,569                  |       | 275,633                     |       |
| Convertible senior notes                                                                                                                                                                    |       | 291,500                  |       | 291,500                     |       |
| Junior subordinated notes                                                                                                                                                                   |       | 288,671                  |       | 288,671                     |       |
| Residential mortgage-backed securities  issued, at estimated fair value                                                                                                                     |       | 2,113,587                |       | 2,462,882                   |       |
| Accounts payable, accrued expenses and  other liabilities                                                                                                                                   |       | 32,893                   |       | 60,124                      |       |
| Accrued interest payable                                                                                                                                                                    |       | 29,750                   |       | 61,119                      |       |
| Accrued interest payable to affiliates                                                                                                                                                      |       | 3,106                    |       | 3,987                       |       |
| Related party payable                                                                                                                                                                       |       | 3,025                    |       | 2,876                       |       |
| Securities sold, not yet purchased                                                                                                                                                          |       | 82,545                   |       | 90,809                      |       |
| Derivative liabilities                                                                                                                                                                      |       | 93,123                   |       | 171,212                     |       |
| **Total liabilities**                                                                                                                                                                       |       | 10,216,998               |       | 11,851,737                  |       |
| **Shareholders’ Equity**                                                                                                                                                               |       |                     |       |                        |       |
| Preferred shares, no par value, 50,000,000  shares authorized and none issued and outstanding at March 31, 2009 and  December 31, 2008                                            |       | —                   |       | —                      |       |
| Common shares, no par value, 250,000,000  shares authorized, and 150,889,325 and 150,881,500 shares issued and  outstanding at March 31, 2009 and December 31, 2008, respectively |       | —                   |       | —                      |       |
| Paid-in-capital                                                                                                                                                                             |       | 2,550,846                |       | 2,550,849                   |       |
| Accumulated other comprehensive loss                                                                                                                                                        |       | (225,928                 | )          | (268,782                    | )          |
| Accumulated deficit                                                                                                                                                                         |       | (1,631,698               | )          | (1,618,722                  | )          |
| **Total shareholders’ equity**                                                                                                                                                         |       | 693,220                  |       | 663,345                     |       |
| **Total liabilities and shareholders’ equity**                                                                                                                                         |       | $                        | 10,910,218 |                        | $          | 12,515,082 |   |

 

See notes tocondensed consolidated financial statements.

 

3

----

 

**KKRFinancial Holdings LLC and Subsidiaries**

**CondensedConsolidated Statements of Operations**

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

** **
| ** **                                                                                                                                                                                    | ** ** | **For the three** | ** ** | **For the three** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                    | ** ** | **months ended**       | ** ** | **months ended**       | ** ** |
| ** **                                                                                                                                                                                    | ** ** | **March 31, 2009**     | ** ** | **March 31, 2008**     | ** ** |
| **Net investment income:**                                                                                                                                                                    | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Securities interest income                                                                                                                                                                    |       | $                           | 28,852     |                        | $          | 39,809 |   |
| Loan interest income                                                                                                                                                                          |       | 129,204                     |       | 216,537                     |       |
| Dividend income                                                                                                                                                                               |       | 261                         |       | 816                         |       |
| Other interest income                                                                                                                                                                         |       | 356                         |       | 11,076                      |       |
| Total investment income                                                                                                                                                                       |       | 158,673                     |       | 268,238                     |       |
| Interest expense                                                                                                                                                                              |       | (89,882                     | )          | (154,065                    | )          |
| Interest expense to affiliates                                                                                                                                                                |       | (5,805                      | )          | (27,818                     | )          |
| Provision for loan losses                                                                                                                                                                     |       | (26,987                     | )          | —                      |       |
| Net investment income                                                                                                                                                                         |       | 35,999                      |       | 86,355                      |       |
| **Other loss:**                                                                                                                                                                               | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Net realized and unrealized gain (loss) on  derivatives and foreign exchange                                                                                                                  |       | 12,396                      |       | (47,016                     | )          |
| Net realized and unrealized loss on  investments                                                                                                                                              |       | (60,204                     | )          | (13,759                     | )          |
| Net realized and unrealized loss on  residential mortgage-backed securities, residential mortgage loans, and  residential mortgage-backed securities issued, carried at estimated fair  value |       | (19,419                     | )          | (9,178                      | )          |
| Net realized and unrealized gain on  securities sold, not yet purchased                                                                                                                       |       | 1,437                       |       | 6,986                       |       |
| Gain on debt restructuring                                                                                                                                                                    |       | 34,571                      |       | —                      |       |
| Other income                                                                                                                                                                                  |       | 1,333                       |       | 4,956                       |       |
| Total other loss                                                                                                                                                                              |       | (29,886                     | )          | (58,011                     | )          |
| **Non-investment expenses:**                                                                                                                                                                  | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Related party management compensation                                                                                                                                                         |       | 11,212                      |       | 9,159                       |       |
| General, administrative and directors  expenses                                                                                                                                               |       | 2,403                       |       | 4,523                       |       |
| Professional services                                                                                                                                                                         |       | 3,385                       |       | 1,857                       |       |
| Loan servicing                                                                                                                                                                                |       | 2,136                       |       | 2,569                       |       |
| Total non-investment expenses                                                                                                                                                                 |       | 19,136                      |       | 18,108                      |       |
| (Loss) income from continuing operations  before income tax benefit                                                                                                                           |       | (13,023                     | )          | 10,236                      |       |
| Income tax benefit                                                                                                                                                                            |       | 47                          |       | —                      |       |
| (Loss) income from continuing operations                                                                                                                                                      |       | (12,976                     | )          | 10,236                      |       |
| Income from discontinued operations                                                                                                                                                           |       | —                      |       | 3,747                       |       |
| Net (loss) income                                                                                                                                                                             |       | $                           | (12,976    | )                           | $          | 13,983 |   |
|                                                                                                                                                                                          |       |                        |       |                        |       |
| Net (loss) income per common share:                                                                                                                                                           |       |                        |       |                        |       |
| Basic                                                                                                                                                                                         |       |                        |       |                        |       |
| (Loss) income per share from continuing  operations                                                                                                                                           |       | $                           | (0.09      | )                           | $          | 0.09 |   |
| Income per share from discontinued  operations                                                                                                                                                |       | $                           | —     |                        | $          | 0.03 |   |
| Net (loss) income per share                                                                                                                                                                   |       | $                           | (0.09      | )                           | $          | 0.12 |   |
| Diluted                                                                                                                                                                                       |       |                        |       |                        |       |
| (Loss) income per share from continuing  operations                                                                                                                                           |       | $                           | (0.09      | )                           | $          | 0.09 |   |
| Income per share from discontinued  operations                                                                                                                                                |       | $                           | —     |                        | $          | 0.03 |   |
| Net (loss) income per share                                                                                                                                                                   |       | $                           | (0.09      | )                           | $          | 0.12 |   |
|                                                                                                                                                                                          |       |                        |       |                        |       |
| Weighted-average number of common shares  outstanding:                                                                                                                                        |       |                        |       |                        |       |
| Basic                                                                                                                                                                                         |       | 149,714                     |       | 115,048                     |       |
| Diluted                                                                                                                                                                                       |       | 149,714                     |       | 115,599                     |       |

 

See notes tocondensed consolidated financial statements.

 

4

----

 

**KKRFinancial Holdings LLC and Subsidiaries**

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

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

** **
| ** **                                                      | ** ** | **Common  Shares** | ** ** | **Paid-In  Capital** | ** ** | **Accumulated Other  Comprehensive  Loss** | ** ** | **Accumulated  Deficit** | ** ** | **Comprehensive  Income** | ** ** | **Total  Shareholders’  Equity** | ** ** |
|-----------------------------------------------------------------|------------|--------------------|------------|----------------------|------------|-------------------------------------------------|------------|--------------------------|------------|---------------------------|------------|---------------------------------------|------------|
| **Balance at January 1, 2009**                             |       | 150,881            |       | $                    | 2,550,849  |                                            | $          | (268,782                 | )          | $                         | (1,618,722 | )                                     |       |   | $ | 663,345 |   |
| Net loss                                                        |       | —             |       | —               |       | —                                          |       | (12,976                  | )          | $                         | (12,976    | )                                     | (12,976    | ) |
| Net change in unrealized gain on cash flow  hedges              |       | —             |       | —               |       | 9,047                                           |       | —                   |       | 9,047                     |       | 9,047                                 |       |
| Net change in unrealized gain on securities  available-for-sale |       | —             |       | —               |       | 33,807                                          |       |                     |       | 33,807                    |       | 33,807                                |       |
| Comprehensive income                                            |       |               |       |                 |       |                                            |       |                     |       | $                         | 29,878     |                                  |       |   |
| Grant of common shares                                          |       | 8                  |       | —               |       | —                                          |       | —                   |       |                      |       | —                                |       |
| Amortization of restricted common shares                        |       | —             |       | (3                   | )          | —                                          |       | —                   |       |                      |       | (3                                    | )          |
| **Balance at March 31, 2009**                              |       | 150,889            |       | $                    | 2,550,846  |                                            | $          | (225,928                 | )          | $                         | (1,631,698 | )                                     |       |   | $ | 693,220 |   |

 

See notes tocondensed consolidated financial statements.

 

5

----

 

**KKR Financial Holdings LLC and Subsidiaries**

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

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

 
| ** **                                                                                                                           | ** ** | **For the three months  ended March 31, 2009** | ** ** | **For the three months  ended March 31, 2008** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|
| **Cash flows from operating activities:**                                                                                            |       |                                                |       |                                                |       |
| Net (loss) income                                                                                                                    |       | $                                                   | (12,976    | )                                                   | $          | 13,983 |   |
| Adjustments to reconcile net (loss) income  to net cash provided by operating activities:                                            |       |                                                |       |                                                |       |
| Net realized and unrealized loss (gain) on  derivatives, foreign exchange, and securities sold, not yet purchased                    |       | (13,833                                             | )          | 50,710                                              |       |
| Gain on debt restructuring                                                                                                           |       | (34,571                                             | )          | —                                              |       |
| Provision for loan losses                                                                                                            |       | 26,987                                              |       | —                                              |       |
| Impairment on securities available-for-sale                                                                                          |       | 33,764                                              |       | —                                              |       |
| Share-based compensation                                                                                                             |       | (3                                                  | )          | 640                                                 |       |
| Net unrealized loss on residential  mortgage-backed securities, residential mortgage loans, and liabilities at  estimated fair value |       | 11,012                                              |       | (9,014                                              | )          |
| Net realized loss on sales of investments                                                                                            |       | 34,847                                              |       | 14,514                                              |       |
| Depreciation and net amortization                                                                                                    |       | (10,872                                             | )          | (6,080                                              | )          |
| Changes in assets and liabilities:                                                                                                   |       |                                                |       |                                                |       |
| Interest and principal receivable                                                                                                    |       | 34,929                                              |       | 27,763                                              |       |
| Other assets                                                                                                                         |       | (5,232                                              | )          | (8,756                                              | )          |
| Related party payable                                                                                                                |       | 149                                                 |       | (4,813                                              | )          |
| Accounts payable, accrued expenses and  other liabilities                                                                            |       | (27,233                                             | )          | (31,035                                             | )          |
| Accrued interest payable                                                                                                             |       | (31,368                                             | )          | 17,688                                              |       |
| Accrued interest payable to affiliates                                                                                               |       | 5,678                                               |       | 21,738                                              |       |
| Net cash provided by operating activities                                                                                            |       | 11,278                                              |       | 87,338                                              |       |
| **Cash flows from investing activities:**                                                                                            |       |                                                |       |                                                |       |
| Principal payments from investments                                                                                                  |       | 248,254                                             |       | 544,309                                             |       |
| Proceeds from sale of investments                                                                                                    |       | 320,570                                             |       | 280,658                                             |       |
| Purchases of investments                                                                                                             |       | (221,490                                            | )          | (786,223                                            | )          |
| Net proceeds, purchases, and settlements of  derivatives                                                                             |       | 10,336                                              |       | 10,769                                              |       |
| Net change in reverse repurchase agreements                                                                                          |       | 8,096                                               |       | 54,929                                              |       |
| Net reductions (additions) to restricted  cash and cash equivalents                                                                  |       | 854,753                                             |       | (15,494                                             | )          |
| Net cash provided by investing activities                                                                                            |       | 1,220,519                                           |       | 88,948                                              |       |
| **Cash flows from financing activities:**                                                                                            |       |                                                |       |                                                |       |
| Net change in repurchase agreements,  secured revolving credit facility, and secured demand loan                                     |       | (8,064                                              | )          | (359,522                                            | )          |
| Net change in asset-backed secured  liquidity notes                                                                                  |       | —                                              |       | (136,596                                            | )          |
| Repayment of residential mortgage-backed  securities issued                                                                          |       | (105,526                                            | )          | (150,954                                            | )          |
| Repayment of collateralized loan obligation  senior secured notes                                                                    |       | (1,104,037                                          | )          | —                                              |       |
| Issuance of collateralized loan obligation  junior secured notes to affiliates                                                       |       | —                                              |       | 200,000                                             |       |
| Issuance of subordinated notes to  affiliates                                                                                        |       | —                                              |       | 15,177                                              |       |
| Distributions on common shares                                                                                                       |       | —                                              |       | (57,620                                             | )          |
| Other capitalized costs                                                                                                              |       | (237                                                | )          | (162                                                | )          |
| Net cash used in financing activities                                                                                                |       | (1,217,864                                          | )          | (489,677                                            | )          |
| **Net increase (decrease) in cash and cash  equivalents**                                                                            |       | 13,933                                              |       | (313,391                                            | )          |
| **Cash and cash equivalents at beginning of period**                                                                                 |       | 41,430                                              |       | 524,080                                             |       |
| **Cash and cash equivalents at end of period**                                                                                       |       | $                                                   | 55,363     |                                                | $          | 210,689 |   |
| **Supplemental cash flow information:**                                                                                              |       |                                                |       |                                                |       |
| Cash paid for interest                                                                                                               |       | $                                                   | 119,393    |                                                | $          | 172,505 |   |
| Cash paid for income taxes                                                                                                           |       | $                                                   | 227        |                                                | $          | — |   |
| **Non-cash investing and financing  activities:**                                                                                    |       |                                                |       |                                                |       |
| Net payable for securities purchased                                                                                                 |       | $                                                   | —     |                                                | $          | 22,596 |   |
| Issuance of restricted common shares                                                                                                 |       | $                                                   | —     |                                                | $          | 15,939 |   |
| Distributions of securities to the  asset-backed secured liquidity noteholders                                                       |       | $                                                   | —     |                                                | $          | 3,623,049 |   |

 

See notes to condensedconsolidated financial statements.

 

6

----

 

**KKRFinancial Holdings LLC and Subsidiaries**

 

**Notesto Condensed Consolidated Financial Statements**

 

**Note 1. Organization**

 

KKR FinancialHoldings LLC together with its subsidiaries (the “Company” or “KKRFinancial”) is a specialty finance company that uses leverage with theobjective of generating competitive risk-adjusted returns. The Company investsin financial assets primarily consisting of below investment grade corporatedebt, including senior secured and unsecured loans, mezzanine loans, high yieldcorporate bonds, distressed and stressed debt securities, marketable andnon-marketable equity securities, and credit default and total rate of returnswaps. The corporate loans the Company invests in are generally referred to assyndicated bank loans, or leveraged loans, and are purchased via assignment orparticipation in either the primary or secondary market. The majority of theCompany’s corporate debt investments are held in collateralized loan obligation(“CLO”) transactions that the Company uses as long term financing for theseinvestments. The Company’s CLO transactions are structured as on-balance sheetsecuritizations of corporate loans and high yield debt securities. The seniorsecured notes issued by the CLO transactions are generally owned by third partyinvestors who are unaffiliated with the Company and the Company owns themajority of the mezzanine and subordinated notes in the CLO transactions.

 

The Company closely monitors its liquidity positionand believes it has sufficient liquidity and access to liquidity to meet itsfinancial obligations for at least the next 12 months. The Company believesthat it is in compliance with the covenants contained in its borrowingagreements.

 

 KKR Financial Advisors LLC (the “Manager”),a wholly owned subsidiary of Kohlberg Kravis Roberts & Co. (FixedIncome) LLC, manages the Company pursuant to a management agreement (the “ManagementAgreement”). Kohlberg Kravis Roberts & Co. (FixedIncome) LLC is a wholly-owned subsidiary of Kohlberg Kravis Roberts &Co. L.P. (“KKR”).

 

**Note 2. Summary of SignificantAccounting Policies**

 

**Basis of Presentation**

 

Theaccompanying condensed consolidated financial statements have been prepared inconformity with accounting principles generally accepted in the United Statesof America (“GAAP”). The condensed consolidated financial statements includethe accounts of the Company, consolidated residential mortgage loansecuritization trusts where the Company is the primary beneficiary, andentities established to complete secured financing transactions that areconsidered to be variable interest entities and for which the Company is theprimary beneficiary.

 

These condensed consolidated financial statementsshould be read in conjunction with the consolidated financial statements andnotes thereto included in the Company’s Annual Report on Form 10-K for theyear ended December 31, 2008. The Company’s results for any interim periodare not necessarily indicative of results for a full year or any other interimperiod. In the opinion of management, all normal recurring adjustments havebeen included for a fair statement of this interim financial information.

 

**Use of Estimates**

 

Thepreparation of financial statements in conformity with GAAP requires managementto make estimates and assumptions that affect the amounts reported in theCompany’s condensed consolidated financial statements and accompanying notes.Actual results could differ from management’s estimates.

 

**Consolidation**

 

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

 

7

----

 

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 FinancialCLO 2007-1, Ltd. (“CLO 2007-1”), KKR Financial CLO2007-A, Ltd. (“CLO 2007-A”) and KKR Financial CLO 2009-1, Ltd. (“CLO2009-1”), are entities established to complete secured financing transactions.These entities are VIEs and are not considered to be qualifying special-purposeentities (“QSPE”) as defined by Statement of Financial Accounting Standards No. 140,*Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities* (“SFAS No. 140”).The Company has determined it is the primary beneficiary of these entities andhas included the accounts of these entities in these condensed consolidatedfinancial statements. Additionally, the Company is the primary beneficiary ofsix residential mortgage loan securitization trusts that are not considered tobe QSPEs under SFAS No. 140 and the Company has therefore included theaccounts of these entities in these condensed consolidated financialstatements.

 

Allinter-company balances and transactions have been eliminated in consolidation.

 

**Fair Value of Financial Instruments**

 

As defined inSFAS No. 157, *Fair Value Measurements*(“SFAS No. 157”), fair value is the price that would be received to sellan asset or paid to transfer a liability in an orderly transaction betweenmarket participants at the measurement date. Where available, fair value isbased on observable market prices or parameters, or derived from such prices orparameters. Where observable prices or inputs are not available, valuationmodels are applied. These valuation techniques involve some level of managementestimation and judgment, the degree of which is dependent on the pricetransparency for the instruments or market and the instruments’ complexity fordisclosure purposes. Beginning in January 2007, assets and liabilitiesrecorded at fair value in the condensed consolidated balance sheets arecategorized based upon the level of judgment associated with the inputs used tomeasure their value. Hierarchical levels, as defined in SFAS No. 157 anddirectly related to the amount of subjectivity associated with the inputs tofair valuations of these assets and liabilities, are as follows:

 

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

 

The types ofassets carried at level 1 fair value generally are equity securitieslisted in active markets.

 

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

 

Fair valueassets and liabilities that are generally included in this category are certaincorporate debt securities, certain corporate loans held for sale and certainfinancial instruments classified as derivatives where the fair value is basedon observable market inputs.

 

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

 

Generally, assetsand liabilities carried at fair value and included in this category are certaincorporate debt securities, certain corporate loans held for sale, certainnon-marketable equity securities, residential mortgage-backed securities,residential mortgage loans, residential mortgage-backed securities issued andcertain derivatives.

 

Theavailability of observable inputs can vary depending on the financial asset orliability and is affected by a wide variety of factors, including, for example,the type of product, whether the product is new, whether the product is tradedon an active exchange or in the secondary market, and the current marketcondition. To the extent that valuation is based on models or inputs that areless observable or unobservable in the market, the determination of fair valuerequires more judgment. Accordingly, the degree of judgment exercised by theCompany in determining fair value is greatest for instruments categorized inlevel 3. In certain cases, the inputs used to measure fair value may fallinto different levels of the fair value hierarchy. In such cases, fordisclosure purposes, the level in the fair value hierarchy within which thefair value measurement in its entirety falls is determined based on the lowestlevel input that is significant to the fair value measurement in its entirety.

 

8

----

 

Fair value isa market-based measure considered from the perspective of a market participantwho holds the asset or owes the liability rather than an entity-specificmeasure. Therefore, even when market assumptions are not readily available, theCompany’s own assumptions are set to reflect those that management believesmarket participants would use in pricing the asset or liability at the measurementdate.

 

Many financialassets and liabilities have bid and ask prices that can be observed in themarketplace. Bid prices reflect the highest price that the Company and othersare willing to pay for an asset. Ask prices represent the lowest price that theCompany and others are willing to accept for an asset. For financial assets andliabilities whose inputs are based on bid-ask prices, the Company does notrequire that fair value always be a predetermined point in the bid-ask range.The Company’s policy is to allow for mid-market pricing and adjusting to thepoint within the bid-ask range that meets the Company’s best estimate of fairvalue.

 

Depending onthe relative liquidity in the markets for certain assets, the Company maytransfer assets to level 3 if it determines that observable quoted prices,obtained directly or indirectly, are not available. Assets and liabilities thatare valued using level 3 of the fair value hierarchy primarily consist ofcertain corporate debt securities, certain non-marketable equity securities, certaincorporate loans held for sale, residential mortgage-backed securities,residential mortgage loans, residential mortgage-backed securities issued andcertain over-the-counter (“OTC”) derivative contracts. The valuation techniquesused for these are described below.

 

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

 

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

 

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

 

**Cash and Cash Equivalents**

 

Cash and cashequivalents include cash on hand, cash held in banks and highly liquidinvestments with original maturities of three months or less. Interest incomeearned on cash and cash equivalents is recorded in other interest income.

 

**Restricted Cash and Cash Equivalents**

 

Restrictedcash and cash equivalents represent amounts that are held by third partiesunder certain of the Company’s financing and derivative transactions. Interestincome earned on restricted cash and cash equivalents is recorded in otherinterest income.

 

**Residential Mortgage-Backed Securities**

 

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

 

9

----

 

**Securities Available-for-Sale**

 

The Companyclassifies its investments in securities as available-for-sale as the Companymay sell them prior to maturity and does not hold them principally for thepurpose of selling them in the near term. These investments are carried atestimated fair value, with unrealized gains and losses reported in accumulatedother comprehensive income (loss). Estimated fair values are based on quotedmarket prices, when available, on estimates provided by independent pricingsources or dealers who make markets in such securities, or internal valuationmodels when external sources of fair value are not available. Upon the sale ofa security, the realized net gain or loss is computed on a weighted-averagecost basis. Purchases and sales of securities are recorded on the trade date.

 

The Companymonitors its available-for-sale securities portfolio for impairments. A loss isrecognized when it is determined that a decline in the estimated fair value ofa security below its amortized cost is other-than-temporary. The Companyconsiders many factors in determining whether the impairment of a security isdeemed to be other-than-temporary, including, but not limited to, the length oftime the security has had a decline in estimated fair value below its amortizedcost and the severity of the decline, the amount of the unrealized loss, theintent and ability of the Company to hold the security for a period of timesufficient for a recovery in value, recent events specific to the issuer orindustry, external credit ratings and recent changes in such ratings.

 

Unamortizedpremiums and unaccreted discounts on securities available-for-sale arerecognized in interest income over the contractual life, adjusted for actualprepayments, of the securities using the effective interest method.

 

**Non-marketable Equity Securities**

 

Non-marketableequity securities consist primarily of private equity investments. Theseinvestments are accounted for under either the cost method or at fair value ifthe fair value option of accounting has been elected under SFAS No. 159, *the Fair Value Option for Financial Assets and FinancialLiabilities – Including an amendment of FASB Statement No. 115*. TheCompany reviews its investments accounted for under the cost method on aquarterly basis for possible other-than-temporary impairment. The Companyreduces the carrying value of the investment and recognizes a loss when theCompany considers a decline in estimated fair value below the cost basis of thesecurity to be other-than-temporary. Non-marketable equity securities areincluded in other assets on the condensed consolidated balance sheets.

 

**Securities Sold, Not Yet Purchased**

 

Securitiessold, not yet purchased consist of equity and debt securities that the Companyhas sold short. In order to facilitate a short sale, the Company borrows thesecurities from another party and delivers the securities to the buyer. TheCompany will be required to “cover” its short sale in the future through thepurchase of the security in the market at the prevailing market price anddeliver it to the counterparty from which it borrowed. The Company is exposedto a loss to the extent that the security price increases during the time fromwhen the Company borrowed the security to when the Company purchases it in themarket to cover the short sale.

 

**Corporate Loans**

 

The Companypurchases participations and assignments in corporate loans in the primary andsecondary market. Loans are held for investment and the Company initiallyrecords loans at their purchase prices. The Company subsequently accounts forloans based on their outstanding principal plus or minus unaccreted purchasediscounts and unamortized purchase premiums. In certain instances, where thecredit fundamentals underlying a particular loan have materially changed insuch a manner that the Company’s expected return may decrease, the Company mayelect to sell a loan held for investment. Interest income on loans includesinterest at stated coupon rates adjusted for accretion of purchase discountsand the amortization of purchase premiums. Unamortized premiums and unaccreteddiscounts are recognized in interest income over the contractual life, adjustedfor actual prepayments, of the loans using the effective interest method.

 

**Residential Mortgage Loans**

 

The Companycarries its residential mortgage loans at estimated fair value, with unrealizedgains and losses reported in income.

 

**Corporate Loans Held for Sale**

 

Corporateloans held for sale consist of leveraged loans that the Company has determinedto no longer hold for investment. Corporate loans held for sale are stated atlower of cost or estimated fair value.

 

10

----

 

**Allowance for Loan Losses**

 

The Company’sallowance for estimated loan losses represents its estimate of probable creditlosses inherent in its corporate loan portfolio held for investment as of thebalance sheet date. When determining the adequacy of the allowance for loanlosses the Company considers historical and industry loss experience, economicconditions and trends, the estimated fair values of its loans, credit qualitytrends and other factors that it determines are relevant. Additions to theallowance for loan losses are charged to current period earnings through theprovision for loan losses. The Company’s allowance for loan losses consists oftwo components, an allocated component and an unallocated component. Amountsdetermined to be uncollectible are charged directly to the allowance for loanlosses.

 

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

 

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

 

**Leasehold Improvements and Equipment**

 

Leaseholdimprovements and equipment are carried at cost less depreciation andamortization and are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of the assets might not berecoverable. Equipment is depreciated using the straight-line method over theestimated useful lives of the respective assets of three years. Leaseholdimprovements are amortized on a straight-line basis over the shorter of their estimateduseful lives or lease terms. Leasehold improvements and equipment, net ofaccumulated depreciation and amortization, are included in other assets.

 

**Borrowings**

 

The Companyfinances the acquisition of its investments, including loans, residential mortgage-backedsecurities and securities available-for-sale, primarily through the use ofsecured borrowings in the form of securitization transactions structured assecured financings and other secured and unsecured borrowings. The Companyrecognizes interest expense on all borrowings on an accrual basis.

 

**Residential Mortgage-Backed Securities Issued**

 

The Companycarries its residential mortgage-backed securities issued at estimated fairvalue, with unrealized gains and losses reported in income.

 

**Trust Preferred Securities**

 

Trusts formedby the Company for the sole purpose of issuing trust preferred securities arenot consolidated by the Company in accordance with FIN 46R as the Companyhas determined that it is not the primary beneficiary of such trusts. TheCompany’s investment in the common securities of such trusts is included inother assets on the Company’s condensed consolidated financial statements.

 

11

----

 

**Derivative Financial Instruments**

 

The Company recognizesall derivatives on the condensed consolidated balance sheet at estimated fairvalue. On the date the Company enters into a derivative contract, the Companydesignates and documents each derivative contract as one of the following atthe time the contract is executed: (i) a hedge of a recognized asset orliability (“fair value” hedge); (ii) a hedge of a forecasted transactionor of the variability of cash flows to be received or paid related to arecognized asset or liability (“cash flow” hedge); (iii) a hedge of a netinvestment in a foreign operation; or (iv) a derivative instrument notdesignated as a hedging instrument (“free-standing derivative”). For a fairvalue hedge, the Company records changes in the estimated fair value of thederivative and, to the extent that it is effective, changes in the fair valueof the hedged asset or liability attributable to the hedged risk, in thecurrent period earnings in the same financial statement category as the hedgeditem. For a cash flow hedge, the Company records changes in the estimated fairvalue of the derivative to the extent that it is effective in othercomprehensive (loss) income. The Company subsequently reclassifies thesechanges in estimated fair value to net income in the same period(s) that thehedged transaction affects earnings in the same financial statement category asthe hedged item. For free-standing derivatives, the Company reports changes inthe fair values in current period non-net investment income.

 

The Companyformally documents at inception its hedge relationships, includingidentification of the hedging instruments and the hedged items, its riskmanagement objectives, strategy for undertaking the hedge transaction and theCompany’s evaluation of effectiveness of its hedged transactions. Periodically,as required by SFAS No. 133, *Accountingfor Derivative Instruments and Hedging Activities*, as amended andinterpreted (“SFAS No. 133”), the Company also formally assesses whetherthe derivative it designated in each hedging relationship is expected to be andhas been highly effective in offsetting changes in estimated fair values orcash flows of the hedged item using either the dollar offset or the regressionanalysis method. If the Company determines that a derivative is not highly effectiveas a hedge, it discontinues hedge accounting.

 

**Foreign Currency**

 

The Companymakes investments in non-United States dollar denominated securities and loans.As a result, the Company is subject to the risk of fluctuation in the exchangerate between the United States dollar and the foreign currency in which itmakes an investment. In order to reduce the currency risk, the Company mayhedge the applicable foreign currency. All investments denominated in a foreigncurrency are converted to the United States dollar using prevailing exchangerates on the balance sheet date. Income, expenses, gains and losses oninvestments denominated in a foreign currency are converted to the UnitedStates dollar using the prevailing exchange rates on the dates when they arerecorded. Foreign exchange gains and losses are recorded in the condensedconsolidated statements of operations.

 

**Manager Compensation**

 

The ManagementAgreement provides for the payment of a base management fee to the Manager, aswell as an incentive fee if the Company’s financial performance exceeds certainbenchmarks. Additionally, the Management Agreement provides for the Manager tobe reimbursed for certain expenses incurred on the Company’s behalf. SeeNote 14 to these condensed consolidated financial statements for thespecific terms of the computation and payment of the incentive fee. The basemanagement fee and the incentive fee are accrued and expensed during the periodfor which they are earned by the Manager.

 

**Share-Based Compensation**

 

The Company accounts for share-based compensation issued to itsdirectors and to the Manager using the fair value based methodology prescribedby SFAS No. 123(R),*Share-Based Payment*(“SFAS No. 123(R)”).Compensationcost related to restricted commonsharesissued to the Company’s directors is measured at its estimated fair value atthe grant date, and isamortized and expensed over thevestingperiod on a straight-line basis. Compensation cost relatedto restricted common sharesand common share options issued to theManager is initially measured at estimated fair value at the grant date, and isremeasured on subsequent dates to the extent theawards are unvested. The Company haselected to use the graded vesting attribution method pursuant to SFAS No. 123(R)to amortize compensation expense for the restricted common shares and commonshare options granted to the Manager.

 

**Income Taxes**

 

The Companyintends to continue to operate in order to qualify as a partnership, and not asan association or publicly traded partnership that is taxable as a corporation,for United States federal income tax purposes. Therefore, the Company is notsubject to United States federal income tax at the entity level, but is subjectto limited state income taxes. Holders of the Company’s shares will be requiredto take into account their allocable share of each item of the Company’sincome, gain, loss, deduction, and credit for the taxable year of the Companyending within or with their taxable year.

 

12

----

 

KKR TRSHoldings, Ltd. (“TRS Ltd.”), KKR Financial Holdings, Ltd. (“KFH Ltd.”),and KFN PEI VII, LLC (“PEI VII”) are taxable as corporations for UnitedStates federal income tax purposes and thus are not consolidated with theCompany for United States federal income tax purposes. For financial reportingpurposes, current and deferred taxes are provided for on the portion ofearnings recognized by the Company with respect to its interest in PEI VII, adomestic taxable corporate subsidiary, because PEI VII is taxed as a regularcorporation under the Internal Revenue Code of 1986, as amended (the “Code”).Deferred income tax assets and liabilities are computed based on temporarydifferences between the GAAP consolidated financial statements and the UnitedStates federal income tax basis of assets and liabilities as of eachconsolidated balance sheet date. CLO 2005-1, CLO 2005-2,CLO 2006-1, CLO 2007-1, CLO 2007-A and CLO 2009-1 are foreignsubsidiaries of the Company that elected to be treated as disregarded entitiesor partnerships for United States federal income tax purposes. Thesesubsidiaries were established to facilitate securitization transactions,structured as secured financing transactions. TRS Ltd. and KFH Ltd.are foreign corporate subsidiaries that were formed to make certain foreign anddomestic 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 exempt from United States federaland state income tax at the corporate entity level because they restrict theiractivities in the United States to trading in stock and securities for theirown account. However, the Company will generally be required to include theircurrent taxable income in the Company’s calculation of its taxable incomeallocable to shareholders.

 

**Earnings Per Share**

 

In accordancewith SFAS No. 128, *Earnings per Share*(“SFAS No. 128”), the Company presents both basic and diluted earnings(loss) per common share in its condensed consolidated financial statements andfootnotes thereto. Basic earnings (loss) per common share (“Basic EPS”)excludes dilution and is computed by dividing net income or loss by theweighted-average number of common shares, including vested restricted commonshares, outstanding for the period. Diluted earnings (loss) per share (“DilutedEPS”) reflects the potential dilution of common share options and unvestedrestricted common shares using the treasury method, and the potential dilutionof convertible senior notes using the if-converted method, if they are notanti-dilutive. See Note 3 to these condensed consolidated financialstatements for earnings (loss) per common share computations.

 

A rightsoffering whose exercise price at issuance is less than the fair value of thestock is considered to have a bonus element, resulting in an adjustment of theprior period number of shares outstanding used to calculate basic and dilutedearnings per share. As a result of the $270.0 million common share rightsoffering that occurred during the third quarter of 2007, prior periodweighted-average number of shares and earnings per share outstanding have beenadjusted to reflect the issuance at less than fair value.

 

**Recent Accounting Pronouncements**

 

In March 2008, the FASB issued SFAS No. 161,*Disclosures about Derivative Instruments andHedging Activities, an Amendment of FASB Statement No. 133*(“SFASNo. 161”). SFAS No. 161 requires enhanced qualitative disclosuresabout objectives and strategies for using derivatives, quantitative disclosuresabout fair value amounts of gains and losses on derivative instruments, anddisclosures about credit-risk-related contingent features in derivativeagreements. The adoption of SFAS No. 161 did not have a material impact on theCompany’s financial statements. The applicable additional disclosures requiredby SFAS No. 161 have been incorporated in the Company’s notes to condensedconsolidated financial statements beginning with the first quarter of 2009.

 

In January 2009,the FASB issued Financial Accounting Standards Board’s Staff Position (“FSP”) EITF 99-20-1,*Amendments to the Impairment Guidance ofEITF Issue No. 99-20* (“FSP EITF 99-20-1”). FSPEITF 99-20-1 eliminates the requirement that a holder’s best estimate ofcash flows be based upon those that “a market participant” would use. Instead,it requires that an other-than-temporary impairment be recognized as a realizedloss when it is “probable” there has been an adverse change in the holder’sestimated cash flows from the cash flows previously projected. FSPEITF 99-20-1 also reiterates and emphasizes the related guidance anddisclosure requirements in accordance with SFAS No. 115, *Accounting for Certain Investments in Debt and EquitySecurities.* FSP EITF 99-20-1 is effective for all periodsending after December 15, 2008 and retroactive application is notpermitted. The Company has taken this FSP into consideration when evaluatingits investments for other-than-temporary impairment.

 

In April 2009, the FASB issued FSP FAS 107-1 and APB 28-1, *Interim Disclosures about Fair Value of Financial Instruments*which amends SFAS No. 107, *Disclosures about FairValue of Financial Instruments*, to require disclosures about fairvalue of financial instruments for interim reporting periods as well as inannual financial statements. This FSP shall be effective for interim reportingperiods ending after June 15, 2009, with early adoption permitted. TheCompany will adopt this FSP beginning the second quarter of 2009 and does notbelieve that its adoption will have a material impact on its financialstatements.

 

In April 2009, the FASB issued FSP FAS 157-4, *DeterminingFair Value When the Volume and Level of Activity for the Asset or LiabilityHave Significantly Decreased and Identifying Transactions That Are Not Orderly,*which provides additional guidance on identifying circumstances that indicate atransaction is not orderly as well as for estimating fair value in accordancewith SFAS No. 157 when the volume and level of activity for the asset orliability have significantly decreased. This FSP shall be effective for interimand annual reporting periods ending after June 15, 2009, with earlyadoption permitted, and shall be applied prospectively. The Company will adopt thisFSP beginning the second quarter of 2009 and is currently evaluating thepotential impact of this FSP on its financial statements.

 

13

----

 

Furthermore, in April 2009, the FASB issued FSP FAS 115-2 and FAS124-2,*Recognition and Presentation ofOther-Than-Temporary Impairments,* which amends theother-than-temporary impairment guidance for debt securities to make theguidance more operational and to improve the presentation and disclosure ofother-than-temporary impairments on debt and equity securities in the financialstatements. This FSP shall be effective for interim and annual reportingperiods ending after June 15, 2009, with early adoption permitted, andshall be applied prospectively. The Company will adopt this FSP beginning thesecond quarter of 2009.

 

**Note 3.Earnings per Share**

 

The Companycalculates basic net income per common share by dividing net income for theperiod by the weighted-average number of shares of its common sharesoutstanding for the period. Diluted net income per common share is calculatedby dividing net income by the weighted-average number of common shares pluspotentially dilutive common shares outstanding during the period. Potentiallydilutive common shares include the assumed exercise of outstanding common shareoptions and assumed vesting of outstanding restricted common shares using thetreasury stock method, as well as the assumed conversion of convertible seniornotes using the if-converted method, if they are not anti-dilutive.

 

The followingtable presents a reconciliation of basic and diluted net income per commonshare, as well as the distributions declared per common share for the threemonths ended March 31, 2009 and 2008 (amounts in thousands, except pershare information):

 
| ** **                                                             | ** ** | **Three months ended  March 31, 2009(1)** | ** ** | **Three months ended  March 31, 2008(1)** | ** ** |
|------------------------------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| (Loss) income from continuing operations                               |       | $                                              | (12,876    | )                                              | $          | 10,030 |   |
| Income from discontinued operations                                    |       | —                                         |       | 3,747                                          |       |
| Net (loss) income                                                      |       | $                                              | (12,876    | )                                              | $          | 13,777 |   |
| **Basic:**                                                             |       |                                           |       |                                           |       |
| Basic weighted-average shares outstanding                              |       | 149,714                                        |       | 115,048                                        |       |
| (Loss) income per share from continuing  operations                    |       | $                                              | (0.09      | )                                              | $          | 0.09 |   |
| Income per share from discontinued  operations                         |       | $                                              | —     |                                           | $          | 0.03 |   |
| Net (loss) income per share                                            |       | $                                              | (0.09      | )                                              | $          | 0.12 |   |
| **Diluted:**                                                           |       |                                           |       |                                           |       |
| Basic weighted-average shares outstanding                              |       | 149,714                                        |       | 115,048                                        |       |
| Dilutive effect of restricted common shares  using the treasury method |       | —                                         |       | 551                                            |       |
| Diluted weighted-average shares  outstanding(2)                        |       | 149,714                                        |       | 115,599                                        |       |
| (Loss) income per share from continuing  operations                    |       | $                                              | (0.09      | )                                              | $          | 0.09 |   |
| Income per share from discontinued  operations                         |       | $                                              | —     |                                           | $          | 0.03 |   |
| Net (loss) income per share                                            |       | $                                              | (0.09      | )                                              | $          | 0.12 |   |
| Distributions declared per common share                                |       | —                                         |       | $                                              | 0.50       |   |

 

----

(1)                                  EffectiveJanuary 1, 2009, the Company adopted FSP No. EITF 03-6-1, *Determining Whether Instruments Granted in Share-Based PaymentTransactions are Participating Securities*. According to this FSP,unvested share-based payment awards that contain non-forfeitable rights todividends or dividend equivalents (whether paid or unpaid) are participatingsecurities and shall be included in the computation of earnings per sharepursuant to the two-class method. In accordance with this FSP, the Company hascalculated earnings per share and determined that the adoption had an immaterialeffect on consolidated results of operations and earnings per share for allperiods presented. No dividend was declared on common shares in the firstquarter of 2009.

 

(2)                                  Potentialanti-dilutive common shares excluded from diluted (loss) income earnings pershare for the three months ended March 31, 2009 and 2008 were 9,403,236and 9,677,430, respectively, related to convertible debt securities.

 

14

----

 

**Note 4. Securities Sold, Not YetPurchased**

 

Securitiessold, not yet purchased consist of equity and debt securities that the Companyhas sold short. As of March 31, 2009, the Company had securities sold, notyet purchased with an amortized cost of $77.2 million and an accumulated netunrealized loss of $5.3 million. As of December 31, 2008, the Company hadsecurities sold, not yet purchased with an amortized cost basis of$97.3 million and an accumulated net unrealized gain of $6.5 million.

 

For the threemonths ended March 31, 2009, the Company had net realized and unrealizedgains on short security sales of $1.4 million compared to net realized andunrealized gains on short security sales of $7.0 million for the threemonths ended March 31, 2008.

 

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

 

The following table summarizes the Company’s securities classified asavailable-for-sale as of March 31, 2009, which are carried at estimatedfair value (amounts in thousands):

 
| **Description**            | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
|----------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|---------------------------|------------|
| Corporate securities       |       | $                   | 635,408    |                         | $          | 3,738                         |       | $                         | (160,026   | ) | $ | 479,120 |   |
| Common and preferred stock |       | 2,542               |       | 548                          |       | —                        |       | 3,090                     |       |
| Total                      |       | $                   | 637,950    |                         | $          | 4,286                         |       | $                         | (160,026   | ) | $ | 482,210 |   |

 

The followingtable shows the gross unrealized losses and fair value of the Company’savailable-for-sale securities, aggregated by length of time that the individualsecurities have been in a continuous unrealized loss position, as of March 31,2009 (amounts in thousands):

 
| ** **           | ** ** | **Less Than 12 months** | ** ** | **12 Months or More**  | ** ** | **Total**                 | ** ** |
|----------------------|------------|------------------------------|------------|------------------------|------------|---------------------------|------------|
| **Description**      | ** ** | **Estimated  Fair Value**    | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| Corporate securities |       | $                            | 202,315    |                   | $          | (104,280                  | )          | $ | 112,654 |   | $ | (55,746 | ) | $ | 314,969 |   | $ | (160,026 | ) |
|                      |            |                              |            |                        |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The unrealizedlosses in the table above are considered to be temporary impairments due tomarket factors and are not reflective of credit deterioration. When evaluatingwhether an impairment is other-than-temporary, the Company performs an analysisof the anticipated future cash flows and the ability and intent to hold theinvestment for a sufficient amount of time to recover the unrealized losses.Additionally, the Company considers the current events specific to the issueror industry including widening credit spreads and external credit ratings, aswell as interest rate volatility. The Company has performed credit analyses inrelation to these investments and has determined that the carrying value ofthese investments is expected to be fully recoverable over their expectedholding period. Because the Company has the intent and ability to hold theseinvestments until recovery, the related unrealized losses are not considered tobe other-than-temporary impairments.

 

During thequarter ended March 31, 2009, the Company recognized a loss totaling$33.8 million for securities that it determined to beother-than-temporarily impaired, which are excluded from the table above. Thesesecurities were determined to be other-than-temporarily impaired either due tomanagement’s determination that recovery in value is no longer likely orbecause the Company has decided to sell the respective security in response tospecific credit concerns regarding the issuer. The charges relating to theimpairment of these securities were recognized in net realized and unrealized(loss) gain on investments in the condensed consolidated statements ofoperations.

 

The followingtable summarizes the Company’s securities classified as available-for-sale asof December 31, 2008, which are carried at estimated fair value (amountsin thousands):

 
| **Description**            | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
|----------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|---------------------------|------------|
| Corporate securities       |       | $                   | 742,474    |                         | $          | 3,676                         |       | $                         | (192,709   | ) | $ | 553,441 |   |
| Common and preferred stock |       | 3,126               |       | —                       |       | (602                          | )          | 2,524                     |       |
| Total                      |       | $                   | 745,600    |                         | $          | 3,676                         |       | $                         | (193,311   | ) | $ | 555,965 |   |

 

15

----

 

The followingtable shows the gross unrealized losses and fair value of the Company’savailable-for-sale securities, aggregated by length of time that the individualsecurities have been in a continuous unrealized loss position, as of December 31,2008 (amounts in thousands):

 
| ** **                 | ** ** | **Less Than 12 months** | ** ** | **12 Months or More**  | ** ** | **Total**                 | ** ** |
|----------------------------|------------|------------------------------|------------|------------------------|------------|---------------------------|------------|
| **Description**            | ** ** | **Estimated  Fair Value**    | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| Corporate securities       |       | $                            | 396,279    |                   | $          | (119,849                  | )          | $ | 121,080 |   | $ | (72,860 | ) | $ | 517,359 |   | $ | (192,709 | ) |
| Common and preferred stock |       | 2,499                        |       | (256                   | )          | 25                        |       | (346 | ) | 2,524 |   | (602 | ) |
| Total                      |       | $                            | 398,778    |                   | $          | (120,105                  | )          | $ | 121,105 |   | $ | (73,206 | ) | $ | 519,883 |   | $ | (193,311 | ) |

 

As of December 31,2008, the Company recognized a loss totaling $460.4 million for securitiesthat it determined to be other-than-temporarily impaired, which are excludedfrom the table above. These securities were determined to beother-than-temporarily impaired either due to management’s determination thatrecovery in value is no longer likely or because the Company has decided tosell the respective security in response to specific credit concerns regarding theissuer. The charges relating to the impairment of these securities wererecognized in net realized and unrealized (loss) gain on investments in thecondensed consolidated statements of operations.

 

During thethree months ended March 31, 2009, the Company had gross realized gainsand losses from the sales of securities available-for-sale of $1.0 millionand $5.8 million, respectively. During the three months ended March 31,2008, the Company had gross realized gains and losses from the sales ofsecurities available-for-sale of $2.2 million and $11.3 million,respectively.

 

Note 10to these condensed consolidated financial statements describes the Company’sborrowings under which the Company has pledged securities available-for-salefor borrowings. The following table summarizes the estimated fair value ofsecurities available-for-sale pledged as collateral under secured financingtransactions as of March 31, 2009 (amounts in thousands):

 
| ** **                                                                                                            | ** ** | **Corporate  Securities** | ** ** | **Common and  Preferred Stock** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|---------------------------------|------------|
| Pledged as collateral for borrowings under  secured revolving credit facility                                         |       | $                         | 74,974     |                            | $          | — |   |
| Pledged as collateral for collateralized  loan obligation senior secured notes and junior secured notes to affiliates |       | 404,146                   |       | —                          |       |
| Total                                                                                                                 |       | $                         | 479,120    |                            | $          | — |   |

 

The followingtable summarizes the estimated fair value of securities available-for-salepledged as collateral under secured financing transactions as of December 31,2008 (amounts in thousands):

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

 

**Note 6. Corporate Loans and Allowancefor Loan Losses**

 

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

 
| ** **                    | ** ** | **March 31, 2009** | ** ** | **December 31, 2008** | ** ** |
|-------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                    | ** ** | **Principal**           | ** ** | **Unamortized  Discount**  | ** ** | **Lower of Cost  or Fair Value  Adjustment** | ** ** | **Net  Carrying  Value** | ** ** | **Principal** | ** ** | **Unamortized  Discount** | ** ** | **Lower of Cost  or Fair Value  Adjustment** | ** ** | **Net  Carrying  Value** | ** ** |
| Corporate loans(1)            |       | $                       | 7,963,994  |                       | $          | (342,108 | ) | $ | — |   | $ | 7,621,886 |   | $ | 7,983,449 |   | $ | (255,877 | ) | $ | — |   | $ | 7,727,572 |   |
| Corporate loans held for sale |       | 308,121                 |       | (7,438                     | )          | (40,782 | ) | 259,901 |   | 472,669 |   | (10,751 | ) | (137,269 | ) | 324,649 |   |
| Total corporate loans         |       | $                       | 8,272,115  |                       | $          | (349,546 | ) | $ | (40,782 | ) | $ | 7,881,787 |   | $ | 8,456,118 |   | $ | (266,628 | ) | $ | (137,269 | ) | $ | 8,052,221 |   |

 

----

(1)                                  Excludesallowance for loan losses of $507.8 million and $480.8 million as of March 31,2009 and December 31, 2008, respectively.

 

16

----

 

The following tablesummarizes the changes in the allowance for loan losses for the Company’scorporate loan portfolio during the quarters ended March 31, 2009 and 2008(amounts in thousands).

 
| ** **                     | ** ** | **March 31, 2009** | ** ** | **March 31, 2008** | ** ** |
|--------------------------------|------------|-------------------------|------------|-------------------------|------------|
| Balance at beginning of period |       | $                       | 480,775    |                    | $          | 25,000 |   |
| Provision for loan losses      |       | 26,987                  |       | —                  |       |
| Charge-offs                    |       | —                  |       | —                  |       |
| Balance at end of period       |       | $                       | 507,762    |                    | $          | 25,000 |   |

 

As of March 31, 2009and December 31, 2008, the Company had an allowance for loan loss of$507.8 million and $480.8 million, respectively. As described inNote 2 to these condensed consolidated financial statements, the allowancefor loan losses represents the Company’s estimate of probable credit lossesinherent in its loan portfolio as of the balance sheet date. The Company’sallowance for loan losses consists of two components, an allocated componentand an unallocated component. The allocated component of the allowance for loanlosses consists of individual loans that are impaired. The unallocatedcomponent of the allowance for loan losses represents the Company’s estimate oflosses inherent, but not identified, in its portfolio as of the balance sheetdate.

 

As of March 31, 2009,the allocated component of the allowance for loan losses totaled $425.1 millionand relates to investments in loans issued by thirteen issuers with anaggregate par amount of $927.0 million and an aggregate amortized costamount of $772.1 million. As of December 31, 2008, the allocatedcomponent of the allowance for loan losses totaled $320.6 million and relatesto investments in loans issued by eleven issuers with an aggregate par amountof $828.2 million and an aggregate amortized cost amount of$715.4 million. The unallocated component of the allowance for loan lossestotaled $82.7 million and $160.2 million as of March 31, 2009 and December 31,2008, respectively. There were no charge-offs during the three months ended March 31,2009 and the Company recorded a charge-off during the year ended December 31,2008 totaling $25.7 million relating to one investment in a corporateloan.

 

Loans placed on non-accrualstatus may or may not be contractually past due at the time of suchdetermination. While on non-accrual status, previously recognized accruedinterest is reversed and charged against current income, and interest income isrecognized only upon actual receipt. When the ultimate collectability of theprincipal is not in doubt, contractual interest is credited to interest incomewhen received using the cost-recovery method, cash-basis method or somecombination of the two methods.

 

As of March 31, 2009and December 31, 2008, the Company had $772.1 million and$358.0 million of loans on non-accrual status, respectively.  The average recorded investment in theimpaired loans during the first three months of 2009 and 2008 was $565.2million and nil, respectively. The amount of interest income recognized usingthe cash-basis method during the time within the period that the loans wereimpaired was $2.1 million and nil for the three months ended 2009 and 2008,respectively.

 

During the three monthsended March 31, 2009, the Company held investments that were in defaultwith a total amortized cost of $749.0 million from twelve issuers. During theyear ended December 31, 2008, the Company held investments that were indefault with a total amortized cost of $312.7 million from three issuers.All corporate loan and debt securities in default during 2009 and 2008 areincluded in the investments for which the allocated component of the Company’sallowance for losses or other-than-temporary impairments are related to as of March 31,2009 and December 31, 2008, respectively.

 

Note 10 to thesecondensed consolidated financial statements describes the Company’s borrowingsunder which the Company has pledged loans for borrowings. The following tablesummarizes the carrying value of corporate loans pledged as collateral undersecured financing transactions as of March 31, 2009 and December 31,2008 (amounts in thousands):

 

17

----

 
| ** **                                                                                                            | ** ** | **As of  March 31, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|
| Pledged as collateral for borrowings under secured revolving credit  facility                                         |       | $                              | 212,588    |                              | $          | 182,899 |   |
| Pledged as collateral for collateralized loan obligation senior  secured notes and junior secured notes to affiliates |       | 7,622,747                      |       | 7,816,154                         |       |
| Total                                                                                                                 |       | $                              | 7,835,335  |                              | $          | 7,999,053 |   |

 

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

 

As of March 31, 2009and December 31, 2008, residential mortgage-backed securities (“RMBS”)totaled $87.9 million and $102.8 million, respectively.

 

Note 10 to thesecondensed consolidated financial statements describes the Company’s borrowingsunder which the Company has pledged RMBS. The following table summarizes theestimated fair value of RMBS pledged as collateral under secured financingtransactions as of March 31, 2009 and December 31, 2008 (amounts inthousands):

 
| ** **                                                                                                            | ** ** | **As of  March 31, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|
| Pledged as collateral for borrowings under secured revolving credit  facility                                         |       | $                              | 82,401     |                              | $          | 96,651 |   |
| Pledged as collateral for collateralized loan obligation senior  secured notes and junior secured notes to affiliates |       | 5,482                          |       | 6,163                             |       |
| Total                                                                                                                 |       | $                              | 87,883     |                              | $          | 102,814 |   |

 

18

----

 

**Note 8. Residential Mortgage Loans**

 

The following tablesummarizes the Company’s residential mortgage loans as of March 31, 2009and December 31, 2008 (amounts in thousands):

 
| ** **                                             | ** ** | **As of  March 31, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|--------------------------------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|
| Residential mortgage loans, at estimated fair value(1) |       | $                              | 2,260,759  |                              | $          | 2,620,021 |   |
|                                                        |            |                                |            |                                   |            |  |  |

 

----

(1)           Excludes realestate owned (“REO”) by the Company as a result of foreclosure on delinquentloans of $11.2 million and $10.8 million as of March 31, 2009 and December 31,2008, respectively. REO is recorded within other assets on the Company’s condensedconsolidated balance sheets.

 

Note 10 to thesecondensed consolidated financial statements describes the Company’s borrowingsunder which the Company has pledged residential mortgage loans. The followingtable summarizes the estimated fair value of residential mortgage loans pledgedas collateral for a secured revolving credit facility as of March 31, 2009and December 31, 2008 (amounts in thousands):

 
| ** **                                                                    | ** ** | **As of  March 31, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|-------------------------------------------------------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|
| Pledged as collateral for borrowings under secured revolving credit  facility |       | $                              | 158,392    |                              | $          | 167,933 |   |
| Pledged as collateral for residential mortgage-backed securities  issued      |       |                           | 2,102,367  |                              |       | 2,452,088 |   |
|                                                                          |       | $                              | 2,260,759  |                              | $          | 2,620,021 |   |

 

The following is areconciliation of carrying amounts of residential mortgage loans for theperiods ended March 31, 2009 and December 31, 2008 (amounts inthousands):

 
| ** **                              | ** ** | **2009** | ** ** | **2008** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|
| Beginning balance                       |       | $        | 2,620,021  |     | $          | 3,921,323 |   |
| Principal payments                      |       | (113,727 | )          | (666,900 | )          |
| Transfers to REO                        |       | (427     | )          | (3,594   | )          |
| Net unrealized loss/unamortized premium |       | (245,108 | )          | (630,808 | )          |
| Ending balance                          |       | $        | 2,260,759  |     | $          | 2,620,021 |   |

 

As of March 31, 2009,thirty-six of the residential mortgage loans owned by the Company with anoutstanding balance of $11.2 million (not included in the table above) wereREO as a result of foreclosure on delinquent loans. As of December 31,2008, thirty-three of the residential mortgage loans owned by the Company withan outstanding balance of $10.8 million (not included in the table above)were REO as a result of foreclosure on delinquent loans.

 

The following tablesummarizes the delinquency statistics of the residential mortgage loans,excluding REOs, as of March 31, 2009 and December 31, 2008 (dollaramounts in thousands):

 
| ** **             | ** ** | **March 31, 2009** | ** ** | **December 31, 2008** | ** ** |
|------------------------|------------|-------------------------|------------|----------------------------|------------|
| **Delinquency Status** | ** ** | **Number  of Loans**    | ** ** | **Principal  Amount**      | ** ** | **Number  of Loans** | ** ** | **Principal  Amount** | ** ** |
| 30 to 59 days     |       | 85                      |       | $                          | 33,812     |   | 93 |   | $ | 37,282 |   |
| 60 to 89 days     |       | 40                      |       | 14,475                     |       | 41 |   | 15,654 |   |
| 90 days or more   |       | 106                     |       | 43,477                     |       | 76 |   | 29,803 |   |
| In foreclosure         |       | 86                      |       | 32,036                     |       | 67 |   | 22,841 |   |
| Total                  |       | 317                     |       | $                          | 123,800    |   | 277 |   | $ | 105,580 |   |

 

As of March 31, 2009and December 31, 2008, the loss exposure or uncollected principal amountrelated to the Company’s delinquent residential mortgage loans in the tableabove exceeded their fair value by $11.3 million and $4.0 million,respectively.

 

19

----

 

**Note 9. Residential Mortgage-Backed SecuritiesIssued**

 

Residential mortgage-backedsecurities issued (“RMBS Issued”) consists of the senior tranches of sixresidential mortgage loan securitization trusts that the Company consolidatesunder GAAP (see Note 2) and for which the Company reports the debt issuedby these trusts that it does not hold on its condensed consolidated balancesheets. The following table summarizes the Company’s RMBS Issued as of March 31,2009 and December 31, 2008 (amounts in thousands):

 
| ** **                                    | ** ** | **March 31, 2009** | ** ** | **December 31, 2008** | ** ** |
|-----------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| **Description**                               | ** ** | **Outstanding**         | ** ** | **Estimated  Fair  Value** | ** ** | **Outstanding** | ** ** | **Estimated  Fair  Value** | ** ** |
| Residential mortgage-backed securities issued |       | $                       | 3,049,448  |                       | $          | 2,113,587 |   | $ | 3,154,974 |   | $ | 2,462,882 |   |
|                                               |            |                         |            |                            |            |  |  |  |  |  |  |  |  |

 

The Company carries thesesecurities at estimated fair value with changes in estimated fair valuereflected in net (loss) income. As of March 31, 2009 and December 31,2008, the weighted average coupon of the RMBS Issued was 3.5% and 3.4%,respectively, and the weighted average years to maturity were 26.5 years and26.8 years as of March 31, 2009 and December 31, 2008, respectively.

 

**Note 10. Borrowings**

 

Certain information withrespect to the Company’s borrowings as of March 31, 2009 is summarized inthe following table (dollar amounts in thousands):

 
| ** **                                        | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted  Average  Borrowing  Rate** | ** ** | **Weighted  Average  Remaining  Maturity  (in days)** | ** ** | **Fair Value of  Collateral(1)** | ** ** |
|---------------------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|-------------------------------------------------------|------------|----------------------------------|------------|
| Secured revolving credit facility(2)              |       | $                           | 267,569    |                                   | 3.50       | %                                                     | 224        |                             | $          | 408,608 |   |
| CLO 2005-1 senior secured notes                   |       | 832,174                     |       | 1.48                                   |       | 2,948                                                 |       | 689,033                          |       |
| CLO 2005-2 senior secured notes                   |       | 799,890                     |       | 1.56                                   |       | 3,162                                                 |       | 671,390                          |       |
| CLO 2006-1 senior secured notes                   |       | 707,092                     |       | 1.61                                   |       | 3,434                                                 |       | 640,927                          |       |
| CLO 2007-1 senior secured notes                   |       | 2,280,402                   |       | 1.77                                   |       | 4,428                                                 |       | 1,521,852                        |       |
| CLO 2007-1 junior secured notes to affiliates(3)  |       | 440,668                     |       | —                                 |       | 4,428                                                 |       | 292,996                          |       |
| CLO 2007-A senior secured notes                   |       | 1,203,580                   |       | 1.96                                   |       | 3,120                                                 |       | 884,638                          |       |
| CLO 2007-A junior secured notes to affiliates(4)  |       | 96,204                      |       | —                                 |       | 3,120                                                 |       | 70,711                           |       |
| CLO 2009-1 senior secured notes                   |       | 560,790                     |       | 5.49                                   |       | 2,946                                                 |       | 596,794                          |       |
| CLO 2009-1 junior secured notes to affiliates (5) |       | 90,429                      |       | —                                 |       | 2,946                                                 |       | 96,235                           |       |
| Convertible senior notes                          |       | 291,500                     |       | 7.00                                   |       | 1,202                                                 |       | —                           |       |
| Junior subordinated notes                         |       | 288,671                     |       | 5.78                                   |       | 10,028                                                |       | —                           |       |
| Total                                             |       | $                           | 7,858,969  |                                   |       |                                                  |       |                             | $          | 5,873,184 |   |

 

----

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

 

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

 

(3)           CLO 2007-1junior secured notes to affiliates consist of (x) $254.1 million ofmezzanine notes with a weighted average borrowing rate of 6.14% and (y) $186.6 millionof subordinated notes that do not have a contractual coupon rate, but insteadreceive a pro rata amount of the net distributions from CLO 2007-1.

 

(4)           CLO 2007-Ajunior secured notes to affiliates consist of (x) $81.1 million ofmezzanine notes with a weighted average borrowing rate of 7.26% and (y) $15.1 millionof subordinated notes that do not have a contractual coupon rate, but insteadreceive a pro rata amount of the net distributions from CLO 2007-A.

 

(5)           CLO 2009-1 juniorsecured notes do not have a contractual coupon rate, but instead receive a prorata amount of the net distributions from CLO 2009-1.

 

20

----

 

The indentures governing theCompany’s CLO transactions include numerous compliance tests, the majority ofwhich relate to the CLO’s portfolio profile. In the event that a portfolioprofile test is not met, the indenture places restrictions on the ability ofthe CLO’s manager to reinvest available principal proceeds generated by thecollateral in the CLOs until the specific test has been cured. In addition tothe portfolio profile tests, the indentures for the CLO transactions includeover-collateralization tests (“OC Tests”) which set the ratio of the collateralvalue of the assets in the CLO to the tranches of debt for which the test isbeing measured, as well as interest coverage tests. If a CLO is not incompliance with an OC Test or an interest coverage 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 the OC test isbrought back into compliance. Due to the failure of OC Tests during the firstquarter of 2009, CLO 2005-2 senior secured notes were paid down by $9.0million, CLO 2006-1 senior secured notes were paid down by $8.9 million,CLO 2007-1 senior secured notes were paid down by $40.6 million and CLO2007-A senior secured notes were paid down by $9.8 million.

 

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

 

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

 
| ** **                                       | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted  Average  Borrowing  Rate** | ** ** | **Weighted  Average  Remaining  Maturity  (in days)** | ** ** | **Fair Value of  Collateral(1)** | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|-------------------------------------------------------|------------|----------------------------------|------------|
| Secured revolving credit facility                |       | $                           | 275,633    |                                   | 3.44       | %                                                     | 699        |                             | $          | 441,812 |   |
| CLO 2005-1 senior secured notes                  |       | 832,025                     |       | 3.84                                   |       | 3,038                                                 |       | 631,937                          |       |
| CLO 2005-2 senior secured notes                  |       | 808,701                     |       | 2.48                                   |       | 3,252                                                 |       | 647,092                          |       |
| CLO 2006-1 senior secured notes                  |       | 715,394                     |       | 2.52                                   |       | 3,524                                                 |       | 623,003                          |       |
| CLO 2007-1 senior secured notes                  |       | 2,318,191                   |       | 2.68                                   |       | 4,518                                                 |       | 1,511,707                        |       |
| CLO 2007-1 junior secured notes to affiliates(2) |       | 436,185                     |       | —                                 |       | 4,518                                                 |       | 277,357                          |       |
| CLO 2007-A senior secured notes                  |       | 1,213,300                   |       | 5.62                                   |       | 3,210                                                 |       | 867,666                          |       |
| CLO 2007-A junior secured notes to affiliates(3) |       | 94,128                      |       | —                                 |       | 3,210                                                 |       | 67,314                           |       |
| Wayzata senior secured notes                     |       | 1,600,000                   |       | 2.95                                   |       | 1,415                                                 |       | 766,024                          |       |
| Convertible senior notes                         |       | 291,500                     |       | 7.00                                   |       | 1,292                                                 |       | —                           |       |
| Junior subordinated notes                        |       | 288,671                     |       | 6.84                                   |       | 10,118                                                |       | —                           |       |
| Subordinated notes to affiliates(4)              |       | 125,000                     |       | —                                 |       | 1,415                                                 |       | 59,846                           |       |
| Total                                            |       | $                           | 8,998,728  |                                   |       |                                                  |       |                             | $          | 5,893,758 |   |

 

----

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

 

(2)           CLO 2007-1junior secured notes to affiliates consist of (x) $249.6 million ofmezzanine notes with a weighted average borrowing rate of 7.03% and (y) $186.6 millionof subordinated notes that do not have a contractual coupon rate, but insteadreceive a pro rata amount of the net distributions from CLO 2007-1.

 

(3)           CLO 2007-Ajunior secured notes to affiliates consist of (x) $79.0 million ofmezzanine notes with a weighted average borrowing rate of 10.90% and (y) $15.1 millionof subordinated notes that do not have a contractual coupon rate, but insteadreceive a pro rata amount of the net distributions from CLO 2007-A.

 

(4)           Subordinatednotes do not have a contractual coupon rate, but instead receive a pro rataamount of the net distributions from Wayzata Funding LLC (“Wayzata”). Note thatthe $125.0 million outstanding is included in collateralized loan obligationjunior secured notes to affiliates on the condensed consolidated balancesheets.

 

On May 9, 2008, the FASB issued FSPAPB14-1, *Accounting for Convertible DebtInstruments That May Be Settled in Cash upon Conversion (including PartialCash Settlement)* (“FSP APB 14-1”). FSP APB 14-1 clarifies theaccounting for convertible debt instruments which may be settled in cash, andin particular specifies that issuers of such instruments should separatelyaccount for the liability and equity components in a manner that will reflectthe entity’s nonconvertible debt borrowing rate when interest cost isrecognized in subsequent periods. The Company has assessed this FSP in relationto its convertible senior notes and determined that it does not have a materialimpact on its condensed consolidated financial statements for the periodspresented.

 

21

----

 

OnMarch 31, 2009, the Company completed the restructuring of Wayzata, itsmarket value CLO transaction. As a result of the restructuring, substantiallyall of Wayzata’s assets have been transferred to CLO 2009-1, a newly formedspecial purpose company, which issued $560.8 million aggregate principal amountof senior notes due April 2017 and $154.3 million aggregate principalamount of subordinated notes due April 2017 to the existing Wayzata noteholders in exchange for cancellation of the Wayzata notes, due November 2012,previously held by each of them. CLO 2009-1 has been structured as a cash flowtransaction and does not contain the market value provisions contained inWayzata. The portfolio manager of the CLO is an affiliate of the Manager. Thenotes issued by CLO 2009-1 are secured by the same collateral that secured theWayzata facility, consisting primarily of senior secured leveraged loans. Aswas the case with Wayzata, the Company and an affiliate of the Managercurrently own all of the subordinated notes issued by the CLO. The subordinatednotes entitle the Company to receive a pro rata**portion of all excess cash flows from the portfolio after all seniorobligations of CLO 2009-1 have been paid in full or otherwise satisfied,including all outstanding principal of the senior notes and interest thereonaccruing at a rate of 3-month LIBOR plus 4.25%.

 

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

 

**Note 11. Derivative Financial Instruments**

 

The Company enters intoderivative transactions in order to hedge its interest rate risk exposure tothe effects of interest rate changes. Additionally, the Company enters intoderivative transactions in the course of its investing. The counterparties tothe Company’s derivative agreements are major financial institutions with whichthe Company and its affiliates may also have other financial relationships. Inthe event of nonperformance by the counterparties, the Company is potentiallyexposed to losses. 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 interestrate derivatives consisting of swaps to hedge a portion of the interest raterisk associated with its borrowings under CLO senior secured notes. The Companydesignates these financial instruments as cash flow hedges. The Company alsouses interest rate swaps to hedge all or a portion of the interest rate riskassociated with certain fixed interest rate investments. The Company designatesthese financial instruments as fair value hedges.

 

**Free-Standing Derivatives**

 

Free-standing derivativesare derivatives that the Company has entered into in conjunction with itsinvestment and risk management activities, but for which the Company has notdesignated the derivative contract as a hedging instrument for accountingpurposes. Such derivative contracts may include credit default swaps, foreignexchange contracts, and interest rate derivatives. Free-standing derivativesalso include investment financing arrangements (total rate of return swaps)whereby the Company receives the sum of all interest, fees and any positivechange in fair value amounts from a reference asset with a specified notionalamount and pays interest on such notional amount plus any negative change infair value amounts from such reference asset.

 

The table below summarizesthe aggregate notional amount and estimated net fair value of the derivativeinstruments as of March 31, 2009 and December 31, 2008 (amounts inthousands):

 
| ** **                      | ** ** | **As of March 31, 2009** | ** ** | **As of December 31, 2008** | ** ** |
|---------------------------------|------------|-------------------------------|------------|----------------------------------|------------|
| ** **                      | ** ** | **Notional**                  | ** ** | **Estimated  Fair Value**        | ** ** | **Notional** | ** ** | **Estimated  Fair Value** | ** ** |
| **Cash Flow Hedges:**           |       |                          |       |                             |       |   |   |   |   |
| Interest rate swaps             |       | $                             | 383,333    |                             | $          | (69,053 | ) | $ | 383,333 |   | $ | (77,668 | ) |
| **Fair Value Hedges:**          |       |                          |       |                             |       |   |   |   |   |
| Interest rate swaps             |       | 32,000                        |       | (3,486                           | )          | 32,000 |   | (2,915 | ) |
| **Free-Standing Derivatives:**  |       |                          |       |                             |       |   |   |   |   |
| Interest rate swaps             |       | 122,420                       |       | 974                              |       | 106,074 |   | 274 |   |
| Credit default swaps—long  |       | 51,000                        |       | (8,796                           | )          | 53,500 |   | (9,782 | ) |
| Credit default swaps—short |       | —                        |       | —                           |       | 222,650 |   | 69,972 |   |
| Total rate of return swaps      |       | 136,447                       |       | (3,205                           | )          | 207,524 |   | (77,224 | ) |
| Total                           |       | $                             | 725,200    |                             | $          | (83,566 | ) | $ | 1,005,081 |   | $ | (97,343 | ) |

 

22

----

 

For all hedges where hedgeaccounting is being applied, effectiveness testing and other procedures toensure the ongoing validity of the hedges are performed at least monthly.During the three months ended March 31, 2009 and 2008, the Companyrecognized an immaterial amount of ineffectiveness in income on the condensedconsolidated statements of operations from its cash flow and fair value hedges.

 

**Note 12. Accumulated Other Comprehensive Loss**

 

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

 
| ** **                                             | ** ** | **As of  March 31, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|--------------------------------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|
| Net unrealized losses on available-for-sale securities |       | $                              | (158,628   | )                                 | $          | (192,435 | ) |
| Net unrealized losses on cash flow hedges              |       | (67,300                        | )          | (76,347                           | )          |
| Accumulated other comprehensive loss                   |       | $                              | (225,928   | )                                 | $          | (268,782 | ) |

 

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

 
| ** **                                                            | ** ** | **Three months  ended March 31,  2009** | ** ** | **Three months  ended March 31,  2008** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| Unrealized gains (losses) on securities available-for-sale:           |       |                                         |       |                                         |       |
| Unrealized holding gains (losses) arising during period               |       | $                                            | 28,946     |                                         | $          | (84,108 | ) |
| Reclassification adjustments for losses realized in net (loss) income |       | 4,861                                        |       | 9,149                                        |       |
| Unrealized gains (losses) on securities available-for-sale            |       | 33,807                                       |       | (74,959                                      | )          |
| Unrealized gains (losses) on cash flow hedges                         |       | 9,047                                        |       | (18,237                                      | )          |
| Other comprehensive income (loss)                                     |       | $                                            | 42,854     |                                         | $          | (93,196 | ) |

 

**Note 13. Share Options and Restricted Shares**

 

The Company has adopted anamended and restated share incentive plan (the “2007 Share Incentive Plan”)that provides for the grant of qualified incentive common share options thatmeet the requirements of Section 422 of the Code, non-qualified commonshare options, 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 shareoption granted under the 2007 Share Incentive Plan may not be less than 100% ofthe fair market value of the common shares at the time the common share optionis granted. Each option to acquire a common share must terminate no more thanten years from the date it is granted. As of March 31, 2009, the 2007Share Incentive Plan authorizes a total of 8,464,625 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. On July 2,2008, the Compensation Committee of the Board of Directors granted 38,349restricted common shares to the Company’s directors pursuant to the 2007 ShareIncentive Plan.

 

23

----

 

The following tablesummarizes restricted common share transactions:

 
| ** **                                     | ** ** | **Manager** | ** ** | **Directors** | ** ** | **Total** | ** ** |
|------------------------------------------------|------------|-------------|------------|---------------|------------|-----------|------------|
| **Unvested shares as of January 1, 2009** |       | 1,097,000   |       | 66,282        |       | 1,163,282 |       |
| Issued                                         |       | —      |       | —        |       | —    |       |
| Vested                                         |       | —      |       | —        |       | —    |       |
| Cancelled                                      |       | —      |       | —        |       | —    |       |
| Forfeited                                      |       | —      |       | —        |       | —    |       |
| **Unvested shares as of March 31, 2009**  |       | 1,097,000   |       | 66,282        |       | 1,163,282 |       |

 

Pursuant to SFAS No. 123(R),the Company is required to value any unvested restricted common shares grantedto the Manager at the current market price. The Company valued the unvestedrestricted common shares granted to the Manager at $0.88 and $12.66 per shareat March 31, 2009 and March 31, 2008, respectively. There were $1.0million and $14.7 million of total unrecognized compensation costs relatedto unvested restricted common shares granted as of March 31, 2009 and2008, respectively. These costs are expected to be recognized over three yearsfrom the date of grant.

 

The following tablesummarizes common share option transactions:

 
| ** **                                 | ** ** | **Number of  Options** | ** ** | **Weighted-Average  Exercise Price** | ** ** |
|--------------------------------------------|------------|------------------------|------------|--------------------------------------|------------|
| **Outstanding as of January 1, 2009** |       | 1,932,279              |       | $                                    | 20.00      |   |
| Granted                                    |       | —                 |       | —                               |       |
| Exercised                                  |       | —                 |       | —                               |       |
| Forfeited                                  |       | —                 |       | —                               |       |
| **Outstanding as of March 31, 2009**  |       | 1,932,279              |       | $                                    | 20.00      |   |

 

As of March 31, 2009and December 31, 2008, 1,932,279 common share options were exercisable. Asof March 31, 2009, the common share options were fully vested and expirein August 2014. For the three months ended March 31, 2009 and 2008,the components of share-based compensation expense are as follows (amounts inthousands):

 
| ** **                                     | ** ** | **Three months ended  March 31, 2009** | ** ** | **Three months ended  March 31, 2008** | ** ** |
|------------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| Restricted shares granted to Manager           |       | $                                           | (140       | )                                           | $          | 462 |   |
| Restricted shares granted to certain directors |       | 137                                         |       | 178                                         |       |
| Total share-based compensation expense         |       | $                                           | (3         | )                                           | $          | 640 |   |

 

**Note 14. Management Agreement and Related PartyTransactions**

 

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

 

The Management Agreementcontains certain provisions requiring the Company to indemnify the Manager withrespect to all losses or damages arising from acts not constituting bad faith,willful misconduct, or gross negligence. The Company has evaluated the impactof these guarantees on its condensed consolidated financial statements anddetermined that they are not material.

 

For the three months ended March 31,2009, the Company incurred $3.6 million in base management fees. For the three months ended March 31,2008, the Company incurred $7.4 million in base management fees. In addition,the Company recognized share-based compensation expense related to common shareoptions and restricted common shares granted to the Manager of $0.5 million forthe three months ended March 31, 2008 (see Note 13). Effective January 1,2009, the Manager has agreed to defer 50% of the monthly base managementfee payable by the Company for the period from January 1, 2009 through November 30,2009. The aggregate amount of fees otherwise payable during the deferral periodwill be payable to the Manager upon the earlier of (x) December 15,2009 and (y) the date of any termination of the Management Agreement 

 

24

----

 

pursuant to either Section 13(a) orSection 15(b) thereof. Base management fees incurred and share-basedcompensation expense relating to common share options and restricted commonshares granted to the Manager are included in related party managementcompensation on the condensed 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 basemanagement fees related to the $230.4 million common share offering and$270.0 million common share rights offering that occurred during the thirdquarter of 2007 until such time as the Company’s common share closing price onthe NYSE is $20.00 or more for five consecutive trading days. Accordingly, theManager permanently waived approximately $2.2 million of base managementfees during each of the three months ended March 31, 2009 and 2008.

 

No incentive fees wereearned or paid to the Manager during the three months ended March 31, 2009and 2008.

 

An affiliate of the Managerhas entered into separate management agreements with the respective investmentvehicles for CLO 2005-1, CLO 2005-2, CLO 2006-1,CLO 2007-1, CLO 2007-A and CLO 2009-1 and is entitled to receive feesfor the services performed as collateral manager. The collateral manager haspermanently waived fees of $8.7 million for the three months ended March 31,2008. Beginning April 15, 2007, the collateral manager ceased waiving feesfor CLO 2005-1 and effective January 1, 2009, the collateral managerceased waiving fees for CLO 2005-2, CLO 2006-1, CLO 2007-1,CLO 2007-A and Wayzata. In addition, beginning January 1, 2009, theManager permanently waived reimbursable general and administrative expensesallocable to the Company in an amount equal to the incremental CLO feesreceived by the Manager. For the three months ended March 31, 2009, the Managerpermanently waived reimbursement of $2.3 million in allocable general andadministrative expenses. For the three months ended March 31, 2008, the Companyreimbursed the Manager $2.5 million for expenses.

 

The Company has invested in corporate loans and debt securities ofentities that are affiliates of KKR. As of March 31, 2009, the aggregatepar amount of these affiliated investments totaled $3.4 billion, orapproximately 35% of the total investment portfolio, and consisted of 24issuers. The total $3.4 billion in investments were comprised of$2.7 billion of corporate loans, $587.4 million of corporate debtsecurities available for sale, and $75.5 million notional amount of totalrate of return swaps referenced to corporate loans issued by affiliates of KKR(included in derivative assets and liabilities on the condensed consolidatedbalance sheet). As of December 31, 2008, the aggregate par amount of theseaffiliated investments totaled $3.3 billion, or approximately 35% of thetotal investment portfolio, and consisted of 23 issuers. The total$3.3 billion in investments were comprised of $2.6 billion ofcorporate loans, $587.3 million of corporate debt securities available forsale, and $92.4 million notional amount of total rate of return swapsreferenced to corporate loans issued by affiliates of KKR (included inderivative assets and liabilities on the condensed consolidated balance sheet).

 

**Note 15. Fair Value Disclosure**

 

Thefollowing table presents information about the Company’s assets and liabilities(including derivatives that are presented net) measured at fair value on arecurring basis as of March 31, 2009, and indicates the fair valuehierarchy of the valuation techniques utilized by the Company to determine suchfair value (amounts in thousands):

 
| ** **                                    | ** ** | **Quoted Prices in  Active Markets  for Identical Assets  (Level 1)** | ** ** | **Significant Other  Observable Inputs  (Level 2)** | ** ** | **Significant  Unobservable Inputs  (Level 3)** | ** ** | **Balance as of  March 31, 2009** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                    | ** ** | ** **                                                                 | ** ** | ** **                                               | ** ** | ** **                                           | ** ** | ** **                             | ** ** |
| **Assets:**                                   | ** ** | ** **                                                                 | ** ** | ** **                                               | ** ** | ** **                                           | ** ** | ** **                             | ** ** |
| Securities available-for-sale                 |       | $                                                                          | 3,090      |                                                     | $          | 403,070                                              |       | $                                      | 76,050     |   | $ | 482,210 |   |
| Residential mortgage-backed securities        |       | —                                                                     |       | —                                                   |       | 87,883                                               |       | 87,883                                 |       |
| Residential mortgage loans                    |       | —                                                                     |       | —                                                   |       | 2,260,759                                            |       | 2,260,759                              |       |
| Non-marketable securities                     |       | —                                                                     |       | —                                                   |       | 5,287                                                |       | 5,287                                  |       |
| Total                                         |       | $                                                                          | 3,090      |                                                     | $          | 403,070                                              |       | $                                      | 2,429,979  |   | $ | 2,836,139 |   |
| ** **                                    | ** ** | ** **                                                                 | ** ** | ** **                                               | ** ** | ** **                                           | ** ** | ** **                             | ** ** |
| **Liabilities:**                              | ** ** | ** **                                                                 | ** ** | ** **                                               | ** ** | ** **                                           | ** ** | ** **                             | ** ** |
| Derivatives, net                              |       | $                                                                          | —     |                                                     | $          | (81,335                                              | )          | $                                      | (2,231     | ) | $ | (83,566 | ) |
| Residential mortgage-backed securities issued |       | —                                                                     |       | —                                                   |       | (2,113,587                                           | )          | (2,113,587                             | )          |
| Securities sold, not yet purchased            |       | (2,172                                                                     | )          | (80,373                                                  | )          | —                                               |       | (82,545                                | )          |
| Total                                         |       | $                                                                          | (2,172     | )                                                        | $          | (161,708                                             | )          | $                                      | (2,115,818 | ) | $ | (2,279,698 | ) |

 

25

----

 

The following table presentsinformation about the Company’s assets measured at fair value on anon-recurring basis as of March 31, 2009, and indicates the fair valuehierarchy of the valuation techniques utilized by the Company to determine suchfair value (amounts in thousands). There were no liabilities measured at fairvalue on a non-recurring basis:

 
| ** **          | ** ** | **Quoted Prices in  Active Markets  for Identical Assets  (Level 1)** | ** ** | **Significant Other  Observable Inputs  (Level 2)** | ** ** | **Significant  Unobservable Inputs  (Level 3)** | ** ** | **Balance as of  March 31, 2009** | ** ** |
|---------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|------------------------------------------------------|------------|----------------------------------------|------------|
| Loans held for sale |       | $                                                                          | —     |                                                     | $          | 259,901                                              |       | $                                      | —     |   | $ | 259,901 |   |
| REO                 |       | —                                                                     |       | —                                                   |       | 11,221                                               |       | 11,221                                 |       |
| Total               |       | $                                                                          | —     |                                                     | $          | 259,901                                              |       | $                                      | 11,221     |   | $ | 271,122 |   |

 

Loans held for sale wereclassified as level 2 given that the assets were valued using quoted prices andother observable inputs in an active market.

 

Thefollowing table presents information about the Company’s assets and liabilities(including derivatives that are presented net) measured at fair value on arecurring basis as of December 31, 2008, and indicates the fair valuehierarchy of the valuation techniques utilized by the Company to determine suchfair value (amounts in thousands):

 
| ** **                                    | ** ** | **Quoted Prices in  Active Markets  for Identical Assets  (Level 1)** | ** ** | **Significant Other  Observable Inputs  (Level 2)** | ** ** | **Significant  Unobservable Inputs  (Level 3)** | ** ** | **Balance as of  December 31, 2008** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                    |       |                                                                       |       |                                                     |       |                                                 |       |                                      |       |
| **Assets:**                                   |       |                                                                       |       |                                                     |       |                                                 |       |                                      |       |
| Securities available-for-sale                 |       | $                                                                          | 2,524      |                                                     | $          | 464,332                                              |       | $                                         | 89,109     |   | $ | 555,965 |   |
| Residential mortgage-backed securities        |       | —                                                                     |       | —                                                   |       | 102,814                                              |       | 102,814                                   |       |
| Residential mortgage loans                    |       | —                                                                     |       | —                                                   |       | 2,620,021                                            |       | 2,620,021                                 |       |
| Non-marketable securities                     |       | —                                                                     |       | —                                                   |       | 5,287                                                |       | 5,287                                     |       |
| Total                                         |       | $                                                                          | 2,524      |                                                     | $          | 464,332                                              |       | $                                         | 2,817,231  |   | $ | 3,284,087 |   |
| ** **                                    |       |                                                                       |       |                                                     |       |                                                 |       |                                      |       |
| **Liabilities:**                              |       |                                                                       |       |                                                     |       |                                                 |       |                                      |       |
| Derivatives, net                              |       | $                                                                          | —     |                                                     | $          | (20,393                                              | )          | $                                         | (76,950    | ) | $ | (97,343 | ) |
| Residential mortgage-backed securities issued |       | —                                                                     |       | —                                                   |       | (2,462,882                                           | )          | (2,462,882                                | )          |
| Securities sold, not yet purchased            |       | (2,220                                                                     | )          | (88,589                                                  | )          | —                                               |       | (90,809                                   | )          |
| Total                                         |       | $                                                                          | (2,220     | )                                                        | $          | (108,982                                             | )          | $                                         | (2,539,832 | ) | $ | (2,651,034 | ) |

 

The following table presentsinformation about the Company’s assets measured at fair value on anon-recurring basis as of December 31, 2008, and indicates the fair valuehierarchy of the valuation techniques utilized by the Company to determine suchfair value (amounts in thousands). There were no liabilities measured at fairvalue on a non-recurring basis:

 
| ** **          | ** ** | **Quoted Prices in  Active Markets  for Identical Assets  (Level 1)** | ** ** | **Significant Other  Observable Inputs  (Level 2)** | ** ** | **Significant  Unobservable Inputs  (Level 3)** | ** ** | **Balance as of  December 31, 2008** | ** ** |
|---------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------|------------|
| Loans held for sale |       | $                                                                          | —     |                                                     | $          | 219,199                                              |       | $                                         | 105,450    |   | $ | 324,649 |   |
| REO                 |       | —                                                                     |       | —                                                   |       | 10,794                                               |       | 10,794                                    |       |
| Total               |       | $                                                                          | —     |                                                     | $          | 219,199                                              |       | $                                         | 116,244    |   | $ | 335,443 |   |

 

Loans held for sale of$105.5 million were transferred into level 3 as of December 31,2008 given that they were valued based on the estimated sale price. REO of$10.8 million were transferred into level 3 as of December 31,2008 as there was little market activity for these assets and the valuation ofREOs required management’s judgment.

 

26

----

 

The followingtable presents additional information about assets, including derivatives thatare measured at fair value on a recurring basis for which the Company hasutilized level 3 inputs to determine fair value, for the three monthsended March 31, 2009 (amounts in thousands):

 
| ** **                                                                                                                                                                                     | ** ** | **Fair Value Measurements Using Significant Unobservable Inputs  (Level 3)** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                     | ** ** | **Securities  Available-  For-Sale**                                                                            | ** ** | **Residential  Mortgage-  Backed  Securities** | ** ** | **Residential  Mortgage  Loans** | ** ** | **Non-  Marketable  Securities** | ** ** | **Derivatives,  net** | ** ** | **Residential  Mortgage-  Backed  Securities  Issued** | ** ** |
| Beginning balance as of January 1,  2009                                                                                                                                                  |       | $                                                                                                               | 89,109     |   | $ | 102,814 |   | $ | 2,620,021 |   | $ | 5,287 |   | $ | (76,950 | ) | $ | (2,462,882 | ) |
| Total gains or losses (realized and  unrealized):                                                                                                                                              |       |                                                                                                            |       |   |   |   |   |   |   |   |   |   |   |
| Included in earnings                                                                                                                                                                           |       | (6,156                                                                                                          | )          | (7,369 | ) | (252,653 | ) | — |   | 7,428 |   | 243,768 |   |
| Included in other comprehensive loss                                                                                                                                                           |       | 1,881                                                                                                           |       | — |   | — |   | — |   | — |   | — |   |
| Net transfers in and/or out of level 3                                                                                                                                                    |       | —                                                                                                          |       | — |   | (427 | ) | — |   | — |   | — |   |
| Purchases, sales, other settlements and  issuances, net                                                                                                                                        |       | (8,784                                                                                                          | )          | (7,562 | ) | (106,182 | ) | — |   | 67,291 |   | 105,527 |   |
| Ending balance as of March 31, 2009                                                                                                                                                       |       | $                                                                                                               | 76,050     |   | $ | 87,883 |   | $ | 2,260,759 |   | $ | 5,287 |   | $ | (2,231 | ) | $ | (2,113,587 | ) |
| The amount of total gains or losses for the  period included in earnings attributable to the change in unrealized  gains or losses relating to assets still held at the reporting date(1) |       | $                                                                                                               | —     |   | $ | (6,800 | ) | $ | (248,213 | ) | $ | — |   | $ | 36,718 |   | $ | 244,001 |   |

 

----

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

 

The following table presentsadditional information about assets, including derivatives, that are measuredat fair value on a recurring basis for which the Company has utilized level 3inputs to determine fair value, for the three months ended March 31, 2008(amounts in thousands):

 
| ** **                                                                                                                                                                                 | ** ** | **Fair Value Measurements Using Significant  Unobservable Inputs  (Level 3)** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                 | ** ** | **Securities  Available-For-Sale**                                                                          | ** ** | **Derivatives,  net** | ** ** |
| Beginning balance as of January 1,  2008                                                                                                                                              |       | $                                                                                                           | 99,498     |   | $ | 802 |   |
| Total gains or losses (realized and  unrealized):                                                                                                                                          |       |                                                                                                        |       |   |   |
| Included in earnings                                                                                                                                                                       |       | —                                                                                                      |       | 764 |   |
| Included in other comprehensive loss                                                                                                                                                       |       | (3,504                                                                                                      | )          | — |   |
| Net transfers out of level 3                                                                                                                                                          |       | —                                                                                                      |       | — |   |
| Purchases, sales, other settlements and  issuances, net                                                                                                                                    |       | (17,340                                                                                                     | )          | (517 | ) |
| Ending balance as of March 31, 2008                                                                                                                                                   |       | $                                                                                                           | 78,654     |   | $ | 1,049 |   |
| 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) |       | $                                                                                                           | —     |   | $ | 764 |   |

 

----

(1)   Amounts are included in net realized andunrealized gain (loss) on derivatives and foreign exchange in thecondensed consolidated statements of operations.

 

**Note 16. Discontinued Operations**

 

The Company isthe successor to KKR Financial Corp. (the “REIT Subsidiary”), a Maryland corporation.On May 4, 2007, the company completed a restructuring transaction (the “RestructuringTransaction”), pursuant to which the REIT Subsidiary became a subsidiary of theCompany. In August 2007, the Company’s board of directors approved a planto exit its residential mortgage investment operations and sell the REITSubsidiary. As of January 1, 2008, the REIT Subsidiary’s assets andliabilities consisted solely of those held by its two asset-backed commercialpaper conduits (the “Facilities”). During March 2008, the Company enteredinto an agreement with the holders of the secured liquidity notes (“SLNs”)issued by the Facilities (the “Noteholders”) in order to terminate theFacilities. With respect to the agreement with the Noteholders, all of the RMBSfunded by the SLNs have been transferred to the Noteholders in satisfaction ofthe SLNs and the Company has paid the Noteholders approximately$42.0 million in conjunction with this resolution. The Company hadpreviously accrued $36.5 million for contingencies related to the resolutionof the Facilities and as a consequence of this transaction, the Companyrecorded an incremental charge during the quarter ended March 31, 2008 of$5.5 million. The agreement with the Noteholders resulted in approximately$3.6 billion par amount of RMBS being transferred to the Noteholders insatisfaction of approximately $3.5 billion par amount of SLNs held by theNoteholders. Accordingly, the Company removed the RMBS and SLNs that related tothe Facilities from its condensed consolidated financial statements as of March 31,2008. Under the agreement with the Noteholders, the Company and its affiliateshave been released from any future obligations or liabilities to theNoteholders.

 

27

----

 

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

 

The Companyhas determined that a sale or transfer of its remaining residential mortgageportfolio is no longer probable. As such, the Company’s remaining residential mortgageinvestment 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 March 31, 2009 have been reclassified for comparativepresentation.

 

As of March 31,2009, the Company’s remaining residential mortgage portfolio consisted of$246.3 million of RMBS, of which $158.4 million represented interests inresidential mortgage securitization trusts that were not structured as QSPEs.The Company consolidates these trusts because it is the primary beneficiary ofthese entities and therefore reported total assets of $2.3 billion andtotal liabilities of $2.1 billion for these trusts in continuingoperations as of March 31, 2009. See Note 8 to these condensedconsolidated financial statements for further discussion.

 

The componentsof income from discontinued operations are as follows (amounts in thousands):

 

| ** **                          | ** ** | **Three months ended  March 31, 2008** | ** ** |
|-------------------------------------|------------|------------------------------------------------------------|------------|
| Net investment income               |       | $                                                          | 16,795     |   |
| Total other loss                    |       | (5,361                                                     | )          |
| Non-investment expenses             |       | (7,687                                                     | )          |
| Income from discontinued operations |       | $                                                          | 3,747      |   |

 

28

----

 

**Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS**

 

*Except where otherwise expressly stated or the context suggestsotherwise, the terms “we,” “us” and “our” refer to KKR Financial Holdings LLCand its subsidiaries.*

 

**Executive Overview**

 

We are a specialty finance company that uses leverage with theobjective of generating competitive risk-adjusted returns. We invest infinancial assets consisting primarily of below investment grade corporate debt,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. The majority of our investments are in senior secured loans of largecapitalization companies. The corporate loans we invest in are generallyreferred to as syndicated bank loans, or leveraged loans, and are purchased viaassignment or participation in either the primary or secondary market. Themajority of our corporate debt investments are held in collateralized loanobligation (“CLO”) transactions that are structured as on-balance sheetsecuritizations and are used as long term financing for these investments. Thesenior secured notes issued by the CLO transactions are generally owned byunaffiliated third party investors and we own the majority of the mezzanine andsubordinated notes in the CLO transactions. Our CLO transactions consist of sixcash flow CLO transactions, KKR Financial CLO 2005-1, Ltd. (“CLO 2005-1”), KKRFinancial CLO 2005-2, Ltd. (“CLO 2005-2”), KKR Financial CLO 2006-1, Ltd. (“CLO2006-1”), KKR Financial CLO 2007-1, Ltd. (“CLO 2007-1”), KKR Financial CLO2007-A, Ltd. (“CLO 2007-A” and, together with CLO 2005-1, CLO 2005-2, CLO2006-1, and CLO 2007-1, the “Cash Flow CLOs”) and KKR Financial CLO 2009-1,Ltd. (“CLO 2009-1”).

 

In addition to our Cash FlowCLOs, a portion of our assets were previously held in Wayzata Funding LLC (“Wayzata”),a market value CLO transaction. OnMarch 31, 2009, we completed the restructuring of Wayzata and replaced itwith CLO 2009-1. As a result of the restructuring, substantially all of Wayzata’sassets have been transferred to CLO 2009-1, a newly formed special purposecompany, which issued $560.8 million aggregate principal amount of senior notesdue April 2017 and $154.3 million aggregate principal amount ofsubordinated notes due April 2017 to the existing Wayzata note holders inexchange for cancellation of the Wayzata notes, due November 2012,previously held by each of them. CLO 2009-1 has been structured as a cash flowtransaction and does not contain the market value provisions contained inWayzata. The portfolio manager of CLO 2009-1 is an affiliate of KKRFinancial Advisors LLC (our “Manager”).The notes issued by CLO 2009-1 are secured by the same collateral that securedthe Wayzata notes, consisting primarily of senior secured leveraged loans. Aswas the case with Wayzata, we and an affiliate of our Manager currently own allof the subordinated notes issued by CLO 2009-1. The subordinated notes entitleus to receive a pro rata**portionof all excess cash flows from the portfolio after all senior obligations of CLO2009-1 have been paid in full or otherwise satisfied, including all outstandingprincipal of the senior notes and interest thereon accruing at a rate of3-month LIBOR plus 4.25%.

 

***Liquidity***

 

Asset price declines, due in significant partto material credit spread widening and deteriorating economic conditions, havenegatively impacted our liquidity. As described above, we own a majority of themezzanine and subordinated notes issued by the Cash Flow CLOs and thereforehave historically received a majority of our cash flows from our investments inthese entities. The indentures governing the Cash Flow CLOs include numerouscompliance tests, the majority of which relate to the CLO’s portfolio profile.In addition to the portfolio profile tests, the indentures for the Cash FlowCLOs include over-collateralization tests (“OC Tests”) which set the ratio ofthe collateral value of the assets in the CLO to the tranches of debt for whichthe test is being measured, as well as interest coverage tests. If a CLO is notin compliance with an OC Test or an interest coverage 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 the OC Test isbrought back into compliance. During the first quarter of 2009, certain of our CashFlow CLOs failed certain of their respective OC Tests as a result ofsignificant asset price declines and rating downgrades of certain investmentsthat occurred during 2008. Accordingly, the cash flows we would generallyexpect to receive from our investments in the mezzanine and subordinated notesissued by the Cash Flow CLOs were used to amortize the most senior class ofnotes. During the first quarter of 2009, the amount of cash that was paid toreduce the principal balances outstanding of the senior notes issued by theCash Flow CLOs totaled $68.3 million. We expect that the majority of our CashFlow CLOs will be out of compliance with their respective OC Tests during 2009and as a result, will not be cash flow positive during  2009.

 

29

----

 

In addition,as described above under “Executive Overview,” all of the interest andprincipal cash proceeds received from the investments held in CLO 2009-1 willbe used to pay down all of the senior notes outstanding prior to us receivingany cash flows from this transaction. Accordingly, during 2009, we do notexpect to receive any cash flows from the investments held in CLO 2009-1.

 

As of March 31, 2009, we hadapproximately $847.7 million of total recourse debt outstanding. Of thisamount, up to $150.0 million of the $267.6 million currentlyoutstanding on our $300.0 million senior secured revolving credit facilitymatures in November 2009 with the remainder maturing in November 2010.The actual amount of the borrowings outstanding as of November 2009 willbe dependent upon the fair value of the assets pledged to the senior securedcredit facility and as a result, the actual amount by which we will pay downoutstanding borrowings may be in excess of the $150.0 million that will beavailable under this facility in November 2009. Based on the estimatedfair value of the assets pledged to this facility as of March 31, 2009,the actual amount of outstanding borrowings that we would be required to payoff would be $167.9 million.

 

Under our $100.0 million unsecured revolving credit agreement with ourManager and Kohlberg Kravis Roberts & Co. (FixedIncome) LLC, the parent of our Manager (the “Standby Agreement”), allprincipal outstanding is due in December 2010. We currently have noborrowings outstanding under this facility. In addition to these amounts, wehave $291.5 million principal amount of convertible notes due to mature inJuly 2012 and have approximately $35.7 million in derivativeliabilities related to total rate of return swaps through which we havefinanced certain loan investments. The majority of this amount matures duringthe fourth quarter of 2009.

 

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

 

We intend tocontinue to operate so that we qualify, for United States federal income taxpurposes, as a partnership and not as an association or a publicly tradedpartnership taxable as a corporation. Holders of our shares are subject toUnited States federal income taxation and, in some cases, state, local andforeign income taxation, on their allocable share of our taxable income,regardless of whether or when they receive cash distributions. In addition,certain of our investments, including investments in foreign corporatesubsidiaries, CLO issuers, including those treated as partnerships ordisregarded entities for United States federal income tax purposes, and debtsecurities, may produce taxable income without corresponding distributions ofcash to us or may produce taxable income prior to or following the receipt ofcash relating to such income. Consequently, in some taxable years, holders ofour shares may recognize taxable income in excess of our cash distributions.Furthermore, if we did not pay cash distributions with respect to a taxableyear, holders of our shares may still have a tax liability attributable totheir allocation of taxable income from us during such year. We expect this tobe the case as we do not expect to make any cash distributions to shareholdersduring 2009 and potentially thereafter.

 

***Investment Portfolio***

 

*Overview*

 

As discussedabove, the majority of our investments are held through CLO transactions thatare managed by an affiliate of our Manager and for which we own the majority,and in some cases all, of the economic interests in the transaction through thesubordinated notes in the transaction. On an unconsolidated basis, ourinvestment portfolio primarily consists of the following as of March 31,2009: (i) mezzanine and subordinated tranches of CLO transactions,totaling a par amount of $1.4 billion; (ii) corporate loans with anaggregate par amount of $401.0 million and an estimated fair value of$113.5 million; (iii) corporate debt securities with an aggregate paramount of $130.8 million and an estimated fair value of $75.0 million; (iv) residentialmortgage-backed securities (“RMBS”) with a par amount of $326.7 millionand estimated fair value of $246.3 million; (v) non-marketable equitysecurities with an aggregate cost basis of $22.8 million; (vi) marketableequity securities with an aggregate estimated fair value of $3.1 million.In addition, we hold other investments including loan investments financedunder total rate of return swaps that are accounted for as derivativetransactions, credit default swaps, shorts on equity and debt instruments, andinterest rate swaps.

 

As ourcondensed consolidated financial statements in this Quarterly Report on Form 10-Qare presented to reflect the consolidation of the CLOs we hold investments in,the information contained in this Management’s Discussion and Analysis ofFinancial Condition and Results of Operations reflects the CLOs on aconsolidated basis consistent with the disclosures in our condensedconsolidated financial statements.

 

30

----

 

*Corporate Debt Investments*

 

Ourinvestments in corporate debt primarily consist of investments in belowinvestment grade corporate loans, often referred to as syndicated bank loans orleveraged loans, and corporate debt securities. As of March 31, 2009, ourcorporate debt investments, excluding investments held through total rate ofreturn swaps, had an aggregate par balance of $9.2 billion, an aggregate netamortized cost of $8.5 billion and an aggregate estimated fair value of$5.6 billion. Included in these amounts is $7.7 billion par amount or $4.8billion estimated fair value of investments held in our Cash Flow CLOs whichhave aggregate senior notes outstanding totaling $5.8 billion and an aggregateof $536.9 million of mezzanine and subordinated notes outstanding that are heldby an affiliate of our Manager. In addition to the investments held by our CashFlow CLOs, they had an aggregate principal cash balances totaling $175.9million as of March 31, 2009.

 

As of March 31, 2009, CLO2009-1 held investments with an aggregate par balance of $1.0 billion and anestimated fair value of $693.0 million. CLO 2009-1 also had an aggregateprincipal cash balance of $0.1 million and senior notes outstanding totaling$560.8 million and subordinated notes outstanding to an affiliate of ourManager totaling $90.4 million as of March 31, 2009.

 

*RMBS Investments*

 

Ourresidential mortgage investment portfolio consists of investments in RMBS withan estimated fair value of $246.3 million as of March 31, 2009. Ofthe $246.3 million of RMBS investments we hold, $158.4 million are insix residential mortgage-backed securitization trusts that we consolidate underGAAP as we hold the majority of the risk of loss on these transactions. Thisresults in us reflecting the financial position and results of these trusts inour condensed consolidated financial statements. Consolidation of these sixentities does not impact our net assets or net income; however, it does resultin us showing the condensed consolidated assets, liabilities, revenues and expenseson our condensed consolidated financial statements. On our condensedconsolidated balance sheet as of March 31, 2009, the $246.3 millionof RMBS is computed as our investments in RMBS of $87.9 million, plus$158.4 million, which represents the difference between residentialmortgage loans of $2.3 billion less residential mortgage-backed securitiesissued of $2.1 billion plus $11.2 million of real estate owned thatis included in other assets on our condensed consolidated balance sheet.

 

**Critical Accounting Policies**

 

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

 

***Fair Value of Financial Instruments***

 

As defined inSFAS No. 157, *Fair Value Measurements*(“SFAS No. 157”), fair value is the price that would be received to sellan asset or paid to transfer a liability in an orderly transaction betweenmarket participants at the measurement date. Where available, fair value isbased on observable market prices or parameters or derived from such prices orparameters. Where observable prices or inputs are not available, valuationmodels are applied. These valuation techniques involve some level of managementestimation and judgment, the degree of which is dependent on the pricetransparency for the instruments or market and the instruments’ complexity fordisclosure purposes. Beginning in January 2007, assets and liabilitiesrecorded at fair value in the condensed consolidated balance sheets arecategorized based upon the level of judgment associated with the inputs used tomeasure their value. Hierarchical levels, as defined in SFAS No. 157 anddirectly related to the amount of subjectivity associated with the inputs tofair valuations of these assets and liabilities, are as follows:

 

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

 

The types ofassets carried at level 1 fair value generally are equity securitieslisted in active markets.

 

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

 

31

----

 

Fair valueassets and liabilities that are generally included in this category are certaincorporate debt securities, certain corporate loans held for sale and certainfinancial instruments classified as derivatives where the fair value is basedon observable market inputs.

 

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

 

Generally,assets and liabilities carried at fair value and included in this category arecertain corporate debt securities, certain corporate loans held for sale,certain non-marketable equity securities, residential mortgage-backedsecurities, residential mortgage loans, residential mortgage-backed securitiesissued and certain derivatives.

 

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

 

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

 

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

 

Depending onthe relative liquidity in the markets for certain assets, we may transferassets to level 3 if we determine that observable quoted prices, obtaineddirectly or indirectly, are not available. Assets and liabilities that arevalued using level 3 of the fair value hierarchy primarily consist ofcertain corporate debt securities, certain non-marketable equity securities,certain corporate loans held for sale, residential mortgage-backed securities,residential mortgage loans, residential mortgage-backed securities issued andcertain over-the-counter (“OTC”) derivative contracts. The valuation techniquesused for these are described below.

 

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

 

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

 

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

 

32

----

 

***Share-Based Compensation***

 

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

 

Because weremeasure the amount of compensation costs associated with the unvestedrestricted common shares and unvested common share options that we issued toour Manager as of each reporting period, our share-based compensation expensereported in our condensed consolidated financial statements will change basedon the estimated fair value of our common shares and this may result inearnings volatility. For the three months ended March 31, 2009,share-based compensation was immaterial. As of March 31, 2009,substantially all of the non-vested restricted common shares issued that aresubject to SFAS No. 123(R) are subject to remeasurement. As of March 31,2009, a $1 increase in the price of our common shares would have increased our futureshare-based compensation expense by approximately $1.1 million and thisfuture share-based compensation expense would be recognized over the remainingvesting periods of our outstanding restricted common shares and common shareoptions. As of March 31, 2009, the common share options were fullyexercised and expire in August 2014. As of March 31, 2009, futureunamortized share-based compensation totaled $1.0 million, of which$0.5 million, $0.4 million, and $0.1 million will be recognized in2009, 2010, and beyond, respectively.

 

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

 

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

 

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

 

We are notrequired to account for our derivative contracts using hedge accounting asdescribed above. If we decide not to designate the derivative contracts ashedges or if we fail to fulfill the criteria necessary to qualify for hedgeaccounting, then the changes in the estimated fair values of our derivativecontracts would affect periodic earnings immediately potentially resulting inthe increased volatility of our earnings. The qualification requirements forhedge accounting are complex and as a result, we must evaluate, designate, andthoroughly document each hedge transaction at inception and performineffectiveness analysis and prepare related documentation at inception and ona recurring basis thereafter. As of March 31, 2009, the estimated fairvalue of our net derivative liabilities totaled $83.6 million.

 

33

----

 

***Impairments***

 

We evaluateour investment portfolio for impairment as of each quarter end or morefrequently if we become aware of any material information that would lead us tobelieve that an investment may be impaired. We evaluate whether the investmentis considered impaired and whether the impairment is other-than-temporary. Ifwe make a determination that the impairment is other-than-temporary, werecognize an impairment loss equal to the difference between the amortized costbasis and the estimated fair value of the investment. We consider many factorsin determining whether the impairment of an investment is other-than-temporary,including but not limited to the length of time the security has had a declinein estimated fair value below its amortized cost and the severity of thedecline, the amount of the loss, the intent and our financial ability to hold theinvestment for a period of time sufficient for a recovery in its estimated fairvalue, recent events specific to the issuer or industry, external creditratings and recent downgrades in such ratings. This process involves aconsiderable amount of subjective judgments by our management. As of March 31,2009, we had aggregate unrealized losses on our securities classified asavailable-for-sale of approximately $160.0 million, which if not recoveredmay result in the recognition of future losses. During the three months ended March 31,2009, we recorded charges for impairments of securities that we determined tobe other-than-temporary totaling $33.8 million.

 

***Allowance for Loan Losses***

 

Our allowancefor estimated loan losses represents our estimate of probable credit lossesinherent in our corporate loan portfolio held for investment. When determiningthe adequacy of the allowance for loan losses, we consider historical andindustry loss experience, economic conditions and trends, the estimated fairvalues of our loans, credit quality trends and other factors that we determineare relevant. This process involves a considerable amount of subjectivejudgments by our management. Additions to the allowance for loan losses arecharged to current period earnings through the provision for loan losses.Amounts determined to be uncollectible are charged directly to the allowancefor loan losses. Our allowance for loan losses consists of two components, anallocated component and an unallocated component.

 

The allocated component of our allowance for loan losses consists ofindividual loans that are impaired and for which the estimated allowance forloan losses is determined in accordance with SFAS No. 114, *Accounting by Creditors for Impairment of a Loan.*We consider a loan to be impaired when, based on current information andevents, we believe it is probable that we will be unable to collect all amountsdue to us based on the contractual terms of the loan. An impaired loan may beleft on accrual status during the period we are pursuing repayment of the loan;however, the loan is placed on non-accrual status at such time as: (i) webelieve that scheduled debt service payments may not be paid when contractuallydue; (ii) the loan becomes 90 days delinquent; (iii) we determinethe borrower is incapable of, or has ceased efforts toward, curing the cause ofthe impairment; or (iv) the net realizable value of the underlyingcollateral securing the loan decreases below our carrying value of such loan.While on non-accrual status, previously recognized accrued interest is reversedif it is determined that such amounts are not collectible and interest incomeis recognized only upon actual receipt.

 

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

 

As of March 31,2009, our allowance for loan losses totaled $507.8 million.

 

**Recent Accounting Pronouncements**

 

In March 2008, the Financial AccountingStandards Board (“FASB”) issuedSFAS No. 161, *Disclosures aboutDerivative Instruments and Hedging Activities, an Amendment of FASB Statement No. 133*(“SFAS No. 161”). SFAS No. 161 requires enhancedqualitative disclosures about objectives and strategies for using derivatives,quantitative disclosures about fair value amounts of gains and losses onderivative instruments, and disclosures about credit-risk-related contingentfeatures in derivative agreements. The adoption of SFAS No. 161 did not have amaterial impact on our financial statements. The applicable additionaldisclosures required by SFAS No. 161 have been incorporated in our notesto condensed consolidated financial statements beginning with the first quarterof 2009.

 

In January 2009,the FASB issued Financial Accounting Standards Board’s Staff Position (“FSP”)EITF 99-20-1, *Amendments to theImpairment Guidance of EITF Issue No. 99-20* (“FSPEITF 99-20-1”). FSP EITF 99-20-1 eliminates the requirement that aholder’s best estimate of cash flows be based upon those that “a marketparticipant” would use. Instead, it requires that an other-than-temporaryimpairment be recognized as a realized loss when it is “probable” there hasbeen an adverse change in the holder’s estimated cash flows from the cash flowspreviously projected. FSP EITF 99-20-1 also reiterates and emphasizes the relatedguidance and disclosure requirements in accordance with SFAS No. 115, *Accounting for Certain Investments in Debt and EquitySecurities.* FSP EITF 99-20-1 is effective for all periodsending after December 15, 2008 and retroactive application is not permitted.We have taken this FSP into consideration when evaluating our investments forother-than-temporary impairment.

 

34

----

 

In April 2009, the FASB issued FSP FAS 107-1 and APB 28-1,*Interim Disclosures about Fair Value of Financial Instruments*,which amends SFAS No. 107*, Disclosures about FairValue of Financial Instruments*, to require disclosures about fairvalue of financial instruments for interim reporting periods as well as inannual financial statements. This FSP shall be effective for interim reportingperiods ending after June 15, 2009, with early adoption permitted. We willadopt this FSP beginning the second quarter of 2009 and do not believe that itsadoption will have a material impact on our financial statements.

 

In April 2009, the FASB issued FSP FAS 157-4, *DeterminingFair Value When the Volume and Level of Activity for the Asset or LiabilityHave Significantly Decreased and Identifying Transaction That Are Not Orderly*,which provides additional guidance on identifying circumstances that indicate atransaction is not orderly as well as for estimating fair value in accordancewith SFAS No. 157 when the volume and level of activity for the asset orliability have significantly decreased. This FSP shall be effective for interimand annual reporting periods ending after June 15, 2009, with earlyadoption permitted, and shall be applied prospectively. We will adopt this FSPbeginning the second quarter of 2009 and are currently evaluating the potentialimpact of this FSP on our financial statements.

 

Furthermore, in April 2009, the FASB issued FSP FAS 115-2 and FAS124-2,*Recognition and Presentation ofOther-Than-Temporary Impairments*, which amends theother-than-temporary impairment guidance for debt securities to make theguidance more operational and to improve the presentation and disclosure ofother-than-temporary impairments on debt and equity securities in the financialstatements. This FSP shall be effective for interim and annual reporting periodsending after June 15, 2009, with early adoption permitted, and shall beapplied prospectively. We will adopt this FSP beginning the second quarter of2009.

 

**Results of Operations**

 

*Summary*

 

Our net lossfor the three months ended March 31, 2009 totaled $13.0 million (or$(0.09) per diluted common share) as compared to net income of$14.0 million (or $0.12 per diluted common share) for the three monthsended March 31, 2008. Loss from continuing operations for the three monthsended March 31, 2009 totaled $13.0 million (or $(0.09) per diluted commonshare) compared to income from continuing operations of $10.2 million (or$0.09 per diluted common share) for the three months ended March 31, 2008.The decrease in income from continuing operations of $23.2 million from thethree months ended March 31, 2008 to 2009 is primarily due to a decline innet investment income attributable to lower interest rates and a smallerinvestment portfolio between the two periods, as well as an increase inrealized losses on investments, provision for loan losses andother-than-temporary impairments on corporate debt and marketable equitysecurities recorded in the first quarter of 2009, partially offset by a gain ondebt restructuring.

 

*Net Investment Income*

 

The followingtable presents the components of our net investment income for the three monthsended March 31, 2009 and 2008:

 

**Comparative Net Investment Income Components**

 

**(Amounts in thousands)**

 
| ** **                                                 | ** ** | **For the three months  ended March 31, 2009** | ** ** | **For the three months  ended March 31, 2008** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| Investment Income:                                         |       |                                                                         |       |                                                                         |       |
| Corporate loans and securities interest  income            |       | $                                                                            | 105,184    |                                                                         | $          | 199,360 |   |
| Residential mortgage loans and securities  interest income |       | 39,001                                                                       |       | 48,204                                                                       |       |
| Other interest income                                      |       | 356                                                                          |       | 11,076                                                                       |       |
| Dividend income                                            |       | 261                                                                          |       | 816                                                                          |       |
| Net discount accretion                                     |       | 13,871                                                                       |       | 8,782                                                                        |       |
| Total investment income                                    |       | 158,673                                                                      |       | 268,238                                                                      |       |
| Interest Expense:                                          |       |                                                                         |       |                                                                         |       |
| Repurchase agreements                                      |       | —                                                                       |       | 28,969                                                                       |       |
| Collateralized loan obligation senior  secured notes       |       | 46,415                                                                       |       | 74,517                                                                       |       |
| Secured revolving credit facility                          |       | 3,942                                                                        |       | 2,634                                                                        |       |
| Secured demand loan                                        |       | —                                                                       |       | 323                                                                          |       |
| Convertible senior notes                                   |       | 5,246                                                                        |       | 5,388                                                                        |       |
| Junior subordinated notes                                  |       | 4,441                                                                        |       | 5,755                                                                        |       |
| Residential mortgage-backed securities  issued             |       | 25,859                                                                       |       | 34,431                                                                       |       |
| Other interest expense                                     |       | 1,242                                                                        |       | 749                                                                          |       |
| Interest rate swaps                                        |       | 2,737                                                                        |       | 1,299                                                                        |       |
| Total interest expense                                     |       | (89,882                                                                      | )          | (154,065                                                                     | )          |
| Interest expense to affiliates                             |       | (5,805                                                                       | )          | (27,818                                                                      | )          |
| Provision for loan loss                                    |       | (26,987                                                                      | )          | —                                                                       |       |
| Net investment income                                      |       | $                                                                            | 35,999     |                                                                         | $          | 86,355 |   |

 

35

----

 

The decreasein net investment income from the three months ended March 31, 2008 to2009 is primarily attributable to a decline in interest rates, a provision forloan loss recorded in the first quarter of 2009, as well as a smallerinvestment portfolio.

 

*Other Loss*

 

The followingtable presents the components of other loss for the three months ended March 31,2009 and 2008:

 

**Comparative Other Loss Components**

**(Amounts in thousands)**

 
| ** **                                                                                                                                                                      | ** ** | **For the three months  ended March 31, 2009** | ** ** | **For the three months  ended March 31, 2008** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| Net realized and unrealized gain (loss) on  derivatives and foreign exchange:                                                                                              |       |                                                                         |       |                                                                         |       |
| Interest rate swaps                                                                                                                                                             |       | $                                                                            | 475        |                                                                         | $          | 3,795 |   |
| Credit default swaps                                                                                                                                                            |       | 7,980                                                                        |       | 13,289                                                                       |       |
| Total rate of return swaps                                                                                                                                                      |       | 6,953                                                                        |       | (62,625                                                                      | )          |
| Common stock warrants                                                                                                                                                           |       | —                                                                       |       | (688                                                                         | )          |
| Foreign exchange(1)                                                                                                                                                             |       | (3,012                                                                       | )          | (787                                                                         | )          |
| Total realized and unrealized gain (loss)  on derivatives and foreign exchange                                                                                                  |       | 12,396                                                                       |       | (47,016                                                                      | )          |
| Net realized loss on residential loans  carried at estimated fair value                                                                                                         |       | (8,407                                                                       | )          | (755                                                                         | )          |
| Net unrealized loss on residential  mortgage-backed securities, residential mortgage loans, and residential  mortgage-backed securities issued, carried at estimated fair value |       | (11,012                                                                      | )          | (8,423                                                                       | )          |
| Net realized loss on investments(2)                                                                                                                                             |       | (26,440                                                                      | )          | (13,759                                                                      | )          |
| Net realized and unrealized gain on  securities sold, not yet purchased                                                                                                         |       | 1,437                                                                        |       | 6,986                                                                        |       |
| Impairment on securities available-for-sale                                                                                                                                     |       | (33,764                                                                      | )          | —                                                                       |       |
| Gain on debt restructuring                                                                                                                                                      |       | 34,571                                                                       |       | —                                                                       |       |
| Other income                                                                                                                                                                    |       | 1,333                                                                        |       | 4,956                                                                        |       |
| Total other loss                                                                                                                                                                |       | $                                                                            | (29,886    | )                                                                            | $          | (58,011 | ) |

 

----

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

(2)                                  Includeslower of cost or estimated fair value adjustment to corporate loans held forsale.

 

As presentedin the table above, other loss totaled $29.9 million for the three months endedMarch 31, 2009 as compared to $58.0 million for the three monthsended March 31, 2008. Total other loss for the three months ended March 31,2009 primarily consists of net realized losses on investments totaling $26.4million, realized and unrealized losses on residential loans and residentialmortgage-backed securities and residential mortgage-backed securities issuedtotaling $19.4 million, and a loss from other-than-temporary impairments onsecurities available-for-sale totaling $33.8 million. The losses were partiallyoffset by net gains on credit default swaps totaling $8.0 million and a gain ondebt restructuring totaling $34.6 million. The gain on debt restructuringreflects the reduction of the reported amount of debt held by an affiliate ofour Manager upon the replacement of Wayzata with CLO 2009-1 on March 31,2009.

 

36

----

 

*Non-InvestmentExpenses*

 

The following table presentsthe components of non-investment expenses for the three months ended March 31,2009 and 2008:

 

**Comparative Non-Investment Expense Components**

**(Amounts in thousands)**

 
| ** **                             | ** ** | **For the three months  ended March 31, 2009** | ** ** | **For the three months  ended March 31, 2008** | ** ** |
|----------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|
| Related party management compensation: |       |                                                |       |                                                |       |
| Base management fees                   |       | $                                                   | 3,625      |                                                | $          | 7,433 |   |
| Share-based compensation               |       | (140                                                | )          | 462                                                 |       |
| CLO management fees                    |       | 7,727                                               |       | 1,264                                               |       |
| Related party management compensation  |       | 11,212                                              |       | 9,159                                               |       |
| Professional services                  |       | 3,385                                               |       | 1,857                                               |       |
| Loan servicing expense                 |       | 2,136                                               |       | 2,569                                               |       |
| Insurance expense                      |       | 303                                                 |       | 161                                                 |       |
| Directors expenses                     |       | 304                                                 |       | 401                                                 |       |
| General and administrative expenses    |       | 1,796                                               |       | 3,961                                               |       |
| Total non-investment expenses          |       | $                                                   | 19,136     |                                                | $          | 18,108 |   |

 

As presented in the tableabove, our non-investment expenses increased from 2008 to 2009 by approximately$1.0 million. The significant components of non-investment expense aredescribed below.

 

Management compensation torelated parties consists of base management fees payable to our Managerpursuant to the Management Agreement, incentive fees, collateral managementfees, and share-based compensation related to restricted common shares andcommon share options granted to our Manager.

 

The base management feepayable was calculated in accordance with the Management Agreement and is basedon an annual rate of 1.75% times our “equity” as defined in the ManagementAgreement. Base management fee decreased by $3.8 million from March 31,2008 to 2009 due to the fact that effective January 1, 2009, the Manageragreed to defer 50% of the monthly base management fee payable by us for theperiod from January 1, 2009 through November 30, 2009. The aggregateamount of fees otherwise payable during the deferral period will be payable tothe Manager upon the earlier of (x) December 15, 2009 and (y) thedate of any termination of the Management Agreement pursuant to either Section 13(a) orSection 15(b) thereof.

 

Our Manager is also entitledto a quarterly incentive fee provided that our quarterly “net income,” asdefined in the Management Agreement, before the incentive fee exceeds a definedreturn hurdle. Incentive fees of nil were earned by the Manager during thethree months ended March 31, 2009 and 2008.

 

An affiliate of our Managerhas entered into separate management agreements with the respective investmentvehicles CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and CLO2009-1 and is entitled to receive fees for the services performed as collateralmanager. Beginning April 15, 2007, the collateral manager ceased waivingfees for CLO 2005-1 and effective January 1, 2009, the collateralmanager ceased waiving fees for CLO 2005-2, CLO 2006-1,CLO 2007-1, CLO 2007-A and Wayzata. Accordingly, CLO management fees increased$6.5 million from March 31, 2008 to 2009. In addition, beginning January1, 2009, our Manager permanently waived reimbursable general and administrativeexpenses allocable to us in an amount equal to the incremental CLO feesreceived by our Manager. For the three months ended March 31, 2009, the Managerpermanently waived reimbursement of $2.3 million in allocable general andadministrative expenses. For the three months ended March 31, 2008, wereimbursed our Manager $2.5 million for expenses.

 

General and administrativeexpenses consist of expenses incurred by our Manager on our behalf that arereimbursable to our Manager pursuant to the Management Agreement. Professionalservices expenses consist 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. Professionalfees increased by $1.5 million primarily due to expenses associated with CLO2009-1. The decrease in general and administrative expenses of$2.2 million was primarily attributable to the rebated CLO fees reducingthe general and administrative expenses otherwise reimbursable to our Manager.

 

*Income TaxProvision*

 

We intend to continue tooperate so that we qualify as a partnership, and not as an association orpublicly traded partnership that is taxable as a corporation, for United Statesfederal income tax purposes. Therefore, we generally are not subject to UnitedStates federal income tax at the entity level, but are subject to limited stateincome taxes. Holders of our shares are required to take into account theirallocable share of each item of our income, gain, loss, deduction and creditfor our taxable year end ending within or with their taxable year.

 

37

----

 

KKR TRS Holdings, Ltd.(“TRS Ltd.”), KKR Financial Holdings, Ltd. (“KFH Ltd.”), and KFNPEI VII, LLC (“PEI VII”) are not consolidated with us for United Statesfederal income tax purposes. For financial reporting purposes, current anddeferred taxes are provided for on the portion of earnings recognized by uswith respect to our interest in PEI VII, a domestic taxable corporatesubsidiary, because PEI VII is taxed as a regular corporation under the Code.Deferred income tax assets and liabilities are computed based on temporarydifferences between the GAAP consolidated financial statements and the UnitedStates federal income tax basis of assets and liabilities as of eachconsolidated balance sheet date. CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO2007-1, CLO 2007-A and CLO 2009-1 are our foreign subsidiaries that elected tobe treated as disregarded entities or partnerships for United States federalincome tax purposes. Those subsidiaries were established to facilitatesecuritization transactions, structured as secured financing transactions.TRS Ltd. and KFH Ltd. are our foreign subsidiaries and are taxed as corporationsfor United States federal income tax purposes. These entities were formed tomake certain foreign and domestic investments from time to time. TRS Ltd.and KFH Ltd. are organized as exempted companies incorporated with limitedliability under the laws of the Cayman Islands, and are generally exempt fromUnited States federal and state income tax at the corporate entity levelbecause they restrict their activities in the United States to trading in stockand securities for their own account. They generally will not be subject tocorporate income tax in our financial statements on their earnings, and noprovisions for income taxes for the quarter ended March 31, 2009 wererecorded; however, we are generally required to include their current taxableincome in our calculation of taxable income allocable to shareholders.

 

We own both REIT anddomestic taxable corporate subsidiaries, none of which are expected to incur a2009 federal or state tax liability.

 

**Investment Portfolio**

 

***Corporate Investment PortfolioSummary***

 

Our corporate investmentportfolio primarily consists of investments in corporate loans and debtsecurities. Our corporate loans primarily consist of senior secured, secondlien and mezzanine loans. The corporate loans we invest in are generally belowinvestment grade and are floating rate indexed to either one-month or three-monthLIBOR. Our investments in corporate debt securities primarily consist ofinvestments in below investment grade corporate bonds that are senior secured,senior unsecured and subordinated. 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 financial performanceand debt service ability.

 

The tables below summarizethe carrying value, amortized cost and estimated fair value of our corporateinvestment portfolio as of March 31, 2009 and December 31, 2008,stratified by 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 ofamortized cost or estimated fair value for loans held for sale. Estimated fairvalues set forth in the tables below are based on dealer quotes and/ornationally recognized pricing services.

 

*CorporateLoans*

 

Our corporate loan portfoliototaled approximately $7.9 billion as of March 31, 2009 and$8.1 billion as of December 31, 2008. Our corporate loan portfolioconsists of debt obligations of corporations, partnerships and other entitiesin the form of senior secured loans, second lien loans and mezzanine loans.

 

The following tablesummarizes our corporate loans portfolio stratified by type as of March 31,2009 and December 31, 2008:

 

**Corporate Loans**

**(Amounts in thousands)**

 
| ** **     | ** ** | **March 31,  2009** | ** ** | **December 31,  2008** | ** ** |
|----------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **     | ** ** | **Carrying  Value (1)**  | ** ** | **Amortized  Cost**         | ** ** | **Estimated  Fair  Value** | ** ** | **Carrying  Value(1)** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair  Value** | ** ** |
| Senior secured |       | $                        | 7,056,631  |                        | $          | 7,056,631 |   | $ | 4,803,475 |   | $ | 7,147,665 |   | $ | 7,147,665 |   | $ | 4,627,121 |   |
| Second lien    |       | 596,806                  |       | 596,806                     |       | 261,836 |   | 655,371 |   | 655,371 |   | 361,196 |   |
| Mezzanine      |       | 228,350                  |       | 228,350                     |       | 103,179 |   | 249,185 |   | 249,185 |   | 109,266 |   |
| Total          |       | $                        | 7,881,787  |                        | $          | 7,881,787 |   | $ | 5,168,490 |   | $ | 8,052,221 |   | $ | 8,052,221 |   | $ | 5,097,583 |   |

 

----

| (1) |   | Total carrying value excludes allowance for loan losses of $507.8  million and $480.8 million as of March 31, 2009 and  December 31, 2008, respectively, and includes loans held for sale of  $259.9 million and $324.6 million as of March 31, 2009 and  December 31, 2008, respectively. |
|-----|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

38

----

 

As of March 31, 2009,$7.8 billion, or 98.4%, of our corporate loan portfolio was floating rateand $0.1 billion, or 1.6%, was fixed rate. As of December 31, 2008,$7.9 billion, or 98.6%, of our corporate loan portfolio was floating rateand $0.1 billion, or 1.4%, was fixed rate. Fixed and floating percentageswere calculated based on the portfolio mix as a percentage of estimated fairvalue.

 

All of our floating ratecorporate loans have index reset frequencies of twelve months or less with themajority being quarterly. The weighted-average coupon on our floating ratecorporate loans was 3.4% and 4.6% as of March 31, 2009 and December 31,2008, respectively, and the weighted-average coupon spread to LIBOR of ourfloating rate corporate loan portfolio was 2.9% as of March 31, 2009 and December 31,2008. The weighted-average years to maturity of our floating rate corporate loanswas 4.8 years and 5.1 years as of March 31, 2009 and December 31,2008, respectively.

 

As of March 31, 2009,our fixed rate corporate loans had a weighted-average coupon of 13.8% andweighted-average years to maturity of 6.2 years, as compared to 13.7% andweighted-average years to maturity of 6.4 years as of December 31,2008.

 

Loans placed on non-accrualstatus may or may not be contractually past due at the time of suchdetermination. While on non-accrual status, previously recognized accrued interestis reversed and charged against current income, and interest income isrecognized only upon actual receipt. When the ultimate collectability of theprincipal is not in doubt, contractual interest is credited to interest incomewhen received using the cost-recovery method, cash-basis method or somecombination of the two methods.

 

As of March 31, 2009and December 31, 2008, we had $772.1 million and $358.0 million ofloans on non-accrual status, respectively. The average recorded investment inthe impaired loans during the first three months of 2009 and 2008 was $565.2million and nil, respectively. The amount of interest income recognized usingthe cash-basis method during the time within the period that the loans wereimpaired was $2.1 million and nil for 2009 and 2008, respectively.

 

During the three monthsended March 31, 2009, we held investments that were in default with atotal amortized cost of $749.0 million from twelve issuers. During the yearended December 31, 2008, we held investments that were in default with atotal amortized cost of $312.7 million from three issuers. All corporateloan and debt securities in default during 2009 and 2008 are included in theinvestments for which the allocated component of our allowance for losses or other-than-temporaryimpairments are related to as of March 31, 2009 and December 31,2008, respectively.

 

The following tablesummarizes the changes in our allowance for loan losses for the quarters ended March 31,2009 and 2008 (amounts in thousands):

 
| ** **                     | ** ** | **March 31, 2009** | ** ** | **March 31, 2008** | ** ** |
|--------------------------------|------------|-------------------------|------------|--------------------|------------|
| Balance at beginning of period |       | $                       | 480,775    |               | $          | 25,000 |   |
| Provision for loan losses      |       | 26,987                  |       | —             |       |
| Charge-offs                    |       | —                  |       | —             |       |
| Balance at end of period       |       | $                       | 507,762    |               | $          | 25,000 |   |

 

As described under CriticalAccounting Policies, our allowance for loan losses represents our estimate ofprobable credit losses inherent in our loan portfolio as of the balance sheetdate. Our allowance for loan losses consists of two components, an allocatedcomponent and an unallocated component. The allocated component of ourallowance for loan losses consists of individual loans that are impaired. Theunallocated component of our allowance for loan losses represents our estimateof losses inherent, but not identified, in our portfolio as of the balancesheet date.

 

As of March 31, 2009,the allocated component relates to investments in loans issued by thirteenissuers with an aggregate par amount of $927.0 million and an aggregateamortized cost amount of $772.1 million. As of December 31, 2008, theallocated component relates to investments in loans issued by eleven issuerswith an aggregate par amount of $828.2 million and an aggregate amortizedcost amount of $715.4 million. The amount recorded to the allocatedcomponent of our allowance for loan losses reflects significant deteriorationin the credit performance of these issuers as demonstrated by default,bankruptcy or a material deterioration of the issuer such that default orrestructuring is considered likely to occur. 

 

The unallocated component ofthe allowance for loan losses totaled $82.7 million and $160.2 million asof March 31, 2009 and December 31, 2008, respectively. There were nocharge-offs during the three months ended March 31, 2009 and we recorded acharge-off during the year ended December 31, 2008 totaling$25.7 million relating to one investment in a corporate loan.

 

39

----

 

We recorded a$14.0 million charge to earnings during the three months ended March 31,2009 for the lower of cost or estimated fair value adjustment for corporateloans held for sale which had an estimated fair value of $259.9 million asof March 31, 2009. We had no corporate loans held for sale during thethree months ended March 31, 2008.

 

The following tablesummarizes the par value of our corporate loan portfolio stratified by Moody’sInvestors Service, Inc. (“Moody’s”) and Standard & Poor’s RatingsServices (“Standard & Poor’s”) ratings category as of March 31,2009 and December 31, 2008:

 

**Corporate Loans**

**(Amounts in thousands)**

 
| **Ratings Category**        | ** ** | **As of  March 31, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|-----------------------------|------------|--------------------------------|------------|-----------------------------------|------------|
| Aaa/AAA                     |       | $                              | —     |                              | $          | — |   |
| Aa1/AA+ through Aa3/AA-     |       | —                         |       | —                            |       |
| A1/A+ through A3/A-         |       | —                         |       | —                            |       |
| Baa1/BBB+ through Baa3/BBB- |       | —                         |       | —                            |       |
| Ba1/BB+ through Ba3/BB-     |       | 2,329,920                      |       | 2,885,285                         |       |
| B1/B+ through B3/B-         |       | 4,644,937                      |       | 4,580,280                         |       |
| Caa1/CCC+ and lower         |       | 1,212,259                      |       | 957,104                           |       |
| Non-rated                   |       | 84,999                         |       | 33,449                            |       |
| Total                       |       | $                              | 8,272,115  |                              | $          | 8,456,118 |   |

 

*CorporateDebt Securities*

 

Our corporate debtsecurities portfolio totaled $479.1 million and $553.4 million as of March 31,2009 and December 31, 2008, respectively. Our corporate debt securitiesportfolio consists of debt obligations of corporations, partnerships and otherentities in the form of senior secured, senior unsecured and subordinatednotes.

 

Thefollowing table summarizes our corporate debt securities portfolio stratifiedby type as of March 31, 2009 and December 31, 2008:

 
| ** **       | ** ** | **March 31, 2009** | ** ** | **December 31, 2008** | ** ** |
|------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **       | ** ** | **Carrying Value**      | ** ** | **Amortized Cost**         | ** ** | **Estimated Fair  Value** | ** ** | **Carrying Value** | ** ** | **Amortized Cost** | ** ** | **Estimated Fair  Value** | ** ** |
| Senior secured   |       | $                       | 34,484     |                       | $          | 39,079 |   | $ | 34,484 |   | $ | 57,641 |   | $ | 75,127 |   | $ | 57,641 |   |
| Senior unsecured |       | 341,700                 |       | 443,577                    |       | 341,700 |   | 400,357 |   | 503,897 |   | 400,357 |   |
| Subordinated     |       | 102,936                 |       | 152,752                    |       | 102,936 |   | 95,443 |   | 163,450 |   | 95,443 |   |
| Total            |       | $                       | 479,120    |                       | $          | 635,408 |   | $ | 479,120 |   | $ | 553,441 |   | $ | 742,474 |   | $ | 553,441 |   |

 

As of March 31, 2009,$431.4 million, or 90.0%, of our corporate debt securities portfolio was fixedrate and $47.7 million, or 10.0%, was floating rate. As of December 31,2008, $494.6 million, or 89.4%, of our corporate debt securities portfolio wasfixed rate and $58.8 million, or 10.6%, was floating rate.

 

As of March 31, 2009,our fixed rate corporate debt securities had a weighted-average coupon of 10.0%and weighted-average years to maturity of 7.0 years, as compared to 10.3%and 6.8 years, as of December 31, 2008. All of our floating ratecorporate debt securities have index reset frequencies of less than twelvemonths. The weighted-average coupon on our floating rate corporate debtsecurities was 4.9% and 7.0% as of March 31, 2009 and December 31,2008, respectively, and the weighted-average coupon spread to LIBOR of ourfloating rate corporate debt securities was 3.6% as of March 31, 2009 and December 31,2008. The weighted-average years to maturity of our floating rate corporatedebt securities was 4.4 years and 4.5 years as of March 31, 2009and December 31, 2008, respectively.

 

During the three monthsended March 31, 2009, we recorded impairment losses totaling$33.8 million for corporate debt and equity securities that we determinedto be other-than-temporarily impaired. These securities were determined to be other-than-temporarilyimpaired either due to our determination that recovery in value is no longerlikely or because we decided to sell the respective security in response tospecific credit concerns regarding the issuer. There were no recordedimpairment losses for corporate debt and equity securities during the threemonths ended March 31, 2008.

 

40

----

 

The following tablesummarizes the par value of our corporate debt securities portfolio stratifiedby Moody’s and Standard & Poor’s ratings category as of March 31,2009 and December 31, 2008:

 

**Corporate Debt Securities**

**(Amounts in thousands)**

 
| **Ratings Category**        | ** ** | **As of  March 31, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|-----------------------------|------------|--------------------------------|------------|-----------------------------------|------------|
| Aaa/AAA                     |       | $                              | —     |                              | $          | — |   |
| Aa1/AA+ through Aa3/AA-     |       | —                         |       | —                            |       |
| A1/A+ through A3/A-         |       | 30,000                         |       | 37,500                            |       |
| Baa1/BBB+ through Baa3/BBB- |       | —                         |       | —                            |       |
| Ba1/BB+ through Ba3/BB-     |       | 32,000                         |       | 32,000                            |       |
| B1/B+ through B3/B-         |       | 388,419                        |       | 408,856                           |       |
| Caa1/CCC+ and lower         |       | 461,579                        |       | 734,303                           |       |
| Non-Rated                   |       | 6,816                          |       | 6,816                             |       |
| Total                       |       | $                              | 918,814    |                              | $          | 1,219,475 |   |

 

***Residential Mortgage Investment Summary***

 

Our residential mortgageinvestment portfolio consists of investments in RMBS with an estimated fairvalue of $246.3 million as of March 31, 2009. The $246.3 millionof RMBS is comprised of $228.7 million of RMBS that are rated investmentgrade or higher and $17.6 million of RMBS that are rated below investmentgrade. Of the $246.3 million of RMBS investments we hold, $158.4 millionare in six residential mortgage-backed securitization trusts that are notstructured as qualifying special-purpose entities as defined by SFAS No. 140.Accordingly, as we own the first loss securities in these trusts, we are deemedto be the primary beneficiary of these entities and as such, consolidate thesetrusts in accordance with GAAP. This results in us reflecting the financialposition and results of these trusts in our condensed consolidated financialstatements. Consolidation of these six entities does not impact our net assetsor net income; however, it does result in us showing the condensed consolidatedassets, liabilities, revenues and expenses on our condensed consolidatedfinancial statements. On our condensed consolidated balance sheet as of March 31,2009, the $246.3 million of RMBS is computed as our investments in RMBS of$87.9 million, plus $158.4 million, which represents the differencebetween residential mortgage loans of $2.3 billion less residentialmortgage-backed securities issued of $2.1 billion plus $11.2 millionof real estate owned that is included in other assets on our condensedconsolidated balance sheet. The $246.3 million of RMBS as of March 31,2009 represents a decrease of 9.0% from $270.7 million as of December 31,2008.

 

As our condensedconsolidated financial statements included in this quarterly report arepresented to reflect the consolidation of the aforementioned residentialmortgage securitization trusts, the information contained in this Management’sDiscussion and Analysis of Financial Condition and Results of Operationsreflects our residential mortgage portfolio presented on a consolidated basisconsistent with the disclosures in our condensed consolidated financialstatements.

 

The table below summarizes thecarrying value, amortized cost, and estimated fair value of our residentialmortgage investment portfolio as of March 31, 2009 and December 31,2008. Carrying value is the value that investments are recorded on ourcondensed 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 when relevantobservable inputs do not exist.

 

**Residential Mortgage Investment Portfolio**

**(Dollar amounts in thousands)**

 
| ** **                             | ** ** | **March 31, 2009** | ** ** | **December 31, 2008** | ** ** |
|----------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                             | ** ** | **Carrying  Value**     | ** ** | **Amortized  Cost**        | ** ** | **Estimated  Fair Value** | ** ** | **Carrying  Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| Residential Mortgage Loans(1)          |       | $                       | 2,260,759  |                       | $          | 3,259,964 |   | $ | 2,260,759 |   | $ | 2,620,021 |   | $ | 3,371,014 |   | $ | 2,620,021 |   |
| Residential Mortgage-Backed Securities |       | 87,883                  |       | 117,718                    |       | 87,883 |   | 102,814 |   | 125,849 |   | 102,814 |   |
| Total                                  |       | $                       | 2,348,642  |                       | $          | 3,377,682 |   | $ | 2,348,642 |   | $ | 2,722,835 |   | $ | 3,496,863 |   | $ | 2,722,835 |   |

 

----

| (1) | Excludes real estate owned (“REO”) as a result of foreclosure on  delinquent loans of $11.2 million and $10.8 million as of March 31, 2009  and December 31, 2008, respectively. |
|-----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

41

----

 

As of March 31, 2009,thirty-six of our residential mortgage loans with an outstanding balance of$11.2 million were REO as a result of foreclosure on delinquent loans. Asof December 31, 2008, thirty-three of our residential mortgage loans ownedby us with an outstanding balance of $10.8 million were REO as a result offoreclosure on delinquent loans.

 

The following tablesummarizes the delinquency statistics of our residential mortgage loans,excluding REOs, as of March 31, 2009 and December 31, 2008 (dollaramounts in thousands):

 
| ** **             | ** ** | **March 31, 2009** | ** ** | **December 31, 2008** | ** ** |
|------------------------|------------|-------------------------|------------|----------------------------|------------|
| **Delinquency Status** | ** ** | **Number  of Loans**    | ** ** | **Principal  Amount**      | ** ** | **Number  of Loans** | ** ** | **Principal  Amount** | ** ** |
| 30 to 59 days     |       | 85                      |       | $                          | 33,812     |   | 93 |   | $ | 37,282 |   |
| 60 to 89 days     |       | 40                      |       | 14,475                     |       | 41 |   | 15,654 |   |
| 90 days or more   |       | 106                     |       | 43,477                     |       | 76 |   | 29,803 |   |
| In foreclosure         |       | 86                      |       | 32,036                     |       | 67 |   | 22,841 |   |
| Total                  |       | 317                     |       | $                          | 123,800    |   | 277 |   | $ | 105,580 |   |

 

**Portfolio Purchases**

 

We purchased $311.2 millionand $739.1 million par amount of investments during the three months endedMarch 31, 2009 and March 31, 2008, respectively.

 

The table below summarizesour investment portfolio purchases for the periods indicated and includes thepar amount of the securities and loans that were purchased:

 

**Investment Portfolio Purchases**

**(Dollar amounts in thousands)**

 
| ** **                         | ** ** | **Three months ended  March 31, 2009** | ** ** | **Three months ended  March 31, 2008** | ** ** |
|------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| ** **                         | ** ** | **Par Amount**                              | ** ** | **%**                                       | ** ** | **Par Amount** | ** ** | **%** | ** ** |
| Securities:                        |       |                                        |       |                                        |       |   |   |   |   |
| Corporate Debt Securities          |       | $                                           | 1,563      |                                        | 0.5        | % | $ | 43,000 |   | 5.8 | % |
| Marketable Equity Securities       |       | —                                      |       | —                                      |       | 1,527 |   | 0.2 |   |
| Total Securities Principal Balance |       | 1,563                                       |       | 0.5                                         |       | 44,527 |   | 6.0 |   |
| Loans:                             |       |                                        |       |                                        |       |   |   |   |   |
| Corporate Loans                    |       | 309,626                                     |       | 99.5                                        |       | 694,573 |   | 94.0 |   |
| Grand Total Principal Balance      |       | $                                           | 311,189    |                                        | 100.0      | % | $ | 739,100 |   | 100.0 | % |

 

The schedule above excludes purchases of securities sold, not yetpurchased, with a par amount of nil and $34.4 million as of March 31,2009 and 2008, respectively.

 

**Shareholders’ Equity**

 

Our shareholders’ equity at March 31,2009 and December 31, 2008 totaled $693.2 million and $663.3 million,respectively. Included in our shareholders’ equity as of March 31, 2009and December 31, 2008 is accumulated other comprehensive loss totaling$(225.9) million and $(268.8) million, respectively.

 

Our average shareholders’equity and return on average shareholders’ equity for the three months ended March 31,2009 was $691.5 million and (7.6)%, respectively, and for the three monthsended March 31, 2008, were $1.6 billion and 3.6%, respectively.Return on average shareholders’ equity is defined as net income divided byweighted average shareholders’ equity.

 

42

----

 

Our book value per share asof March 31, 2009 and December 31, 2008 was $4.59 and $4.40,respectively, and is computed based on 150,889,325 and 150,881,500 sharesissued and outstanding as March 31, 2009 and December 31, 2008,respectively.

 

**Liquidity and Capital Resources**

 

We actively manage ourliquidity position with the objective of preserving our ability to fund ouroperations and fulfill our commitments on a timely and cost-effective basis. Asof March 31, 2009, we had unrestricted cash and cash equivalents totaling$55.4 million.

 

The majority of ourinvestments are held in Cash Flow CLOs. Accordingly, the majority of our cashflows have historically been received from our investments in the mezzanine andsubordinated notes of our Cash Flow CLOs. Current market economic conditionshave had a material adverse impact on our cash flows and liquidity. During thefirst quarter of 2009, certain of our Cash Flow CLOs were out of compliancewith certain compliance tests (specifically, OC Tests) outlined in theirrespective indentures and as a result, the cash flows we would generally expectto receive from our Cash Flow CLO holdings was paid to the senior note holdersof the Cash Flow CLOs that were out of compliance with their respective OC Tests.During the first quarter of 2009, the amount of cash that was paid to reducethe principal balances outstanding of the senior notes issued by our Cash FlowCLOs totaled $68.3 million. Based on our current market conditions, mostnotably the market values of corporate loans, we expect that the majority of ourCash Flow CLOs will be out of compliance with their respective OC Tests during2009 and as a result, we expect that the majority of the cash flows that wewould generally expect to receive will be used to reduce the principal balancesof the senior notes issued by our Cash Flow CLOs.

 

In addition, as previouslydescribed under “Executive Overview,” all of the interest and principal cashproceeds received from the investments held in CLO 2009-1 will be used to paydown all of the senior notes outstanding prior to us receiving any cash flowsfrom this transaction. Accordingly, we do not expect to receive any cash flowsfrom the investments held in CLO 2009-1 during 2009.

 

As of March 31, 2009,we had approximately $847.7 million of total recourse debt outstanding.Included in this amount is $267.6 million outstanding under our $300.0 millionsenior secured credit facility. Under the terms of this credit facility, theaggregate commitment amount is reduced from $300.0 million to $150.0 million inNovember 2009 and we are required to pay down the outstanding balance toat least $150.0 million by November 2009. The actual amount of the borrowingsoutstanding as of November 2009 will be dependent upon the fair value ofthe assets pledged to the senior secured credit facility and as a result theactual amount by which we will pay down outstanding borrowings to may be inexcess of the $150.0 million that will be available under this facility in November 2009.Based on the estimated fair value of the assets pledged to this facility as of March 31,2009, the actual amount of outstanding borrowings that we would be required topay off would be $167.9 million.

 

In addition to the $847.7million of total recourse debt outstanding, we have a standby unsecuredrevolving credit agreement (the “Standby Agreement”) that has been provided byour Manager and Kohlberg Kravis Roberts & Co. (Fixed Income) LLC, theparent of our Manager. Under the Standby Agreement, through which we have a$100.0 million unsecured revolving credit facility from our Manager, allprincipal outstanding is due in December 2010. We currently have noborrowings outstanding under this facility. In addition to these amounts, wehave $291.5 million principal amount of convertible notes due to mature inJuly 2012. We also have approximately $35.7 million in derivativeliabilities related to total rate of return swaps through which we havefinanced certain loan investments. The majority of this amount matures duringthe fourth quarter of 2009. Based on our current liquidity and access toliquidity through the Standby Agreement, we believe that we are able to meetour obligations for at least the next 12 months.

 

The credit governing oursenior secured credit facility contains negative covenants that restrict ourability, among other things, to pay dividends to our shareholders or makecertain other restricted payments, including a prohibition on distributions toour shareholders in an amount in excess of what would be required to pay allfederal, state and local income taxes arising from the taxable income and gainthat our shareholders incur in connection with the ownership of our common shares.We do not currently expect that any cash distributions will be made during2009.

 

43

----

 

**Sources of Funds**

 

*Cash FlowCLO Transactions*

 

As of March 31, 2009,we had six CLO transactions outstanding, CLO 2005-1, CLO 2005-2,CLO 2006-1, CLO 2007-1, CLO 2007-A and CLO 2009-1. An affiliateof our Manager owns a 37% interest in junior notes of both CLO 2007-1 andCLO 2007-A, and a 20% interest in junior notes of CLO 2009-1. The aggregate paramount of the junior notes in CLO 2007-1, CLO 2007-A and CLO 2009-1 held by theaffiliate of our Manager is $627.3 million, which is reflected ascollateralized loan obligation junior secured notes to affiliates on ourcondensed consolidated balance sheet. In accordance with GAAP, we consolidateeach of these CLO transactions. We utilize CLOs to fund our investments incorporate loans and corporate debt securities. The indentures governing ourCash Flow CLOs include numerous compliance tests, the majority of which relateto the CLO’s portfolio profile. In the event that a portfolio profile test isnot met, the indenture places restrictions on the ability of the CLO’s managerto reinvest available principal proceeds generated by the collateral in theCLOs until the specific test has been cured. In addition to the portfolioprofile tests, the indentures for the CLO transactions include OC Tests whichset the ratio of the collateral value of the assets in the CLO to the tranchesof debt for which the test is being measured, as well as interest coveragetests. For purposes of the calculation, collateral value is the par value ofthe assets unless an asset is in default, is a discounted obligation, or is aCCC-rated asset in excess of the percentage of CCC-rated asset limit specified foreach CLO transaction.

 

If an asset is in default,the indenture for each Cash Flow CLO transaction defines the value used todetermine the collateral value, which value is generally the lower of marketvalue of the asset or the recovery value proscribed for the asset based on itstype and rating by Standard & Poor’s or Moody’s.

 

A discount obligation is anasset with a purchase price of less than a particular percentage of par. Thediscount obligation amounts are specified in each Cash Flow CLO transaction andare generally set at a purchase price of less than 80% of par for corporateloans and 75% of par for corporate debt securities.

 

The indenture for each CashFlow CLO transaction specifies a CCC-threshold for the percentage of totalassets in the CLO that can be rated CCC. All assets in excess of the CCCthreshold specified for the respective CLO are included in the OC Tests atmarket value and not par.

 

Defaults of assets in CashFlow CLOs, ratings downgrade of assets in Cash Flow CLOs to CCC, price declinesof CCC assets in excess of the proscribed CCC threshold amount, and pricedeclines in assets classified as discount obligations may reduce the OC ratiosuch that a Cash Flow CLO is not in compliance. If a Cash Flow CLO is not incompliance with an OC Test, cash flows normally payable to the holders ofjunior classes of notes will be used by the CLO to amortize the most seniorclass of notes until such point as the OC Test is brought back into compliance.Declines in asset prices, particularly in the corporate loan and high yieldsecurities asset classes during the fourth quarter of 2008, have been of ahistoric magnitude and have therefore increased the risk of failing the OCTests on all CLO transactions. Accordingly, we expect that one or more of ourCLO transactions will be out of compliance with the OC Tests for periods oftime. While being out of compliance with an OC Test would not impact ourinvestment portfolio or results of operations, it would impact our unrestrictedcash flows available for operations, new investments and dividenddistributions. As of the date we filed this Quarterly Report on Form 10-Q,we believe that we are or will be failing one or more of the OC Tests for eachof our Cash Flow CLO transactions.

 

The following table summarizesseveral of the material tests and metrics for each of our Cash Flow CLOs. Thisinformation is based on the March 2009 monthly reports which areprepared by the independent third-party trustee for each Cash Flow CLOtransaction:

 

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

 

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

 

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

 

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

 

44

----

 

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

 

·                  Senior OC Testminimum: Minimum senior OC requirement per the respective CLO’s indenture.

 

·                  Actual seniorOC Test: Actual senior OC amount as of December 2008 report date.

 

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

 

·                  Subordinated OCTest minimum: Minimum subordinated OC requirement per the respective CLO’sindenture.

 

·                  Actualsubordinated OC Test: Actual subordinated OC amount as of December 2008report date.

 

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

 
| **(dollar amounts in thousands)** | ** ** | **CLO 2005-1** | ** ** | **CLO 2005-2** | ** ** | **CLO 2006-1** | ** ** | **CLO 2007-1** | ** ** | **CLO 2007-A** | ** ** |
|-----------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| Investments                       |       | $              | 1,044,686  |           | $          | 1,001,880      |       | $              | 1,049,516  |           | $          | 3,481,974 |   | $ | 1,528,917 |   |
| Senior IC ratio minimum           |       | 115.0          | %          | 125.0          | %          | 115.0          | %          | 115.0          | %          | 120.0          | %          |
| Actual senior IC ratio            |       | 394.4          | %          | 351.8          | %          | 319.3          | %          | 417.7          | %          | 265.7          | %          |
| CCC amount                        |       | $              | 110,722    |           | $          | 132,804        |       | $              | 257,152    |           | $          | 825,205 |   | $ | 278,892 |   |
| CCC percentage of portfolio       |       | 10.6           | %          | 13.3           | %          | 24.5           | %          | 23.7           | %          | 18.2           | %          |
| CCC threshold percentage          |       | 5.0            | %          | 7.5            | %          | 7.5            | %          | 7.5            | %          | 7.5            | %          |
| Senior OC Test minimum            |       | 119.4          | %          | 123.0          | %          | 143.1          | %          | 159.1          | %          | 119.7          | %          |
| Actual senior OC Test             |       | 124.1          | %          | 125.0          | %          | 138.3          | %          | 138.2          | %          | 118.2          | %          |
| Cushion / (Excess)                |       | $              | 36,408     |           | $          | 14,858         |       | $              | (30,197    | )              | $          | (412,587 | ) | $ | (17,449 | ) |
| Subordinated OC Test minimum      |       | 106.2          | %          | 106.9          | %          | 114.0          | %          | 120.1          | %          | 109.9          | %          |
| Actual OC Test                    |       | 104.7          | %          | 103.1          | %          | 104.4          | %          | 98.6           | %          | 102.6          | %          |
| Cushion / (Excess)                |       | $              | (13,374    | )              | $          | (34,414        | )          | $              | (80,203    | )              | $          | (595,228 | ) | $ | (97,035 | ) |

 

As reflected in the tableabove, each of our cash flow CLO transactions are in compliance with theirrespective IC ratio tests based on the March 2009 monthly reports forthe respective CLOs. Based on the March 2009 monthly reports, CLO 2005-1and CLO 2005-2 are in compliance with their respective senior OC Tests and noneof the CLOs are in compliance with their respective subordinated OC Tests.

 

The indenture governing CLO2009-1 does not contain the portfolio and coverage tests that apply to the CashFlow CLOs. This is due to CLO 2009-1 having a turbo amortization featurewhereby all principal and interest cash flows are paid to the senior noteholders prior to the subordinated note holders receiving any cash payments.

 

45

----

 

*Off-BalanceSheet Commitments*

 

As of March 31, 2009,we had committed to purchase corporate loans with aggregate commitmentstotaling $141.1 million. This amount reflects unsettled trades as of March 31,2009.

 

We participate in certainfinancing arrangements, including revolvers and delayed draw facilities,whereby we are committed to provide funding at the discretion of the borrowerup to a specific predetermined amount. As of March 31, 2009, we hadunfunded financing commitments totaling $40.3 million.

 

**PartnershipTax Matters**

 

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

 

We intend to continue tooperate so that we qualify, for United States federal income tax purposes, as apartnership and not as an association or a publicly traded partnership taxableas a corporation. Holders of our shares are subject to United States federalincome taxation and, in some cases, state, local and foreign income taxation,on their allocable share of our taxable income, regardless of whether or whenthey receive cash distributions. In addition, certain of our investments,including investments in foreign corporate subsidiaries, CLO issuers, includingthose treated as partnerships or disregarded entities for United States federalincome tax purposes, and debt securities, may produce taxable income withoutcorresponding distributions of cash to us or may produce taxable income priorto or following the receipt of cash relating to such income. Consequently, insome taxable years, holders of our shares may recognize taxable income inexcess of our cash distributions. Furthermore, if we did not pay cashdistributions with respect to a taxable year, holders of our shares may stillhave a tax liability attributable to their allocation of taxable income from usduring such year. We expect this to be the case as we do not expect to make anycash distributions to shareholders during 2009 and potentially thereafter.

 

46

----

 

***Qualifying Income Exception***

 

We intend to continue tooperate so that we qualify as a partnership, and not as an association or apublicly traded partnership taxable as a corporation, for United States federalincome tax purposes. In general, if a partnership is “publicly traded” (asdefined in the Code), it will be treated as a corporation for United Statesfederal income purposes. A publicly traded partnership will, however, be taxedas a partnership, and not as a corporation, for United States federal incometax purposes, so long as it is not required to register under the InvestmentCompany Act and at least 90% of its gross income for each taxable yearconstitutes “qualifying income” within the meaning of Section 7704(d) ofthe Code. We refer to this exception as the “qualifying income exception.”Qualifying income generally includes rents, dividends, interest (to the extentsuch interest is neither derived from the “conduct of a financial or insurancebusiness” nor based, directly or indirectly, upon “income or profits” of anyperson), and capital gains from the sale or other disposition of stocks, bondsand real property. Qualifying income also includes other income derived fromthe business of investing in, among other things, stocks and securities.

 

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

 

**Our 1940 Act Status**

 

We are organized as aholding company that conducts its operations primarily through majority-ownedsubsidiaries and we intend to continue to conduct our operations so that we arenot required to register as an investment company under the Investment CompanyAct of 1940, as amended (the “1940 Act”). Section 3(a)(1)(C) of the1940 Act defines an investment company as any issuer that is engaged orproposes to engage in the business of investing, reinvesting, owning, holdingor trading in securities and owns or proposes to acquire “investment securities”(within the meaning of the 1940 Act) having a value exceeding 40% of the valueof the issuer’s total assets (exclusive of U.S. government securities and cashitems) on an unconsolidated basis (the “40% test”). Excluded from the term “investmentsecurities” are, among others, securities issued by majority-owned subsidiariesunless the subsidiary is an investment company or relies on the exceptions fromthe definition of an investment company provided by Section 3(c)(1) orSection 3(c)(7) of the 1940 Act (a “fund”). The 1940 Act defines a “majority-ownedsubsidiary” of a person as any company 50% or more of the outstanding votingsecurities (*i.e.*, thosesecurities presently entitling the holder thereof to vote for the election ofdirectors of the company) of which are owned by that person, or by anothercompany that is, itself, a majority-owned subsidiary of that person. We areresponsible for determining whether any of our subsidiaries is majority-owned.We treat subsidiaries in which we own at least 50% of the outstanding votingsecurities, including those that issue collateralized loan obligations or “CLOs”,as majority-owned for purposes of the 40% test.

 

We monitor our holdingsregularly to confirm our continued compliance with the 40% test. Some of oursubsidiaries may rely solely on Section 3(c)(1) or Section 3(c)(7) ofthe 1940 Act. In order for us to satisfy the 40% test, securities issued to usby those subsidiaries or any of our subsidiaries that are not majority-owned,together with any other “investment securities” that we may own, may not have acombined value in excess of 40% of the value of our total assets on anunconsolidated basis and exclusive of U.S. government securities and cashitems. However, most of our subsidiaries rely on exceptions provided byprovisions of, and rules and regulations promulgated under, the 1940 Act(other than Section 3(c)(1) or Section 3(c)(7) of the 1940Act) to avoid being defined and regulated as an investment company. In order toconform to these exceptions, our subsidiaries may be limited with respect tothe assets in which each of them can invest and/or the types of securities eachof them may issue. We must, therefore, monitor each subsidiary’s compliancewith its applicable exception and our freedom of action, and that of oursubsidiaries, may be limited as a result. For example, our subsidiaries thatissue CLOs generally rely on Rule 3a-7 under 1940 Act, while KKR FinancialHoldings II, LLC, or “KFH II,” our subsidiary that is taxed as a real estateinvestment trust or “REIT,” for United States federal income tax purposes,generally relies on Section 3(c)(5)(C) of the 1940 Act. Each of theseexceptions requires, among other things that the subsidiary (i) not issueredeemable securities and (ii) engage in the business of holding certaintypes of assets, consistent with the terms of the exception. We do not treatour interests in majority-owned subsidiaries that rely on Section 3(c)(5)(C) of,or Rule 3a-7 under, the 1940 Act as investment securities when calculatingour 40% test.

 

We sometimes refer to oursubsidiaries that rely on Rule 3a-7 under the 1940 Act as “CLOsubsidiaries.” Rule 3a-7 under the 1940 Act is available to certainstructured financing vehicles that are engaged in the business of holdingfinancial assets that, by their terms, convert into cash within a finite timeperiod and that issue fixed income securities entitling holders to receivepayments that depend primarily on the cash flows from these assets, providedthat, among other things, the structured finance vehicle does not engage incertain portfolio management practices resembling those employed by mutualfunds. Accordingly, each of these CLO subsidiaries is subject to an indenture(or similar transaction documents) that contains specific guidelines andrestrictions limiting the discretion of the CLO subsidiary and its collateralmanager. In particular, these guidelines and restrictions prohibit the CLOsubsidiary from acquiring and disposing of assets primarily for the purpose 

 

47

----

 

of recognizing gains or decreasing lossesresulting from market value changes. Thus, a CLO subsidiary cannot acquire ordispose of assets primarily to enhance returns to the owner of the equity inthe CLO subsidiary; however, subject to this limitation, sales and purchases ofassets may be made so long as doing so does not violate guidelines contained inthe CLO subsidiary’s relevant transaction documents. A CLO subsidiary generallycan, for example, sell an asset if the collateral manager believes that itscredit quality has declined since its acquisition or that the credit profile ofthe obligor will deteriorate and the proceeds of permitted dispositions may bereinvested in additional collateral, subject to fulfilling the requirements setforth in Rule 3a-7 under the 1940 Act and the CLO subsidiary’s relevanttransaction documents. As a result of these restrictions, our CLO subsidiariesmay suffer losses on their assets and we may suffer losses on our investmentsin those CLO subsidiaries.

 

We sometimes refer to KFHII, our subsidiary that relies on Section 3(c)(5)(C) of the 1940 Act,as our “REIT subsidiary.” Section 3(c)(5)(C) of the 1940 Act isavailable to companies that are primarily engaged in the business of purchasingor otherwise acquiring mortgages and other liens on and interests in realestate. While the Securities and Exchange Commission (“SEC”) has notpromulgated rules to address precisely what is required for a company tobe considered to be “primarily engaged in the business of purchasing orotherwise acquiring mortgages and other liens on and interests in real estate,”the SEC’s Division of Investment Management, or the “Division,” has taken theposition, through a series of no-action and interpretive letters, that acompany may rely on Section 3(c)(5)(C) of the 1940 Act if, amongother things, at least 55% of the company’s assets consist of mortgage loansand other assets that are considered the functional equivalent of mortgageloans (collectively, “qualifying real estate assets”), and at least 25% of thecompany’s assets consist of real estate-related assets (reduced by the excessof the company’s qualifying real estate assets over the required 55%), leavingno more than 20% of the company’s assets to be invested in miscellaneousassets. The Division has also provided guidance as to the types of assets thatcan be considered qualifying real estate assets. Because the Division’sinterpretive letters are not binding except as they relate to the companies towhom they are addressed, if the Division were to change its position as to,among other things, what assets might constitute qualifying real estate assetsour REIT subsidiary might be required to change its investment strategy tocomply with the changed position. We cannot predict whether such a change wouldbe adverse.

 

Based on current guidance,our REIT subsidiary classifies investments in mortgage loans as qualifying realestate assets, as long as the loans are “fully secured” by an interest in realestate on which we retain the right to foreclose. That is, if the loan-to-valueratio of the loan is equal to or less than 100%, then the mortgage loan isconsidered to be a qualifying real estate asset. Mortgage loans with loan-to-valueratios in excess of 100% are considered to be only real estate-related assets.Our REIT subsidiary considers agency whole pool certificates to be qualifyingreal estate assets. Examples of agencies that issue whole pool certificates arethe Federal National Mortgage Association, the Federal Home Loan MortgageCorporation and the Government National Mortgage Association. An agency wholepool certificate is a certificate issued or guaranteed as to principal andinterest by the U.S. government or by a federally chartered entity, thatrepresents the entire beneficial interest in the underlying pool of mortgageloans. By contrast, an agency certificate that represents less than the entirebeneficial interest in the underlying mortgage loans is not considered to be aqualifying real estate asset, but is considered to be a real estate-relatedasset.

 

Most non-agencymortgage-backed securities do not constitute qualifying real estate assets,because they represent less than the entire beneficial interest in the relatedpool of mortgage loans; however, based on Division guidance where our REITsubsidiary’s investment in non-agency mortgage- backed securities is the “functionalequivalent” of owning the underlying mortgage loans, our REIT subsidiary maytreat those securities as qualifying real estate assets. Moreover, investmentsin mortgage-backed securities that do not constitute qualifying real estateassets will be classified as real estate- related assets. Therefore, based uponthe specific terms and circumstances related to each non-agency mortgage-backedsecurity that our REIT subsidiary owns, our REIT subsidiary will make adetermination of whether that security should be classified as a qualifyingreal estate asset or as a real estate- related asset; and there may beinstances where a security is recharacterized from being a qualifying realestate asset to a real estate-related asset, or conversely, from being a realestate-related asset to being a qualifying real estate asset based upon theacquisition or disposition or redemption of related classes of securities fromthe same securitization trust. If our REIT subsidiary acquires securities that,collectively, receive all of the principal and interest paid on the relatedpool of underlying mortgage loans (less fees, such as servicing and trusteefees, and expenses of the securitization), and that subsidiary has foreclosurerights with respect to those mortgage loans, then our REIT subsidiary willconsider those securities, collectively, to be qualifying real estate assets.If another entity acquires any of the securities that are expected to receivecash flow from the underlying mortgage loans, then our REIT subsidiary willconsider whether it has appropriate foreclosure rights with respect to the underlyingloans and whether its investment is a first loss position in deciding whetherthese securities should be classified as qualifying real estate assets. If ourREIT subsidiary owns more than one subordinate class, then, to determine theclassification of subordinate classes other than the first loss class, our REITsubsidiary will consider whether such classes are contiguous with the firstloss class (with no other classes absorbing losses after the first loss classand before any other subordinate classes that our REIT subsidiary owns),whether our REIT subsidiary owns the entire amount of each such class andwhether our REIT subsidiary would continue to have appropriate foreclosurerights in connection with each such class if the more subordinate classes wereno longer outstanding. If the answers to any of these questions is no, then ourREIT subsidiary would expect not to classify that particular class, or classessenior to that class, as qualifying real estate assets.

 

48

----

 

As noted above, if thecombined values of the investment securities issued by our subsidiaries thatmust rely on Section 3(c)(1) or Section 3(c)(7) of the 1940Act, together with any other investment securities we may own, exceeds 40% of thevalue of our total assets (exclusive of U.S. government securities and cashitems) on an unconsolidated basis, we may be deemed to be an investmentcompany. If we fail to maintain an exception, exemption or other exclusion fromthe 1940 Act, we could, among other things, be required either (i) tochange substantially the manner in which we conduct our operations to avoidbeing subject to the 1940 Act or (ii) to register as an investmentcompany. Either of these would likely have a material adverse effect on us, ourability to service our indebtedness and to make distributions on our shares,and on the market price of our shares and any other securities we may issue. Ifwe were required to register as an investment company under the 1940 Act, wewould become subject to substantial regulation with respect to our capitalstructure (including our ability to use leverage), management, operations,transactions with certain affiliated persons (within the meaning of the 1940Act), portfolio composition (including restrictions with respect todiversification and industry concentration) and other matters. Additionally,our Manager would have the right to terminate our management agreement.Moreover, if we were required to register as an investment company, we would nolonger be eligible to be treated as a partnership for United States federalincome tax purposes. Instead, we would be classified as a corporation for taxpurposes and would be able to avoid corporate taxation only to the extent thatwe were able to elect and qualify as a regulated investment company (“RIC”)under applicable tax rules. Because our eligibility for RIC status would dependon our investments and sources of income at the time that we were required toregister as an investment company, there can be no assurance that we would beable to qualify as a RIC. If we were to lose partnership status and fail toqualify as a RIC, we would be taxed as a regular corporation. See “PartnershipTax Matters—*Qualifying Income Exception*.”

 

We have not requested approvalor guidance from the SEC or its staff with respect to our 1940 Actdeterminations, including, in particular: our treatment of any subsidiary asmajority-owned; the compliance of subsidiary with Section 3(c)(5)(C) of,or Rule 3a-7 under, the 1940 Act, including any subsidiary’sdeterminations with respect to the consistency of its assets or operations withthe requirements thereof; or whether our investments in one or moresubsidiaries constitute investment securities for purposes of the 40% test. Ifthe SEC were to disagree with our treatment of one or more subsidiaries asbeing excepted from the 1940 Act pursuant to Rule 3a-7 or Section 3(c)(5)(C),or with our determination that one or more of our other investments do notconstitute investment securities for purposes of the 40% test, we and/or one ormore of our subsidiaries would need to adjust our investment strategies orinvestments in order for us to continue to pass the 40% test or register as aninvestment company, which could have a material adverse effect on us. Moreover,we may be required to adjust our investment strategy and investments if the SECor its staff provides more specific or different guidance regarding theapplication of relevant provisions of, and rules under, the 1940 Act. Suchguidance could provide additional flexibility, or it could further inhibit ourability, or the ability of a subsidiary, to pursue a chosen investmentstrategy, which could have a material adverse effect on us.

 

**Quantitative and Qualitative Disclosures About MarketRisk**

 

*CurrencyRisks*

 

From time to time, we maymake investments that are denominated in a foreign currency through which wemay be subject to foreign currency exchange risk.

 

*LiquidityRisk*

 

Liquidity risk is defined asthe risk that we will be unable to fulfill our obligations on a timely basis,continuously borrow funds in the market on a cost-effective basis to fundactual or proposed commitments, or liquidate assets when needed at a reasonableprice.

 

A material event thatimpacts capital markets participants may impair our ability to accessadditional liquidity. If our cash resources are at any time insufficient tosatisfy our liquidity requirements, we may have to sell assets or issue debt oradditional equity securities.

 

49

----

 

Our ability to meet ourlong-term liquidity and capital resource requirements may be subject to ourability to obtain additional debt financing and equity capital. We may increaseour capital resources through offerings of equity securities (possiblyincluding common shares and one or more classes of preferred shares),securitization transactions structured as secured financings, and senior orsubordinated notes. If we are unable to renew, replace or expand our sources offinancing on acceptable terms, it may have an adverse effect on our businessand results of operations and our ability to make distributions toshareholders. Upon liquidation, holders of our debt securities and lenders withrespect to other borrowings will receive, and any holders of preferred sharesthat we may issue in the future may receive, a distribution of our availableassets prior to holders of our common shares. The decisions by investors andlenders to enter into equity, and financing transactions with us will dependupon a number of factors, including our historical and projected financialperformance, compliance with the terms of our current credit arrangements,industry and market trends, the availability of capital and our investors’ andlenders’ policies and rates applicable thereto, and the relative attractivenessof alternative investment or lending opportunities.

 

We have established a formalliquidity contingency plan which provides guidelines for liquidity management.We determine our current liquidity position and forecast liquidity based onanticipated changes in the balance sheet. 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. A decrease in the fair value of ourinvestments held through total rate of return swaps would result in us postingadditional collateral. Conversely, an increase in the fair value of these swapswould result in us receiving a portion of the previously posted collateral.

 

The table below summarizesthe potential impact on our liquidity position under different stress scenariosas applied to our investments held through total rate of return swap agreements(amounts in thousands):

 
| ** **                 | ** ** | **Impact on liquidity due to (decrease) increase in fair value of investments** | ** ** |
|----------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                 | ** ** | **-10.0%**                                                                                                                             | ** ** | **-7.5%** | ** ** | **-5.0%** | ** ** | **-2.5%** | ** ** | **0.0%** | ** ** | **2.5%** | ** ** | **5.0%** | ** ** | **7.5%** | ** ** | **10.0%** | ** ** |
| Total rate of return swaps |       | $                                                                                                                                      | (5,882     | ) | $ | (4,411 | ) | $ | (2,941 | ) | $ | (1,470 | ) | $ | — |   | $ | 1,470 |   | $ | 2,941 |   | $ | 4,411 |   | $ | 5,882 |   |
|                            |            |                                                                                                                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As discussed above in “Liquidityand Capital Resources,” current market conditions have had a material adverseimpact on our cash flows from CLOs as a result of our CLOs being out ofcompliance with their OC Tests. However, based on our current liquidity andaccess to liquidity, we believe that we are able to meet our obligations for atleast the next 12 months. As of March 31, 2009, we had unencumberedcash and cash equivalents totaling $55.4 million.

 

*CreditSpread Exposure*

 

Our investments are subjectto spread risk. Our investments in floating rate loans and securities arevalued based on a market credit spread over LIBOR and for which the value isaffected by changes in the market credit spreads over LIBOR. Our investments infixed rate loans and securities are valued based on a market credit spread overthe rate payable on fixed rate United States Treasuries of like maturity.Increased credit spreads, or credit spread widening, will have an adverseimpact on the value of our investments while decreased credit spreads, orcredit spread tightening, will have a positive impact on the value of ourinvestments.

 

*DerivativeRisk*

 

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 derivative transactionsdepends on the ability to predict market movements which cannot be guaranteed.As such, participation in derivative instruments may result in greater lossesas we would have to sell or purchase an investment at inopportune times forprices other than current market prices or may force us to hold an asset wemight otherwise have sold. In addition, as certain derivative instruments areunregulated, they are difficult to value and are therefore susceptible toliquidity 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 with respectto derivative instruments are not available for investment purposes.

 

50

----

 

*CounterpartyRisk*

 

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 a loss.We may obtain only a limited recovery or may obtain no recovery in suchcircumstances, thereby reducing liquidity and earnings.

 

*InterestRate Risk*

 

Interest rate risk isdefined as the sensitivity of our current and future earnings to interest ratevolatility, variability of spread relationships, the difference in repricingintervals between our assets and liabilities and the effect that interest ratesmay have on our cash flows and the prepayment rates experienced on ourinvestments that have embedded borrower optionality. The objective of interestrate risk management is to achieve earnings, preserve capital and achieveliquidity by minimizing the negative impacts of changing interest rates, assetand liability mix, and prepayment activity.

 

We are exposed to basis riskbetween our investments and our borrowings. Interest rates on our floating rateinvestments and our variable rate borrowings do not reset on the same day orwith the same frequency and, as a result, we are exposed to basis risk with respectto index reset frequency. Our floating rate investments may reprice on indicesthat are different than the indices that are used to price our variable rateborrowings and, as a result, we are exposed to basis risk with respect torepricing index. The basis risks noted above, in addition to other forms ofbasis risk that exist between our investments and borrowings, may be materialand could negatively impact future net interest margins.

 

Interest rate risk impactsour interest income, interest expense, prepayments, and the fair value of ourinvestments, interest rate derivatives, and liabilities. We manage our interestrate risk using various techniques ranging from the purchase of floating rateinvestments to the use of interest rate derivatives. We generally fund ourvariable rate investments with variable rate borrowings with similar interestrate reset frequencies.

 

The following tablesummarizes the estimated net fair value of our derivative instruments held at March 31,2009 and December 31, 2008 (amounts in thousands):

 

**Derivative Fair Value**

 
| ** **                      | ** ** | **As of  March 31, 2009** | ** ** | **As of  December 31, 2008** | ** ** |
|---------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **Notional**                             | ** ** | **Estimated  Fair Value**              | ** ** | **Notional** | ** ** | **Estimated  Fair Value** | ** ** |
| **Cash Flow Hedges:**           |       |                                     |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | $                                        | 383,333    |                                        | $          | (69,053 | ) | $ | 383,333 |   | $ | (77,668 | ) |
| **Fair Value Hedges:**          |       |                                     |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | 32,000                                   |       | (3,486                                      | )          | 32,000 |   | (2,915 | ) |
| **Free-Standing Derivatives:**  |       |                                     |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       | 122,420                                  |       | 974                                         |       | 106,074 |   | 274 |   |
| Credit default swaps—long  |       | 51,000                                   |       | (8,796                                      | )          | 53,500 |   | (9,782 | ) |
| Credit default swaps—short |       | —                                   |       | —                                      |       | 222,650 |   | 69,972 |   |
| Total rate of return swaps      |       | 136,447                                  |       | (3,205                                      | )          | 207,524 |   | (77,224 | ) |
| Total                           |       | $                                        | 725,200    |                                        | $          | (83,566 | ) | $ | 1,005,081 |   | $ | (97,343 | ) |

 

**Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

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

 

51

----

 

**Item 4. CONTROLS AND PROCEDURES**

 

The Company’s management evaluated, with theparticipation of the Company’s principal executive and principal financialofficer, the effectiveness of the Company’s disclosure controls and procedures(as defined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”)) as of March 31,2009. Based on their evaluation, the Company’s principal executive andprincipal financial officer concluded that the Company’s disclosure controlsand procedures as of March 31, 2009 were designed and were functioningeffectively to provide reasonable assurance that the information required to bedisclosed by the Company in reports filed under the Exchange Act is (i) recorded,processed, summarized, and reported within the time periods specified in theSEC’s rules and forms, and (ii) accumulated and communicated tomanagement, including the principal executive and principal financial officers,as appropriate, to allow timely decisions regarding disclosure.

 

There has been no change in the Company’s internalcontrol over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) that occurred during the three monthsending March 31, 2009, that has materially affected, or is reasonablylikely to materially affect, the Company’s internal control over financialreporting.

 

**PART II. OTHER INFORMATION**

 

**Item 1. LegalProceedings**

 

We have been named as aparty in various legal actions which include the matters described below. Wehave denied, or believe we have a meritorious defense and will deny liabilityin the significant cases pending against us discussed below. Based on currentdiscussion and consultation with counsel, we believe that the resolution ofthese matters will not have a material impact on our financial condition orcash flow.

 

On August 7, 2008,the members of our board of directors and certain of our current andformer executive officers and we were named in a putative class actioncomplaint filed by Charter Township of Clinton Police and Fire RetirementSystem in the United States District Court for the Southern District of NewYork (the “Charter Litigation”). On March 13, 2009, the leadplaintiff filed an Amended Complaint, which deleted as defendants the membersof our board of directors and named as individual defendants only our formerchief executive officer Saturnino S. Fanlo, our former chief executive officerDavid A. Netjes, and our current chief financial officer Jeffrey B. Van Horn(the “Individual Defendants,” and, together with the Company,“Defendants’). The Amended Complaint alleges that our April 2,2007 registration statement and prospectus and the financial statementsincorporated therein contained material omissions in violation of Section 11of the Securities Act of 1933, as amended (the “1933 Act”), regardingthe risks and potential losses associated with our realestate-related assets, our ability to finance our real estate-relatedassets, and the adequacy of our loss reserves for our real estate-relatedassets (the “alleged Section 11 violation”). The Amended Complaintfurther alleges that, pursuant to Section 15 of the 1933 Act,the Individual Defendants have legal responsibility for the alleged Section 11violation.  On April 27, 2009, Defendants filed a motion to dismissthe Amended Complaint for failure to state a claim under the 1933 Act.

 

On August 15, 2008,the members of our board of directors and our executive officers (the “KosteckaIndividual Defendants”) were named in a shareholder derivative action broughtby Raymond W. Kostecka, a purported shareholder, in the Superior Court ofCalifornia, County of San Francisco (the “California DerivativeAction”). We are named as a nominal defendant. The complaint in theCalifornia Derivative Action asserts claims against the Director and OfficerDefendants for breaches of fiduciary duty, abuse of control, grossmismanagement, waste of corporate assets, and unjust enrichment in connectionwith the conduct at issue in the Charter Litigation, including the filing ofthe April 2, 2007 Registration Statement with alleged materialmisstatements and omissions. By Order dated January 8, 2009, theCourt approved the parties’ stipulation to stay the proceedings in theDerivative Action until the Charter Litigation is dismissed on the pleadings orwe file an answer to the Charter Litigation.

 

On March 23, 2009, the members of our board of directors andcertain of our executive officers (the “Haley Individual Defendants”) werenamed in a shareholder derivative action filed in the United States DistrictCourt for the Southern District of New York by Paul B. Haley, a purportedshareholder (the “New York Derivative Action”). We are named as a nominaldefendant. The complaint in the New York DerivativeAction asserts claims against the Haley Individual Defendants for breachesof fiduciary duty, breaches of the duty of full disclosure, and forcontribution in connection with the conduct at issue in the CharterLitigation, including the filing of the April 2,2007 registration statement with alleged material misstatements andomissions. As of April 30, 2009, the complaint in the New YorkDerivative Action had not been served on any defendant.

 

**Item 1A. RiskFactors**

 

There have been no material changes in our riskfactors from those disclosed in our Annual Report on Form 10-K for theyear ended December 31, 2008.

 

52

----

 

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

 

None.

 

**Item 3. DefaultsUpon Senior Securities**

 

None.

 

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

 

None.

 

**Item 5. OtherInformation**

 

None.

 

**Item 6. Exhibits**

 

31.1Chief Executive Officer Certification

31.2Chief Financial Officer Certification

32Certification Pursuant to 18 U.S.C. Section 1350

 

53

----

 

**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, KKR Financial Holdings LLC has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 

KKR Financial Holdings LLC

 
| **Signature**             | ** ** | **Title**                                                             |
|---------------------------|------------|-----------------------------------------------------------------------|
|                      |       |                                                                  |
|                      |       |                                                                  |
| /s/  WILLIAM C. SONNEBORN |       | Chief  Executive Officer (Principal Executive Officer)                |
| **William C. Sonneborn**  |       |                                                                  |
| ** **                |       |                                                                  |
|                      |       |                                                                  |
| /s/  JEFFREY B. VAN HORN  |       | Chief  Financial Officer (Principal Financial and Accounting Officer) |
| **Jeffrey B. Van Horn**   |       |                                                                  |

 

Date: May 7,2009

 

54

----