** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

** **

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** **

**FORM 10-Q**

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

 

**For the transition periodfrom                  to                  **

** **

**Commission file number 001-33437**

** **

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** **

**KKR FINANCIAL HOLDINGS LLC**

(Exact name ofregistrant as specified in its governing instruments)

 

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

 

**(415) 315-3620**

Registrant’stelephone number, including area code

 

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

 

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

 

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

 

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

 

The registrant’s number of common shares outstandingas of November 5, 2007 was 115,248,990.

 

 

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** **

**TABLE OFCONTENTS**

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

 

2

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**PART I. FINANCIAL INFORMATION**

 

**Item1. Financial Statements**

 

**KKRFinancial Holdings LLC and Subsidiaries Condensed Consolidated Balance Sheets(Unaudited)(Amounts in thousands, except share information)**

 
| ** **                                                                                                                                                                                | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| **Assets**                                                                                                                                                                                |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                |       | $                      | 644,403    |                  | $          | 5,125 |   |
| Restricted cash  and cash equivalents                                                                                                                                                     |       | 571,049                |       | 137,992               |       |
| Securities  available-for-sale, $1,446,086 and $831,537 pledged as collateral as of  September 30, 2007 and December 31, 2006, respectively                                          |       | 1,453,562              |       | 964,440               |       |
| Loans, net of  allowance for loan losses of $25,000 and $0 as of September 30, 2007 and  December 31, 2006, respectively                                                             |       | 7,074,731              |       | 3,334,260             |       |
| Derivative  assets                                                                                                                                                                        |       | 10,698                 |       | 2,817                 |       |
| Interest and  principal receivable                                                                                                                                                        |       | 124,196                |       | 55,472                |       |
| Receivable for  securities sold                                                                                                                                                           |       | 168,506                |       | 1,358                 |       |
| Non-marketable  equity securities                                                                                                                                                         |       | 20,084                 |       | 166,323               |       |
| Reverse  repurchase agreements                                                                                                                                                            |       | 34,660                 |       | —                |       |
| Investment in  unconsolidated affiliate                                                                                                                                                   |       | —                 |       | 104,035               |       |
| Other assets                                                                                                                                                                              |       | 71,871                 |       | 50,286                |       |
| Assets of  discontinued operations                                                                                                                                                        |       | 8,770,814              |       | 12,743,069            |       |
| **Total  assets**                                                                                                                                                                         |       | $                      | 18,944,574 |                  | $          | 17,565,177 |   |
| **Liabilities**                                                                                                                                                                           |       |                   |       |                  |       |
| Repurchase  agreements                                                                                                                                                                    |       | $                      | 2,318,904  |                  | $          | 1,087,662 |   |
| Collateralized  loan obligation senior secured notes                                                                                                                                      |       | 4,679,278              |       | 2,252,500             |       |
| Collateralized  loan obligation junior secured notes to affiliates                                                                                                                        |       | 431,293                |       | —                |       |
| Secured  revolving credit facility                                                                                                                                                        |       | 168,000                |       | 34,710                |       |
| Secured demand  loan                                                                                                                                                                      |       | 29,577                 |       | 41,658                |       |
| Convertible  senior notes                                                                                                                                                                 |       | 300,000                |       | —                |       |
| Junior  subordinated notes                                                                                                                                                                |       | 329,908                |       | 257,743               |       |
| Subordinated  notes to affiliates                                                                                                                                                         |       | 131,417                |       | —                |       |
| Accounts  payable, accrued expenses and other liabilities                                                                                                                                 |       | 15,323                 |       | 19,113                |       |
| Accrued interest  payable                                                                                                                                                                 |       | 92,457                 |       | 48,066                |       |
| Accrued interest  payable to affiliates                                                                                                                                                   |       | 29,404                 |       | —                |       |
| Related party  payable                                                                                                                                                                    |       | 4,974                  |       | 6,901                 |       |
| Securities sold,  not yet purchased                                                                                                                                                       |       | 69,704                 |       | —                |       |
| Derivative  liabilities                                                                                                                                                                   |       | 22,420                 |       | 2,715                 |       |
| Liabilities of  discontinued operations                                                                                                                                                   |       | 8,651,267              |       | 12,090,678            |       |
| **Total  liabilities**                                                                                                                                                                    |       | 17,273,926             |       | 15,841,746            |       |
| **Shareholders’  Equity**                                                                                                                                                            |       |                   |       |                  |       |
| Preferred  shares, no par value, 50,000,000 shares authorized and none issued and  outstanding at September 30, 2007 and December 31, 2006                                           |       | —                 |       | —                |       |
| Common shares,  no par value, 250,000,000 shares authorized and 111,316,698 and 80,464,713  shares issued and outstanding at September 30, 2007 and December 31,  2006, respectively |       | —                 |       | —                |       |
| Paid-in-capital                                                                                                                                                                           |       | 2,111,099              |       | 1,671,135             |       |
| Accumulated  other comprehensive (loss) income                                                                                                                                            |       | (72,797                | )          | 70,520                |       |
| Accumulated  deficit                                                                                                                                                                      |       | (367,654               | )          | (18,224               | )          |
| **Total  shareholders’ equity**                                                                                                                                                      |       | 1,670,648              |       | 1,723,431             |       |
| **Total  liabilities and shareholders’ equity**                                                                                                                                      |       | $                      | 18,944,574 |                  | $          | 17,565,177 |   |

 

See notes to condensedconsolidated financial statements.

 

3

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**KKR Financial Holdings LLC andSubsidiaries Condensed Consolidated Statements of Operations(Unaudited)(Amounts in thousands, except per share information)**

** **
| ** **                                                                                                     | ** ** | **For the three**      | ** ** | **For the three**      | ** ** | **For the nine**       | ** ** | **For the nine**       | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                     | ** ** | **months ended**            | ** ** | **months ended**            | ** ** | **months ended**            | ** ** | **months ended**            | ** ** |
| ** **                                                                                                     | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** |
| **Net  investment income:**                                                                                    |       |                             |       |                             |       |                             |       |                             |       |
| Securities  interest income                                                                                    |       | $                                | 35,354     |                             | $          | 22,237                           |       | $                                | 80,134     |   | $ | 54,748 |   |
| Loan interest  income                                                                                          |       | 131,375                          |       | 66,788                           |       | 283,161                          |       | 164,829                          |       |
| Dividend income                                                                                                |       | 782                              |       | 945                              |       | 2,722                            |       | 2,740                            |       |
| Other interest  income                                                                                         |       | 11,850                           |       | 2,638                            |       | 20,101                           |       | 5,928                            |       |
| Total investment  income                                                                                       |       | 179,361                          |       | 92,608                           |       | 386,118                          |       | 228,245                          |       |
| Interest expense                                                                                               |       | (107,027                         | )          | (53,558                          | )          | (232,148                         | )          | (123,318                         | )          |
| Interest expense  to affiliates                                                                                |       | (21,148                          | )          | —                           |       | (29,404                          | )          | —                           |       |
| Provision for  loan losses                                                                                     |       | (25,000                          | )          | —                           |       | (25,000                          | )          | —                           |       |
| Net investment  income                                                                                         |       | 26,186                           |       | 39,050                           |       | 99,566                           |       | 104,927                          |       |
| **Other  income:**                                                                                             |       |                             |       |                             |       |                             |       |                             |       |
| Net realized and  unrealized (loss) gain on derivatives and foreign exchange                                   |       | (16,041                          | )          | 357                              |       | (2,422                           | )          | 3,666                            |       |
| Net realized  gain on investments                                                                              |       | 53,400                           |       | 2,781                            |       | 87,164                           |       | 4,922                            |       |
| Net realized and  unrealized gain on securities sold, not yet purchased                                        |       | 2,220                            |       | —                           |       | 2,795                            |       | 52                               |       |
| Other income                                                                                                   |       | 2,759                            |       | 2,270                            |       | 7,347                            |       | 2,890                            |       |
| Total other  income                                                                                            |       | 42,338                           |       | 5,408                            |       | 94,884                           |       | 11,530                           |       |
| **Non-investment  expenses:**                                                                                  |       |                             |       |                             |       |                             |       |                             |       |
| Related party  management compensation                                                                         |       | 4,925                            |       | 19,759                           |       | 39,338                           |       | 47,977                           |       |
| General,  administrative and directors expenses                                                                |       | 3,842                            |       | 3,304                            |       | 14,094                           |       | 8,664                            |       |
| Professional  services                                                                                         |       | 2,195                            |       | 1,095                            |       | 3,495                            |       | 2,584                            |       |
| Total  non-investment expenses                                                                                 |       | 10,962                           |       | 24,158                           |       | 56,927                           |       | 59,225                           |       |
| Income from  continuing operations before equity in income of unconsolidated affiliate and  income tax expense |       | 57,562                           |       | 20,300                           |       | 137,523                          |       | 57,232                           |       |
| Equity in income  of unconsolidated affiliate                                                                  |       | —                           |       | 914                              |       | 12,706                           |       | 914                              |       |
| Income from  continuing operations before income tax expense                                                   |       | 57,562                           |       | 21,214                           |       | 150,229                          |       | 58,146                           |       |
| Income tax  expense                                                                                            |       | 386                              |       | 453                              |       | 1,245                            |       | 885                              |       |
| Income from  continuing operations                                                                             |       | 57,176                           |       | 20,761                           |       | 148,984                          |       | 57,261                           |       |
| (Loss) income  from discontinued operations                                                                    |       | (318,683                         | )          | 11,855                           |       | (309,096                         | )          | 40,674                           |       |
| Net (loss)  income                                                                                             |       | $                                | (261,507   | )                                | $          | 32,616                           |       | $                                | (160,112   | ) | $ | 97,935 |   |
|                                                                                                           |       |                             |       |                             |       |                             |       |                             |       |
| Net (loss)  income per common share:                                                                           |       |                             |       |                             |       |                             |       |                             |       |
| Basic                                                                                                          |       |                             |       |                             |       |                             |       |                             |       |
| Income per share  from continuing operations                                                                   |       | $                                | 0.65       |                             | $          | 0.26                             |       | $                                | 1.82       |   | $ | 0.72 |   |
| (Loss) income  per share from discontinued operations                                                          |       | $                                | (3.64      | )                                | $          | 0.15                             |       | $                                | (3.78      | ) | $ | 0.51 |   |
| Net (loss)  income per share                                                                                   |       | $                                | (2.99      | )                                | $          | 0.41                             |       | $                                | (1.96      | ) | $ | 1.23 |   |
| Diluted                                                                                                        |       |                             |       |                             |       |                             |       |                             |       |
| Income per share  from continuing operations                                                                   |       | $                                | 0.65       |                             | $          | 0.25                             |       | $                                | 1.80       |   | $ | 0.71 |   |
| (Loss) income  per share from discontinued operations                                                          |       | $                                | (3.63      | )                                | $          | 0.15                             |       | $                                | (3.73      | ) | $ | 0.51 |   |
| Net (loss)  income per share                                                                                   |       | $                                | (2.98      | )                                | $          | 0.40                             |       | $                                | (1.93      | ) | $ | 1.22 |   |
|                                                                                                           |       |                             |       |                             |       |                             |       |                             |       |
| Weighted-average  number of common shares outstanding:                                                         |       |                             |       |                             |       |                             |       |                             |       |
| Basic                                                                                                          |       | 87,443                           |       | 79,928                           |       | 81,692                           |       | 79,413                           |       |
| Diluted                                                                                                        |       | 87,696                           |       | 81,043                           |       | 82,747                           |       | 80,015                           |       |
|                                                                                                           |       |                             |       |                             |       |                             |       |                             |       |
| Distributions  declared per common share                                                                       |       | $                                | 0.56       |                             | $          | 0.49                             |       | $                                | 1.66       |   | $ | 1.34 |   |

 

See notes to condensedconsolidated financial statements.

 

4

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**KKR Financial Holdings LLC andSubsidiariesCondensed Consolidated Statement of Changes in Shareholders’ Equity(Unaudited)(Amounts in thousands)**

** **
| ** **                                                      | ** ** | ** ** | ** ** | ** **  | ** ** | **Accumulated**        | ** ** | ** **      | ** ** | ** **        | ** ** | ** **             | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|-------------|------------|------------------------|------------|-----------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                      | ** ** | ** ** | ** ** | ** **  | ** ** | **Other**              | ** ** | ** **      | ** ** | ** **        | ** ** | **Total**              | ** ** |
| ** **                                                      | ** ** | **Common** | ** ** | **Paid-In** | ** ** | **Comprehensive**      | ** ** | **Accumulated** | ** ** | **Comprehensive** | ** ** | **Shareholders’** | ** ** |
| ** **                                                      | ** ** | **Shares** | ** ** | **Capital** | ** ** | **(Loss) Income** | ** ** | **Deficit**     | ** ** | **Loss**          | ** ** | **Equity**             | ** ** |
| **Balance  at January 1, 2007**                                 |       | 80,465     |       | $           | 1,671,135  |                   | $          | 70,520          |       | $                 | (18,224    | )                      |       |   | $ | 1,723,431 |   |
| Cumulative  effect of adjustment from adoption of SFAS No. 159  |       | —     |       | —      |       | —                 |       | (55,728         | )          |              |       | (55,728                | )          |
| Net loss                                                        |       | —     |       | —      |       | —                 |       | (160,112        | )          | $                 | (160,112   | )                      | (160,112   | ) |
| Net change in  unrealized loss on cash flow hedges              |       | —     |       | —      |       | (53,960                | )          | —          |       | (53,960           | )          | (53,960                | )          |
| Net change in  unrealized loss on securities available-for-sale |       | —     |       | —      |       | (89,357                | )          | —          |       | (89,357           | )          | (89,357                | )          |
| Comprehensive  loss                                             |       |       |       |        |       |                   |       |            |       | $                 | (303,429   | )                      |       |   |
| Cash  distributions on common shares                            |       | —     |       | —      |       | —                 |       | (133,590        | )          |              |       | (133,590               | )          |
| Proceeds from  issuance of common shares, net of offering costs |       | 30,852     |       | 437,675     |       | —                 |       | —          |       |              |       | 437,675                |       |
| Amortization of  restricted common shares                       |       | —     |       | 2,043       |       | —                 |       | —          |       |              |       | 2,043                  |       |
| Amortization of  common share options                           |       | —     |       | 246         |       | —                 |       | —          |       |              |       | 246                    |       |
| **Balance  at September 30, 2007**                              |       | 111,317    |       | $           | 2,111,099  |                   | $          | (72,797         | )          | $                 | (367,654   | )                      |       |   | $ | 1,670,648 |   |

 

See notes to condensedconsolidated financial statements.

 

5

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** **

**KKR Financial Holdings LLC and SubsidiariesCondensed****Consolidated Statements of Cash Flows(Unaudited)(Amounts in thousands)**

 
| ** **                                                                                                   | ** ** | **Nine months ended**  | ** ** | **Nine months ended**  | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                   | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** |
| **Cash  flows from operating activities:**                                                                   |       |                             |       |                             |       |
| Net (loss)  income                                                                                           |       | $                                | (160,112   | )                                | $          | 97,935 |   |
| Adjustments to  reconcile net (loss) income to net cash provided by operating activities:                    |       |                             |       |                             |       |
| Net realized and  unrealized gains on derivatives, foreign exchange, and securities sold, not  yet purchased |       | (24,722                          | )          | (1,259                           | )          |
| Write-off of  debt issuance costs                                                                            |       | 2,247                            |       | —                           |       |
| Provision for  loan losses                                                                                   |       | 25,000                           |       | —                           |       |
| Share-based  compensation                                                                                    |       | 2,289                            |       | 22,077                           |       |
| Unrealized loss  on trading securities, whole loans, and liabilities at fair value                           |       | 183,011                          |       | —                           |       |
| Net realized  gains on sales of investments                                                                  |       | (43,565                          | )          | (4,920                           | )          |
| Depreciation and  net amortization                                                                           |       | 3,948                            |       | 1,838                            |       |
| Deferred income  tax benefit                                                                                 |       | —                           |       | (704                             | )          |
| Equity in income  of unconsolidated affiliate                                                                |       | (12,706                          | )          | (914                             | )          |
| Changes in  assets and liabilities:                                                                          |       |                             |       |                             |       |
| Interest and  principal receivable                                                                           |       | (31,785                          | )          | (24,338                          | )          |
| Other assets                                                                                                 |       | (16,237                          | )          | (5,075                           | )          |
| Related party  payable                                                                                       |       | (1,923                           | )          | 2,553                            |       |
| Accounts  payable, accrued expenses and other liabilities                                                    |       | 116,136                          |       | 22,163                           |       |
| Accrued interest  payable                                                                                    |       | 29,404                           |       | 5,994                            |       |
| Accrued interest  payable to affiliates                                                                      |       | 29,004                           |       | —                           |       |
| Net cash  provided by operating activities                                                                   |       | 99,989                           |       | 115,350                          |       |
| **Cash  flows from investing activities:**                                                                   |       |                             |       |                             |       |
| Principal  payments from investments                                                                         |       | 2,973,566                        |       | 3,603,387                        |       |
| Proceeds from  sales of investments                                                                          |       | 3,125,000                        |       | 559,543                          |       |
| Purchases of  investments                                                                                    |       | (4,342,073                       | )          | (6,636,324                       | )          |
| Net proceeds,  purchases, and settlements of derivatives                                                     |       | 40,570                           |       | 973                              |       |
| Net additions to  restricted cash and cash equivalents                                                       |       | (502,324                         | )          | (135,637                         | )          |
| Net change in  reverse repurchase agreements                                                                 |       | (34,660                          | )          | —                           |       |
| Restricted cash  and cash equivalents acquired due to consolidation of KKR Financial CLO  2007-1, Ltd.       |       | 57,104                           |       | —                           |       |
| Additions of  leasehold improvements and equipment                                                           |       | (244                             | )          | (5,132                           | )          |
| Investment in  unconsolidated affiliate                                                                      |       | (60,327                          | )          | (39,290                          | )          |
| Net cash provided  by (used in) investing activities                                                         |       | 1,256,612                        |       | (2,652,480                       | )          |
| **Cash  flows from financing activities:**                                                                   |       |                             |       |                             |       |
| Proceeds from  common share offerings and common share option exercises                                      |       | 437,675                          |       | 1,150                            |       |
| Distributions on  common shares                                                                              |       | (133,590                         | )          | (107,717                         | )          |
| Net change in  repurchase agreements, secured revolving credit facility, and secured demand  loan            |       | (3,675,629                       | )          | (4,535,974                       | )          |
| Net change in  asset-backed secured liquidity notes                                                          |       | (3,736,390                       | )          | 6,202,555                        |       |
| Proceeds from  issuance of mortgage-backed securities                                                        |       | 3,319,547                        |       | —                           |       |
| Repayment of  mortgage-backed securities                                                                     |       | (99,323                          | )          | —                           |       |
| Issuance of  collateralized loan obligation senior secured notes                                             |       | 2,426,778                        |       | 752,500                          |       |
| Issuance of  collateralized loan obligation junior secured notes to affiliates                               |       | 262,103                          |       | —                           |       |
| Issuance of  convertible senior notes                                                                        |       | 300,000                          |       | —                           |       |
| Issuance of  junior subordinated notes                                                                       |       | 70,000                           |       | 250,000                          |       |
| Issuance of  subordinated notes to affiliates                                                                |       | 131,417                          |       | —                           |       |
| Other  capitalized costs                                                                                     |       | (19,911                          | )          | (39,192                          | )          |
| Net cash (used  in) provided by financing activities                                                         |       | (717,323                         | )          | 2,523,322                        |       |
| **Net  increase (decrease) in cash and cash equivalents**                                                    |       | 639,278                          |       | (13,808                          | )          |
| **Cash  and cash equivalents at beginning of period**                                                        |       | 5,125                            |       | 16,110                           |       |
| **Cash  and cash equivalents at end of period**                                                              |       | $                                | 644,403    |                             | $          | 2,302 |   |
|                                                                                                         |       |                             |       |                             |       |
| **Supplemental  cash flow information:**                                                                     |       |                             |       |                             |       |
| Cash paid for  interest                                                                                      |       | $                                | 424,725    |                             | $          | 987,072 |   |
| Cash paid for  taxes                                                                                         |       | $                                | 1,775      |                             | $          | 3,518 |   |
| **Non-cash  investing and financing activities:**                                                            |       |                             |       |                             |       |
| Net (receivable)  payable for securities (sold) purchased                                                    |       | $                                | (180,689   | )                                | $          | 275,622 |   |
| Issuance of  restricted common shares                                                                        |       | $                                | 845        |                             | $          | 163 |   |
| Transfers of  loans held for investment to held for sale                                                     |       | $                                | —     |                             | $          | 606,134 |   |
| Affiliate  contributions for collateralized loan obligation junior secured notes                             |       | $                                | 169,209    |                             | $          | — |   |

 

See notes to condensedconsolidated financial statements.

 

6

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**KKRFinancial Holdings LLC and Subsidiaries**

 

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

 

**Note 1.Organization**

 

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

 

KKR Financial Holdings LLC is a Delaware limitedliability company and was organized on January 17, 2007. KKR Financial HoldingsLLC is the successor to KKR Financial Corp. (the “REIT Subsidiary”), a Marylandcorporation. KKR Financial Corp. was originally incorporated in the State ofMaryland on July 7, 2004 and elected to be treated as a real estate investmenttrust (“REIT”) for U.S. federal income tax purposes. On May 4, 2007, KKRFinancial completed a restructuring transaction (the “Restructuring Transaction”),pursuant to which the REIT Subsidiary became a subsidiary of KKR Financial andeach outstanding share of the REIT Subsidiary’s common stock was converted intoone of KKR Financial’s common shares, which are publicly traded on the New YorkStock Exchange (“NYSE”). KKR Financial intends to be treated as a partnership,and not as an association or publicly traded partnership that is taxable as acorporation, for U.S. federal income tax purposes. The RestructuringTransaction has been accounted for as a reorganization of entities under commoncontrol whereby the consolidated assets and liabilities of the Company wererecorded at the historical cost of the REIT Subsidiary, as reflected on itsconsolidated financial statements. The Company is considered the REITSubsidiary’s successor for accounting purposes, and the REIT Subsidiary’sconsolidated financial statements for prior periods are the Company’shistorical consolidated financial statements presented herein.

 

Significant disruptions in both the residentialmortgage and asset-backed commercial paper markets during the third quarter of2007 had a material adverse impact on both the values and related financings ofthe Company’s investments in residential mortgage loans and mortgage-backedsecurities. In light of these adverse market conditions that occurred, theCompany took several steps which are further described in the notes to thesecondensed consolidated financial statements. The Company’s management believesthat these steps, coupled with the Company’s available liquidity, provide theCompany with the ability to meet all of its obligations for the foreseeablefuture.

 

In August 2007, the Company’sBoard of Directors approved the Company’s plan to exit its residential mortgageinvestment operations and to sell the REIT Subsidiary. Accordingly, the Companyhas reported its residential mortgage investment operations, including the REITSubsidiary, as a discontinued operation in this Form 10-Q. Accordingly,the Company has presented the results of operations from the REIT Subsidiary asa discontinued operation for the current quarterly period. Because the REITSubsidiary was the Company’s reporting entity prior to the consummation of theRestructuring Transaction, results of operations for periods prior to, orincluding the period prior to, the consummation of the Restructuring Transactiononly reflects the Company’s residential mortgage investment operations asdiscontinued operations. Assets and liabilities related to the Company’sresidential mortgage investment operations for all periods presented areincluded in assets of discontinued operations and liabilities of discontinuedoperations, respectively, on the Company’s condensed consolidated balancesheets. Unless otherwise noted, amountsand disclosures contained in these condensed consolidated financial statementsand notes relate to the Company’s continuing operations.

 

On August 21, 2007, the Company consummated a commonshare offering of 16.0 million common shares to seven unaffiliatedinstitutional investors in separately negotiated transactions registered underthe Securities Act of 1933, as amended (the “1933 Act”) at a price of $14.40per common share, which was the closing price of the Company’s common shares onthe NYSE on August 17, 2007. Proceeds from the transaction totaled $230.4million and the Company will use the net proceeds for general corporatepurposes.

 

On the same date, the Company announced a rightsoffering of common shares to its common shareholders of up to $270.0 million inwhich the Company distributed non-transferable rights to subscribe for 18.75 millioncommon shares. Each holder of common shares received 0.19430 common sharerights for each common share held at the close of business on August 30, 2007,the record date for the rights offering, and the common share rights expired onSeptember 19, 2007. The subscription price for the common shares offered in therights offering was $14.40 per common share, which was the closing price of theCompany’s common shares on August 17, 2007. In connection with this rightsoffering, certain principals of Kohlberg Kravis Roberts & Co. L.P. (“KKR”)agreed to provide a backstop commitment to purchase up to approximately $100.0million of common shares at the price of $14.40 to the extent the rightsoffering was not fully subscribed by the Company’s common shareholders. TheCompany’s common shareholders and certain principals of KKR exercised commonshare rights totaling 14.8 million and 3.9 million common shares, respectively.The Company received proceeds of $213.4 million and $56.6 million on September19, 2007 and October 2, 2007, respectively, which the Company will use forgeneral corporate purposes. Total expenses incurred by the Company related tothe common share rights offering totaled $6.1 million.

 

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

 

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

 

**Basis ofPresentation**

 

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

 

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

 

**Use of Estimates**

** **

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

 

**Consolidation**

 

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

 

KKR Financial CLO 2005-1, Ltd. (“CLO 2005-1”), KKRFinancial CLO 2005-2, Ltd. (“CLO 2005-2”), KKR Financial CLO 2006-1, Ltd.(“CLO 2006-1”), KKR Financial CLO 2007-1, Ltd. (“CLO 2007-1”), KKR FinancialCLO 2007-4, Ltd. (“CLO 2007-4”), and KKR Financial CLO 2008-1, Ltd. (“CLO2008-1”) 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 StandardsNo. 140, *Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities*(“SFASNo. 140”). The Company has determined it is the primary beneficiary ofthese entities and has included the accounts of these entities in thesecondensed consolidated financial statements. Additionally, the Company is theprimary beneficiary of six residential mortgage loan securitization trusts thatare not considered to be QSPEs under SFAS No. 140 and the Company hastherefore included the accounts of these entities in these condensedconsolidated financial statements.

 

All inter-company balances and transactions have beeneliminated in consolidation.

 

**Cash and Cash Equivalents**

** **

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

 

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**Restricted Cashand Cash Equivalents**

** **

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

 

**SecuritiesAvailable-for-Sale**

** **

The Company classifies its investments in securitiesas available-for-sale since the Company may sell the securities prior tomaturity and does not hold the securities principally for the purpose ofselling the securities in the near term. These investments are carried atestimated fair value, with unrealized gains and losses reported in accumulatedother comprehensive income (loss). Estimated fair values are based on quotedmarket prices, when available, or on estimates provided by independent pricingsources or dealers who make markets in such securities. Upon the sale of asecurity, the realized net gain or loss is computed on a specific identification basis.

 

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

 

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

 

**Non-marketableEquity Securities**

** **

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

 

**Securities Sold, Not YetPurchased**

 

**Securitiessold, not yet purchased consist of equity and debt securities that the Companyhas sold, but did not own prior to the sale. In order to facilitate a shortsale, the Company borrows the securities from another party and delivers thesecurities to the buyer. The Company will be required to “cover” its short salein the future through the purchase of the security in the market at theprevailing market price and deliver it to the counterparty from which itborrowed. The Company is exposed to a loss to the extent that the securityprice increases during the time from when the Company borrowed the security towhen the Company purchases it in the market to cover the short sale. Changes inthe value of these securities are reflected in net realized and unrealized gainon securities sold, not yet purchased on the Company’s condensed consolidatedstatements of operations.**

** **

**Loans**

** **

The Company purchases participations in corporateleveraged loans and commercial real estate loans in the primary and secondarymarket. Loans are held for investment and the Company initially records loansat their purchase prices. The Company accounts for these loans based on theiroutstanding principal plus or minus unaccreted purchase discounts andunamortized purchase premiums. In certain instances, where the creditfundamentals underlying a particular loan have materially changed in such amanner that the Company’s expected return may decrease, the Company may electto sell a loan held for investment. Once the determination has been made by theCompany that it will no longer hold the loan for investment, the Companyaccounts for the loan at the lower of amortized cost or estimated fair value.

 

Interest income on loans represents interest at statedcoupon rates adjusted for accretion of purchase discounts and amortization ofpurchase premiums. For corporate and commercial real estate loans, unamortizedpremiums and discounts 

 

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are recognized in interest income over the contractuallife, adjusted for actual prepayments, of the loans using the effectiveinterest method.

 

**Allowance andProvision for Loan Losses**

** **

The Company maintains an allowance for loan losses ata level that the Company believes is adequate based on an evaluation of knownand inherent risks related to its loan investments. When determining theadequacy of the allowance for loan losses the Company considers, among otherfactors, historical and industry loss experience, economic conditions andtrends, the estimated fair values of its loans, credit quality trends and otherfactors that the Company determines are relevant. Loans are generally evaluatedfor impairment individually, but loans purchased on a pooled basis withrelatively smaller balances and substantially similar characteristics may beevaluated collectively for impairment.

 

The Company’s investments in commercial real estateloans and corporate loans are not homogeneous and the Company individuallyreviews each of the loans for impairment and uses relevant information in itsanalysis, including, but not limited to, current estimated fair values, currentvaluation multiples, estimated fair values and quality of collateral, projectedoperating cash flows and projected liquidation cash flows. The Companyconsiders a loan to be impaired when, based on current information and events,the Company believes it is probable that it will be unable to collect allamounts due to the Company based on the contractual terms of the loan. When aloan is impaired, the allowance for loan losses is increased by the amount ofthe excess of the amortized cost basis of the loan over its estimated fairvalue. Increases in the allowance for loan losses are recognized in the Company’sresults of operations as a provision for loan losses. When the Company makes adetermination that some or all of a loan is uncollectible, the Companycharges-off or writes-down the loan and the allowance for loan losses isreduced.

 

An impaired loan may be left on accrual status duringthe period the Company is pursuing repayment of the loan; however, the loan isplaced on non-accrual status at such time as: (i) management believes thatscheduled debt service payments may not be paid when contractually due;(ii) the loan becomes 90 days delinquent; (iii) managementdetermines the borrower is incapable of, or has ceased efforts toward, curingthe cause of the impairment; or (iv) the net realizable value of theunderlying collateral securing the loan decreases below the Company’s carryingvalue of such loan. While on non-accrual status, previously recognized accruedinterest is reversed and interest income is recognized only uponactual receipt.

 

**LeaseholdImprovements and Equipment**

** **

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

 

**Borrowings**

** **

The Company finances the acquisition of itsinvestments, including loans and securities available-for-sale, primarilythrough the use of secured borrowings in the form of securitizationtransactions structured as secured financings, repurchase agreements, warehousefacilities, demand loans, and other secured and unsecured borrowings. TheCompany recognizes interest expense on all borrowings on an accrual basis.

 

**Trust PreferredSecurities**

** **

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

 

**DerivativeFinancial Instruments**

** **

The Company recognizes all derivatives on itscondensed consolidated balance sheet at estimated fair value. On the date theCompany enters into a derivative contract, the Company designates and documentseach derivative contract as one of 

 

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the following: (i) a hedge of a recognized assetor liability (“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 currentperiod earnings in the same financial statement category as the hedged item.For a cash flow hedge, the Company records changes in the estimated fair valueof the derivative to the extent that it is effective in other comprehensive income(loss). The Company subsequently reclassifies these changes in estimated fairvalue to net income in the same period(s) that the hedged transactionaffects earnings in the same financial statement category as the hedged item.For free-standing derivatives, the Company reports changes in the fair valuesin current period other income.

 

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

 

**Foreign Currency**

** **

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

 

**ManagerCompensation**

** **

The Management Agreement provides for the payment of abase management fee to the Manager, as well as an incentive fee if the Company’sfinancial performance exceeds certain benchmarks. See Note 13 for thespecific terms of the computation and payment of the incentive fee. The basemanagement fee and the incentive fee are accrued and expensed during the periodfor which they are earned by the Manager.

 

**Share-BasedCompensation**

** **

The Company accounts for share-based compensationissued to its directors and to the Manager using the fair value basedmethodology prescribed by SFAS No. 123(R), *Share-BasedPayment* (“SFAS No. 123(R)”). Compensation cost related torestricted common shares issued to the Company’s directors is measured at itsestimated fair value at the grant date, and is amortized and expensed ratablyover the vesting period. Compensation cost related to restricted common sharesand common share options issued to the Manager is initially measured atestimated fair value at the grant date, and is remeasured on subsequent datesto the extent the awards are unvested. The Company has elected to use thegraded vesting attribution method pursuant to SFAS No. 123(R) toamortize compensation expense for the restricted common shares and common shareoptions granted to the Manager.

 

**Income Taxes**

** **

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

 

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The REIT Subsidiary, presented as a discontinuedoperation for financial statement purposes, has elected to be taxed as a REITand is required to comply with the provisions of the Internal Revenue Code of1986, as amended, (the “Code”), with respect thereto. Accordingly, the REITSubsidiary is not subject to federal income tax to the extent that its distributionssatisfy the REIT requirements and certain asset, income and ownership tests andrecordkeeping requirements are fulfilled. Even though the REIT Subsidiaryqualifies for federal taxation as a REIT, it may be subject to some amount offederal, state, local and foreign taxes based on the REIT Subsidiary’s taxableincome.

 

KKR TRS Holdings, Inc. (“TRS Inc.”), KKR TRS Holdings,Ltd. (“TRS Ltd.”), CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-4,and CLO 2008-1 are not consolidated for federal income tax return purposes. Forfinancial reporting purposes, current and deferred taxes are provided for onthe portion of earnings recognized by the Company with respect to its interestin TRS Inc., a domestic taxable corporate subsidiary, because it is taxedas a regular subchapter C corporation under the provisions of the Code.

 

Deferred income tax assets and liabilities arecomputed based on temporary differences between the GAAP consolidated financialstatements and the federal income tax basis of assets and liabilities as ofeach consolidated balance sheet date. TRS Ltd., CLO 2005-1, CLO 2005-2,CLO 2006-1, CLO 2007-1, CLO 2007-4, and CLO 2008-1, the Company’s foreigntaxable corporate subsidiaries, are organized as exempted companiesincorporated with limited liability under the laws of the Cayman Islands, andare generally exempt from federal and state income tax at the corporate entitylevel because they restrict their activities in the United States to trading instock and securities for their own account. Therefore, despite their status astaxable corporate subsidiaries, they generally will not be subject to corporateincome tax on their earnings, and no provisions for income taxes for thequarter ended September 30, 2007 were required. However, the Company willgenerally be required to include their current taxable income in thecalculation of its taxable income allocable to shareholders.

 

**Earnings Per Share**

** **

In accordance with SFAS No. 128, *Earnings per Share*(“SFAS No. 128”), the Company presents both basic and dilutedearnings per common share (“EPS”) in its condensed consolidated financialstatements and footnotes thereto. Basic earnings per common share (“Basic EPS”)excludes dilution and is computed by dividing net income or loss allocable tocommon shareholders by the weighted-average number of common shares, includingvested restricted common shares, outstanding for the period. Diluted earningsper share (“Diluted EPS”) reflects the potential dilution of common shareoptions and unvested restricted common shares using the treasury method, andthe potential dilution of convertible senior notes using the if-convertedmethod, if they are not anti-dilutive. See Note 4 for EPS computations.

 

A rights offering whose exercise price at issuance isless than the fair value of the stock is considered to have a bonus element,resulting in an adjustment of the prior period number of shares outstanding tocalculate basic and diluted earnings per share. As a result of the rightsoffering, prior period weighted-average number of shares and earnings per shareoutstanding has been adjusted to reflect the issuance at less than fair value.

 

**RecentAccounting Pronouncements**

 

In February 2006, the FASB issued SFASNo. 155, *Accounting for Certain Hybrid FinancialInstruments* (“SFAS No. 155”). Key provisions of SFASNo. 155 include: (1) a broad fair value measurement option forcertain hybrid financial instruments that contain an embedded derivative thatwould otherwise require bifurcation; (2) clarification that only the simplestseparations of interest payments and principal payments qualify for theexception afforded to interest-only strips and principal-only strips fromderivative accounting under paragraph 14 of SFAS No. 133*,* thereby narrowing such exception; (3) a requirementthat beneficial interests in securitized financial assets be analyzed todetermine whether they are free-standing derivatives or whether they are hybridinstruments that contain embedded derivatives requiring bifurcation;(4) clarification that concentrations of credit risk in the form ofsubordination are not embedded derivatives; and (5) elimination of theprohibition on a QSPE holding passive derivative financial instruments thatpertain to beneficial interests that are or contain a derivative financialinstrument. In general, these changes will reduce the operational complexityassociated with bifurcating embedded derivatives, and increase the number ofbeneficial interests in securitization transactions, including interest-onlystrips and principal-only strips, required to be accounted for in accordancewith SFAS No. 133. The Company adopted SFAS No. 155 as of the beginning of2007 and the adoption of SFAS No. 155 did not have a material impact on theCompany’s condensed consolidated financial statements.

 

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

 

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In September 2006, the FASB issued SFASNo. 157, *Fair Value Measurements*(“SFASNo. 157”). This statement defines fair value, establishes a framework formeasuring fair value in GAAP and expands disclosures about fair valuemeasurements. SFAS No. 157 does not require any new fair valuemeasurements. The Company adopted SFAS No. 157 as of the beginning of 2007and the adoption of SFAS No. 157 did not have a material impact on themanner in which the Company measures the fair value of its financial instruments,but did result in certain additional disclosures, which are contained inNote 14.

 

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

 

The Company adopted SFAS No.159 as of the beginning of 2007 and elected to apply the fair value option forits investments in residential mortgage loans and residential mortgage-backedsecurities, which are currently reflected as a discontinued operation forfinancial statement purposes. The Company elected the fair value option for itsresidential mortgage investments for the purpose of enhancing the transparencyof its financial condition as fair value is consistent with how the Companymanages the risks of residential mortgage investments. The transitionadjustment to beginning accumulated deficit that was recorded as of January 1,2007 due to the adoption of SFAS No. 159 was a loss of $55.7 million. Thefollowing table presents information about the eligible instruments for whichthe Company elected the fair value option and for which transition adjustmentswere recorded as of January 1, 2007 (amounts in thousands):

 
| ** **                                                  | ** ** | ** **                      | ** ** | ** **                             | ** ** | **Carrying Value at**  | ** ** |
|-------------------------------------------------------------|------------|---------------------------------|------------|----------------------------------------|------------|----------------------------------|------------|
| ** **                                                  | ** ** | ** **                      | ** ** | **Transition Adjustment to** | ** ** | **January 1, 2007**    | ** ** |
| ** **                                                  | ** ** | **Carrying Value at** | ** ** | **Accumulated Deficit**           | ** ** | **(After Adoption of** | ** ** |
| ** **                                                  | ** ** | **January 1, 2007**   | ** ** | **Gain/(Loss)**                        | ** ** | **SFAS No. 159)**      | ** ** |
| Residential  mortgage loans                                 |       | $                               | 5,109,261  |                                   | $          | (35,653                          | )          | $ | 5,073,608 |   |
| Allowance for  loan losses                                  |       | (1,500                          | )          | 1,500                                  |       | —                           |       |
| Residential  mortgage-backed securities (1)                 |       | 7,536,196                       |       | (21,575                                | )          | 7,536,196                        |       |
| Cumulative  effect of the adoption of the fair value option |       |                            |       | $                                      | (55,728    | )                                |       |   |
|                                                             |            |                                 |            |                                        |            |                                  |            |  |  |  |

 

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(1)    Priorto January 1, 2007, residential mortgage-backed securities were classified asavailable-for-sale and carried at fair value. Accordingly, the election of thefair value option for mortgage-backed securities did not change their carryingvalue and resulted in a reclassification from accumulated other comprehensiveincome (loss) to beginning accumulated deficit.

 

In June 2007, the American Institute of CertifiedPublic Accountants (“AICPA”) issued Statement of Position (“SOP”) 07-1, *Clarification of the Scope of the Audit and Accounting Guide,**Investment Companies**and Accounting for Parent Companies and Equity Method Investors forInvestments in Investment Companies.* This SOP provides guidance fordetermining whether an entity is within the scope of the AICPA Audit andAccounting Guide *Investment Companies* (the “Guide”).Entities that are within the scope of the Guide are required, among otherthings, to carry their investments at fair value, with changes in fair valueincluded in earnings. In October 2007, the effective date of SOP 07-1 wasindefinitely deferred. The Company is currently evaluating this new guidanceand has not determined whether it will be required to apply the provisions ofthe Guide in presenting its financial statements.

 

On July 25, 2007, the FASB authorized a proposed FASBStaff Position (the “proposed FSP”) that, if approved for issuance by the FASB,will affect the accounting for the Company’s convertible senior notes. Theproposed FSP will require that the initial debt proceeds be allocated between aliability component and an equity component. The resulting debt discount wouldbe amortized over the period the debt is expected to be outstanding asadditional interest expense. The proposed FSP is expected to be effective forfiscal years beginning after December 15, 2007 and would require retrospectiveapplication. The Company is currently evaluating the impact of adopting theproposed FSP.

 

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**Note 3. Discontinued Operations**

 

In August 2007, the Company’sBoard of Directors approved a plan to exit the Company’s residential mortgageinvestment operations and to sell the REIT Subsidiary. Accordingly, the Companyhas reported its residential mortgage investment operations, including the REITSubsidiary, as a discontinued operation. The assets and liabilities of theCompany’s residential mortgage investment operations consist primarily ofinvestments in residential mortgage loans and securities, interest andprincipal receivable from its residential mortgage loans and securities, cashand restricted cash and equivalents balances, and debt and related interestpayable consisting of repurchase agreements and secured liquidity notes thatare used to finance investments in residential mortgage loans and securities.Investments in residential mortgage loans and securities are accounted for atfair value as the Company elected the fair value option of accounting for itsinvestments in residential mortgage loans and securities as of January 1, 2007.Changes in the fair value of residential mortgage loans and securities areincluded in income (loss) from discontinued operations on the Company’scondensed consolidated statements of operations.

 

The Company’s decision toexit its residential mortgage investment operations business and sell its REITSubsidiary was based on various considerations including, but not limited to,the following: (i) the Company’s restructuring from a REIT to a publicly tradedLLC which enabled the Company to execute its core business of investing incorporate loans and debt securities without having to invest in residentialmortgage assets to qualify as a REIT; and (ii) the material adverse change inthe mortgage industry and associated liquidity crisis in the capital marketsthat arose during the third quarter of 2007, which resulted in the Company’sinability to finance its residential mortgage investments on reasonablefinancial terms. 

 

During the quarter endedSeptember 30, 2007, the REIT Subsidiary sold approximately $5.2 billion ofresidential mortgage-backed securities and recognized a loss of approximately$65.0 million. Included in the $5.2 billion of residential mortgage-backedsecurities that were sold were approximately $3.4 billion of residentialmortgage-backed securities rated AAA/Aaa that were issued by securitizationtrusts where the Company owns the subordinated interests. The Companyconsolidates these securitization trusts as it is the primary beneficiary underFIN 46R, and as a result, the sales were accounted for by the Company on aconsolidated basis as issuances of residential mortgage-backed securities. TheCompany has elected the fair value option under SFAS No. 159 for theresidential mortgage-backed securities issued by the securitization trusts andtherefore is carrying mortgage-backed securities issued by securitizationtrusts at fair value with changes in fair value reflected in income (loss) fromdiscontinued operations.

 

As of September 30, 2007,$0.6 billion of residential mortgage loans and $4.5 billion of residentialmortgage-backed securities were pledged as collateral for non-recourse securedliquidity notes issued by two asset-backed secured liquidity note conduitfacilities (the “Facilities”) that are accounted for as subsidiaries of theREIT Subsidiary because the REIT Subsidiary is the primary beneficiary of theseentities under FIN 46R. On October 18, 2007, the Company announced that theREIT Subsidiary had consummated a restructuring of the Facilities. Pursuant tothe terms of the restructuring, the maturity date of the secured liquiditynotes issued by the Facilities was extended with approximately 50% of theprincipal balance due on February 15, 2008, and the remaining principal balancedue on March 13, 2008. Under the terms of the restructuring, the Companycontinues to have the right, but not the obligation, to repurchase or refinancethe collateral which collateralizes the Facilities and pay off the Facilitiesprior to the scheduled maturity dates of the security liquidity notes.

 

During the quarter endedSeptember 30, 2007, the Company recorded a charge for discontinuedoperations of approximately $243.7 million. The amount of the charge recordedby the Company consists of (i) the REIT Subsidiary’s investment in theFacilities, which was comprised of (a) a subordinated interest in thecollateral owned by the Facilities, and (b) approximately $38.3 million of cashinvested, and (ii) contingencies related to the restructuring and anticipatedfuture termination of the Facilities and expenses consisting of legal, accounting,and consulting fees. Because the secured liquidity notes issued by theFacilities are non-recourse to the REIT Subsidiary and the Company, the Company’sloss from the operations of the Facilities is limited to the Company’s netinvestment in the Facilities. The components of the Company’s charge fordiscontinued operations consists of its investment in the Facilities of approximately$199.9 million, a reserve for contingent liabilities of $36.5 million, and anaccrual for legal, accounting, and consulting fees of approximately $7.3million.

 

14

----

 

Summarized financialinformation for discontinued operations is as follows (amounts in thousands):

 
| ** **                                            | ** ** | **As of**                   | ** ** | **As of**                  | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                            | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
| **Assets**                                            |       |                             |       |                            |       |
| Restricted cash                                       |       | $                                | 69,339     |                            | $          | 73 |   |
| Trading  securities                                   |       | 4,538,653                        |       | —                          |       |
| Securities  available-for-sale                        |       | —                           |       | 7,536,196                       |       |
| Loans                                                 |       | 4,118,030                        |       | 5,107,761                       |       |
| Derivative  assets                                    |       | (2,656                           | )          | 60,616                          |       |
| Interest and  principal receivable                    |       | 18,710                           |       | 33,117                          |       |
| Receivable  (payable) for securities sold (purchased) |       | 12,367                           |       | (1,358                          | )          |
| Other assets                                          |       | 16,371                           |       | 6,664                           |       |
| Assets of  discontinued operations                    |       | $                                | 8,770,814  |                            | $          | 12,743,069 |   |

** **
| ** **                                    | ** ** | **As of**                   | ** ** | **As of**                  | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
| **Liabilities**                               |       |                             |       |                            |       |
| Repurchase  agreements                        |       | $                                | 269,622    |                            | $          | 3,369,427 |   |
| Mortgage-backed  securities issued            |       |                             | 3,251,091  |                            |       | — |   |
| Asset-backed  secured liquidity notes         |       | 4,969,211                        |       | 8,705,601                       |       |
| Accounts  payable, accrued expenses and other |       | 146,839                          |       | 26,725                          |       |
| Accrued interest  payable (receivable)        |       | 14,504                           |       | (11,075                         | )          |
| Liabilities of  discontinued operations       |       | $                                | 8,651,267  |                            | $          | 12,090,678 |   |

 

The components of (loss)income from discontinued operations are as follows (amounts in thousands):

 
| ** **                                  | ** ** | **Three months ended** | ** ** | **Three months ended** | ** ** | **Nine months ended**  | ** ** | **Nine months ended**  | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                  | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** |
| Net investment  income                      |       | $                                | 8,956      |                             | $          | 15,622                           |       | $                                | 40,176     |   | $ | 52,713 |   |
| Other (loss)  income                        |       | (187,536                         | )          | 150                              |       | (202,230                         | )          | 148                              |       |
| Non-investment  expenses                    |       | (140,103                         | )          | (3,917                           | )          | (147,042                         | )          | (12,187                          | )          |
| (Loss) income  from discontinued operations |       | $                                | (318,683   | )                                | $          | 11,855                           |       | $                                | (309,096   | ) | $ | 40,674 |   |

 

During the quarter endedSeptember 30, 2007, in connection with the aforementioned sale by the Companyof approximately $5.2 billion of residential mortgage-backed securities, theCompany terminated seven interest rate derivatives with an aggregate notionalamount of $3.8 billion. The terminated interest rate derivatives had previouslybeen designated as cash flow hedges under SFAS No. 133 and at the time oftermination had a market value of approximately $28.6 million that was includedin other comprehensive income, a component of shareholders’ equity. As thehedged forecasted transaction is no longer expected to occur, the Companyrecognized the $28.6 million gain which is included in income (loss) fromdiscontinued operations. Additionally, the Company undesignated four interestrate derivatives that had been designated as cash flow hedges with an aggregatenotional amount of $610.7 million as the hedged forecasted transaction is nolonger expected to occur and recognized the related unrealized loss into income(loss) from discontinued operations of approximately $0.2 million that had beenincluded in other comprehensive income. During the period subsequent to theundesignation through the end of the quarter ending September 30, 2007, theseinterest rate derivatives generated unrealized losses of approximately $2.5million that is included in income (loss) from discontinued operations.

 

As previously described, theCompany has elected the fair value option for its trading securities(consisting of investments in residential mortgage loans and residentialmortgage-backed securities) and for mortgage-backed securities issued. As ofSeptember 30, 2007, trading securities which total $4.5 billion were all valuedutilizing level 2 inputs as described under SFAS No. 157. Additionally,mortgage-backed securities issued with a balance of $3.3 billion were alsovalued using level 2 inputs.

 

**Note 4. Earnings per Share**

 

The Company calculates basic net income per commonshare by dividing net income for the period by the weighted-average number ofits common shares outstanding for the period. Diluted net income per commonshare is calculated by dividing net income by the weighted-average number ofcommon shares plus potentially dilutive common shares outstanding during theperiod. Potentially dilutive common shares include the assumed exercise ofoutstanding common share options and assumed vesting of outstanding restrictedcommon shares using the treasury stock method, as well as the assumed conversionof convertible senior notes using the if-converted method, if they are notanti-dilutive.

 

15

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The following table presents a reconciliation of basicand diluted net income per common share for the three and nine months endedSeptember 30, 2007 and September 30, 2006 (amounts in thousands, except pershare information):

 
| ** **                                                                               | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                               | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                               | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| Income from  continuing operations                                                       |       | $                                | 57,176     |                            | $          | 20,761 |   | $ | 148,984 |   | $ | 57,261 |   |
| (Loss) income  from discontinued operations                                              |       | (318,683                         | )          | 11,855                          |       | (309,096 | ) | 40,674 |   |
| Net (loss)  income                                                                       |       | $                                | (261,507   | )                               | $          | 32,616 |   | $ | (160,112 | ) | $ | 97,935 |   |
|                                                                                     |       |                             |       |                            |       |   |   |   |   |
| **Basic:**                                                                               |       |                             |       |                            |       |   |   |   |   |
| Basic  weighted-average shares outstanding                                               |       | 87,443                           |       | 79,928                          |       | 81,692 |   | 79,413 |   |
| Income per share  from continuing operations                                             |       | $                                | 0.65       |                            | $          | 0.26 |   | $ | 1.82 |   | $ | 0.72 |   |
| (Loss) income  per share from discontinued operations                                    |       | $                                | (3.64      | )                               | $          | 0.15 |   | $ | (3.78 | ) | $ | 0.51 |   |
| Net (loss)  income per share                                                             |       | $                                | (2.99      | )                               | $          | 0.41 |   | $ | (1.96 | ) | $ | 1.23 |   |
|                                                                                     |       |                             |       |                            |       |   |   |   |   |
| **Diluted:**                                                                             |       |                             |       |                            |       |   |   |   |   |
| Basic  weighted-average shares outstanding                                               |       | 87,443                           |       | 79,928                          |       | 81,692 |   | 79,413 |   |
| Dilutive effect  of share options and restricted common shares using the treasury method |       | 253                              |       | 1,115                           |       | 1,055 |   | 602 |   |
| Diluted  weighted-average shares outstanding (1)                                         |       | 87,696                           |       | 81,043                          |       | 82,747 |   | 80,015 |   |
| Income per share  from continuing operations                                             |       | $                                | 0.65       |                            | $          | 0.25 |   | $ | 1.80 |   | $ | 0.71 |   |
| (Loss) income  per share from discontinued operations                                    |       | $                                | (3.63      | )                               | $          | 0.15 |   | $ | (3.73 | ) | $ | 0.51 |   |
| Net (loss)  income per share                                                             |       | $                                | (2.98      | )                               | $          | 0.40 |   | $ | (1.93 | ) | $ | 1.22 |   |

 

----

(1)    Potential anti-dilutive commonshares excluded from diluted (loss) income earnings per share for the threemonths ended September 30, 2007 were 1,932 for share options.

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

 

Securities sold, not yet purchased consist of equityand debt securities that the Company has sold short. As of September 30, 2007,the Company had securities sold, not yet purchased with an amortized cost basisof $67.2 million and an accumulated net unrealized loss of $2.5 million. TheCompany did not have any securities sold, not yet purchased as of December 31,2006.

 

For the three months ending September 30, 2007, theCompany had net realized gains on short security sales of $5.2 million and netunrealized losses on short security sales of $2.9 million, compared to no netrealized or unrealized gains or losses on short security sales for the threemonths ending September 30, 2006. For the nine months ending September 30,2007, the Company had net realized gains of $5.3 million on short securitysales and net unrealized losses of $2.5 million on short security sales,compared to net realized gains of $0.1 million on short security sales and nounrealized gains or losses on short security sales for the nine months endedSeptember 30, 2006.

 

16

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

** **

The following table summarizes the Company’ssecurities classified as available-for-sale as of September 30, 2007, which arecarried at estimated fair value (amounts in thousands):

 
| ** **                             | ** ** | **Amortized** | ** ** | **Gross Unrealized** | ** ** | **Gross Unrealized** | ** ** | **Estimated**       | ** ** |
|----------------------------------------|------------|---------------|------------|---------------------------|------------|---------------------------|------------|---------------------|------------|
| **Description**                        | ** ** | **Cost**      | ** ** | **Gains**                 | ** ** | **Losses**                | ** ** | **Fair Value** | ** ** |
| Commercial  mortgage-backed securities |       | $             | 32,000     |                      | $          | —                    |       | $                   | (1,118     | ) | $ | 30,882 |   |
| Corporate  securities                  |       | 1,445,090     |       | 16,601                    |       | (80,326                   | )          | 1,381,365           |       |
| Common and  preferred stock            |       | 45,821        |       | 96                        |       | (4,602                    | )          | 41,315              |       |
| Total                                  |       | $             | 1,522,911  |                      | $          | 16,697                    |       | $                   | (86,046    | ) | $ | 1,453,562 |   |

 

The following table shows the gross unrealized lossesand fair value of the Company’s available-for-sale securities, aggregated bylength of time that the individual securities have been in a continuousunrealized loss position, as of September 30, 2007 (amounts in thousands):

 
| ** **                             | ** ** | **Less than 12 months** | ** ** | **12 Months or More** | ** ** | **Total**           | ** ** |
|----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|---------------------|------------|
| **Description**                        | ** ** | **Fair Value**                    | ** ** | **Unrealized Losses**           | ** ** | **Fair Value** | ** ** | **Unrealized Losses** | ** ** | **Fair Value** | ** ** | **Unrealized Losses** | ** ** |
| Commercial  mortgage-backed securities |       | $                                      | 30,882     |                                 | $          | (1,118              | )          | $ | — |   | $ | — |   | $ | 30,882 |   | $ | (1,118 | ) |
| Corporate  securities                  |       | 997,354                                |       | (75,527                              | )          | 18,268              |       | (4,799 | ) | 1,015,622 |   | (80,326 | ) |
| Common and  preferred stock            |       | 29,364                                 |       | (4,602                               | )          | —              |       | — |   | 29,364 |   | (4,602 | ) |
| Total                                  |       | $                                      | 1,057,600  |                                 | $          | (81,247             | )          | $ | 18,268 |   | $ | (4,799 | ) | $ | 1,075,868 |   | $ | (86,046 | ) |

 

The unrealized losses in the above table are temporaryimpairments due to market factors and are not reflective of creditdeterioration. The Company has performed credit analyses in relation to theseinvestments and has determined that the carrying value of these investments isexpected to be fully recoverable over their expected holding period. Becausethe Company has the intent and ability to hold these investments untilrecovery, the unrealized losses are not considered to be other-than-temporaryimpairments.

 

The following table summarizes the Company’ssecurities classified as available-for-sale as of December 31, 2006, whichare carried at estimated fair value (amounts in thousands):

 
| ** **                             | ** ** | **Amortized** | ** ** | **Gross Unrealized** | ** ** | **Gross Unrealized** | ** ** | **Fair Value Hedge** | ** ** | **Estimated**       | ** ** |
|----------------------------------------|------------|---------------|------------|---------------------------|------------|---------------------------|------------|--------------------------------|------------|---------------------|------------|
| **Description**                        | ** ** | **Cost**      | ** ** | **Gains**                 | ** ** | **Losses**                | ** ** | **Adjustment**                 | ** ** | **Fair Value** | ** ** |
| Commercial  mortgage-backed securities |       | $             | 32,000     |                      | $          | 36                        |       | $                              | —     |                | $          | (13 | ) | $ | 32,023 |   |
| Asset-backed  securities               |       | 31,071        |       | 203                       |       | (37                       | )          | —                         |       | 31,237              |       |
| Corporate  securities                  |       | 799,900       |       | 36,697                    |       | (4,385                    | )          | —                         |       | 832,212             |       |
| Common and  preferred stock            |       | 68,113        |       | 1,314                     |       | (459                      | )          | —                         |       | 68,968              |       |
| Total                                  |       | $             | 931,084    |                      | $          | 38,250                    |       | $                              | (4,881     | )                   | $          | (13 | ) | $ | 964,440 |   |

 

The following table shows the gross unrealized lossesand fair value of the Company’s available-for-sale securities, aggregated bylength of time that the individual securities have been in a continuousunrealized loss position, as of December 31, 2006 (amounts in thousands):

 
| ** **                  | ** ** | **Less than 12 months** | ** ** | **12 Months or More** | ** ** | **Total**           | ** ** |
|-----------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|---------------------|------------|
| **Description**             | ** ** | **Fair Value**                    | ** ** | **Unrealized Losses**           | ** ** | **Fair Value** | ** ** | **Unrealized Losses** | ** ** | **Fair Value** | ** ** | **Unrealized Losses** | ** ** |
| Asset-backed  securities    |       | $                                      | 7,462      |                                 | $          | (37                 | )          | $ | — |   | $ | — |   | $ | 7,462 |   | $ | (37 | ) |
| Corporate  securities       |       | 61,848                                 |       | (4,106                               | )          | 18,907              |       | (279 | ) | 80,755 |   | (4,385 | ) |
| Common and  preferred stock |       | 33,063                                 |       | (459                                 | )          | —              |       | — |   | 33,063 |   | (459 | ) |
| Total                       |       | $                                      | 102,373    |                                 | $          | (4,602              | )          | $ | 18,907 |   | $ | (279 | ) | $ | 121,280 |   | $ | (4,881 | ) |

 

17

----

 

The unrealized losses in the above table are temporaryimpairments due to market factors and are not reflective of creditdeterioration. The Company has performed credit analyses in relation to theseinvestments and has determined that the carrying value of these investments isexpected to be fully recoverable over their expected holding period. Becausethe Company has the intent and ability to hold these investments untilrecovery, the unrealized losses are not considered to be other-than-temporaryimpairments.

 

During the three and nine month periods endedSeptember 30, 2007, the Company’s gross realized gains from the sales ofavailable-for-sale securities were $3.8 million and $35.7 million,respectively. The Company had gross realized losses of $2.6 million and $4.8million from the sales of available-for-sale securities during the three andnine months ended September 30, 2007, respectively. During the three and ninemonths ended September 30, 2006, the Company’s gross realized gains from thesales of available-for-sale securities were $3.0 million and $5.1 million, respectively.The Company had gross realized losses of $1.1 million and $1.2 million from thesales of available-for-sale securities during the three months and nine monthsended September 30, 2006, respectively.

 

Note 9 to these condensed consolidated financialstatements describes the Company’s borrowings under which the Company haspledged securities available-for-sale for borrowings under repurchaseagreements and all other secured financing transactions. The following tablesummarizes the estimated fair value of securities available-for-sale pledged ascollateral under repurchase agreements and all other secured financingtransactions as of September 30, 2007 (amounts in thousands):

 
| ** **                                                                                                             | ** ** | **Commercial**      | ** ** | ** **     | ** ** | ** **               | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|----------------|------------|--------------------------|------------|
| ** **                                                                                                             | ** ** | **Mortgage-Backed** | ** ** | **Corporate**  | ** ** | **Common and**      | ** ** |
| ** **                                                                                                             | ** ** | **Securities**      | ** ** | **Securities** | ** ** | **Preferred Stock** | ** ** |
| Pledged as  collateral for borrowings under repurchase agreements                                                      |       | $                   | 13,514     |           | $          | 320,235                  |       | $ | — |   |
| Pledged as  collateral for borrowings under secured revolving credit facility                                          |       | —              |       | 50,720         |       | —                   |       |
| Pledged as  collateral for borrowings under secured demand loan                                                        |       | —              |       | —         |       | 38,864                   |       |
| Pledged as  collateral for collateralized loan obligation senior secured notes and junior  secured notes to affiliates |       | 17,368              |       | 1,005,385      |       | —                   |       |
| Total                                                                                                                  |       | $                   | 30,882     |           | $          | 1,376,340                |       | $ | 38,864 |   |

 

The following table summarizes the estimated fairvalue of securities available-for-sale pledged as collateral under repurchaseagreements, asset-backed secured liquidity notes, and all other securedfinancing transactions as of December 31, 2006 (amounts in thousands):

 
| ** **                                                                     | ** ** | **Commercial**      | ** ** | ** **              | ** ** | ** **               | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------|------------|-------------------------|------------|--------------------------|------------|
| ** **                                                                     | ** ** | **Mortgage-Backed** | ** ** | **Corporate**           | ** ** | **Common and**      | ** ** |
| ** **                                                                     | ** ** | **Securities**      | ** ** | **Securities (1)** | ** ** | **Preferred Stock** | ** ** |
| Pledged as  collateral for borrowings under repurchase agreements              |       | $                   | 32,023     |                    | $          | 310,856                  |       | $ | — |   |
| Pledged as  collateral for borrowings under secured revolving credit facility  |       | —              |       | 33,186                  |       | —                   |       |
| Pledged as  collateral for borrowings under secured demand loan                |       | —              |       | —                  |       | 47,056                   |       |
| Pledged as  collateral for collateralized loan obligation senior secured notes |       | —              |       | 408,416                 |       | —                   |       |
| Total                                                                          |       | $                   | 32,023     |                    | $          | 752,458                  |       | $ | 47,056 |   |

 

----

**(**1**)**    Includes asset-backedsecurities.

 

**Note 7. Loans**

 

The following table summarizes the Company’s loaninvestments as of September 30, 2007 and December 31, 2006 (amounts inthousands):

 
| ** **                                           | ** ** | **As of**                   | ** ** | **As of**                  | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                           | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
| Corporate loans,  at net amortized cost              |       | $                                | 6,985,483  |                            | $          | 3,225,567 |   |
| Commercial real  estate loans, at net amortized cost |       | 114,248                          |       | 108,693                         |       |
| Allowance for  loan losses                           |       | (25,000                          | )          | —                          |       |
| Total                                                |       | $                                | 7,074,731  |                            | $          | 3,334,260 |   |

 

18

----

 

The following table summarizes the components of thecarrying value of the Company’s loan investments recorded at net amortized costas of September 30, 2007 (amounts in thousands):

 
| ** **                    | ** ** | ** **    | ** ** | **Unamortized** | ** ** | **Net**                 | ** ** |
|-------------------------------|------------|---------------|------------|-----------------|------------|-------------------------|------------|
| ** **                    | ** ** | **Principal** | ** ** | **Discount**    | ** ** | **Amortized Cost** | ** ** |
| Corporate loans               |       | $             | 7,043,880  |            | $          | (58,397                 | )          | $ | 6,985,483 |   |
| Commercial real  estate loans |       | 114,341       |       | (93             | )          | 114,248                 |       |
| Total                         |       | $             | 7,158,221  |            | $          | (58,490                 | )          | $ | 7,099,731 |   |
|                               |            |               |            |                 |            |                         |            |  |  |  |  |

 

The following table summarizes the components of thecarrying value of the Company’s loans as of December 31, 2006 (amounts inthousands):
| ** **                    | ** ** | ** **    | ** ** | **Unamortized** | ** ** | **Net**                 | ** ** |
|-------------------------------|------------|---------------|------------|-----------------|------------|-------------------------|------------|
| ** **                    | ** ** | **Principal** | ** ** | **Discount**    | ** ** | **Amortized Cost** | ** ** |
| Corporate loans               |       | $             | 3,232,414  |            | $          | (6,847                  | )          | $ | 3,225,567 |   |
| Commercial real  estate loans |       | 108,790       |       | (97             | )          | 108,693                 |       |
| Total loans                   |       | $             | 3,341,204  |            | $          | (6,944                  | )          | $ | 3,334,260 |   |

 

Note 9 to these condensed consolidated financialstatements describes the Company’s borrowings under which the Company haspledged loans for borrowings under repurchase agreements and all other securedfinancing transactions. The following table summarizes the carrying value ofloans pledged as collateral under repurchase agreements and all other securedfinancing transactions as of September 30, 2007 (amounts in thousands):

 
| ** **                                                                                                             | ** ** | ** **               | ** ** | **Commercial Real** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|--------------------------|------------|
| ** **                                                                                                             | ** ** | **Corporate Loans** | ** ** | **Estate Loans**    | ** ** |
| Pledged as  collateral for borrowings under repurchase agreements                                                      |       | $                        | 1,739,089  |                     | $          | — |   |
| Pledged as  collateral for borrowings under secured revolving credit facility                                          |       | 48,628                   |       | —                   |       |
| Pledged as  collateral for collateralized loan obligation senior secured notes and junior  secured notes to affiliates |       | 5,197,766                |       | 114,248                  |       |
| Total                                                                                                                  |       | $                        | 6,985,483  |                     | $          | 114,248 |   |

 

The following table summarizes the carrying value ofloans pledged as collateral under repurchase agreements and all other securedfinancing transactions as of December 31, 2006 (amounts in thousands):

 
| ** **                                                                     | ** ** | ** **               | ** ** | **Commercial Real** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------|------------|--------------------------|------------|
| ** **                                                                     | ** ** | **Corporate Loans** | ** ** | **Estate Loans**    | ** ** |
| Pledged as  collateral for borrowings under repurchase agreements              |       | $                        | 596,976    |                     | $          | 15,000 |   |
| Pledged as  collateral for borrowings under secured revolving credit facility  |       | 174,893                  |       | —                   |       |
| Pledged as  collateral for collateralized loan obligation senior secured notes |       | 2,452,066                |       | 93,693                   |       |
| Total                                                                          |       | $                        | 3,223,935  |                     | $          | 108,693 |   |

 

As of September 30, 2007 and December 31, 2006,no loans were delinquent. During the quarter ended September 30, 2007, theCompany recorded a provision for loan losses of $25.0 million which reflectsthe Company’s estimate of probable losses, but not realized in the Company’sloan portfolio as of September 30, 2007. As of December 31, 2006, the Companyhad no allowance for loan losses.

 

**Note 8. Investment in UnconsolidatedAffiliate**

** **

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

 

19

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During the second quarter of 2007, the three specialpurpose entities which KFH had previously consolidated were combined in onesecured financing transaction, CLO 2007-1 (see description under Borrowings inNote 9). Because the Company holds the majority of the subordinated interestsin CLO 2007-1, the Company has determined that it is the primary beneficiary ofCLO 2007-1 and therefore consolidates the accounts of CLO 2007-1 into thesefinancial statements.

 

**Note 9. Borrowings**

 

The Company leverages its portfolio of securities andloans through the use of repurchase agreements, warehouse facilities, demandloans, and securitization transactions structured as secured financings.

 

Certain information withrespect to the Company’s borrowings as of September 30, 2007 is summarized inthe following table (dollar amounts in thousands):

 
| ** **                                         | ** ** | ** **      | ** ** | ** **    | ** ** | **Weighted**       | ** ** | ** **                          | ** ** |
|----------------------------------------------------|------------|-----------------|------------|---------------|------------|--------------------|------------|-------------------------------------|------------|
| ** **                                         | ** ** | ** **      | ** ** | **Weighted**  | ** ** | **Average**        | ** ** | ** **                          | ** ** |
| ** **                                         | ** ** | ** **      | ** ** | **Average**   | ** ** | **Remaining**      | ** ** | ** **                          | ** ** |
| ** **                                         | ** ** | **Outstanding** | ** ** | **Borrowing** | ** ** | **Maturity**       | ** ** | **Fair Value**                 | ** ** |
| ** **                                         | ** ** | **Borrowings**  | ** ** | **Rate**      | ** ** | **(in days)** | ** ** | **of Collateral ****(1)** | ** ** |
| Repurchase  agreements                             |       | $               | 2,318,904  |          | 5.76       | %                  | 204        |                                | $          | 1,923,977 |   |
| Secured  revolving credit facility                 |       | 168,000         |       | 6.07          |       | 632                |       | 98,862                              |       |
| Secured demand  loan                               |       | 29,577          |       | 5.75          |       | 31                 |       | 38,864                              |       |
| CLO 2005-1  senior secured notes                   |       | 831,278         |       | 5.68          |       | 3,496              |       | 967,950                             |       |
| CLO 2005-2  senior secured notes                   |       | 752,000         |       | 5.78          |       | 3,710              |       | 974,590                             |       |
| CLO 2006-1  senior secured notes                   |       | 727,500         |       | 5.87          |       | 3,982              |       | 983,523                             |       |
| CLO 2007-1  senior secured notes                   |       | 2,368,500       |       | 6.30          |       | 4,976              |       | 2,774,326                           |       |
| CLO 2007-1  junior secured notes to affiliates (2) |       | 431,293         |       | —        |       | 4,976              |       | 505,192                             |       |
| Convertible  senior notes                          |       | 300,000         |       | 7.00          |       | 1,750              |       | —                              |       |
| Junior  subordinated notes                         |       | 329,908         |       | 7.74          |       | 10,616             |       | —                              |       |
| Subordinated  notes to affiliates (3)              |       | 131,417         |       | —        |       | —             |       | 144,361                             |       |
| Total                                              |       | $               | 8,388,377  |          |       |               |       |                                | $          | 8,411,645 |   |

 

----

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

 

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

 

(3)            Subordinated notes donot have a contractual coupon rate, but instead receive a pro rata amount ofthe net distributions from CLO 2007-4 and CLO 2008-1.

 

20

----

 

 

Certain information with respect to the Company’sborrowings as of December 31, 2006 is summarized in the following table(dollar amounts in thousands):

 
| ** **                         | ** ** | ** **      | ** ** | ** **    | ** ** | **Weighted**       | ** ** | ** **                      | ** ** |
|------------------------------------|------------|-----------------|------------|---------------|------------|--------------------|------------|---------------------------------|------------|
| ** **                         | ** ** | ** **      | ** ** | **Weighted**  | ** ** | **Average**        | ** ** | ** **                      | ** ** |
| ** **                         | ** ** | ** **      | ** ** | **Average**   | ** ** | **Remaining**      | ** ** | ** **                      | ** ** |
| ** **                         | ** ** | **Outstanding** | ** ** | **Borrowing** | ** ** | **Maturity**       | ** ** | **Fair Value**             | ** ** |
| ** **                         | ** ** | **Borrowings**  | ** ** | **Rate**      | ** ** | **(in days)** | ** ** | **of Collateral (1)** | ** ** |
| Repurchase  agreements             |       | $               | 455,301    |          | 5.62       | %                  | 22         |                            | $          | 244,359 |   |
| Secured  revolving credit facility |       | 34,710          |       | 6.07          |       | 905                |       | 208,536                         |       |
| Secured demand  loan               |       | 41,658          |       | 5.88          |       | 1                  |       | 47,056                          |       |
| CLO 2005-1  senior secured notes   |       | 773,000         |       | 5.78          |       | 3,769              |       | 984,837                         |       |
| CLO 2005-2  senior secured notes   |       | 752,000         |       | 5.65          |       | 3,983              |       | 982,976                         |       |
| CLO 2006-1  senior secured notes   |       | 727,500         |       | 5.73          |       | 4,255              |       | 1,001,405                       |       |
| CDO 2005-1  repurchase agreements  |       | 1,074           |       | 6.45          |       | 18                 |       | 1,434                           |       |
| CLO 2006-2  repurchase agreements  |       | 631,287         |       | 5.95          |       | 1                  |       | 734,348                         |       |
| Junior  subordinated notes         |       | 257,743         |       | 7.71          |       | 10,811             |       | —                          |       |
| Total                              |       | $               | 3,674,273  |          |       |               |       |                            | $          | 4,204,951 |   |

 

----

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

 

On May 22, 2007, the Company closed CLO 2007-1, a $3.5billion secured financing transaction. The Company issued $2.4 billion ofsenior secured notes at par to unaffiliated investors with a weighted-averagecoupon of three-month LIBOR plus 0.53% and issued $244.7 million of mezzaninenotes and $186.6 million of subordinated notes to the KKR Strategic CapitalFunds. During the quarter ended September 30, 2007, the Company recordedinterest expense of $15.6 million for the notes issued to the KKR StrategicCapital Funds and as of September 30, 2007 the Company had accrued interestpayable to the KKR Strategic Capital Funds totaling $23.9 million.

 

DuringJune 2007, the Company issued $72.2 million of junior subordinated notes to KKRFinancial Capital Trust VI (the “Trust”), an entity the Company formed forissuing trust preferred securities and through which the Company received $70.0million in gross proceeds through the Trust’s issuance of trust preferredsecurities to unaffiliated investors. Interest is payable quarterly at afloating rate equal to three-month LIBOR plus 2.50%. During the quarter endedSeptember 30, 2007, the Company recorded interest expense on these notes of$1.4 million.

 

On July 23, 2007 the Company issued an aggregate of$300.0 million of 7.000% convertible senior notes maturing on July 15, 2012(the “Notes”) to qualified institutional buyers. The Notes represent seniorunsecured obligations of the Company and bear interest at the rate of 7.000%per year. Interest is payable semi-annually on January 15 and July 15 of eachyear, beginning January 15, 2008.

 

The Notes are convertible into the Company’s commonshares, initially at a conversion rate of 31.08 shares per $1,000 principal ofNotes, which is equivalent to an initial conversion price of $32.175 per commonshare. On July 23, 2007, the Company’s closing share price was $23.74. TheNotes are convertible prior to the maturity date at any time on or after June15, 2012 and also under the following circumstances: (a) a holder may surrenderany of its Notes for conversion during any calendar quarter beginning afterSeptember 30, 2007 (and only during such calendar quarter) if, and only if, theclosing sale price of the Company’s common shares for at least 20 trading days(whether or not consecutive) in the period of 30 consecutive trading daysending on the last trading day of the preceding calendar quarter is greaterthan 130% of the conversion price per common share in effect on the applicabletrading day; (b) a holder may surrender any of its Notes for conversion duringthe five consecutive trading-day period following any five consecutivetrading-day period in which the trading price of the Notes was less than 98% ofthe product of the closing sale price of the Company’s common shares multipliedby the applicable conversion rate; (c) a holder may surrender for conversionany of its Notes if those Notes have been called for redemption, at any timeprior to the redemption date, even if the Notes are not otherwise convertibleat such time; and (d) a holder may surrender any of its Notes for conversion ifthe Company engages in certain specified transactions, as defined in theindenture covering the Notes.

 

In connection with the Company’s common share rightsoffering (see Note 1 for description) during the third quarter, the Companyadjusted the conversion rate for the Notes pursuant to the governing indenturefor the Notes. The new conversion

 

21

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price for the Notes is approximately $31.00 and waseffective on September 21, 2007. The new conversion rate for each $1,000principal amount of Notes is 32.2581 of the Company’s common shares.

 

**Note 10.Derivative Financial Instruments**

 

The Company enters into derivative transactions inorder to hedge its interest rate risk exposure to the effects of interest ratechanges. Additionally, the Company enters into derivative transactions in thecourse of its investing. The counterparties to the Company’s derivativeagreements are major financial institutions with which the Company and itsaffiliates may also have other financial relationships. In the event ofnonperformance by the counterparties, the Company is potentially exposed tolosses. The counterparties to the Company’s derivative agreements haveinvestment grade ratings and, as a result, the Company does not anticipate thatany of the counterparties will fail to fulfill their obligations.

 

**Cash Flow and FairValue Hedges**

** **

The Company uses interest rate derivatives consistingof swaps to hedge a portion of the interest rate risk associated with itsborrowings under CLO senior secured notes. The Company designates thesefinancial instruments as cash flow hedges. The Company also uses interest rateswaps to hedge all or a portion of the interest rate risk associated withcertain fixed interest rate investments. The Company designates these financialinstruments as fair value hedges.

 

**Free-StandingDerivatives**

** **

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

 

The table below summarizes the estimated net fairvalue of the derivative instruments as of September 30, 2007 andDecember 31, 2006 (amounts in thousands):

 
| ** **                         | ** ** | **As of  September 30, 2007** | ** ** | **As of  December 31, 2006** | ** ** |
|------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                         | ** ** | **Notional**                                 | ** ** | **Fair Value**                         | ** ** | **Notional** | ** ** | **Fair Value** | ** ** |
| **Cash  Flow Hedges:**             |       |                                         |       |                                        |       |   |   |   |   |
| Interest rate  swaps               |       | $                                            | 383,333    |                                        | $          | (3,114 | ) | $ | 150,000 |   | $ | (1,711 | ) |
| **Fair  Value Hedges:**            |       |                                         |       |                                        |       |   |   |   |   |
| Interest rate  swaps               |       | 32,000                                       |       | (334                                        | )          | 32,000 |   | 13 |   |
| **Free-Standing  Derivatives:**    |       |                                         |       |                                        |       |   |   |   |   |
| Interest rate  swaptions           |       | —                                       |       | —                                      |       | 31,000 |   | 75 |   |
| Interest rate  swaps               |       | 150,000                                      |       | 640                                         |       | — |   | — |   |
| Credit default  swaps – long  |       | 66,000                                       |       | 274                                         |       | 3,000 |   | 179 |   |
| Credit default  swaps – short |       | 273,000                                      |       | 6,521                                       |       | 275,000 |   | (797 | ) |
| Total rate of  return swaps        |       | 445,811                                      |       | (16,141                                     | )          | 222,647 |   | 2,343 |   |
| Common stock  warrants             |       | —                                       |       | 432                                         |       | — |   | — |   |
| Net fair value                     |       | $                                            | 1,350,144  |                                        | $          | (11,722 | ) | $ | 713,647 |   | $ | 102 |   |

 

During the three and nine months ended September 30,2007 and September 30, 2006, the Company recognized an immaterial amount ofineffectiveness in income from its cash flow and fair value hedges.

 

**Note 11.Accumulated Other Comprehensive (Loss) Income**

 

The components of accumulated other comprehensive(loss) income were as follows (amounts in thousands):

 

22

----

 
| ** **                                                      | ** ** | **As of**                   | ** ** | **As of**                  | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                      | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
| Net unrealized  (losses) gains on available-for-sale securities |       | $                                | (69,683    | )                               | $          | 19,674 |   |
| Net unrealized  (losses) gains on cash flow hedges              |       | (3,114                           | )          | 50,846                          |       |
| Accumulated  other comprehensive (loss) income                  |       | $                                | (72,797    | )                               | $          | 70,520 |   |

 

The changes in the components of other comprehensive(loss) income were as follows (amounts in thousands):

 
| ** **                                                                                                                                                                            | ** ** | **Three months**  | ** ** | **Three months**  | ** ** | **Nine months**   | ** ** | **Nine months**   | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                            | ** ** | **ended**              | ** ** | **ended**              | ** ** | **ended**              | ** ** | **ended**              | ** ** |
| ** **                                                                                                                                                                            | ** ** | **September 30,** | ** ** | **September 30,** | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                                                                                                                                            | ** ** | **2007**               | ** ** | **2006**               | ** ** | **2007**               | ** ** | **2006**               | ** ** |
| Unrealized  (losses) gains on securities available-for-sale:                                                                                                                          |       |                   |       |                   |       |                   |       |                   |       |
| Unrealized  holding (losses) gains arising during period                                                                                                                              |       | $                      | (73,218    | )                      | $          | 25,259                 |       | $                      | (72,577    | ) | $ | 21,745 |   |
| Translation  adjustment to accumulated deficit in conjunction with fair value option  election for residential mortgage-backed securities, currently held as  discontinued operations |       | —                 |       | —                 |       | 21,575                 |       | —                 |       |
| Reclassification  adjustments for losses (gains) realized in net income                                                                                                               |       | (1,309                 | )          | 1,857                  |       | (30,457                | )          | 3,721                  |       |
| Unrealized  losses on available-for-sale securities from investment in unconsolidated  affiliate                                                                                      |       | —                 |       | —                 |       | (7,898                 | )          | —                 |       |
| Unrealized  (losses) gains on securities available-for-sale                                                                                                                           |       | (74,527                | )          | 27,116                 |       | (89,357                | )          | 25,466                 |       |
| Unrealized  (losses) gains on cash flow hedges:                                                                                                                                       |       |                   |       |                   |       |                   |       |                   |       |
| Unrealized  holding (losses) gains arising during period                                                                                                                              |       | (35,469                | )          | (64,044                | )          | (25,391                | )          | 8,349                  |       |
| Reclassification  adjustments for gains realized in discontinued operations                                                                                                           |       | (28,569                | )          | —                 |       | (28,569                | )          | —                 |       |
| Unrealized  (losses) gains on cash flow hedges                                                                                                                                        |       | (64,038                | )          | (64,044                | )          | (53,960                | )          | 8,349                  |       |
| Other  comprehensive (loss) income                                                                                                                                                    |       | $                      | (138,565   | )                      | $          | (36,928                | )          | $                      | (143,317   | ) | $ | 33,815 |   |

 

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

 

The Company has adopted an amended and restated shareincentive plan (the “2007 Share Incentive Plan”) that provides for the grant ofqualified incentive common share options that meet the requirements ofSection 422 of the Code, non-qualified common share options, shareappreciation rights, restricted common shares and other share-based awards. The2007 Share Incentive Plan was adopted on May 4, 2007. The Compensation Committeeof the Board of Directors administers the plan. Share options and othershare-based awards may be granted to the Manager, directors, officers and anykey employees of the Manager and to any other individual or entity performingservices for the Company.

 

The exercise price for any share option granted underthe 2007 Share Incentive Plan may not be less than 100% of the fair marketvalue of the common shares at the time the common share option is granted. Eachoption to acquire a common share must terminate no more than ten years from thedate it is granted. As of September 30, 2007, the 2007 Share Incentive Planauthorizes a total of 8,214,625 shares that may be used to satisfy awards underthe 2007 Share Incentive Plan. The Company made its initial grants onAugust 12, 2004 and August 19, 2004, the dates that the Companyclosed its initial private placement of common shares and the date that theover-allotment option was exercised, respectively. On July 2, 2007, theCompensation Committee of the Board of Directors granted 34,277 restrictedcommon shares to the Company’s directors pursuant to the 2007 Share IncentivePlan.

 

The following table summarizes restricted common sharetransactions:

 
| ** **                                                              | ** ** | **Manager** | ** ** | **Directors** | ** ** | **Total**  | ** ** |
|-------------------------------------------------------------------------|------------|-------------|------------|---------------|------------|------------|------------|
| **Unvested shares as of January 1, 2007** |       | 1,647,955   |       | 52,033        |       | 1,699,988  |       |
| Issued                                                                  |       | —      |       | 34,277        |       | 34,277     |       |
| Vested                                                                  |       | (1,022,955  | )          | (13,653       | )          | (1,036,608 | )          |
| Forfeited                                                               |       | —      |       | —        |       | —     |       |
| **Unvested  shares as of September 30, 2007**                           |       | 625,000     |       | 72,657        |       | 697,657    |       |

 

23

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The restricted common shares granted to the directorswere valued using the fair market value at the time of grant, which was $24.65and $21.30 per share for the restricted common shares granted in 2007 and 2006.Pursuant to SFAS No. 123(R), the Company is required to value any unvestedrestricted common shares granted to the Manager at the current market price.The Company valued the unvested restricted common shares at $16.85 and $24.54per share at September 30, 2007 and September 30, 2006, respectively.

 

The following table summarizes common share optiontransactions:

 
| ** **                                | ** ** | **Number**          | ** ** | **Weighted Average** | ** ** |
|-------------------------------------------|------------|---------------------|------------|---------------------------|------------|
| ** **                                | ** ** | **of Options** | ** ** | **Exercise Price**   | ** ** |
| **Outstanding  as of January 1, 2007**    |       | 1,932,279           |       | $                         | 20.00      |   |
| Granted                                   |       | —              |       | —                    |       |
| Exercised                                 |       | —              |       | —                    |       |
| Forfeited                                 |       | —              |       | —                    |       |
| **Outstanding  as of September 30, 2007** |       | 1,932,279           |       | $                         | 20.00      |   |

 

There were no common share options exercised duringthe nine months ended September 30, 2007. 1,932,279 common share options wereexercisable at both September 30, 2007 and December 31, 2006. The common shareoptions are valued using the Black-Scholes model using the followingassumptions:

 
| ** **     | ** ** | **As of**                   | ** ** | **As of**                   | ** ** |
|----------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **     | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** |
| Expected life  |       | 6.9 years                        |       | 7.9 years                        |       |
| Discount rate  |       | 4.86                             | %          | 4.65                             | %          |
| Volatility     |       | 41.00                            | %          | 17.00                            | %          |
| Dividend yield |       | 10.57                            | %          | 9.00                             | %          |

 

The estimated fair value of the common share optionswas $2.39 and $1.72 at September 30, 2007 and September 30, 2006, respectively.For the three and nine months ended September 30, 2007 and September 30, 2006,the components of share-based compensation expense are as follows (amounts inthousands):

 
| ** **                                      | ** ** | **For the three** | ** ** | **For the three** | ** ** | **For the nine** | ** ** | **For the nine** | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                      | ** ** | **months ended**       | ** ** | **months ended**       | ** ** | **months ended**      | ** ** | **months ended**      | ** ** |
| ** **                                      | ** ** | **September 30,**      | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** | **September 30,**     | ** ** |
| ** **                                      | ** ** | **2007**                    | ** ** | **2006**                    | ** ** | **2007**                   | ** ** | **2006**                   | ** ** |
| Options granted  to Manager                     |       | $                           | (192       | )                           | $          | 813                        |       | $                          | 246        |   | $ | 304 |   |
| Restricted  shares granted to Manager           |       | (4,389                      | )          | 9,230                       |       | 1,651                      |       | 21,316                     |       |
| Restricted  shares granted to certain directors |       | 178                         |       | 108                         |       | 392                        |       | 457                        |       |
| Total share-based  compensation expense         |       | $                           | (4,403     | )                           | $          | 10,151                     |       | $                          | 2,289      |   | $ | 22,077 |   |

 

**Note 13.** **Management Agreementand Related Party Transactions**

 

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

 

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

 

24

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For the three and nine months ended September 30,2007, the Company incurred $8.2 million and $22.5 million in basemanagement fees, respectively. In addition, the Company recognized share-basedcompensation expense related to common share options and restricted commonshares granted to the Manager of $(4.6) million and $1.9 million,respectively, for the three and nine months ended September 30, 2007 (seeNote 12). The Company also reimbursed the Manager $1.9 million and $5.8million for expenses for the three and nine months ended September 30, 2007, respectively.For the three and nine months ended September 30, 2006, the Company incurred$7.2 million and $21.6 million in base management fees, respectively. Inaddition, the Company recognized share-based compensation expense related tocommon share options and restricted common shares granted to the Manager of$10.0 million and $21.6 million, respectively, for the three and ninemonths ended September 30, 2006 (see Note 12). The Company also reimbursedthe Manager $1.5 million and $4.3 million for expenses for the three and ninemonths ending September 30, 2006, respectively. Base management fees incurredand share-based compensation expense relating to common share options andrestricted common shares 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 base management fees from the$230.4 million common share offering and $270.0 million common share rightsoffering that occurred during the third quarter of 2007 until such time as theCompany’s common share closing price on the NYSE is $20.00 or more for fiveconsecutive trading days. Accordingly, the Manager waived approximately $0.5million of base management fees during the quarter ended September 30, 2007.

 

Incentive fees of nil and $12.6 million were earned bythe Manager during the three and nine months ended September 30, 2007,respectively. The Manager earned $2.5 million and $4.8 million in incentivefees for the three and nine months ended September 30, 2006, respectively.

 

An affiliate of the Manager has entered into separatemanagement agreements with the respective investment vehicles for CLO 2005-1,CLO 2005-2, CLO 2006-1, and CLO 2007-1 and is entitled to receive fees for theservices performed as collateral manager. Beginning April 15, 2007, thecollateral manager ceased waiving fees for CLO 2005-1 for which the Companyrecorded an expense of $1.3 million and $2.3 million for the three and ninemonths ended September 30, 2007, respectively. As of September 30, 2007, thecollateral manager has permanently waived approximately $18.6 million in fees. Thecollateral manager evaluates such waivers on a quarterly basis and there are noassurances that the collateral manager will waive such management feessubsequent to those dates.

 

**Note 14.  Fair Value Disclosures**

 

Effective January 1, 2007,the Company adopted SFAS No. 157, which requires additional disclosures aboutthe Company’s assets and liabilities that are measured at fair value.

 

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

 

Level 1: Inputs are unadjusted,quoted prices in active markets for identical assets or liabilities at themeasurement date.

 

The types of assets carriedat Level 1 fair value generally are equity securities listed in active markets.

 

Level 2:  Inputs other than quoted prices included inLevel 1 that are observable for the asset or liability, either directly orindirectly. Level 2 inputs include quoted prices for similar instruments inactive markets, and inputs other than quoted prices that are observable for theasset or liability.

 

Fair value assets andliabilities that are generally included in this category are mortgage-backed securitiesand mortgage loans (which are currently reflected as assets of discontinuedoperations for financial

 

25

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statement purposes) wherethe mortgage loans on the Company’s financial statements consist ofmortgage-backed securities where the issuing trust has been consolidated on theCompany’s consolidated financial statements, certain corporate and commercialreal estate debt securities and loan investments, and certain financialinstruments classified as derivatives where the fair value is based onobservable market inputs.

 

Level 3: Inputs areunobservable inputs for the asset or liability, and include situations wherethere is little, if any, market activity for the asset or liability. In certaincases, the inputs used to measure fair value may fall into different levels ofthe fair value hierarchy. In such cases, the level in the fair value hierarchywithin which the fair value measurement in its entirety falls has beendetermined based on the lowest level input that is significant to the fairvalue measurement in its entirety. The Company’s assessment of the significanceof a particular input to the fair value measurement in its entirety requiresjudgment, and considers factors specific to the asset.

 

Generally, assets andliabilities carried at fair value and included in this category are certaincorporate loans, debt securities and certain derivatives.

 

The following table presentsinformation about the Company’s assets and liabilities (including derivativesthat are presented net) measured at fair value on a recurring basis as ofSeptember 30, 2007, and indicates the fair value hierarchy of the valuationtechniques utilized by the Company to determine such fair value.

 
| ** **                           | ** ** | **Quoted Prices in**     | ** ** | ** **                 | ** ** | ** **                   | ** ** | ** **                       | ** ** |
|--------------------------------------|------------|------------------------------------|------------|----------------------------|------------|------------------------------|------------|----------------------------------|------------|
| ** **                           | ** ** | **Active Markets**            | ** ** | **Significant Other** | ** ** | **Significant**              | ** ** | ** **                       | ** ** |
| ** **                           | ** ** | **for Identical Assets** | ** ** | **Observable Inputs** | ** ** | **Unobservable Inputs** | ** ** | **Balance as of**      | ** ** |
| **(amounts in thousands)** | ** ** | **(Level 1)**                 | ** ** | **(Level 2)**         | ** ** | **(Level 3)**           | ** ** | **September 30, 2007** | ** ** |
| Securities  available-for-sale       |       | $                                  | 41,315     |                       | $          | 1,311,209                    |       | $                                | 101,038    |   | $ | 1,453,562 |   |
| Derivatives, net                     |       | —                             |       | (12,153                    | )          | 431                          |       | (11,722                          | )          |
| Securities sold,  not yet purchased  |       | (34,851                            | )          | (34,853                    | )          | —                       |       | (69,704                          | )          |
| Total                                |       | $                                  | 6,464      |                       | $          | 1,264,203                    |       | $                                | 101,469    |   | $ | 1,372,136 |   |

 

The following table presents additional informationabout assets or liabilities, including derivatives that are measured at fairvalue on a recurring basis for which the Company has utilized Level 3 inputs todetermine fair value, for the three months ended September 30, 2007:

 
| ** **                                                                                                                                                                              | ** ** | **Fair Value Measurements Using** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                                                                                              | ** ** | **Significant Unobservable Inputs**    | ** ** |
| ** **                                                                                                                                                                              | ** ** | **(Level 3)**                               | ** ** |
| ** **                                                                                                                                                                              | ** ** | **Securities**                                   | ** ** | ** ** | ** ** |
| ** **                                                                                                                                                                              | ** ** | **Available-For-**                               | ** ** | **Derivatives,** | ** ** |
| **(amounts in thousands)**                                                                                                                                                    | ** ** | **Sale**                                         | ** ** | **net** | ** ** |
| Beginning  balance as of June 30, 2007                                                                                                                                                  |       | $                                                | 57,000     |   | $ | 1,317 |   |
| Total gains or  losses (realized and unrealized):                                                                                                                                       |       |                                             |       |   |   |
| Included in  earnings                                                                                                                                                                   |       | —                                           |       | 145 |   |
| Included in  other comprehensive loss                                                                                                                                                   |       | (538                                             | )          | — |   |
| Net transfers  into level 3                                                                                                                                                             |       | 44,576                                           |       | — |   |
| Purchases, sales,  other settlements and issuances, net                                                                                                                                 |       | —                                           |       | (1,031 | ) |
| Ending balance  as of September 30, 2007                                                                                                                                                |       | $                                                | 101,038    |   | $ | 431 |   |
|                                                                                                                                                                                    |       |                                             |       |   |   |
| The amount of  total gains or losses for the period included in earnings attributable to the  change in unrealized gains or losses relating to assets still held at the  reporting date |       | $                                                | —     |   | $ | 145 |   |

 

26

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The following table presents additional informationabout assets, including derivatives that are measured at fair value on arecurring basis for which the Company has utilized Level 3 inputs to determinefair value, for the nine months ended September 30, 2007:

 
| ** **                                                                                                                                                                              | ** ** | **Fair Value Measurements Using** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                                                                                              | ** ** | **Significant Unobservable Inputs**    | ** ** |
| ** **                                                                                                                                                                              | ** ** | **(Level 3)**                               | ** ** |
| ** **                                                                                                                                                                              | ** ** | **Securities**                                   | ** ** | ** ** | ** ** |
| ** **                                                                                                                                                                              | ** ** | **Available-For-**                               | ** ** | **Derivatives,** | ** ** |
| **(amounts in thousands)**                                                                                                                                                    | ** ** | **Sale**                                         | ** ** | **net** | ** ** |
| Beginning  balance as of December 31, 2006                                                                                                                                              |       | $                                                | 104,498    |   | $ | — |   |
| Total gains or  losses (realized and unrealized):                                                                                                                                       |       |                                             |       |   |   |
| Included in  earnings                                                                                                                                                                   |       | —                                           |       | 431 |   |
| Included in  other comprehensive loss                                                                                                                                                   |       | (36                                              | )          | — |   |
| Net transfers  into level 3                                                                                                                                                             |       | 44,074                                           |       | — |   |
| Purchases,  sales, other settlements and issuances, net                                                                                                                                 |       | (47,498                                          | )          | — |   |
| Ending balance  as of September 30, 2007                                                                                                                                                |       | $                                                | 101,038    |   | $ | 431 |   |
|                                                                                                                                                                                    |       |                                             |       |   |   |
| The amount of  total gains or losses for the period included in earnings attributable to the  change in unrealized gains or losses relating to assets still held at the  reporting date |       | $                                                | —     |   | $ | 431 |   |

 

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

 

**Note 15.  Subsequent Events**

** **

On November 1, 2007, the Company’s Board of Directorsdeclared a cash distribution for the three months ended September 30, 2007 onthe Company’s common shares of $0.50 per common share, payable on November 29,2007 to shareholders of record as of the close of business on November 15,2007.

 

As described in Note 1 to these condensed consolidatedfinancial statements, on October 2, 2007 certain principals of KKR purchased3.9 million common shares resulting in proceeds of $56.6 million pursuant to abackstop commitment in connection with the Company’s common share rightoffering.

 

As described in Note 3 tothese condensed consolidated financial statements, on October 18, 2007 theCompany announced that the REIT Subsidiary had consummated a restructuring ofthe Facilities. Pursuant to the terms of the restructuring, the maturity dateof the secured liquidity notes issued by the Facilities was extended withapproximately 50% of the principal balance due on February 15, 2008, and theremaining principal balance due on March 13, 2008. Under the terms of therestructuring the Company continues to have the right, but not the obligation,to repurchase or refinance the collateral (residential mortgage loans andsecurities) and pay off the Facilities prior to aforementioned maturity dates.

 

On October 31, 2007, the Company closed KKR FinancialCLO 2007-A, Ltd. (“CLO 2007-A”), a $1.5 billion CLO transaction that providesten-year term financing for investments in corporate loans and securities. Theinvestments that are owned by CLO 2007-A collateralize the CLO 2007-Anon-recourse debt, and as a result, those investments are not available to theCompany, its creditors, or shareholders. CLO 2007-A issued a total of $1.2billion of senior secured notes at par to unaffiliated investors, andapproximately $48.8 million of rated mezzanine notes and approximately $45.3million of unrated subordinated notes were issued at par to the KKR StrategicCapital Funds.

 

On October 31, 2007, the Company closed an €800.0million warehouse facility that is structured as a repurchase facility toprovide financing for investments in non-U.S. dollar corporate loans andsecurities. The investments that are owned by the warehouse facilitycollateralize the warehouse facility, and as a result, those investments arenot available to the Company, its creditors, or shareholders.

 

On November 5, 2007, the Company closed WayzataFunding LLC, which is a $2.0 billion CLO transaction that provides five-yearterm financing for investments in corporate loans and securities. Theinvestments owned by Wayzata Funding LLC collateralize non-recourse debt issuedby Wayzata Funding LLC. As a result, those investments are not available to theCompany, its creditors, or shareholders. Wayzata Funding LLC will issue a totalof $1.6 billion of senior secured notes at par to unaffiliated investors andapproximately $148.0 million of unrated subordinated notes will be issued atpar to the KKR Strategic Capital Funds.

 

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**Item 2.   Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

*Unlessotherwise expressly stated or the context suggests otherwise, the terms “we,” “us”and “our” refer, as of dates and for periods on and after May 4, 2007 to KKRFinancial Holdings LLC and its subsidiaries and, as of dates and for periodsprior to May 4, 2007, to our predecessor, KKR Financial Corp., and itssubsidiaries; “Manager” means KKR Financial Advisors LLC; “KKR” means Kohlberg KravisRoberts & Co. L.P. and its affiliated companies (excluding portfoliocompanies that are minority or majority owned or managed by funds associatedwith KKR); “Management Agreement” means the amended and restated managementagreement between KKR Financial Holdings LLC and the Manager. The followingmanagement’s discussion and analysis (“MD&A”) is intended to assist thereader in understanding our business. The MD&A is provided as a supplementto, and should be read in conjunction with, our Condensed ConsolidatedFinancial Statements and accompanying notes included in this Quarterly Reporton Form 10-Q and our Consolidated Financial Statements and accompanying notesincluded in our Annual Report on Form 10-K for the year ended December 31,2006.*

 

**ForwardLooking Statements**

 

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

 

**ExecutiveOverview**

 

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

 

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

 

Our income is generatedprimarily from (i) net interest income and dividend income, (ii) realizedand unrealized gains and losses on our derivative instruments that are notaccounted for as hedges, (iii) realized gains and losses from the sales ofinvestments, (iv) realized and unrealized gains and losses on securities sold,not yet purchased, and (v) fee income.

 

During the third quarter of2007, there were material adverse changes in the mortgage industry and thecapital markets experienced significant disruptions which had a materialnegative impact on our ability to finance our residential mortgage investmentson terms and conditions which met our return on equity requirements. Mostnotably, the asset-backed commercial paper market was negatively impacted asinvestors significantly reduced and to a certain extent no longer invested incommercial paper backed by structured financial instruments, includingresidential mortgage investments. The disruptions in the asset-backedcommercial paper market were exacerbated by the fact that commercial banks andinvestment banks materially curtailed or discontinued providing their customerswith financing for residential mortgage investments. The secondary impact ofthe lack of financing and liquidity for residential mortgage investments wasthat market values of residential mortgage investments decreased materiallybecause traditional buyers were unable to obtain financing.

 

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In response to theaforementioned market disruptions that occurred during the quarter, we tookseveral steps to ensure that we had adequate liquidity to respond to thecurrent market environment. Specifically, we executed the followingtransactions: (i) we sold $5.2 billion of residential mortgage loans andmortgage-backed securities and recognized a loss of approximately $65.0million, which was reduced by gains on the termination of related interest ratehedges of approximately $28.6 million, and thereby recognized a net loss ofapproximately $36.4 million; (ii) we received gross proceeds of $230.4 millionthrough the issuance of 16.0 million common shares at $14.40 to sevenunaffiliated institutional investors; (iii) we completed a share rights offeringwhich generated gross proceeds of $270.0 million ($56.6 million received inOctober 2007 under a backstop agreement with certain principals of KKR throughwhich 3.9 million shares were issued) through the issuance of 18.75 millionshares at $14.40 per common share; (iv) we sold $139.6 million of our privateequity investments to unaffiliated third parties and recognized a net gain of$51.6 million; and (v) we made the decision to dispose of our real estateinvestment trust subsidiary, KKR Financial Corp. (“REIT Subsidiary”), and exitthe business of investing in residential mortgage investments. Accordingly, ourresidential mortgage investment business and REIT Subsidiary are reported as adiscontinued operation for all periods presented and, for the three and ninemonths ended September 30, 2007, we recorded charges totaling $243.7 millionrelating thereto. Unless otherwise noted, information contained in ourManagement Discussion and Analysis of this quarterly report relates to ourcontinuing operations.

 

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

 

***Cash Distributions to Shareholders***

 

OnNovember 1, 2007, our Board of Directors declared a cash distribution for thequarter ended September 30, 2007 on our common shares of $0.50 per commonshare. The aggregate distribution amount of $57.6 million is payable onNovember 29, 2007 to our common shareholders of record as of the close ofbusiness on November 15, 2007.

 

***Investment Portfolio***

 

As of September 30, 2007 our investment portfoliototaled $8.6 billion, representing an increase of 91.1% from $4.5 billion as ofDecember 31, 2006. As of September 30, 2007, our investment portfolioprimarily consisted of corporate loans and securities totaling $8.4 billion,commercial real estate loans and securities totaling $145.1 million, andmarketable equity securities consisting of preferred and common stock totaling$41.3 million. In addition, we held investments in non-marketable equitysecurities totaling $20.1 million as of September 30, 2007.

 

***Financing Transactions***

 

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

 

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

 

On July 23, 2007, we issued an aggregate of $300.0million of 7.000% convertible notes maturing on July 15, 2012 (the “Notes”) toqualified institutional buyers. The Notes represent senior unsecuredobligations of us and bear interest at the rate of 7.000% per year. Interest ispayable semi-annually on January 15 and July 15 of each year, beginning January15, 2008.

 

The Notes are convertible into our common shares,initially at a conversion rate of 31.08 shares per $1,000 principal of Notes,which is equivalent to an initial conversion price of $32.175 per common share.The Notes are convertible prior to the maturity date at any time on or afterJune 15, 2012 and also under the following circumstances: (i) a holder maysurrender any of its Notes for conversion during any calendar quarter beginningafter September 30, 2007 (and only during such calendar quarter) if, and onlyif, the closing sale price of our common shares for at least 20 trading days(whether or not consecutive) in the period of 30 consecutive trading daysending on the last trading day of the preceding calendar quarter is greaterthan 130% of the conversion price per common share in effect on the applicabletrading day; (ii) a holder may

 

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surrender any of its Notes for conversion during thefive consecutive trading-day period following any five consecutive trading-dayperiod in which the trading price of the Notes was less than 98% of the productof the closing sale price of our common shares multiplied by the applicableconversion rate; (iii) a holder may surrender for conversion any of its Notesif those Notes have been called for redemption, at any time prior to theredemption date, even if the Notes are not otherwise convertible at such time;and (iv) a holder may surrender any of its Notes for conversion if we engage incertain specified transactions, as defined in the indenture covering the Notes.

 

In connection with the aforementioned common sharerights offering during the third quarter, we adjusted the conversion rate forour Notes pursuant to the governing indenture for the Notes. The new conversionprice for the Notes is approximately $31.00 and was effective September 21,2007. The new conversion rate for each $1,000 principal amount of Notes is32.2581 of our common shares.

 

**Critical Accounting Policies**

 

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

 

***RevenueRecognition***

*** ***

We account for interest income on our investmentsusing the effective yield method. For investments purchased at par, theeffective yield is the contractual coupon rate on the investment. Unamortizedpremiums and unaccreted discounts on non-residential mortgage-backed securitiesare recognized in interest income over the contractual life, adjusted foractual prepayments, of the securities using the effective interest method. Forsecurities representing beneficial interests in securitizations that are nothighly rated (i.e., subordinated tranches of residential mortgage-backedsecurities, which are currently presented as discontinued operations forfinancial statement purposes), unamortized premiums and unaccreted discountsare recognized over the contractual life, adjusted for estimated prepayments andestimated credit losses of the securities using the effective interest method.Actual prepayment and credit loss experience is reviewed quarterly andeffective yields are recalculated when differences arise between prepaymentsand credit losses originally anticipated compared to amounts actually receivedplus anticipated future prepayments.

 

Interest income on loans includes interest at statedcoupon rates adjusted for accretion of purchase discounts and amortization ofpurchase premiums. For corporate and commercial real estate loans, unamortizedpremiums and unaccreted discounts are recognized in interest income over thecontractual life, adjusted for actual prepayments, of the loans using theeffective interest method.

 

As of September 30, 2007, unamortized purchasepremiums and unaccreted purchase discounts on our investment portfolio totaled$0.7 million and $82.8 million, respectively.

 

Upon adoption of SFAS No.159, *The Fair Value Option for Financial Assets andFinancial Liabilities—Including an amendment of FASB Statement No. 115*(“SFAS No. 159”) as of January 1, 2007 as disclosed below under “RecentAccounting Pronouncements”, we carry our investments in residentialmortgage-backed securities and residential mortgage loans, which are currentlypresented as discontinued operations for financial statement purposes, at fairvalue with changes in fair value recorded in loss (income) from discontinuedoperations.

 

***Share-BasedCompensation***

*** ***

We account for share-based compensation issued tomembers of our Board of Directors and our Manager using the fair value basedmethodology in accordance with SFAS No. 123(R), *Share-Based Payment* (“SFAS No. 123(R)”). We do not haveany employees, although we believe that members of our Board of Directors aredeemed to be employees for purposes of interpreting and applying accountingprinciples relating to share-based compensation. We record as compensationcosts the restricted common shares that we issued to members of our Board ofDirectors at estimated fair value as of the grant date and we amortize the costinto expense over the three-year vesting period using the straight-line method.We record

 

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compensation costs for restricted common shares andcommon share options that we issued to our Manager at estimated fair value asof the grant date and we remeasure the amount on subsequent reporting dates tothe extent that the restricted common shares and/or common share options havenot vested. Unvested restricted common shares are valued using observablesecondary market prices. Unvested common share options are valued using theBlack-Scholes model and assumptions based on observable market data forcomparable companies. We amortize compensation expense related to therestricted common shares and common share options that we granted to ourManager using the graded vesting attribution method in accordance with SFAS No.123(R).

 

Because we remeasure the amount of compensation costsassociated with the unvested restricted common shares and unvested common shareoptions that we issued to our Manager as of each reporting period, our share-basedcompensation expense reported in our condensed consolidated financialstatements will change based on the estimated fair value of our common sharesand this may result in earnings volatility. For the three and nine months endedSeptember 30, 2007, share-based compensation (benefit) expense totaled $(4.4)million and $2.3 million, respectively. As of September 30, 2007, substantiallyall of the non-vested common share options and restricted common shares issuedthat are subject to SFAS No. 123(R) are subject to remeasurement. Asof September 30, 2007, a $1 increase in the price of our common shareswould have increased our future share-based compensation expense by approximately$0.2 million and this future share-based compensation expense would berecognized over the remaining vesting periods of our outstanding restrictedcommon shares and common share options. As of September 30, 2007, futureunamortized share-based compensation totaled $3.7 million, of which$1.1 million, $2.4 million and $0.2 million will be recognized in 2007,2008 and beyond, respectively.

 

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

*** ***

We recognize all derivatives on our condensedconsolidated balance sheet at estimated fair value. On the date we enter into aderivative contract, we designate and document each derivative contract as oneof the following: (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 (loss) income. We subsequentlyreclassify these changes in estimated fair value to net income in the sameperiod(s) that the hedged transaction affects earnings in the samefinancial statement category as the hedged item. For free-standing derivatives,we report changes in the fair values in current period other income.

 

We formally document at inception our hedgerelationships, including identification of the hedging instruments and thehedged items, our risk management objectives, strategy for undertaking thehedge transaction and our evaluation of effectiveness of our hedgedtransactions. Periodically, as required by SFAS No. 133, *Accounting for Derivative Instruments and HedgingActivities*, as amended and interpreted (“SFAS No. 133”), wealso formally assesses whether the derivative we designated in each hedging relationshipis expected to be and has been highly effective in offsetting changes inestimated fair values or cash flows of the hedged item using either the dollaroffset or the regression analysis method. If we determine that a derivative isnot highly effective as a hedge, we discontinue hedge accounting.

 

We are not required to account for our derivativecontracts using hedge accounting as described above. If we decide not todesignate the derivative contracts as hedges or if we fail to fulfill thecriteria necessary to qualify for hedge accounting, then the changes in theestimated fair values of our derivative contracts would immediately affectperiodic earnings, potentially resulting in the increased volatility of ourearnings. The qualification requirements for hedge accounting are complex andas a result we must evaluate, designate, and thoroughly document each hedgetransaction at inception and perform ineffectiveness analysis and preparerelated documentation at inception and on a recurring basis thereafter. As ofSeptember 30, 2007, the estimated fair value of our derivatives that areaccounted for as hedges totaled $(3.4) million.

 

***Impairments***

*** ***

We evaluate our investment portfolio for impairment asof each quarter end or more frequently if we become aware of any materialinformation that would lead us to believe that an investment may be impaired.We evaluate whether the investment is considered impaired and whether theimpairment is other-than-temporary. If we make a determination that theimpairment is other-than-temporary, we recognize an impairment loss equal tothe difference between the amortized cost

 

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basis and the estimated fair value of the investment.We consider many factors in determining whether the impairment of an investmentis other-than-temporary, including but not limited to the length of time thesecurity has had a decline in estimated fair value below its amortized cost,the amount of the loss, our 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.

 

**Recent AccountingPronouncements**

 

In February 2006, the FASB issued SFASNo. 155, *Accounting for Certain Hybrid FinancialInstruments* (“SFAS No. 155”). Key provisions of SFASNo. 155 include: (1) a broad fair value measurement option forcertain hybrid financial instruments that contain an embedded derivative thatwould otherwise require bifurcation; (2) clarification that only thesimplest separations of interest payments and principal payments qualify forthe exception afforded to interest-only strips and principal-only strips fromderivative accounting under paragraph 14 of SFAS No. 133*,* thereby narrowing such exception; (3) a requirementthat beneficial interests in securitized financial assets be analyzed todetermine whether they are freestanding derivatives or whether they are hybridinstruments that contain embedded derivatives requiring bifurcation;(4) clarification that concentrations of credit risk in the form ofsubordination are not embedded derivatives; and (5) elimination of theprohibition on a QSPE holding passive derivative financial instruments thatpertain to beneficial interests that are or contain a derivative financialinstrument. In general, these changes will reduce the operational complexityassociated with bifurcating embedded derivatives, and increase the number ofbeneficial interests in securitization transactions, including interest-onlystrips and principal-only strips, required to be accounted for in accordancewith SFAS No. 133. We adopted SFAS No. 155 as of the beginning of 2007 andthe adoption of SFAS No. 155 did not have a material impact on our condensedconsolidated financial statements.

 

In June 2006, the FASB issued InterpretationNo. 48, *Accounting for Uncertainty in IncomeTaxes—an interpretation of FASB Statement No. 109* (“FIN 48”).FIN 48 clarifies the accounting for uncertainty in income taxes recognized inan enterprise’s financial statements in accordance with FASB StatementNo. 109, *Accounting for Income Taxes*. FIN48 prescribes a recognition threshold and measurement attribute for thefinancial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. We adopted FIN 48 as of the beginning of2007 and the adoption of FIN 48 did not have a material impact on ourcondensed consolidated financial statements.

 

In June 2007, theAmerican Institute of Certified Public Accountants  (AICPA) issued Statement of Position (SOP)07-1, *Clarification of the Scope of the Audit andAccounting Guide* Investment Companies *andAccounting for Parent Companies and Equity Method Investors for Investments inInvestment Companies.*This SOP provides guidance for determiningwhether an entity is within the scope of the AICPA Audit and Accounting Guide *Investment Companies*(the “Guide”). Entities that are withinthe scope of the Guide are required, among other things, to carry theirinvestments at fair value, with changes in fair value included in earnings. InOctober 2007, the effective date of SOP 07-1 was indefinitely deferred. TheCompany is currently evaluating this new guidance and has not determinedwhether it will be required to apply the provisions of the Guide in presentingits financial statements.

 

On July 25, 2007, theFASB authorized a proposed FASB Staff Position (the “proposed FSP”) that, ifapproved for issuance by the FASB, will affect the accounting for the Notes.The proposed FSP will require that the initial debt proceeds be allocatedbetween a liability component and an equity component. The resulting debtdiscount would be amortized over the period the debt is expected to beoutstanding as additional interest expense. The proposed FSP is expected to beeffective for fiscal years beginning after December 15, 2007 and would requireretrospective application. We are currently evaluating the impact of adoptingproposed FSP. 

 

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

 

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

 

We adopted SFAS No. 159 as of January 1, 2007 andelected to apply the fair value option for our investments in residentialmortgage loans and residential mortgage-backed securities, which are currentlyreflected as discontinued operations for financial statement purposes.Additionally, we intend to consistently apply the election of the fair valueoption to any future residential mortgage investments. We have elected the fairvalue option for our residential mortgage investments for the purpose ofenhancing the transparency of our financial condition as fair value isconsistent with how we

 

32

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manages the risks of our residential mortgageinvestments. The transition adjustment to beginning accumulated deficit thatwas recorded as of January 1, 2007 due to the adoption of SFAS No. 159 was aloss of $55.7 million. The following table presents information about theeligible instruments for which the Company elected the fair value option andfor which transition adjustments were recorded as of January 1, 2007 (amountsin thousands):

 
| ** **                                                  | ** ** | **Carrying Value at  January 1, 2007** | ** ** | **Transition Adjustment to  Accumulated Deficit  Gain/(Loss)** | ** ** | **Carrying Value at  January 1, 2007  (After Adoption of  SFAS No. 159)** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|
| Residential  mortgage loans                                 |       | $                                                          | 5,109,261  |                                                                          | $          | (35,653                                                                                                           | )          | $ | 5,073,608 |   |
| Allowance for  loan losses                                  |       | (1,500                                                     | )          | 1,500                                                                         |       | —                                                                                                            |       |
| Residential  mortgage-backed securities (1)                 |       | 7,536,196                                                  |       | (21,575                                                                       | )          | 7,536,196                                                                                                         |       |
| Cumulative  effect of the adoption of the fair value option |       |                                                       |       | $                                                                             | (55,728    | )                                                                                                                 |       |   |
|                                                             |            |                                                            |            |                                                                               |            |                                                                                                                   |            |  |  |  |

 

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

 

**Results of Operations**

 

**Threeand nine months ended September 30, 2007 compared to three and nine monthsended September 30, 2006**

 

*Summary*

 

Our net loss for the three and nine months endedSeptember 30, 2007 totaled $261.5 million (or $2.98 per diluted common share)and $160.1 million (or $1.93 per diluted common share), respectively, ascompared to net income of $32.6 million (or $0.40 per diluted common share) and$97.9 million (or $1.22 per diluted common share) for the three and nine monthsended September 30, 2006, respectively.

 

33

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*Net Investment Income*

 

The following table presents the components of our netinvestment income for the three and nine months ended September 30, 2007 and2006:

 

**ComparativeNet Investment Income Components (Amounts in thousands)**

 
| ** **                                                   | ** ** | **For the three  months ended  September 30,  2007** | ** ** | **For the three  months ended  September 30,  2006** | ** ** | **For the nine  months ended  September 30,  2007** | ** ** | **For the nine  months ended  September 30,  2006** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| Investment  Income:                                          |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Corporate loans  and securities interest income              |       | $                                                                        | 160,922    |                                                                     | $          | 80,298                                                                  |       | $                                                                       | 348,587    |   | $ | 192,223 |   |
| Commercial real  estate loans and securities interest income |       | 3,407                                                                    |       | 7,518                                                                    |       | 9,718                                                                   |       | 23,045                                                                  |       |
| Other interest  income                                       |       | 11,850                                                                   |       | 2,638                                                                    |       | 20,101                                                                  |       | 5,928                                                                   |       |
| Common and  preferred stock dividend income                  |       | 782                                                                      |       | 945                                                                      |       | 2,722                                                                   |       | 2,740                                                                   |       |
| Net discount  accretion                                      |       | 2,400                                                                    |       | 1,209                                                                    |       | 4,990                                                                   |       | 4,309                                                                   |       |
| Total investment  income                                     |       | 179,361                                                                  |       | 92,608                                                                   |       | 386,118                                                                 |       | 228,245                                                                 |       |
| Interest  Expense:                                           |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Repurchase  agreements                                       |       | 22,927                                                                   |       | 21,701                                                                   |       | 52,193                                                                  |       | 46,488                                                                  |       |
| Collateralized  loan obligation senior secured notes         |       | 69,250                                                                   |       | 23,498                                                                   |       | 149,404                                                                 |       | 61,883                                                                  |       |
| Secured  revolving credit facility                           |       | 3,190                                                                    |       | 3,303                                                                    |       | 6,580                                                                   |       | 6,172                                                                   |       |
| Secured demand  loan                                         |       | 513                                                                      |       | 615                                                                      |       | 1,728                                                                   |       | 1,692                                                                   |       |
| Convertible  senior notes                                    |       | 4,183                                                                    |       | —                                                                   |       | 4,183                                                                   |       | —                                                                  |       |
| Junior  subordinated notes                                   |       | 6,481                                                                    |       | 3,109                                                                    |       | 16,502                                                                  |       | 4,477                                                                   |       |
| Other interest  expense                                      |       | 768                                                                      |       | 1,358                                                                    |       | 2,034                                                                   |       | 2,631                                                                   |       |
| Interest rate  swap                                          |       | (285                                                                     | )          | (26                                                                      | )          | (476                                                                    | )          | (25                                                                     | )          |
| Total interest  expense                                      |       | 107,027                                                                  |       | 53,558                                                                   |       | 232,148                                                                 |       | 123,318                                                                 |       |
| Interest expense  to affiliates                              |       | 21,148                                                                   |       | —                                                                   |       | 29,404                                                                  |       | —                                                                  |       |
| Provision for  loan losses                                   |       | 25,000                                                                   |       | —                                                                   |       | 25,000                                                                  |       | —                                                                  |       |
| Net investment  income                                       |       | $                                                                        | 26,186     |                                                                     | $          | 39,050                                                                  |       | $                                                                       | 99,566     |   | $ | 104,927 |   |

 

As presented in the table above, our net investmentincome decreased by $12.9 million and $5.4 million for the three and ninemonths ended September 30, 2007 compared to the three and nine months endedSeptember 30, 2006. Net investment income in the table above does not includeequity in income of unconsolidated affiliate of nil and $12.7 million for thethree and nine months ended September 30, 2007, respectively. Equity in incomeof unconsolidated affiliate totaled $0.1 million for each of the three and ninemonth periods ended September 30, 2006. Equity in income of unconsolidatedaffiliate reflects our pro rata interest in the net income of a limited partnershipthat was formed to hold the subordinated interests in three entities formed toexecute secured financing transactions in the form of collateralized loanobligations (“CLOs”). On May 22, 2007, we closed CLO 2007-1 which includes thethree entities previously held by our unconsolidated affiliate. We hold themajority of the economic returns of CLO 2007-1, and therefore consolidate thisentity under GAAP because we are the primary beneficiary. Additionally, we holdthe majority of the economic returns of KKR Financial CLO 2007-4, Ltd. (“CLO2007-4”) and KKR Financial CLO 2008-1, Ltd. (“CLO 2008-1”), which are twoadditional structured finance vehicles that were formed to execute CLOtransactions. As we are the primary beneficiary of these entities, we consolidatethem in accordance with GAAP. The minority economic interest in the returns ofCLO 2007-1, CLO 2007-4 and CLO 2008-1 are owned by KKR Strategic Capital Funds.Interest expense to affiliates represents the net returns generated by CLO2007-1, CLO 2007-4 and CLO 2008-1 that are attributable to the KKR StrategicCapital Funds.

 

Included in net investment income for the three andnine months ended September 30, 2007 is a provision for loan losses of $25.0million related to our corporate loan portfolio. This provision is for lossesthat we have estimated as being probable, but unrealized, in our corporate loanportfolio as of September 30, 2007.

 

34

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*Other Income*

 

The following table presents the components of ourother income for the three and nine months ended September 30, 2007 andSeptember 30, 2006:

 

**ComparativeOther Income Components (Amounts in thousands)**

 
| ** **                                                                     | ** ** | **For the three  months ended  September 30,  2007** | ** ** | **For the three  months ended  September 30,  2006** | ** ** | **For the nine  months ended  September 30,  2007** | ** ** | **For the nine  months ended  September 30,  2006** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| Net realized and  unrealized (loss) gain on derivatives and foreign exchange:  |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Interest rate  swaptions                                                       |       | $                                                                        | 15         |                                                                     | $          | (113                                                                    | )          | $                                                                       | 15         |   | $ | (55 | ) |
| Interest rate  swaps                                                           |       | (822                                                                     | )          | (152                                                                     | )          | (822                                                                    | )          | —                                                                  |       |
| Credit default  swaps                                                          |       | 1,424                                                                    |       | (460                                                                     | )          | 2,397                                                                   |       | (384                                                                    | )          |
| Total rate of  return swaps                                                    |       | (16,834                                                                  | )          | 1,222                                                                    |       | (4,465                                                                  | )          | 2,929                                                                   |       |
| Common stock  warrants                                                         |       | 145                                                                      |       | —                                                                   |       | 432                                                                     |       | —                                                                  |       |
| Foreign exchange  translation                                                  |       | 31                                                                       |       | (140                                                                     | )          | 21                                                                      |       | 1,176                                                                   |       |
| Total realized  and unrealized (loss) gain on derivatives and foreign exchange |       | (16,041                                                                  | )          | 357                                                                      |       | (2,422                                                                  | )          | 3,666                                                                   |       |
| Net realized  gain on investments                                              |       | 53,400                                                                   |       | 2,781                                                                    |       | 87,164                                                                  |       | 4,922                                                                   |       |
| Net realized and  unrealized gain on securities sold, not yet purchased        |       | 2,220                                                                    |       | —                                                                   |       | 2,795                                                                   |       | 52                                                                      |       |
| Other income                                                                   |       | 2,759                                                                    |       | 2,270                                                                    |       | 7,347                                                                   |       | 2,890                                                                   |       |
| Total other  income                                                            |       | $                                                                        | 42,338     |                                                                     | $          | 5,408                                                                   |       | $                                                                       | 94,884     |   | $ | 11,530 |   |

 

As presented in the table above, other income totaled$42.3 million and $94.9 million for the three and nine months endedSeptember 30, 2007, respectively, as compared to $5.4 million and $11.5 millionfor the three and nine months ended September 30, 2006, respectively. Theincrease in total other income is primarily attributable to approximately $51.6million of net realized gains on the sale of seven private equity investments,partially offset by unrealized losses related to total rate of return swaps.

 

*Non-Investment Expenses*

 

The following table presents the components of ournon-investment expenses for the three and nine months ended September 30, 2007and September 30, 2006:

 

**ComparativeNon-Investment Expense Components (Amounts in thousands)**

 
| ** **                                      | ** ** | **For the three  months ended  September 30,  2007** | ** ** | **For the three  months ended  September 30,  2006** | ** ** | **For the nine  months ended  September 30,  2007** | ** ** | **For the nine  months ended  September 30,  2006** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| Related party  management compensation:         |       |                                                                     |       |                                                                     |       |                                                                    |       |                                                                    |       |
| Base management  fees                           |       | $                                                                        | 8,229      |                                                                     | $          | 7,218                                                                   |       | $                                                                       | 22,502     |   | $ | 21,591 |   |
| Incentive fee                                   |       | —                                                                   |       | 2,498                                                                    |       | 12,620                                                                  |       | 4,766                                                                   |       |
| Share-based  compensation                       |       | (4,581                                                                   | )          | 10,043                                                                   |       | 1,897                                                                   |       | 21,620                                                                  |       |
| CLO management fees                             |       | 1,277                                                                    |       | —                                                                   |       | 2,319                                                                   |       | —                                                                  |       |
| Related party  management compensation          |       | 4,925                                                                    |       | 19,759                                                                   |       | 39,338                                                                  |       | 47,977                                                                  |       |
| General,  administrative and directors expenses |       | 3,842                                                                    |       | 3,304                                                                    |       | 14,094                                                                  |       | 8,664                                                                   |       |
| Professional  services                          |       | 2,195                                                                    |       | 1,095                                                                    |       | 3,495                                                                   |       | 2,584                                                                   |       |
| Total non-investment  expenses                  |       | $                                                                        | 10,962     |                                                                     | $          | 24,158                                                                  |       | $                                                                       | 56,927     |   | $ | 59,225 |   |

 

As presented in the table above, our non-investmentexpenses decreased by $13.2 million and $2.3 million for the three and ninemonths ended September 30, 2007, respectively, compared to the three months andnine months ended September 30, 2006. The significant components ofnon-investment expense are described below.

 

Management compensation to related parties consists ofbase management fees payable to our Manager pursuant to the Management Agreement,incentive management fees, CLO management fees, and share-based compensationrelated to restricted common shares and common share options granted to ourManager. The base management fee payable was calculated in accordance with theManagement Agreement and is based on an annual rate of 1.75% times our “equity”as defined in the Management

 

35

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Agreement. Our Manager is also entitled to anincentive fee provided that our quarterly “net income,” as defined in theManagement Agreement, before the incentive fee exceeds a defined return hurdle.

 

General, administrative and directors expenses consistof expenses incurred by our Manager on our behalf that are reimbursable to ourManager pursuant to the Management Agreement. Professional services expensesconsist of legal, accounting and other professional services. The decrease innon-investment expense is primarily due to a decrease in share-basedcompensation related to the vesting of restricted common shares granted to ourManager in the three and nine months ending September 30, 2007 compared to thethree and nine months ending September 30, 2006.

 

*Income Tax Provision*

 

Weare no longer treated as a real-estate investment trust (“REIT”) for U.S. federal income tax purposes;however, we intend to be treated as a partnership, and not as an association orpublicly traded partnership that is taxable as a corporation, for U.S. federalincome tax purposes. Therefore, we are not subject to U.S. federal income taxat the entity-level, but are subject to limited state income taxes. Holders ofour shares will be required to take into account their allocable share of eachitem of our income, gain, loss, deduction, and credit for our taxable year endending within or with their taxable year.

 

The REIT Subsidiary, which is presented as adiscontinued operation for financial statement purposes, elected to be taxed asa REIT and we believe that it has complied with the provisions of the Code withrespect thereto. Accordingly, the REIT subsidiary is not subject to federalincome tax to the extent that its distributions to us satisfy the REITrequirements and certain asset, income and ownership tests, and recordkeepingrequirements are fulfilled.

 

KKR TRS Holdings Inc. (“TRS Inc.”), our domestictaxable corporate subsidiary, is taxed as a regular subchapter C corporationunder the provisions of the Code. TRS Inc. was formed to make, from time totime, certain investments that would not be REIT qualifying investments if madedirectly by us, and to earn income that would not be REIT qualifying income ifearned directly by us. For the three and nine months ending September 30, 2007,TRS Inc. had pre-tax net (loss) income of $(1.0) million and $1.1 million,respectively, and for the three and nine months ending September 30, 2007, theprovision for income taxes totaled $(0.5) million and $0.4 million,respectively. As of September 30, 2007, TRS Inc. had a net income taxreceivable of $1.2 million and a deferred tax liability of $0.2 million.

 

KKR Financial CLO 2005-1, Ltd., KKR Financial CLO2005-2, Ltd., KKR Financial CLO 2006-1 Ltd., CLO 2007-1, CLO 2007-4, and CLO2008-1 are foreign taxable corporate subsidiaries that were established tofacilitate securitization transactions, structured as secured financingtransactions, and KKR TRS Holdings, Ltd., is a foreign taxable corporatesubsidiary that was formed to make from time to time, certain foreigninvestments. They are organized as exempted companies incorporated with limitedliability under the laws of the Cayman Islands, and are generally exempt fromfederal and state income tax at the corporate entity level because theyrestrict their activities in the United States to trading in stock andsecurities for their own account. Therefore, despite their status as taxablecorporate subsidiaries, they generally will not be subject to corporate incometax in our financial statements on their earnings, and no provisions for incometaxes for the three and nine months ending September 30, 2007 were recorded;however, we are generally required to include their current taxable income inour calculation of taxable income allocable to shareholders.

 

**FinancialCondition**

 

**Summary**

 

The tables below summarize the carrying value,amortized cost, and estimated fair value of our investment portfolio as ofSeptember 30, 2007 and December 31, 2006, classified by interest rate type.Carrying value is the value that investments are recorded at on our condensedconsolidated balance sheets and is estimated fair value for securities, amortizedcost for corporate and commercial real estate loans held for investment and thelower of amortized cost or estimated fair value for loans held for sale.Estimated fair values set forth in the tables below are based on dealer quotesand/or nationally recognized pricing services.

 

 

36

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The table below summarizes our investment portfolio asof September 30, 2007 classified by interest rate type:

 

**InvestmentPortfolio(Dollar amounts in thousands)**
| ** **                                             | ** ** | **Carrying Value** | ** ** | **Amortized Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Portfolio Mix %  by Fair Value** | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|--------------------------------|------------|--------------------------------------------------------|------------|
| **Floating  Rate:**                                    |       |                    |       |                    |       |                           |       |                                                   |       |
| Corporate Loans                                        |       | $                       | 6,820,571  |                    | $          | 6,820,571                      |       | $                                                      | 6,689,048  |   | 79.3 | % |
| Corporate Debt  Securities                             |       | 220,974                 |       | 234,776                 |       | 220,974                        |       | 2.6                                                    |       |
| Commercial Real  Estate Loans                          |       | 114,248                 |       | 114,248                 |       | 112,963                        |       | 1.3                                                    |       |
| Total Floating Rate                                    |       | 7,155,793               |       | 7,169,595               |       | 7,022,985                      |       | 83.2                                                   |       |
| **Fixed  Rate:**                                       |       |                    |       |                    |       |                           |       |                                                   |       |
| Corporate Loans                                        |       | 164,912                 |       | 164,912                 |       | 163,548                        |       | 1.9                                                    |       |
| Corporate Debt  Securities                             |       | 1,160,391               |       | 1,210,314               |       | 1,160,391                      |       | 13.8                                                   |       |
| Commercial Real  Estate Debt Securities                |       | 30,882                  |       | 32,000                  |       | 30,882                         |       | 0.4                                                    |       |
| Total Fixed Rate                                       |       | 1,356,185               |       | 1,407,226               |       | 1,354,821                      |       | 16.1                                                   |       |
| **Marketable  and Non-Marketable Equity Securities:**  |       |                    |       |                    |       |                           |       |                                                   |       |
| Common and  Preferred Stock                            |       | 41,315                  |       | 45,821                  |       | 41,315                         |       | 0.5                                                    |       |
| Non-Marketable  Equity Securities                      |       | 20,084                  |       | 20,084                  |       | 20,084                         |       | 0.2                                                    |       |
| Total Marketable  and Non-Marketable Equity Securities |       | 61,399                  |       | 65,905                  |       | 61,399                         |       | 0.7                                                    |       |
| Total (1)                                              |       | $                       | 8,573,377  |                    | $          | 8,642,726                      |       | $                                                      | 8,439,205  |   | 100.0 | % |

 

----

(1)       Total carrying value excludes allowancefor loan losses of $25.0 million.

 

The schedule above excludes equity securities sold,not yet purchased, with an amortized cost of $67.2 million as of September 30,2007 and for which the Company had accumulated net unrealized losses of $2.5million.

 

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

 

**InvestmentPortfolio(Dollar amounts in thousands)**

 
| ** **                                             | ** ** | **Carrying Value** | ** ** | **Amortized Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Portfolio Mix %  by Fair Value** | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|--------------------------------|------------|--------------------------------------------------------|------------|
| **Floating  Rate:**                                    |       |                    |       |                    |       |                           |       |                                                   |       |
| Corporate Loans                                        |       | $                       | 3,200,567  |                    | $          | 3,200,567                      |       | $                                                      | 3,221,334  |   | 71.8 | % |
| Corporate Debt  Securities                             |       | 357,696                 |       | 344,650                 |       | 357,696                        |       | 8.0                                                    |       |
| Commercial Real  Estate Loans                          |       | 108,693                 |       | 108,693                 |       | 109,192                        |       | 2.4                                                    |       |
| Total Floating  Rate                                   |       | 3,666,956               |       | 3,653,910               |       | 3,688,222                      |       | 82.2                                                   |       |
| **Fixed  Rate:**                                       |       |                    |       |                    |       |                           |       |                                                   |       |
| Corporate Loans                                        |       | 25,000                  |       | 25,000                  |       | 25,000                         |       | 0.6                                                    |       |
| Corporate Debt  Securities                             |       | 505,753                 |       | 486,321                 |       | 505,753                        |       | 11.3                                                   |       |
| Commercial Real  Estate Debt Securities                |       | 32,023                  |       | 32,000                  |       | 32,023                         |       | 0.7                                                    |       |
| Total Fixed Rate                                       |       | 562,776                 |       | 543,321                 |       | 562,776                        |       | 12.6                                                   |       |
| **Marketable  and Non-Marketable Equity Securities:**  |       |                    |       |                    |       |                           |       |                                                   |       |
| Common and  Preferred Stock                            |       | 68,968                  |       | 68,113                  |       | 68,968                         |       | 1.5                                                    |       |
| Non-Marketable  Equity Securities                      |       | 166,323                 |       | 166,323                 |       | 166,323                        |       | 3.7                                                    |       |
| Total Marketable  and Non-Marketable Equity Securities |       | 235,291                 |       | 234,436                 |       | 235,291                        |       | 5.2                                                    |       |
| Total                                                  |       | $                       | 4,465,023  |                    | $          | 4,431,667                      |       | $                                                      | 4,486,289  |   | 100.0 | % |

 

 

37

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**AssetQuality**

 

*Asset Quality Review*

 

We evaluate and monitor the asset quality of ourinvestment portfolio by performing detailed credit reviews and by monitoringkey credit statistics and trends. We monitor the credit rating of ourinvestment portfolio through the use of both Moody’s Investor Services, Inc. (“Moody’s”)and Standard & Poor’s Ratings Service (“Standard & Poor’s”)ratings, and Moody’s weighted average rating factor, or WARF. WARF is thequantitative equivalent of Moody’s traditional rating categories (e.g., Ba1,Ba2, etc.) and is used by Moody’s in its credit enhancement calculations forsecuritization transactions. By monitoring both Moody’s and Standard &Poor’s ratings and Moody’s WARF we can monitor trends and changes in the creditratings of our investment portfolio.

 

*Investment Securities*

 

The following table summarizes the par value of ourdebt investment securities portfolio by investment class stratified by Moody’sand Standard & Poor’s ratings category as of September 30, 2007:

 

**InvestmentSecurities(Amounts in thousands)**

** **
| **Ratings Category**    | ** ** | **Corporate  Debt  Securities** | ** ** | **Commercial  Real Estate Debt  Securities** | ** ** | **Total** | ** ** |
|------------------------------|------------|---------------------------------|------------|--------------------------------------------------------|------------|-----------|------------|
| Aaa/AAA                      |       | $                               | —     |                                                   | $          | —    |       | $ | — |   |
| Aa1/AA+ through  Aa3/AA-     |       | —                          |       | —                                                 |       | —    |       |
| A1/A+ through  A3/A-         |       | —                          |       | —                                                 |       | —    |       |
| Baa1/BBB+  through Baa3/BBB- |       | —                          |       | —                                                 |       | —    |       |
| Ba1/BB+ through  Ba3/BB-     |       | 204,500                         |       | 32,000                                                 |       | 236,500   |       |
| B1/B+ through  B3/B-         |       | 449,065                         |       | —                                                 |       | 449,065   |       |
| Caa1/CCC+ and  lower         |       | 778,500                         |       | —                                                 |       | 778,500   |       |
| Non-Rated                    |       | 36,681                          |       | —                                                 |       | 36,681    |       |
| Total                        |       | $                               | 1,468,746  |                                                   | $          | 32,000    |       | $ | 1,500,746 |   |

 

The following table summarizes the par value of ourdebt investment securities portfolio by investment class stratified by Moody’sand Standard & Poor’s ratings category as of December 31, 2006:

 

**InvestmentSecurities(Amounts in thousands)**

** **
| **Ratings Category**    | ** ** | **Corporate  Debt  Securities** | ** ** | **Commercial  Real Estate Debt  Securities** | ** ** | **Total** | ** ** |
|------------------------------|------------|---------------------------------|------------|--------------------------------------------------------|------------|-----------|------------|
| Aaa/AAA                      |       | $                               | —     |                                                   | $          | —    |       | $ | — |   |
| Aa1/AA+ through  Aa3/AA-     |       | —                          |       | —                                                 |       | —    |       |
| A1/A+ through A3/A-          |       | —                          |       | —                                                 |       | —    |       |
| Baa1/BBB+  through Baa3/BBB- |       | 21,071                          |       | 18,000                                                 |       | 39,071    |       |
| Ba1/BB+ through  Ba3/BB-     |       | 160,500                         |       | 14,000                                                 |       | 174,500   |       |
| B1/B+ through  B3/B-         |       | 370,315                         |       | —                                                 |       | 370,315   |       |
| Caa1/CCC+ and  lower         |       | 208,505                         |       | —                                                 |       | 208,505   |       |
| Non-Rated                    |       | 86,500                          |       | —                                                 |       | 86,500    |       |
| Total                        |       | $                               | 846,891    |                                                   | $          | 32,000    |       | $ | 878,891 |   |

 

*Loans*

 

Our corporate loan portfolio totaled $7.0 billion asof September 30, 2007 and $3.2 billion as of December 31, 2006. Ourcorporate loan portfolio consists of debt obligations of corporations,partnerships and other entities in the form of first and second lien loans,mezzanine loans and bridge loans.

 

We performed an allowance for loan losses analysis asof September 30, 2007 and December 31, 2006, and we have made thedetermination that an allowance for loan losses of $25.0 million and nil wasrequired for our corporate loan portfolio as of September 30, 2007 andDecember 31, 2006, respectively.

 

38

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

 

**CorporateLoans(Amounts in thousands)**

 
| **Ratings Category**    | ** ** | **As of  September 30, 2007** | ** ** | **As of  December 31, 2006** | ** ** |
|------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                      |       | $                                            | —     |                                        | $          | — |   |
| Aa1/AA+ through  Aa3/AA-     |       | —                                       |       | —                                      |       |
| A1/A+ through  A3/A-         |       | —                                       |       | —                                      |       |
| Baa1/BBB+  through Baa3/BBB- |       | 63,246                                       |       | 77,326                                      |       |
| Ba1/BB+ through  Ba3/BB-     |       | 3,487,761                                    |       | 1,764,598                                   |       |
| B1/B+ through  B3/B-         |       | 2,620,959                                    |       | 1,153,856                                   |       |
| Caa1/CCC+ and  lower         |       | 373,284                                      |       | 93,340                                      |       |
| Non-Rated                    |       | 498,630                                      |       | 143,294                                     |       |
| Total                        |       | $                                            | 7,043,880  |                                        | $          | 3,232,414 |   |

 

Our commercial real estate loan portfolio totaled$114.2 million and $108.7 million as of September 30, 2007 andDecember 31, 2006, respectively.

 

We performed an allowance for loan losses analysis asof September 30, 2007 and December 31, 2006, and we have made thedetermination that no allowance for loan losses was required for our commercialreal estate loan portfolio as of September 30, 2007 and December 31, 2006.

 

The following table summarizes the par value of ourcommercial real estate loan portfolio stratified by Moody’s andStandard & Poor’s ratings category as of September 30, 2007 andDecember 31, 2006:

 

**Commercial RealEstate Loans(Amounts in thousands)**

** **
| **Ratings Category**    | ** ** | **As of  September 30, 2007** | ** ** | **As of  December 31, 2006** | ** ** |
|------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                      |       | $                                            | —     |                                        | $          | — |   |
| Aa1/AA+ through  Aa3/AA-     |       | —                                       |       | —                                      |       |
| A1/A+ through  A3/A-         |       | —                                       |       | —                                      |       |
| Baa1/BBB+  through Baa3/BBB- |       | —                                       |       | —                                      |       |
| Ba1/BB+ through  Ba3/BB-     |       | 15,000                                       |       | 2,908                                       |       |
| B1/B+ through  B3/B-         |       | 99,341                                       |       | 90,882                                      |       |
| Caa1/CCC+ and  lower         |       | —                                       |       | —                                      |       |
| Non-Rated                    |       | —                                       |       | 15,000                                      |       |
| Total                        |       | $                                            | 114,341    |                                        | $          | 108,790 |   |

 

 

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**AssetRepricing Characteristics**

 

*Summary*

 

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

 

**InvestmentPortfolio(Dollar amounts in thousands)**

 
| ** **                              | ** ** | **As of September 30, 2007** | ** ** | **As of December 31, 2006** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                              | ** ** | **Amortized Cost**                          | ** ** | **Portfolio Mix**                          | ** ** | **Amortized Cost** | ** ** | **Portfolio Mix** | ** ** |
| **Floating  Rate:**                     |       |                                             |       |                                            |       |   |   |   |   |
| Corporate Loans                         |       | $                                                | 6,820,571  |                                            | 79.5       | % | $ | 3,200,567 |   | 76.3 | % |
| Corporate Debt  Securities              |       | 234,776                                          |       | 2.7                                             |       | 344,650 |   | 8.2 |   |
| Commercial Real  Estate Loans           |       | 114,248                                          |       | 1.4                                             |       | 108,693 |   | 2.6 |   |
| Total Floating  Rate                    |       | 7,169,595                                        |       | 83.6                                            |       | 3,653,910 |   | 87.1 |   |
| **Fixed  Rate:**                        |       |                                             |       |                                            |       |   |   |   |   |
| Corporate Loans                         |       | 164,912                                          |       | 1.9                                             |       | 25,000 |   | 0.6 |   |
| Corporate Debt  Securities              |       | 1,210,314                                        |       | 14.1                                            |       | 486,321 |   | 11.6 |   |
| Commercial Real  Estate Debt Securities |       | 32,000                                           |       | 0.4                                             |       | 32,000 |   | 0.7 |   |
| Total Fixed Rate                        |       | 1,407,226                                        |       | 16.4                                            |       | 543,321 |   | 12.9 |   |
| Total                                   |       | $                                                | 8,576,821  |                                            | 100.0      | % | $ | 4,197,231 |   | 100.0 | % |

 

The table above excludes marketable equity securitieswith a fair value of $41.3 million and amortized cost of $45.8 million, andnon-marketable equity securities with a fair value of $20.1 million andamortized cost of $20.1 million as of September 30, 2007. The table above alsoexcludes marketable equity securities with a fair value of $69.0 million andamortized cost of $68.1 million, and non-marketable equity securities with afair value of $166.3 million and amortized cost of $166.3 million as of December 31,2006.

 

*Corporate Loans and Securities*

 

All of our floating rate corporate loans andsecurities have index reset frequencies of less than twelve months with themajority of the loans resetting at least quarterly. The weighted-average couponon our floating rate corporate loans and securities was 7.79% and 8.00% as ofSeptember 30, 2007 and December 31, 2006, respectively. As of September30, 2007 and December 31, 2006, the weighted-average years to maturity ofour floating rate corporate loans and securities was 5.8 years and6.0 years, respectively.

 

As of September 30, 2007, our fixed rate corporateloans and debt securities had a weighted average coupon of 10.31% and aweighted average years to maturity of 7.2 years, as compared to 9.75% and6.3 years, respectively, as of December 31, 2006.

 

*Commercial Real Estate Loans andSecurities*

 

All of our floating rate commercial real estate loanshave index reset frequencies of less than twelve months. The weighted-averagecoupon on our floating rate commercial real estate loans was 8.44% and 8.42% asof September 30, 2007 and December 31, 2006, respectively. As of September30, 2007 and December 31, 2006, the weighted-average years to maturity ofour floating rate commercial real estate loans was 1.7 years and2.5 years, respectively.

 

As of September 30, 2007, our fixed rate commercialreal estate securities had a weighted average coupon of 7.12% and a weighted-averageyears to maturity of 29.2 years, as compared to 7.12% and 29.9 years,respectively, as of December 31, 2006. As of September 30, 2007 and December31, 2006, we owned no fixed rate commercial real estate loans.

 

 

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** **

**PortfolioPurchases**

 

We purchased $2.2 billion and $5.1 billion paramount of investments during the three and nine months ended September 30,2007, compared to $1.1 billion and $2.6 billion for the three and nine monthsended September 30, 2006, respectively.

 

The table belowsummarizes our investment portfolio purchases for the periods indicated andincludes the par amount, or face amount, of the securities and loans that werepurchased:

 

**Investment Portfolio Purchases(Dollar amounts in thousands)**

** **
| ** **                         | ** ** | **Three months ended   September 30, 2007** | ** ** | **Three months ended   September 30, 2006** | ** ** | **Nine months ended   September 30, 2007** | ** ** | **Nine months ended   September 30, 2006** | ** ** |
|------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                         | ** ** | **Par Amount**                                                  | ** ** | **%**                                                                | ** ** | **Par Amount**                                                 | ** ** | **%**                                                               | ** ** | **Par Amount** | ** ** | **%** | ** ** | **Par Amount** | ** ** | **%** | ** ** |
| Securities:                        |       |                                                                 |       |                                                                 |       |                                                                |       |                                                                |       |   |   |   |   |   |   |   |   |
| Corporate Debt Securities          |       | $                                                                    | 184,500    |                                                                 | 8.4        | %                                                                   | $          | 167,500                                                             |       | 15.8 | % | $ | 942,500 |   | 18.4 | % | $ | 507,516 |   | 19.6 | % |
| Marketable Equity Securities       |       | 2,225                                                                |       | 0.1                                                                  |       | —                                                              |       | —                                                              |       | 42,859 |   | 0.8 |   | — |   | — |   |
| Non-Marketable Equity Securities   |       | 5,690                                                                |       | 0.2                                                                  |       | —                                                              |       | —                                                              |       | 13,190 |   | 0.3 |   | — |   | — |   |
| Total Securities Principal Balance |       | 192,415                                                              |       | 8.7                                                                  |       | 167,500                                                             |       | 15.8                                                                |       | 998,549 |   | 19.5 |   | 507,516 |   | 19.6 |   |
| Loans:                             |       |                                                                 |       |                                                                 |       |                                                                |       |                                                                |       |   |   |   |   |   |   |   |   |
| Corporate Loans                    |       | 2,013,571                                                            |       | 91.3                                                                 |       | 877,356                                                             |       | 82.6                                                                |       | 4,115,402 |   | 80.5 |   | 2,063,858 |   | 79.7 |   |
| Commercial Real Estate Loans       |       | —                                                               |       | —                                                               |       | 17,000                                                              |       | 1.6                                                                 |       | — |   | — |   | 17,000 |   | 0.7 |   |
| Total Loans Principal Balance      |       | 2,013,571                                                            |       | 91.3                                                                 |       | 894,356                                                             |       | 84.2                                                                |       | 4,115,402 |   | 80.5 |   | 2,080,858 |   | 80.4 |   |
| Grand Total Principal Balance      |       | $                                                                    | 2,205,986  |                                                                 | 100.0      | %                                                                   | $          | 1,061,856                                                           |       | 100.0 | % | $ | 5,113,951 |   | 100.0 | % | $ | 2,588,374 |   | 100.0 | % |

 

**            DiscontinuedOperations**

 

In August 2007, our Board ofDirectors approved a plan to exit our residential mortgage investmentoperations and sell our REIT Subsidiary. Accordingly, we have reported ourresidential mortgage investment operations, including the REIT Subsidiary, as adiscontinued operation for all periods presented. The assets and liabilities ofour residential mortgage investment operations consist primarily of investmentsin residential mortgage loans and securities, interest and principal receivablefrom our residential mortgage loans and securities, cash and restricted cashand equivalents balances, and debt and related interest payable consisting ofrepurchase agreements and secured liquidity notes that are used to financeinvestments in residential mortgage loans and securities. Investments inresidential mortgage loans and securities are accounted for at fair value as weelected the fair value option of accounting for our investments in residentialmortgage loans and securities as of January 1, 2007. Changes in the fair valueof residential mortgage loans and securities are included in (losses) incomefrom discontinued operations on our condensed consolidated statements ofoperations.

Our decision to exit theresidential mortgage investment operations business and sell our REITSubsidiary was based on various considerations including, but not limited to,the following: (i) our restructuring from a REIT to a publicly traded LLC whichenabled us to execute our core business of investing in corporate loans anddebt securities without having to invest in residential mortgage assets toqualify as a REIT; and (ii) the material adverse change in the mortgageindustry and associated liquidity crisis in the capital markets that aroseduring the third quarter of 2007, which resulted in us being unable to financeour residential mortgage investments on reasonable financial terms.

During the quarter endedSeptember 30, 2007, we sold approximately $5.2 billion of residential mortgage-backedsecurities and recognized a loss of approximately $65.0 million. Included inthe $5.2 billion sale of residential mortgage-backed securities that were soldwere approximately $3.4 billion of residential mortgage backed securities ratedAAA/Aaa that were issued by securitization trusts where we own the subordinateinterests. We consolidate these securitization trusts as we are the primarybeneficiary under FIN 46R, and as a result, the sales were accounted for on aconsolidated basis as issuances of residential mortgage-backed securities. Weelected the fair value option under SFAS No. 159 for the residentialmortgage-backed securities issued by the securitization trusts and thereforeare carrying mortgage-backed securities issued by securitization trusts at fairvalue with changes in fair value reflected in income (loss) from discontinuedoperations.

As of September 30, 2007,$0.6 billion of residential mortgage loans and $4.5 billion of residentialmortgage-backed securities were pledged as collateral for non-recourse securedliquidity notes issued by two asset-backed secured liquidity note conduitfacilities (the “Facilities”) that are accounted for as subsidiaries of theREIT Subsidiary as the REIT Subsidiary is the primary beneficiary of these entitiesunder FIN 46R. On October 18, 2007, we announced that the REIT Subsidiary hadconsummated a restructuring of the Facilities. Pursuant to the terms of therestructuring, the maturity date of the secured liquidity notes issued by theFacilities was extended with approximately 50% of the principal balance due onFebruary 15, 2008 and the remaining principal balance due on March 13,2008.  Under the terms of therestructuring, we continue to have the right, but not the obligation torepurchase or refinance the collateral which collateralizes the Facilities andpay off the Facilities prior to the scheduled maturity dates of the securedliquidity notes.

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During the quarter endedSeptember 30, 2007, we recorded a charge for discontinued operations ofapproximately $243.7 million. The components of this charge consists of anapproximate $199.9 million investment in the Facilities, a reserve of $36.5million for contingencies related to restructuring and anticipated future terminationof the Facilities, and an accrual for legal, accounting, and consulting fees ofapproximately $7.3 million.

Summarized financialinformation for discontinued operations is as follows (amounts in thousands): 

| ** **                              | ** ** | **As of  September 30, 2007** | ** ** | **As of  December 31, 2006** | ** ** |
|-----------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| Assets of discontinued  operations      |       | $                                            | 8,770,814  |                                        | $          | 12,743,069 |   |
| Liabilities of  discontinued operations |       | $                                            | 8,651,267  |                                        | $          | 12,090,678 |   |

 

(Loss) income from discontinued operations is as follows (amounts inthousands): 
| ** **                                  | ** ** | **Three months ended** | ** ** | **Three months ended** | ** ** | **Nine months ended**  | ** ** | **Nine months ended**  | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                  | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** |
| (Loss) income  from discontinued operations |       | $                                | (318,683   | )                                | $          | 11,855                           |       | $                                | (309,096   | ) | $ | 40,674 |   |
|                                             |            |                                  |            |                                  |            |                                  |            |                                  |            |  |  |  |  |

 

**Shareholders’ Equity**

 

Our shareholders’ equity at eachof September 30, 2007 and December 31, 2006 totaled $1.7 billion. Includedin our shareholders’ equity as of September 30, 2007 and December 31, 2006is accumulated other comprehensive (loss) income totaling $(72.8) million and$70.5 million, respectively.

 

              Ouraverage shareholders’ equity and return on average shareholders’ equity for thethree and nine months ended September 30, 2007 were $1.6 billion and(64.7)%, and $1.7 billion and (12.8)%, respectively. Our average shareholders’equity and return on average shareholders’ equity for the three and nine monthsended September 30, 2006 were $1.7 billion and 7.5%, and $1.7 billion and7.7%, respectively. Return on average shareholders’ equity is defined as netincome (loss) divided by weighted-average shareholders’ equity.

 

Our book value per common shareas of September 30, 2007 and December 31, 2006 was $15.01 and $21.42,respectively, and was computed based on 111,316,698 and 80,464,713 sharesissued and outstanding as September 30, 2007 and December 31, 2006,respectively.

 

On August 21, 2007, weconsummated a common share offering of 16.0 million common shares to sevenunaffiliated institutional investors in separately negotiated publictransactions registered under the Securities Act of 1933, as amended (the “1933Act”), at a price of $14.40 per share, which was the closing price of ourcommon shares on the New York Stock Exchange (“NYSE”) on August 17, 2007.Proceeds from the transaction totaled $230.4 million and we will use the net proceedsfor general corporate purposes.

 

On the same date, we announceda rights offering of our common shares of up to $270.0 million in which wedistributed non-transferable rights to subscribe for 18.75 million commonshares. Each holder of common shares received 0.19430 rights for each commonshare held at the close of business on August 30, 2007, the record date for therights offering. The subscription price for the common shares offered in therights offering was $14.40 per common share, which was the closing price of ourcommon shares on August 17, 2007. In connection with this rights offering,certain principals of KKR agreed to provide a backstop commitment to purchaseup to approximately $100.0 million of common shares at the price of $14.40 tothe extent the rights offering was not fully subscribed. The rights offeringexpired on September 19, 2007 and generated gross proceeds totaling $213.4million, which we will use for general corporate purposes. On October 2, 2007,certain principals of KKR purchased 3.9 million common shares pursuant to thebackstop commitment for proceeds generating $56.6 million, which we will usefor general corporate purposes.

 

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**Liquidity and Capital Resources**

 

We manage our liquidity withthe intention of maintaining the continuing ability to fund our operations andfulfill our commitments on a timely and cost-effective basis. Based on changesin our working capital, for any given period the cash flows provided byoperating activities may be less than the cumulative distributions paid on ourshares for such period and such shortfall, if any, may be funded through theissuance of unsecured indebtedness or through the borrowing of additionalamounts through the pledging of certain of our assets. Our Board of Directorsconsiders available liquidity when declaring distributions to shareholders.

 

Significant disruptions in theresidential mortgage and asset-backed commercial paper markets during the thirdquarter of 2007 had a material adverse impact on both the values and relatedfinancings of our investments in residential mortgage loans and mortgage-backedsecurities. In light of the adverse market conditions that occurred, we tookseveral steps as described in the “Executive Overview” above.

 

As a result of these steps, webelieve that our liquidity level and access to additional funding is in excessof that necessary to enable us to meet our anticipated liquidity requirementsincluding, but not limited to, funding our purchases of investments, requiredcash payments and additional collateral under our borrowings and our derivativetransactions, required periodic cash payments related to our derivativetransactions, payment of fees and expenses related to our Management Agreement,payment of general corporate expenses and general corporate capitalexpenditures and distributions to our shareholders. As of September 30, 2007,we owed our Manager $5.0 million for the payment of management fees andreimbursable expenses pursuant to the Management Agreement.

 

Any material event that impactscapital markets participants may impair our ability to access additionalliquidity. If our cash resources are at any time insufficient to satisfy ourliquidity requirements, we may have to sell assets or issue debt or additionalequity securities.

 

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 (possibly includingcommon shares and one or more classes of preferred shares), medium-term notes,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.

 

Any material event that impactscapital markets participants may also impair our ability to access additionalliquidity and we may therefore be required to sell some or all of our portfolioinvestments in order to maintain sufficient liquidity. Such sales may be atprices lower than the carrying value of our investments, which would result inour recognition of such losses and reduced income.

 

We have entered into variousfinancing and derivative transactions in the normal course of business whichcontain terms and conditions that include bilateral margin postingrequirements. During periods of increased adverse market volatility, we areexposed to the risk that we may have to post additional margin collateral,which may have a material adverse impact on our available liquidity. As aresult, our contingent liquidity reserves may not be sufficient in the event ofa material adverse change in the credit markets and related market price marketvolatility. For additional information, werefer you to both the risk factors previously disclosed in the Company’s Form10-K for the period ended December 31, 2006 and risk factors discussed underthe caption “Risk Factors” under Item 8.01 in the Current Report on Form 8-Kfiled by the Company with the Securities and Exchange Commission on June 1,2007.

 

We are no longer treated as aREIT for U.S. federal income tax purposes and, as a result, will not be subjectto the REIT requirement to make distributions to our shareholders, although wecurrently intend to distribute approximately 75% to 95% of our taxable incometo our shareholders. However, distributions by us must be approved by, and willbe subject to the sole discretion of, our Board of Directors and will besubject to various considerations including, but not limited to, our financialperformance, liquidity requirements, distribution restrictions contained in ourcurrent or future financing facilities, our distribution yield relative to ourpeers and other relevant factors identified by our Board of Directors.

 

We do not believe that the saleof the REIT Subsidiary or the exit of our residential mortgage investmentoperations will have a negative recurring impact on our liquidity.

 

43

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As described in the “Executive Overview” above, we recorded a chargetotaling $243.7 million related to the exit of our residential mortgageinvestment operations and the sale of the REIT Subsidiary which has or willreduce the Company’s liquidity by the amount of the charge.

 

**Sources ofFunds**

 

*SecuritizationTransactions*

* *

*On May 22, 2007, we closed CLO 2007-1, a $3.5 billion secured financingtransaction. We issued $2.4 billion of senior secured notes at par tounaffiliated investors with a weighted-average coupon of three-month LIBOR plus0.53% and issued $244.7 million of mezzanine notes and $186.6 million ofsubordinated notes to KKR Strategic Capital Funds.*

* *

*RepurchaseAgreements*

* *

Asof September 30, 2007, we had $2.3 billion outstanding on repurchasefacilities with seven counterparties with a weighted average effective rate of5.76% and a weighted average remaining term to maturity of 24 days. Due to thefact that we borrow under repurchase agreements based on the estimated fairvalue of our pledged investments and that changes in interest rates and creditspreads can negatively impact the valuation of our pledged investments, ourongoing ability to borrow under our repurchase facilities may be limited andour lenders may initiate margin calls in the event interest rates change or thevalue of our pledged securities declines as a result of adverse changes ininterest rates or credit spreads.

 

*SecuredCredit Facility*

* *

DuringJune 2006 our $275.0 million secured revolving credit facility matured andwas replaced with a $375.0 million three year senior secured revolving creditfacility. During September 2006, the facility was amended to increase thetotal commitment amount to $800.0 million with the option to further increasethe commitment amount to $900.0 million at any time so long as no default orevent of default on the facility has occurred and subject to addition of newlenders, increases in the commitments of existing lenders, or a combinationthereof. The new senior secured revolving credit facility matures inJune 2009 and consists of two tranches. Outstanding borrowings under thesenior secured revolving credit facility bear interest at either (i) analternate base rate per annum equal to the greater of (a) the prime ratein effect on such day, and (b) the federal funds rate in effect on suchday plus 0.50%, or (ii) an interest rate per annum equal to the LIBOR ratefor the applicable interest period plus 0.50% for borrowings under tranche A ofthe facility and 0.75% for borrowings under tranche B of the facility. As ofSeptember 30, 2007, we had $168.0 million in borrowings outstanding undertranche B of this facility. In connection with our restructuring transaction,the facility was further amended in May 2007 to add us and certain of ourwholly-owned subsidiaries as borrowers.

 

*JuniorSubordinated Notes*

* *

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

 

*Convertible Debt*

 

On July 23, 2007, we issued anaggregate of $300.0 million of 7.000% convertible notes maturing on July 15,2012 to qualified institutional buyers. The Notes represent seniorunsecured obligations of us and bear interest at the rate of 7.000% per year.Interest is payable semi-annually on January 15 and July 15 of each year,beginning January 15, 2008.

 

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

 

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common shares multiplied by theapplicable conversion rate; (iii) a holder may surrender for conversion any ofits Notes if those Notes have been called for redemption, at any time prior tothe redemption date, even if the Notes are not otherwise convertible at suchtime; and (iv) a holder may surrender any of its Notes for conversion if weengage in certain specified transactions, as defined in the indenture coveringthe Notes.

 

In connection with our commonshare rights offering during the third quarter, we adjusted the conversion ratefor our Notes pursuant to the governing indenture for the Notes. The newconversion price for the Notes is approximately $31.00 and was effectiveSeptember 21, 2007. The new conversion rate for each $1,000 principal amount ofNotes is 32.2581 of our common shares.

 

*Common Share Issuance*

 

As discussed above in “Shareholders’Equity”, on August 21, 2007, we consummated a common share offering withproceeds from the transaction totaling $230.4 million. On the same date, weannounced a rights offering of common shares to our common shareholders of upto $270.0 million. In connection with this rights offering, certain principalsof KKR agreed to provide a backstop commitment to purchase a certain amount ofcommon shares to the extent the rights offering was not fully subscribed. Therights offering expired on September 19, 2007 with proceeds totaling $270.0million, including $56.6 million of proceeds received from the backstopcommitment on October 2, 2007. The net proceeds received from the common share offeringand common share rights offering will be used for general corporate purposes.

 

*CapitalUtilization and Leverage*

* *

Asof September 30, 2007 and December 31, 2006, we had shareholders’ equitytotaling $1.7 billion, and our leverage was 5.0 times and 2.1 times equity,respectively.

 

*Off-Balance*Sheet Commitments

* *

TheCompany participates in certain financing arrangements, including revolvers anddelayed draw facilities, whereby the Company is committed to provide funding atthe discretion of the borrower up to a specific predetermined amount. As ofSeptember 30, 2007, the Company had unfunded financing commitments totaling$164.3 million.

 

**REIT Matters**

** **

As of September 30, 2007, webelieve that our REIT Subsidiary, presented as a discontinued operation,qualified as a REIT under the provisions of the Internal Revenue Code of 1986,as amended (the "Code"). The Code requires, among other things, thatat the end of each calendar quarter at least 75% of our REIT Subsidiary’s totalassets must be “real estate assets” as defined in the Code. The Code alsorequires that each year at least 75% of our REIT Subsidiary’s gross income comefrom real estate sources and 95% of our REIT Subsidiary’s gross income comefrom real estate sources and certain other passive sources itemized in theCode, such as dividends and interest. As of September 30, 2007, we believe thatour REIT Subsidiary was in compliance with such requirements. As of September30, 2007, we also believe that our REIT Subsidiary met all of the REITrequirements regarding the ownership of its common shares and the distributionof its taxable income. However, the sections of the Code and the correspondingU.S. Treasury Regulations that relate to qualification and taxation as a REITare highly technical and complex, and our REIT Subsidiary’s qualification andtaxation as a REIT depends upon its ability to meet various qualification testsimposed under the Code (such as those described above), including through itsactual annual operating results, asset composition, distribution levels anddiversity of share ownership. Accordingly, no assurance can be given that ourREIT Subsidiary has been organized and has operated, or will continue to beorganized and operated, in a manner so as to qualify or remain qualified as aREIT.

 

To maintain our REIT Subsidiary’sstatus as a REIT for federal income tax purposes, our REIT Subsidiary isrequired to distribute at least 90% of its REIT taxable income for each year.In addition, for each taxable year, to avoid certain federal excise taxes, ourREIT Subsidiary is required to declare and pay dividends amounting to certaindesignated percentages of our REIT Subsidiary’s taxable income by the end ofsuch taxable year. For the period covered by our calendar year 2006 federal taxreturn, we believe that our REIT Subsidiary met all of the distributionrequirements of a REIT.

 

**Exemption from Regulation under the Investment Company Act**

** **

We intend to conduct ouroperations so that we are not required to register as an investment companyunder the Investment Company Act. Our subsidiaries that issue collateralizedloan obligations (“CLOs”) generally will rely on Rule 3a-7, an exemption fromthe Investment Company Act provided for certain structured financing vehicles. Accordingly,each

 

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of our CLO subsidiaries thatrely on Rule 3a-7 is subject to an indenture that contains specific guidelinesand restrictions, including a prohibition on the CLO issuers from acquiring anddisposing of assets primarily for the purposes of recognizing gains ordecreasing losses resulting from market value changes. Certain sales andpurchases of assets may be made so long as the CLOs do not violate theguidelines contained in the indentures and are not based primarily on thechanges in market value. We can, however, continue to sell assets withoutlimitation if we believe the credit profile of the obligor will deteriorate. Theproceeds of permitted dispositions may be reinvested in collateral that isconsistent with the credit profile of the CLO under specific and predeterminedguidelines.

 

In addition, the combined valueof the investment securities issued by our subsidiaries that are excepted bySection 3(c)(1) or 3(c)(7) of the Investment Company Act, together with anyother investment securities we may own, may not exceed 40% of our total assetson an unconsolidated basis. This requirement limits the types of businesses inwhich we may engage through these subsidiaries.

 

**Quantitative and Qualitative Disclosures About Market Risk**

 

**Market Risks**

 

*CurrencyRisks*

 

From time to time, we may makeinvestments that are denominated in a foreign currency through which we may besubject to foreign currency exchange risk.

 

*InflationRisks*

 

Our investment portfoliocomprises the majority of our assets and our investments are financial innature. Changes in interest rates and credit spreads may have a materialadverse impact on our financial condition, results of operations and liquidity.Changes in interest rates do not necessarily correlate with inflation rates orchanges in inflation rates.

 

*Interest RateRisk*

 

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

 

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

 

Interest rate risk impacts ourinterest income, interest expense, prepayments, and the fair value of ourinvestments, interest rate derivatives, and liabilities. We manage interestrate risk and make interest rate risk decisions by evaluating our projectedearnings under selected interest rate scenarios. We also use static measures ofinterest rate risk including duration. During periods of increasing interestrates we are biased to purchase investments that are floating rate and we havehad that bias since our inception. We manage our interest rate risk usingvarious techniques ranging from the purchase of floating rate

 

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investments to the use of interest rate derivatives. We generally fundour floating rate investments with floating rate borrowings with similarinterest rate reset frequencies. We generally fund our fixed rate investmentswith short-term floating rate borrowings and we may use interest ratederivatives to hedge the variability of the cash flows associated with ourexisting or forecasted floating rate borrowings. Hedging activities are complexand accounting for interest rate derivatives as fair value or cash flow hedgesin accordance with SFAS No. 133 is difficult.

 

Prepayments will impact theaverage lives of our fixed rate and hybrid investments and, as a result, we areexposed to the risk that the amount of floating rate borrowings that we haveswapped from floating rate to fixed rate is materially different than weexpected because the average life of the fixed rate investment has eitherextended or contracted. If the difference is material, we may have to adjustthe amount of our interest rate derivative position and such action couldgenerate a loss if we terminated any of the interest rate derivatives or it maynegatively impact our future earnings if we have to increase our interest ratederivative positions because the average lives of our investments haveextended.

 

The following table summarizesthe estimated net fair value of our derivative instruments held at September30, 2007 and December 31, 2006 (amounts in thousands):

 

**DerivativeFair Value**

** **
| ** **                      | ** ** | **As of   September 30, 2007** | ** ** | **As of   December 31, 2006** | ** ** |
|---------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                      | ** ** | **Notional**                                       | ** ** | **Fair Value**                               | ** ** | **Notional** | ** ** | **Fair Value** | ** ** |
| **Cash Flow Hedges:**           |       |                                               |       |                                              |       |   |   |   |   |
| Interest rate swaps             |       | $                                                  | 383,333    |                                              | $          | (3,114 | ) | $ | 150,000 |   | $ | (1,711 | ) |
| **Fair Value Hedges:**          |       |                                               |       |                                              |       |   |   |   |   |
| Interest rate swaps             |       | 32,000                                             |       | (334                                              | )          | 32,000 |   | 13 |   |
| **Free-Standing Derivatives:**  |       |                                               |       |                                              |       |   |   |   |   |
| Interest rate swaptions         |       | —                                             |       | —                                            |       | 31,000 |   | 75 |   |
| Interest rate swaps             |       | 150,000                                            |       | 640                                               |       | — |   | — |   |
| Credit default swaps—long  |       | 66,000                                             |       | 274                                               |       | 3,000 |   | 179 |   |
| Credit default swaps—short |       | 273,000                                            |       | 6,521                                             |       | 275,000 |   | (797 | ) |
| Total rate of return swaps      |       | 445,811                                            |       | (16,141                                           | )          | 222,647 |   | 2,343 |   |
| Common stock warrants           |       | —                                             |       | 432                                               |       | — |   | — |   |
| Net fair value                  |       | $                                                  | 1,350,144  |                                              | $          | (11,722 | ) | $ | 713,647 |   | $ | 102 |   |

 

*RiskManagement*

 

We seek to manage our interestrate risk exposure to protect our investment portfolio and related borrowingsagainst the effects of major interest rate changes. We generally seek to manageour interest rate risk by:

 

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

 

•         Monitoring and adjusting, if necessary, thereset index and interest rates related to our investments and our borrowings;

 

•         Attempting to structure our borrowing agreementsto have a range of different maturities, terms, amortizations and interest rateadjustment periods; and

 

•         Using interest rate derivatives to adjust theinterest rate sensitivity of our investment portfolio and our borrowings.

 

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

** **

See discussion of quantitativeand qualitative disclosures about market risk in “Quantitative and QualitativeDisclosures About Market Risk” section of Management’s Discussion and Analysisof Financial Condition and Results of Operations.

 

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**Item 4.**                          Controls and Procedures

** **

The Company’s managementevaluated, with the participation of the Company’s principal executive andprincipal financial officer, the effectiveness of the Company’s disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”)) as ofSeptember 30, 2007. Based on their evaluation, the Company’s principalexecutive and principal financial officer concluded that the Company’sdisclosure controls and procedures as of September 30, 2007 were designed andwere functioning effectively to provide reasonable assurance that theinformation required to be disclosed by the Company in reports filed under theExchange Act is (i) recorded, processed, summarized, and reported withinthe time periods specified in the SEC’s rules and forms, and(ii) accumulated and communicated to management, including the principalexecutive and principal financial officers, as appropriate, to allow timelydecisions regarding disclosure.

 

There has been no change in theCompany’s internal control over financial reporting (as defined in Rules13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the Company’sthree and nine months ending September 30, 2007, that has materially affected,or is reasonably likely to materially affect, the Company’s internal controlover financial reporting.

 

**PART II. OTHER INFORMATION**

 

**Item 1.**                          *Legal Proceedings*

** **

None.

 

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

** **

In addition to risk factorsdisclosed in our Annual Report on Form 10-K for the fiscal year ended December31, 2006 (see Part I, Item IA), set forth in this section is an additional riskfactor we currently believe would be applicable to our operation and businessstrategy.

 

***Periods of adverse market volatilitycould adversely affect our liquidity.***

 

Duringperiods of increased adverse market volatility, such as the recent disruptionin the residential mortgage and global asset-backed commercial paper market, weare exposed to the risk that we may have to post additional margin collateral,which may have a material adverse impact on our available liquidity. As aresult, our contingent liquidity reserves may not be sufficient in the event ofa material adverse change in the credit markets and related market price marketvolatility.

 

**Item 2 *.******                       Unregistered Sales of Equity Securities and Useof Proceeds***

 

None.

 

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

** **

None.

 

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

** **

None.

 

**Item 5.**                          *Other Information*

** **

None.

 

**Item 6.**                          *Exhibits*

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

 

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**SIGNATURES**

 

Pursuant to the requirements ofthe Securities Exchange Act of 1934, KKR Financial Holdings LLC has duly causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 
|                         |       | KKR  Financial Holdings LLC                                           |
|-------------------------|------------|-----------------------------------------------------------------------|
|                    |       |                                                                  |
| **Signature**           | ** ** | **Title**                                                             |
| ** **              | ** ** | ** **                                                            |
| /s/ SATURNINO S. FANLO  |       | Chief  Executive Officer (Principal Executive Officer)                |
| **Saturnino S. Fanlo**  | ** ** | ** **                                                            |
| ** **              | ** ** | ** **                                                            |
| /s/ JEFFREY B. VAN HORN |       | Chief  Financial Officer (Principal Financial and Accounting Officer) |
| **Jeffrey B. Van Horn** | ** ** | ** **                                                            |
| ** **              | ** ** | ** **                                                            |
| Date:  November 7, 2007 |       |                                                                  |

 

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