PART I

Item 1. BUSINESS

Our Company

We are a specialty finance company that invests in multiple asset classes and uses leverage to generate competitive leveraged risk-adjusted returns. We seek to achieve our investment objective by allocating capital primarily to the following asset classes: (i) residential mortgage loans and mortgage-backed securities; (ii) corporate loans and debt securities; (iii) commercial real estate loans and debt securities; and (iv) asset-backed securities. We also invest opportunistically in other types of investments from time to time, including investments in marketable and non-marketable equity securities.

Our objective is to provide competitive returns to our investors through a combination of dividends and capital appreciation. As part of our multi-asset class strategy, we seek to invest opportunistically in those asset classes that can generate favorable leveraged risk-adjusted returns, subject to maintaining our status as a real estate investment trust, or REIT, and our exemption from regulation under the Investment Company Act of 1940, or the Investment Company Act. The implementation of our multi-asset class strategy also diversifies our investment portfolio. Investing in multiple asset classes does not, however, reduce or eliminate many of the risks associated with our investment portfolio such as geographic concentration risk, asset class concentration risk, market risk and credit risk.

Our income is generated primarily from the difference between the interest and dividend income earned on our investments and the cost of our borrowings, plus (i) realized and unrealized gains and losses on our free-standing derivatives, (ii) realized gains and losses from the sales of investments, and (iii) fee income.

We are externally managed and advised by KKR Financial Advisors LLC pursuant to a management agreement. Our Manager is an affiliate of KKR, a leading sponsor of private equity funds and one of the oldest and most experienced private equity firms specializing in leveraged buyouts. Certain individuals associated with KKR serve on our board of directors and our Manager’s investment committee.

We are a Maryland corporation that is taxed as a REIT for federal income tax purposes. We were organized in July 2004 and completed our initial private placement of shares of our common stock in August 2004.

On June 29, 2005, we completed our initial public offering, or IPO, of 37,500,000 shares of our common stock and received approximately $848.8 million of net proceeds therefrom. Our common stock is listed on the NYSE under the symbol “KFN” and began trading on June 24, 2005.

Our Manager

We are externally managed and advised by KKR Financial Advisors LLC, an affiliate of KKR, pursuant to a management agreement. Our Manager was formed in July 2004. All of our executive officers are employees of our Manager or one or more of its affiliates. The executive offices of our Manager are located at Four Embarcadero Center, Suite 2050, San Francisco, California 94111 and the telephone number of our Manager’s executive offices is (415) 315-3620.

Pursuant to the terms of the management agreement, our Manager provides us with our management team, along with appropriate support personnel. Our Manager is responsible for our operations and performs all services and activities relating to the management of our assets, liabilities and operations. Our Manager is at all times subject to the direction of our board of directors and has only such functions and authority as we delegate to it. As of February 28, 2006, affiliates of our Manager had 44 employees.

Our Strategy

We seek to achieve our investment objective by allocating capital primarily to the following four targeted asset classes: (i) residential mortgage loans and mortgage-backed securities; (ii) corporate loans and debt securities; (iii) commercial real estate loans and debt securities; and (iv) asset-backed securities. We also invest opportunistically in other types of investments from time to time, including investments in marketable and non-marketable equity securities. Our objective is to provide competitive returns to our investors through a combination of dividends and capital appreciation. As part of our multi-asset class strategy, we seek to invest opportunistically in those asset classes that can generate favorable leveraged risk-adjusted returns, subject to maintaining our status as a REIT, and our exemption from regulation under the Investment Company Act. The implementation of our multi-asset class strategy also diversifies our investment portfolio. Investing in multiple asset classes does not, however, reduce or eliminate many of the risks associated with our investment portfolio such as geographic concentration risk, asset class concentration risk, market risk and credit risk.

Our Manager utilizes its access to the resources and professionals of KKR, along with the same philosophy of value creation KKR employs in managing private equity funds, in order to create a portfolio that is designed to provide competitive returns to investors. We make asset class allocation decisions based on various factors including: relative value, leveraged risk-adjusted returns, current and projected credit fundamentals, current and projected macroeconomic considerations, current and projected supply and demand, credit and market risk concentration considerations, liquidity, all-in cost of financing and financing availability, and maintaining our REIT status.

From time to time, we make certain investments, including debt, equity and derivative investments, utilizing KKR TRS Holdings, Inc., our domestic taxable REIT subsidiary. We will opportunistically pursue this strategy whenever we are constrained by the rules related to maintaining our REIT status and, in the case of non-real estate or derivative investments, whenever the projected returns on these investments, net of income taxes, are comparable to the projected leveraged risk-adjusted returns on investments made in the REIT. We are not required to distribute the earnings of our domestic taxable REIT subsidiary; accordingly, we may retain in our domestic taxable REIT subsidiary some or all of the net income earned by our domestic taxable REIT subsidiary.

We use leverage in order to increase potential returns to our stockholders. The use of leverage may also have the effect of increasing losses when economic conditions are unfavorable. Our investment policies require no minimum or maximum leverage and our Manager and its investment committee have the discretion, without the need for further approval by our board of directors, to increase the amount of leverage we incur above our targeted range.

Our strategy in each asset class is as follows:

Residential Mortgage Loans and Mortgage-Backed Securities. Our investments in this asset class principally consist of (i) adjustable rate and hybrid adjustable rate residential mortgage-backed securities, backed by prime and super-prime credit quality non-agency residential mortgages, (ii) agency-backed adjustable rate and hybrid adjustable rate residential mortgage-backed securities, and (iii) prime and super-prime credit quality adjustable rate or hybrid adjustable rate mortgage loans. We currently invest in prime and super-prime credit quality mortgage loans and non-agency mortgage-backed securities. We define “prime” credit quality as a mortgage where the borrower’s original FICO® score is between 680-710, and define “super-prime” credit quality as a mortgage where the borrower’s original FICO® score is greater than 710. We do own mortgage loans where the borrower’s original FICO® score is below 600. We do not currently invest in sub-prime or non-prime mortgage loans or mortgage-backed securities, although we may do so in the future. Hybrid adjustable rate mortgage-backed securities and mortgage loans have interest rates that have an initial fixed period (typically three, five, seven or ten years) and thereafter reset at regular intervals in a manner similar to adjustable rate mortgage-backed securities and

mortgage loans. Agency-backed securities include mortgage-backed securities, which represent the entire ownership interest in pools of mortgage loans secured by residential real property and are guaranteed as to principal and interest by federally chartered entities such as the Federal National Mortgage Association, better known as “Fannie Mae,” the Federal Home Loan Mortgage Corporation, better known as “Freddie Mac,” and, in the case of the Government National Mortgage Association, better known as “Ginnie Mae,” by the U.S. government. A majority of the residential mortgage-backed securities, or RMBS, in which we invest consists of non-agency adjustable rate and three- and five-year hybrid adjustable-rate mortgage-backed securities. We also invest in mortgage loans purchased directly from select financial institutions. We base our decision on whether to invest in adjustable rate or hybrid adjustable rate mortgage loans and mortgage-backed securities on various factors including, but not limited to, relative value, supply and demand, costs of hedging, forward London Inter-Bank Offered Rate, or LIBOR, interest rate volatility and the overall shape of the U.S. Treasury and interest rate swap yield curves.

The agency mortgage-backed securities market is very large; however, only a very small portion meets our investment criteria primarily due to the fact that (i) many of the agency mortgage-backed securities do not fulfill the “whole-loan” requirement of the Investment Company Act, and (ii) only a small portion of the market of agency mortgage-backed securities have market prices that meet our purchase price objectives given our bias of minimizing purchase premiums on investments with prepayment risk or no call protection. Accordingly, we may not be able to find sufficient quantities of RMBS to purchase in order to achieve our investment objectives.

Corporate Leveraged Loans and High Yield Securities. We invest in debt obligations of corporations, partnerships and other entities in the form of first and second lien loans, mezzanine loans and bridge facilities, which we collectively refer to as leveraged loans given the high proportion of debt typically in their capital structure, as well as in high yield debt securities. These entities may be owned by KKR and/or other private equity investors. Many of the leveraged loans and high yield securities in which we invest have an explicit rating from one or more nationally-recognized statistical rating agencies. The majority of our investments in leveraged loans and high yield securities are rated between Ba1 and B3 by Moody’s Investors Services, Inc., or Moody’s, and between BB+ and B- by Standard & Poor’s Ratings Service, or Standard & Poor’s. We also invest in leveraged loans and high yield securities that are rated below B3 by Moody’s and B- by Standard & Poor’s and/or that do not have an explicit rating from one or more nationally-recognized statistical rating agencies.

Commercial Real Estate Debt. We invest in debt secured by commercial real estate or issued by owners or operators of commercial real estate properties. These investments include commercial mortgage-backed securities, or CMBS, mezzanine loans, bridge loans and debt and preferred stock issued by public and private commercial real estate companies and REITs. Most of the CMBS in which we invest are rated between A1 and B3 by Moody’s and between A+ and B- by Standard & Poor’s and most of the mezzanine loans and bridge loans in which we invest are rated B3 or lower by Moody’s and B- or lower by Standard & Poor’s and/or may not have an explicit rating from one or more nationally-recognized statistical rating agencies.

Asset-Backed Securities. We invest in investment grade and non-investment grade asset-backed securities. We also make investments in investment grade and non-investment grade collateralized debt obligations, or CDOs, and collateralized loan obligations, or CLOs, backed by high yield securities, corporate leveraged loans, CMBS, and/or asset-backed securities. Most of the asset-backed securities in which we invest are rated between A1 and B1 by Moody’s and between A+ and B+ by Standard & Poor’s.

Marketable and Non-Marketable Equity Securities. To a lesser extent, subject to maintaining our qualification as a REIT, invest from time to time in common stock and preferred stock of private and public companies that may or may not be related to the real estate business. A material amount of our equity investments may include private equity investments in companies affiliated with KKR.

Our Investment Process

Our Manager evaluates each one of our investment opportunities based on its leveraged risk-adjusted return subject to our current investment guidelines. Our investment process is summarized as follows:

· asset allocation;

· investment sourcing and screening;

· credit research and due diligence;

· Investment Committee review and approval;

· recurring monitoring; and

· buy or sell based on price targets and relative value parameters.

Asset Allocation. Our Manager utilizes the same philosophy employed by KKR’s investment professionals in managing private equity funds with the objective of creating a portfolio that is designed to provide competitive leveraged risk-adjusted returns to our stockholders. Our Manager uses a combination of “top-down” and “bottom-up” analyses. Our top-down approach utilizes macro analysis of relative asset valuations, economic outlook, interest rate expectations, credit fundamentals and technical factors to target specific industries and asset classes. Our bottom-up approach includes rigorous analysis of credit, industry trends and dynamics and dislocation events to select specific credits in which to invest.

Investment Sourcing and Screening. Our Manager sources transactions through a variety of channels, including its relationships with KKR, corporate executives, commercial and investment banks, financial sponsors and intermediaries. The investment professionals of our Manager screen the sourced opportunities and make the decision whether to proceed to due diligence based on the industry, credit structure, relative value, and projected leveraged risk-adjusted return. We believe that our Manager’s investment selection process benefits from its access to the resources and professionals of KKR.

Credit Research and Due Diligence. When conducting due diligence, our Manager evaluates critical business and financial risk considerations, as well as tax, accounting, environmental and legal issues, in determining whether or not to proceed with an investment. The Manager’s investment evaluation utilizes a relative value framework and rigorous credit analysis focused on credit fundamentals rather than the momentum of the overall markets and emphasizes free cash flow computed under base and stress case scenarios, normalized levels of capital expenditures, stability of margins, structure, competitive position, management track record and industry trends.

Our Manager leverages KKR’s relationships with accountants, consultants, lawyers, investment banks and industry experts when conducting due diligence. In addition, when KKR has conducted due diligence prior to referring an investment opportunity to us, subject to KKR’s contractual obligations and applicable securities laws, our Manager may benefit from the due diligence already conducted by KKR.

Investment Committee Review and Approval. For each proposed investment, our Manager’s investment committee reviews each of our Manager’s investment memoranda and related financial projections for opportunities that have been previously evaluated and approved by the investment professionals of our Manager. Our Manager reviews potential investment opportunities and many investment opportunities are not pursued. For investment opportunities that fulfill our investment objectives the Manager prepares a credit memorandum summarizing the credit underwriting and due diligence performed and submits the credit memorandum to the investment committee. The investment memorandum summarizes the factors relevant to the specific investment, including pricing (including applicable interest and default rates), term, collateral (if any), financial condition and historical financial data, quality of issuer’s management team, leverage, debt service coverage, covenants, industry overview, competitive position within the industry, ratings, trends (company- and industry-specific) and other relevant information regarding the issuer and

includes a summary of the diligence performed by the investment professional in preparing the memorandum and evaluating the investment opportunity. Investment opportunities must receive a unanimous approval by the investment committee to be consummated.

Our Manager’s investment committee has approved a majority of the investments it has reviewed. The investment committee has decided on limited occasions, however, not to approve a specific investment based on concerns raised by members of the investment committee relating to the subject company, specific investment terms or industry. In addition, the investment committee has delayed certain investments subject to the performance of further satisfactory due diligence.

Our Manager’s investment committee reviews investment opportunities for us and for the entities established by us to implement our securitization financings, but not for any other clients of our Manager or any other KKR affiliates.

Monitoring. Our Manager monitors our portfolio using daily, quarterly and annual analyses in order to make decisions regarding the portfolio investments.

· Daily analysis includes morning market meetings, industry and company pricing runs, industry and company reports and discussions with KKR industry and operating company personnel on an as-needed basis;

· Quarterly analysis includes the preparation of quarterly operating results, reconciliation of actual results to projections, updates to the financial model (baseline and stress case) and investment committee portfolio review; and

· Annual analysis consists of the preparation of annual credit memoranda, review and sign-off of updated annual credit memoranda by the investment professionals of the Manager.

Buy and Sell Discipline. Our Manager does not make buy or sell decisions based on price momentum models or philosophy. Our Manager makes purchase and sale decisions based on achieving price targets, changes in credit fundamentals, changes in industry fundamentals, changes in management credibility, relative asset-class valuations, macro-economic factors and technical factors. Returns on our investments consist primarily of interest income, dividend income and related fees, as opposed to capital gains.

Investment Guidelines. We have established and comply with investment policies and procedures and investment guidelines that are reviewed and approved by our Manager’s investment committee and our board of directors. The investment committee meets as frequently as necessary in order for us to achieve our investment objectives. We review our investment portfolio and related compliance with our investment policies and procedures and investment guidelines at each regularly scheduled board of directors meeting.

Our board of directors and our Manager’s investment committee have adopted the following guidelines, among others, for our investments and borrowings:

· no investment shall be made that would cause us to fail to qualify as a REIT for federal income tax purposes;

· no investment shall be made that would cause us to be regulated as an investment company under the Investment Company Act;

· with the exception of real estate and lodging, no industry shall represent greater than 20% of the securities in our portfolio; and

· the maximum aggregate investment in non-securitized residential mortgages is limited to four times consolidated stockholders’ equity computed in accordance with GAAP.

These investment guidelines may be changed by a majority of our board of directors without the approval of our stockholders.

Our board of directors has also adopted a separate set of investment guidelines and procedures to govern our relationship with KKR. We have also adopted compliance policies to govern our interaction with KKR, including when KKR is in receipt of material non-public information.

Our Financing Strategy

We use leverage in order to increase potential returns to our stockholders. Our use of leverage may, however, also have the effect of increasing losses when economic conditions are unfavorable. As of December 31, 2005, our leverage was 8.1 times the amount of our equity. Our investment policies require no minimum or maximum leverage and our Manager and its investment committee will have the discretion, without the need for further approval by our board of directors, to increase the amount of our leverage.

We finance the majority of our residential mortgage loans and mortgage-backed security investments on a non-term financing basis through the use of repurchase agreements. With repurchase agreements, we borrow against mortgage loans, the mortgage-backed securities, high yield securities, asset-backed securities, and/or preferred stock securities we own. Under these agreements, we sell our mortgage loans, mortgage-backed securities, high yield securities, asset-backed securities, and/or preferred stock securities to a counterparty and agree to repurchase the same securities from the counterparty at a price equal to the original sales price plus an interest factor. These repurchase agreements are accounted for as debt, secured by the underlying assets. During the period of a repurchase agreement, we receive the principal and interest on the related collateral and pay interest to the counterparty.

Our repurchase agreement counterparties are commercial and investment banks with whom we have agreements in place that cover the terms of our transactions. All our repurchase agreement counterparties are approved by our Manager.

Asset-Backed Commercial Paper

In addition to using repurchase agreements, we finance a portion of our residential mortgage loans and residential mortgage-backed securities using our $5 billion asset-backed secured liquidity note facility that closed on September 30, 2005. This facility provides us with an alternative source of funding our residential mortgage-backed securities by issuing asset-backed secured liquidity notes that are rate A-1+, P-1, and F1+, by Standard and Poor’s, Moody’s, and Fitch Inc, respectively. Issuances of asset-backed secured liquidity notes are recorded as borrowings on our Consolidated Balance Sheet.

Warehouse Facilities

In addition to repurchase agreements and asset-backed secured liquidity notes, we rely on warehouse credit facilities for capital needed to fund our investments in adjustable rate and hybrid adjustable rate mortgage loans, commercial real estate loans, and leveraged loans. These facilities are typically lines of credit from commercial and investment banks that we can draw from to fund our investments. Warehouse facilities are typically collateralized loans made to investors who invest in securities and loans that in turn pledge the resulting securities and loans to the warehouse lender. Third-party custodians, usually banks, typically hold the securities and loans funded with the warehouse facility borrowings, including the securities, loans, notes, mortgages and other important loan documentation, for the benefit of the lender who is deemed to own the securities and loans and, if there is a default under the warehouse, for the benefit of the warehouse lender. We have established formal relationships with multiple counterparties for the purpose of maintaining financing relationships on favorable terms.

Collateralized Debt Obligations and Collateralized Loan Obligations

We finance our non-residential real estate assets on a term financing basis using collateralized debt obligations, or CDOs, collateralized loan obligations, or CLOs, and other match-funded financing

structures. CDOs and CLOs are multiple class debt securities, or bonds, secured by pools of assets, such as leveraged loans, high yield securities, commercial real estate loans, commercial real estate mortgage-backed securities and asset-backed securities. Like typical securitization structures, in a CDO and CLO (i) the assets are pledged to a trustee for the benefit of the holders of the bonds, (ii) one or more classes of the bonds are rated by one or more rating agencies and (iii) one or more classes of the bonds are marketed to a wide variety of fixed income investors, which enables the sponsor to achieve a relatively low cost of long-term financing. Unlike typical securitization structures, the underlying assets may be sold, subject to certain limitations, without a corresponding pay-down of the CDO and CLO provided the proceeds are reinvested in qualifying assets. As a result, CDOs and CLOs enable the sponsor to actively manage, subject to certain limitations, the pool of assets. We believe CDO and CLO financing structures are an appropriate term financing vehicle for our targeted non-residential real estate asset classes, because they enable us to obtain long-term cost of funds and minimize the risk that we have to refinance our liabilities prior to the maturities of our investments while giving us the flexibility to manage credit risk.

During the year ended December 31, 2005, we closed two $1.0 billion collateralized loan obligation transactions through which we have issued $1.5 billion in collateralized loan obligation senior secured notes to finance investments in corporate loans and securities.

Our Hedging and Interest Rate Risk Management Strategy

Repurchase agreements generally have maturities of 30 days and the weighted average life of the mortgage-backed securities we own is generally longer. The difference in maturities, in addition to reset dates and reference indices, creates potential interest rate risk.

We use interest rate derivatives to hedge all or a portion of our interest rate risk associated with our borrowings. The tax laws applicable to REITs generally restrict our ability to enter into hedging transactions.

We engage in a variety of interest rate management techniques that seek to mitigate changes in interest rates or potentially other influences on the values of our assets. Our interest rate management techniques may include:

· interest rate swaps;

· interest rate swaptions;

· interest cancelable swaps;

· interest rate caps;

· interest rate corridors;

· eurodollar futures contracts and options on such contracts; and

· other interest rate and non-interest rate derivatives.

These techniques may also be used in an attempt to protect us against declines in the market value of our assets that result from general trends in debt markets.

We enter into interest rate swap agreements to offset the potential adverse effects of rising interest rates under certain short-term borrowings. The interest rate swap agreements have historically been structured such that we receive payments based on a variable interest rate and make payments based on a fixed interest rate. The variable interest rate on which payments are received is calculated based on various reset mechanisms for LIBOR. The repurchase agreements generally have maturities of 30 days and carry interest rates that correspond to LIBOR rates for those same periods. The swap agreements are intended to fix our borrowing cost and are not held for speculative or trading purposes.

Interest rate management techniques do not eliminate interest rate and basis risk but seek to mitigate interest rate risk. For example, if both long-term and short-term interest rates were to increase significantly, it could be expected that:

· the weighted average life of the mortgage-backed securities would be extended because prepayments of the underlying mortgage loans would decrease; and

· the market value of fixed rate mortgage-backed securities would decline as long-term interest rates increased.

In order for our interest rate derivatives to qualify as fair value or cash flow hedges under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” or SFAS No. 133, we must fulfill many complex requirements including, but not limited to, hedge correlation requirements.

As stated above, our income is generated primarily from the net interest spread on our investment portfolio. Set forth below are factors that may adversely impact our net interest spread.

Match Funding. We expect to use long-term financing on a match funded basis to minimize interest rate risk in our portfolio. Match funding is the financing of our investments on a basis where the duration of the investments approximates the duration of the borrowings used to finance the investments. For any period during which our investment portfolio and related borrowings are not match funded, we may be exposed to the risk that our investment portfolio will reprice more slowly than the borrowings that we use to finance a significant portion of our investment portfolio. Increases in interest rates under these circumstances, particularly short-term interest rates on our short-term borrowings, may significantly adversely affect the net interest income that we earn on our investment portfolio.

Prepayments. Prepayment rates experienced on loans and securities in our investment portfolio may be influenced by changes in the overall level of interest rates, changes in the shape of the yield curve, and a variety of economic, geographic and other factors beyond our control, and consequently, we can not predict prepayment rates with certainty. The yield on our investment portfolio may be affected by the difference between the actual prepayment rates that we realize on our investment portfolio and the prepayment rates that we project on our investment portfolio.

Hedging. We use interest rate derivatives to hedge a portion of the interest rate risk associated with our borrowings. There are limitations to our ability to hedge all of the negative consequences associated with changes in interest rates and prepayment rates. Furthermore, we are subject to the costs associated with hedging which include the premiums paid for any interest rate derivatives and the cost of swapping floating rate borrowings to fixed rate borrowings.

Credit Losses. We will experience credit losses on our investment portfolio and such credit losses will have an adverse affect on our investment portfolio performance.

Leverage. We use borrowings to finance a significant portion of our investment portfolio. The use of leverage involves risks, including the risk that losses are materially increased or magnified and increasing liquidity risk in the event that one or more of our financing counterparties terminate our financings and/or require us to provide additional collateral to secure their financing facilities.

Investment Company Act Exemption

We operate our business so as to be exempt from regulation under the Investment Company Act. We monitor our portfolio of investments periodically to confirm that we and each of our subsidiaries continue to qualify for the applicable exemptions from the definition of an investment company under the Investment Company Act. We monitor our portfolio so that at least 55% of our assets are considered to be “qualifying real estate assets,” and so that at least an additional 25% of our investments constitute “real estate-related assets” or additional qualifying real estate assets, thereby allowing us to qualify for the

exemption from the definition of an investment company provided in Section 3(c)(5)(C) of the Investment Company Act. We measure and satisfy the tests with respect to our assets on an unconsolidated basis.

We generally expect that a substantial majority of our investments in mortgage loans, mortgage-backed securities and commercial real estate debt will be considered qualifying real estate assets under the Section 3(c)(5)(C) exemption from the Investment Company Act. We also generally expect that any RMBS or CMBS in which we invest that do not constitute qualifying real estate assets will constitute real estate-related assets. The treatment of CDOs, asset-backed securities, leveraged loans and stressed and distressed debt securities as qualifying real estate assets or real estate-related assets will be based on the characteristics of the underlying collateral and our rights with respect to the collateral, including whether we have foreclosure rights with respect to the underlying real estate collateral. We do not generally expect that our investments in corporate leveraged loans, mezzanine loans, high yield corporate bonds, asset-backed securities or private equity will constitute qualifying real estate assets or real estate-related assets.

Maintaining our exemption from regulation under the Investment Company Act limits our ability to make certain favorable investments.

Management Agreement

A management agreement governs the relationship between our Manager and us and describes the services to be provided by our Manager and its compensation for those services. Our Manager’s management of our business is under the direction of our board of directors and the management agreement requires our Manager to manage our business affairs in conformity with the policies and the investment guidelines that are approved and monitored by our board of directors. Among other things, our Manager is responsible for (i) the selection, purchase and sale of our portfolio investments, (ii) our financing and risk management activities, and (iii) providing us with investment advisory services.

The initial term of the management agreement expires on December 31, 2006 and is automatically renewed for a one-year term each anniversary date thereafter. Our independent directors review our Manager’s performance annually and, following the initial term, the management agreement may be terminated annually (upon 180 days notice) upon the affirmative vote of at least two-thirds of our independent directors, or by a vote of the holders of a majority of the outstanding shares of our common stock, based upon (i) unsatisfactory performance by the Manager that is materially detrimental to us or (ii) a determination that the management fees payable to our Manager are not fair, subject to our Manager’s right to prevent such a termination pursuant to clause (ii) by accepting a mutually acceptable reduction of management fees. Any such termination would require us to pay a substantial termination fee to our Manager.

We may also terminate the management agreement without payment of the termination fee with 30 days’ prior written notice for cause, which is defined as (i) our Manager’s continued material breach of any provision of the management agreement following a period of 30 days after written notice thereof, (ii) our Manager’s fraud, misappropriation of funds, or embezzlement against us, (iii) our Manager’s gross negligence in the performance of its duties under the management agreement, (iv) the commencement of any proceeding relating to our Manager’s bankruptcy or insolvency, (v) the dissolution of our Manager or (vi) a change of control of our Manager. Cause does not include unsatisfactory performance, even if that performance is materially detrimental to our business. Our Manager may terminate the management agreement, without payment of the termination fee, in the event we become regulated as an investment company under the Investment Company Act. Furthermore, our Manager may decline to renew the management agreement by providing us with 180 days written notice. Our Manager may also terminate the management agreement upon 60 days written notice if we default in the performance of any material term of the agreement and the default continues for a period of 30 days after written notice to us, whereupon we would be required to pay our Manager a termination fee.

Our Manager is entitled to receive a base management fee from us, incentive compensation based on certain performance criteria and a termination fee if we decide to terminate the management agreement without cause or if our Manager terminates the management agreement due to our default. We believe that the base management fee and incentive compensation that our Manager is entitled to receive are comparable to the base management fee and incentive compensation received by managers of comparable externally managed REITs. The following table summarizes the fees payable to our Manager pursuant to the management agreement:

Fee				Summary Description
Base Management Fee				The base management fee is payable monthly in arrears in an amount equal to 1¤12 of our equity (as defined in the management agreement) multiplied by 1.75%.
Incentive Fee				The incentive fee is payable quarterly in an amount equal to the product of: (i) 25% of the dollar amount by which (a) our Net Income, before the incentive fee, per weighted average share of common stock for such quarter, exceeds (b) an amount equal to the product of (A) the weighted average of the price per share of the common stock in our August 2004 private placement and the prices per share of our common stock in any subsequent offerings by us multiplied by (B) the greater of (1) 2.00% and (2) 0.50% plus one-fourth of the ten-year U.S. treasury rate for such quarter multiplied by (ii) the weighted average number of shares of common stock outstanding in such quarter. “Net Income” is determined by calculating the net income available to owners of common stock before non-cash equity compensation expense, computed in accordance with accounting principles generally accepted in the United States of America, or GAAP.
Termination Fee				A termination fee is payable by us for termination without cause or non-renewal by us of the management agreement or if our Manager terminates the management agreement due to our default and shall be equal to four times the sum of the average annual base management fee and the average annual incentive fee for the two 12-month periods immediately preceding the date of termination, calculated as of the end of the most recently completed fiscal quarter prior to the date of termination.

An affiliate of our Manager has entered into separate management agreements with the respective investment vehicles for each of our first two collateralized loan obligation transactions and is entitled to receive fees for the services performed as collateral manager. To date, the collateral manager has waived approximately $1.5 million of management fees payable to it from KKR Financial CLO 2005-1, Ltd., which covers the period commencing in March 2005 and ending in April 2006 and has waived approximately $0.8 million of management fees payable to it from KKR Financial CLO 2005-2, Ltd., which covers the period commencing November 2005 and ending in May 2006. The waivers for KKR Financial CLO 2005-1,

Ltd. and KKR Financial CLO 2005-2, Ltd., expire in April 2006 and May 2006, respectively, and there is no guarantee that the collateral manager will waive such management fees subsequent to those dates.

Competition

Our net income depends, in large part, on our ability to acquire assets at favorable spreads over our borrowing costs. A number of entities compete with us to make the types of investments that we plan to make. We compete with other REITs, financial companies, public and private funds, commercial and investment banks and commercial finance companies. For additional information concerning the competitive risks we face, see Item 1A., “Risk Factors—Risks Related to Our Operation and Business Strategy—We operate in a highly competitive market for investment opportunities.”

Staffing

We do not have any employees. We are managed by KKR Financial Advisors LLC, our Manager, pursuant to the management agreement between our Manager and us. Our Manager is 100% owned by KKR Financial LLC and all of our executive officers are employees and/or officers of KKR Financial LLC. As of February 28, 2006, KKR Financial LLC had 42 full-time employees and two founders.

As of February 28, 2006, a break-down of KKR Financial LLC’s 42 full-time employees and two founders by functional area is summarized in the table below:

Number of Individuals		Functional Area
2		Executive Management
15		Due Diligence, Investment Management and Asset-Liability Management
20		Finance, Information Systems, and Human Resources
7		Administration

Tax Status

We are taxed as a REIT for federal income tax purposes. To qualify as a REIT, we must meet various tax law requirements, including, among others, requirements relating to the nature of our assets, the sources of our income, the timing and amount of distributions that we make and the composition of our stockholders. As a REIT, we generally are not subject to federal income tax on income that we distribute to our stockholders on a current basis. If we fail to qualify as a REIT in any taxable year, we will be subject to federal income tax at regular corporate rates, and we may be precluded from qualifying as a REIT for the subsequent four taxable years following the year during which we lost our qualification. Further, even to the extent that we qualify as a REIT, we will be subject to tax at normal corporate rates on net income or capital gains not distributed to our stockholders, and we may be subject to other taxes, including payroll taxes, and state and local income, franchise, property, sales and other taxes. Moreover, our domestic taxable REIT subsidiary, including KKR TRS Holdings, Inc., is subject to federal income taxation and to various other taxes. Any dividends received from us, with limited exceptions, will not be eligible for taxation at the preferred capital gain rates that currently apply to dividends received by individuals, trusts and estates from taxable corporations.

Termination by us of the management agreement with our Manager without cause is difficult and costly.

The management agreement provides that it may only be terminated by us without cause annually after December 31, 2006 upon the affirmative vote of at least two-thirds of our independent directors, or by a vote of the holders of a majority of the outstanding shares of our common stock, based upon (1) unsatisfactory performance by our Manager that is materially detrimental to us or (2) a determination that the management fee payable to our Manager is not fair, subject to our Manager’s right to prevent such a termination under this clause (2) by accepting a mutually acceptable reduction of management fees. Our Manager will be provided 180 days’ prior notice of any such termination and will be paid a termination fee equal to four times the sum of the average annual base management fee and the average annual incentive fee for the two 12-month periods immediately preceding the date of termination, calculated as of the end of the most recently completed fiscal quarter prior to the date of termination. These provisions would result in substantial cost to us if we terminate the management agreement, thereby adversely affecting our ability to terminate our Manager without cause.

Certain of our investments may create a conflict of interest with KKR and other affiliates.

Subject to complying with our investment guidelines, our Manager may at times cause us to invest in corporate leveraged loans, high yield securities and equity securities of companies affiliated with KKR. To the extent KKR is the owner of all or a majority of the outstanding equity securities, KKR may have the ability to elect all of the members of the board of directors of a company we invest in and thereby control its policies and operations, including the appointment of management, future issuances of common stock or other securities, the payments of dividends, if any, on its common stock, the incurrence of debt by it, amendments to its certificate of incorporation and bylaws and entering into extraordinary transactions, and KKR’s interests may not in all cases be aligned with our interests. In addition, KKR may have an interest in pursuing acquisitions, divestitures and other transactions that, in their judgment, could enhance their equity investment, even though such transactions might involve risks to holders of indebtedness. For example, KKR could cause a company in which we invest to make acquisitions that increase its indebtedness or to sell revenue generating assets. In addition, with respect to companies in which we have an equity investment, to the extent that KKR is the controlling shareholder it will be able to determine the outcome of all matters requiring stockholder approval and will be able to cause or prevent a change of control of the company we invest in or a change in the composition of its board of directors and could preclude any unsolicited acquisition of that company regardless as to whether we agree with such determination. So long as KKR continues to own a significant amount of the voting power of a company we invest in, even if such amount is less than 50%, it will continue to influence strongly, or effectively control, that company’s decisions. As a result, our interests with respect to the management, investment decisions, or operations of those companies may at times be in direct conflict with those of KKR. In addition, to the extent that affiliates of our Manager or KKR invest in companies in which we have an investment, similar conflicts between our interests and theirs may arise.

We will compete with other investment entities affiliated with KKR for access to its investment professionals and principals.

KKR manages several private equity funds, and we believe that KKR and its affiliates will establish and manage other investment entities in the future. If any such investment entities have an investment focus similar to our focus, we may compete with those entities for access to the benefits that our relationship with KKR provides to us. In particular, during 2005 we entered into several private equity investments pursuant to which we are co-investing alongside KKR private equity funds. Our ability to continue to engage in these types of opportunities in the future depends, to a significant extent, on the contractual obligations that KKR has to the limited partners of its private equity funds with respect to co-investment opportunities as well as on competing demands for these investment opportunities by other investment entities established by KKR and its affiliates.

Our access to confidential information may restrict our ability to take action with respect to some investments, which, in turn, may negatively affect the potential return to stockholders.

We, directly or through our Manager, may obtain confidential information about the companies in which we have invested or may invest. If we do possess confidential information about such companies, there may be restrictions on our ability to make, dispose of, increase the amount of, or otherwise take action with respect to, an investment in those companies. Our relationship with KKR could create a conflict of interest to the extent our Manager becomes aware of inside information concerning investments or potential investment targets. We have implemented compliance procedures and practices designed to ensure that inside information is not used for making investment decisions on our behalf. We cannot assure you, however, that these procedures and practices will be effective. In addition, this conflict and these procedures and practices may limit the freedom of our Manager to make potentially profitable investments, which could have an adverse effect on our operations.

Our Manager’s liability is limited under the management agreement, and we have agreed to indemnify our Manager against certain liabilities.

Pursuant to the management agreement, our Manager will not assume any responsibility other than to render the services called for thereunder and will not be responsible for any action of our board of directors in following or declining to follow its advice or recommendations. Our Manager and its members, managers, officers and employees will not be liable to us, any subsidiary of ours, our directors, our stockholders or any subsidiary’s stockholders for acts performed in accordance with and pursuant to the management agreement, except by reason of acts constituting bad faith, willful misconduct, gross negligence, or reckless disregard of their duties under the management agreement. We have agreed to indemnify our Manager and its members, managers, officers and employees and each person controlling our Manager with respect to all expenses, losses, damages, liabilities, demands, charges and claims arising from acts of such indemnified party not constituting bad faith, willful misconduct, gross negligence, or reckless disregard of duties, performed in good faith in accordance with and pursuant to the management agreement.

Risks Related to Our Operation and Business Strategy

We have a limited operating history and limited experience as a REIT.

We have a limited operating history and experience as a REIT. We are subject to all of the business risks and uncertainties associated with any business, including the risk that we will not achieve our investment objectives and that the value of your investment could decline substantially. There can be no assurance that we will be able to generate sufficient revenue from operations to pay our operating expenses and make or sustain distributions to stockholders.

Our internal controls over financial reporting contain material weaknesses. If we fail to remedy these weaknesses or otherwise fail to achieve and maintain effective internal controls on a timely basis, our internal controls would be considered ineffective for purposes of Section 404 of the Sarbanes-Oxley Act of 2002. Ineffective internal controls also could have an adverse effect on our future operations.

We are a public reporting company subject to the rules and regulations established from time to time by the Securities and Exchange Commission, or SEC, and New York Stock Exchange. These rules and regulations, among other things, will require us to establish and periodically evaluate procedures with respect to internal controls over financial reporting. In connection with its audit of our consolidated financial statements for the period ended December 31, 2004, our independent registered public accounting firm on March 8, 2005 identified to us three matters involving our internal controls over financial reporting that it considered to be reportable conditions under standards established by the American Institute of Certified Public Accountants, which reportable conditions in its judgment constituted material weaknesses. Under these standards, in each of these areas the design or operation of our internal controls did not reduce to a relatively low level the risk that misstatements caused by error or fraud in amounts that would be material may occur and not be detected within a timely period.

The first reportable condition related to our failure to have well-established internal controls over our financial closing and reporting process. Specifically, through the March 8, 2005 letter date, several of our Manager’s employees in the areas of accounting and financial reporting had been with our Manager for a limited period of time, and additional internal controls needed to be established with respect to the segregation of duties of these individuals in the posting and review of individual journal entries. Moreover, additional specific internal controls were required regarding verification and reconciliation of our general ledger as our financial statements are closed on a monthly basis. The second reportable condition related to our reliance on data gathering and processing methods based upon information gathered after transaction dates that entail a greater risk of error. Specifically, in preparation of our financial statements and underlying records, we relied on custodian statements, bank statements and other information gathered after the transaction dates to identify transactions and amounts that needed to be recorded. These data-gathering and processing methods entail greater risk of error than do methods involving timely processing of transactions. The third reportable condition related to our failure to be as self sufficient with respect to the application of accounting policies for complex transactions as we ultimately need to be. As with the first reportable condition discussed above, the existence of this condition at March 8, 2005 principally related to the limited periods of time that several of our Manager’s accounting and financial reporting staff had been employed by our Manager, and the need at such time for these individuals to establish more robust procedures for the ongoing selection and application of accounting policies for many of our transactions.

We are actively remediating the reportable conditions identified but no assurance can be given that all such conditions will be fully remedied in a timely fashion. If we fail to remedy these weaknesses or otherwise fail to achieve and maintain effective internal controls on a timely basis, our internal controls would be considered ineffective for purposes of Section 404 of the Sarbanes-Oxley Act.

We may change our investment strategy and operational policies without stockholder consent, which may result in riskier investments and adversely affect the market price of our common stock and our ability to make distributions to our stockholders.

We may change our investment strategy at any time without the consent of our stockholders, which could result in our making investments that are different from, and possibly riskier than, the investments described in this Annual Report on Form 10-K. A change in our investment strategy may increase our exposure to credit risk and market risk. Furthermore, our board of directors determines our operational policies and may amend or revise our policies, including our policies with respect to our REIT status, acquisitions, growth, operations, indebtedness, capitalization and distributions or approve transactions that deviate from these policies, without a vote of, or notice to, our stockholders. Operational policy changes could adversely affect the market price of our common stock and our ability to make distributions to our stockholders.

Our Manager’s failure to identify and invest in securities and loans that meet our investment criteria or perform its responsibilities under the management agreement may adversely affect our ability for future growth.

Our ability to achieve our investment objective will depend on our ability to grow, which in turn will depend on our Manager’s ability to identify and invest in securities that meet our investment criteria. Accomplishing this result on a cost-effective basis will be largely a function of our Manager’s structuring of the investment process, its ability to provide competent, attentive and efficient services to us, and our access to financing on acceptable terms. The senior management team of our Manager has substantial responsibilities under the management agreement. In order to grow, our Manager will need to hire, train, supervise and manage new employees successfully. Any failure to manage our future growth effectively could have a material adverse effect on our business, financial condition and results of operations.

We operate in a highly competitive market for investment opportunities.

A number of entities compete with us to make the types of investments that we plan to make. We compete with other REITs, financial companies, public and private funds, commercial and investment banks and commercial finance companies. Many of our competitors are substantially larger and have considerably greater financial, technical and marketing resources than we do. Several other REITs have recently raised, or are expected to raise, significant amounts of capital, and may have investment objectives that overlap with ours, which may create competition for investment opportunities. Some competitors may have a lower cost of funds and access to funding sources that are not available to us. In addition, some of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments and establish more relationships than us. We cannot assure you that the competitive pressures we face will not have a material adverse effect on our business, financial condition and results of operations. Also, as a result of this competition, we may not be able to take advantage of attractive investment opportunities from time to time, and we can offer no assurance that we will be able to identify and make investments that are consistent with our investment objectives.

Failure to procure adequate capital and funding would adversely affect our results and may, in turn, negatively affect the market price of shares of our common stock and our ability to make distributions to our stockholders.

We depend upon the availability of adequate funding and capital for our operations. As a REIT, we are required to distribute annually at least 90% of our REIT taxable income, determined without regard to the deduction for dividends paid and excluding net capital gain, to our stockholders and are therefore not able to retain our earnings for new investments (excluding earnings generated by KKR TRS Holdings, Inc., and any other domestic taxable REIT subsidiary, subject to the REIT requirements). We cannot assure you that any, or sufficient, funding or capital will be available to us in the future on terms that are acceptable to us. In the event that we cannot obtain sufficient funding on acceptable terms, there may be a negative impact on the market price of our common stock and our ability to make distributions to our stockholders.

We leverage our portfolio investments, which may adversely affect our return on our investments and may reduce cash available for distribution.

We expect to leverage our portfolio investments through borrowings, generally through the use of warehouse facilities, bank credit facilities, repurchase agreements, asset-backed secured liquidity notes, mortgage loans on real estate, securitizations, including the issuance of CDOs, loans to entities in which we hold, directly or indirectly, interests in pools of properties or loans, and other borrowings. The percentage of leverage varies depending on our ability to obtain credit facilities and the lender’s and rating agencies’ estimate of the stability of the portfolio investments’ cash flow. Our return on our investments and cash available for distribution to our stockholders may be reduced to the extent that changes in market conditions cause the cost of our financing to increase relative to the income that can be derived from the assets acquired. Our debt service payments reduce cash flow available for distributions to stockholders. We may not be able to meet our debt service obligations and, to the extent that we cannot, we risk the loss of some or all of our assets to foreclosure or sale to satisfy our debt obligations. We leverage certain of our investments through repurchase agreements and asset-backed secured liquidity notes. A decrease in the value of the assets may lead to margin calls that we will have to satisfy. We may not have the funds available to satisfy any such margin calls.

If credit spreads widen before we obtain long-term financing for our net assets we may experience a material reduction in the economic value of the assets that we have acquired.

We price our net assets based on our assumptions about future levels of credit spreads (the risk premium for taking credit risk which is the difference between the risk free rate and the interest rate paid on the investment) for term financing of those assets. We expect to obtain longer term financing for these assets at a spread over a certain benchmark, such as the yield on United States Treasury bonds, swaps, or LIBOR. If the spread that investors will pay over the benchmark widens and the rates we charge on our loans or the income we generate from our other assets are not increased accordingly, we may experience a material adverse reduction in the economic value of the assets that we have acquired.

If we are unable to continue to securitize our portfolio successfully, we may be unable to grow or fully execute our business strategy and our earnings may decrease.

We intend to continue to structure our securitization transactions so that we must account for them as secured borrowings in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and as a result we are precluded from using sale accounting to recognize any gain or loss. To securitize our portfolio investments, we may create a wholly-owned subsidiary and contribute a pool of portfolio investments to the subsidiary. An inability to securitize our portfolio successfully could limit our ability to grow our business or fully execute our business strategy and could decrease our earnings, if any. Moreover, the successful

securitization of our portfolio investments might expose us to losses as the residual portfolio investments in which we do not sell interests will tend to be those that are riskier and more likely to generate losses.

We may not be able to acquire eligible securities for a CDO or CLO issuance, or may not be able to issue CDO or CLO securities on attractive terms that closely match-fund the duration of our assets and liabilities, which may require us to seek more costly financing for our investments or to liquidate assets.

We intend to continue to finance certain of our portfolio investments on a long-term basis, such as through the issuance of CDOs and CLOs. We use these short term facilities to finance the acquisition of securities until a sufficient quantity of securities is accumulated, at which time we intend to refinance these facilities through a securitization, such as a CDO or CLO issuance, or other long-term financing. As a result, we are subject to the risk that we will not be able to acquire, during the period that our short-term facilities are available, a sufficient amount of eligible securities to maximize the efficiency of a CDO or CLO issuance. We also bear the risk that we will not be able to obtain short-term credit facilities or may not be able to renew any short-term credit facilities after they expire should we find it necessary to extend our short-term credit facilities to allow more time to seek and acquire the necessary eligible securities for a long-term financing. Inability to renew our short-term credit facilities may require us to seek more costly financing for our investments or to liquidate assets. In addition, conditions in the capital markets may make the issuance of a CDO or CLO less attractive to us when we do have a sufficient pool of collateral. If we are unable to issue a CDO or CLO to finance these assets, we may be required to seek other forms of potentially less attractive financing or otherwise to liquidate the assets.

The use of CDO or CLO financings with over-collateralization requirements may have a negative impact on our cash flow.

The terms of the CDOs and CLOs we issue generally provide that the principal amount of assets must exceed the principal balance of the related bonds by a certain amount. This excess collateral requirement is commonly referred to as “over-collateralization.” The CDO and CLO terms provide that, if losses exceed the specified levels based on rating agencies’ (or the financial guaranty insurer’s, if applicable) analyses of the characteristics of the assets pledged to collateralize the bonds, the required level of over-collateralization may be insufficient and as a result we may be subject to restrictions that limit our ability to receive cash flows from assets pledged to secure CDOs or CLOs. We cannot assure you that the performance tests will be satisfied, nor can we assure you, in advance of completing negotiations with the rating agencies or other key transaction parties on our future CDO and CLO financings, of the effects of the actual terms of the delinquency tests, over-collateralization terms, cash flow release mechanisms or other significant factors regarding the release of cash flow to us. Failure to obtain favorable terms with regard to these matters may materially and adversely affect our liquidity. If our assets fail to perform as anticipated, our over-collateralization or other forms of credit enhancement associated with our CDO and CLO financings will likely increase on future transactions, thereby resulting in increased borrowing costs.

We may be required to repurchase loans or securities that we have sold in connection with CDOs and CLOs.

If any of the loans or securities that we originate or acquire and sell or securitize does not comply with representations and warranties that we make about certain characteristics of the loans, the borrowers and the underlying properties, we may be required to repurchase such loans or securities (including from a trust vehicle used to facilitate a structured financing of the assets through CDOs and CLOs) or replace them with substitute loans or securities. In addition, in the case of loans or securities that we have sold instead of retained, we may be required to indemnify purchasers for losses or expenses incurred as a result of a breach of a representation or warranty. Any significant repurchases or indemnification payments could materially and adversely affect our liquidity, financial condition and operating results.

The B Notes in which we invest may be subject to additional risks relating to the privately negotiated structure and terms of the transaction, which may result in losses to us.

A B Note is a mortgage loan typically (i) secured by a first mortgage on a single large commercial property or group of related properties and (ii) subordinated to an A Note secured by the same first mortgage on the same collateral. As a result, if a borrower defaults, there may not be sufficient funds remaining for B Note holders after payment to the A Note holders. B Notes reflect similar credit risks to comparably rated commercial mortgage-backed securities. Since each transaction is privately negotiated, however, B Notes can vary in their structural characteristics and risks. For example, the rights of holders of B Notes to control the process following a borrower default may be limited in certain investments. We cannot predict the terms of each B Note investment. B Notes also are less liquid than commercial mortgage-backed securities, thus we may be unable to dispose of performing, underperforming or non-performing B Note investments. The higher risks associated with our subordinate position in our B Note investments could subject us to increased risk of losses.

An increase in our borrowing costs relative to the interest we receive on our portfolio investments may adversely affect our profitability, which may negatively affect cash available for distribution to our stockholders.

As our repurchase agreements and other short-term borrowing instruments mature, we will be required either to enter into new repurchase agreements and other short-term borrowings or to sell certain of our portfolio investments. An increase in short-term interest rates at the time that we seek to enter into new repurchase agreements may reduce the spread between our returns on our portfolio investments and the cost of our borrowings. This change in interest rates would adversely affect our returns on our portfolio investments that are fixed rate and/or subject to prepayment or extension risk, including our mortgage loans and mortgage-backed securities investments, which might reduce earnings and, in turn, cash available for distribution to our stockholders.

We may enter into derivative contracts that could expose us to contingent liabilities in the future.

Part of our investment strategy involves entering into derivative contracts that will require us to fund cash payments in certain circumstances. These payments will be contingent liabilities and therefore may not appear on our balance sheet. Our ability to fund these contingent liabilities will depend on the liquidity of our assets and access to capital at the time, and the need to fund these contingent liabilities could adversely impact our financial condition.

Hedging against interest rate exposure may adversely affect our earnings, which could adversely affect cash available for distribution to our stockholders.

We enter into interest rate swap agreements and other interest rate hedging strategies. Our hedging activity will vary in scope based on the level of interest rates, the type of portfolio investments held, and other changing market conditions. Interest rate hedging may fail to protect or could adversely affect us because, among other things:

· interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates;

· available interest rate hedging may not correspond directly with the interest rate risk for which protection is sought;

· the duration of the hedge may not match the duration of the related liability or asset;

· the amount of income that a REIT may earn from hedging transactions to offset interest rate losses is limited by federal tax provisions governing REITs;

· the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and

· the party owing money in the hedging transaction may default on its obligation to pay.

Any hedging activity we engage in may adversely affect our earnings, which could adversely affect cash available for distribution to our stockholders. Therefore, while we may enter into such transactions to seek to reduce interest rate risks, unanticipated changes in interest rates may result in poorer overall investment performance than if we had not engaged in any such hedging transactions. In addition, the degree of correlation between price movements of the instruments used in a hedging strategy and price movements in the portfolio positions being hedged or liabilities being hedged may vary materially. Moreover, for a variety of reasons, we may not seek to establish a perfect correlation between such hedging instruments and the portfolio holdings being hedged. Any such imperfect correlation may prevent us from achieving the intended hedge and expose us to risk of loss.

Hedging instruments often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities and involve risks and costs.

The cost of using hedging instruments increases as the period covered by the instrument increases and during periods of rising and volatile interest rates. We may increase our hedging activity and thus increase our hedging costs during periods when interest rates are volatile or rising and hedging costs have increased. In addition, hedging instruments involve risk since they often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities. Consequently, there are no requirements with respect to record keeping, financial responsibility or segregation of customer funds and positions. Furthermore, the enforceability of agreements underlying derivative transactions may depend on compliance with applicable statutory, commodity and other regulatory requirements and, depending on the identity of the counterparty, applicable international requirements. The business failure of a hedging counterparty with whom we enter into a hedging transaction will most likely result in a default. Default by a party with whom we enter into a hedging transaction may result in the loss of unrealized profits and force us to cover our resale commitments, if any, at the then current market price. Although generally we will seek to reserve the right to terminate our hedging positions, it may not always be possible to dispose of or close out a hedging position without the consent of the hedging counterparty, and we may not be able to enter into an offsetting contract in order to cover our risk. We cannot assure you that a liquid secondary market will exist for hedging instruments purchased or sold, and we may be required to maintain a position until exercise or expiration, which could result in losses.

We make investments in non-U.S. dollar denominated investments, which subject us to currency rate exposure and the uncertainty of foreign laws and markets.

We purchase investments denominated in foreign currencies. A change in foreign currency exchange rates may have an adverse impact on returns on any of these non-dollar denominated investments. Although we may hedge our foreign currency risk subject to the REIT income qualification tests, we may not be able to do so successfully and may incur losses on these investments as a result of exchange rate fluctuations. Investments in foreign countries also subject us to risks of multiple and conflicting tax laws and regulations and political and economic instability abroad, which could adversely affect our receipt of interest income on these investments.

Risks Related To Our Investments

We may not realize gains or income from our investments.

We seek to generate both current income and capital appreciation. The securities in which we invest may not appreciate in value, however, and, in fact, may decline in value, and the debt securities in which we invest may default on interest and/or principal payments. Accordingly, we may not be able to realize gains or income from our investments. Any gains that we do realize may not be sufficient to offset any other losses we experience. Any income that we realize may not be sufficient to offset our expenses.

Declines in the market values of our investments may adversely affect periodic reported results and credit availability, which may reduce earnings and, in turn, cash available for distribution to our stockholders.

A substantial portion of our assets are, and we believe are likely to continue to be, classified for accounting purposes as “available-for-sale.” Changes in the market values of those assets will be directly charged or credited to stockholders’ equity. As a result, a decline in values may reduce the book value of our assets. Moreover, if the decline in value of an available-for-sale security is considered by our Manager to be other than temporary, such decline will reduce earnings.

A decline in the market value of our assets may adversely affect us particularly in instances where we have borrowed money based on the market value of those assets. If the market value of those assets declines, the lender may require us to post additional collateral to support the loan. If we were unable to post the additional collateral, we would have to sell the assets at a time when we might not otherwise choose to do so. A reduction in credit available may reduce our earnings and, in turn, cash available for distribution to stockholders.

Further, credit facility providers may require us to maintain a certain amount of cash invested or to set aside unlevered assets sufficient to maintain a specified liquidity position which would allow us to satisfy our collateral obligations. As a result, we may not be able to leverage our assets as fully as we would choose, which could reduce our return on equity. In the event that we are unable to meet these contractual obligations, our financial condition could deteriorate rapidly.

Market values of our investments may decline for a number of reasons, such as causes related to changes in prevailing market rates, increases in defaults, increases in voluntary prepayments for those investments that we have that are subject to prepayment risk, and widening of credit spreads.

Some of our portfolio investments are recorded at fair value as determined by our Manager and, as a result, there is uncertainty as to the value of these investments.

Some of our portfolio investments are, and we believe are likely to continue to be, in the form of securities that have limited liquidity or are not publicly traded. The fair value of securities and other investments that have limited liquidity or are not publicly traded may not be readily determinable. We value these investments quarterly at fair value as determined by our Manager. Because such valuations are inherently uncertain, may fluctuate over short periods of time and may be based on estimates, our determinations of fair value may differ materially from the values that would have been used if a ready market for these securities existed. The value of our common stock could be adversely affected if our determinations regarding the fair value of these investments are materially higher than the values that we ultimately realize upon their disposal.

Changes in interest rates could negatively affect the value of our investments, which could result in reduced earnings or losses and negatively affect the cash available for distribution to our stockholders.

We invest in mortgage loans and mortgage-backed securities and other fixed-rate debt investments. Under a normal yield curve, an investment in these instruments will decline in value if interest rates increase. We also invest in floating rate debt investments, for which decreases in interest rates may have a

negative effect on value. Declines in market value may ultimately reduce earnings or result in losses to us, which may negatively affect cash available for distribution to our stockholders.

In particular, a significant risk associated with our investment in mortgage loans and mortgage-backed securities and other fixed-rate debt investments is the risk that both long-term and short-term interest rates will increase significantly. If rates were to increase significantly, the market value of these securities would decline and, with respect to mortgage-backed securities, the duration and weighted average life of the investments would increase. We could realize a loss if the securities were sold. At the same time, an increase in short-term interest rates would increase the amount of interest owed on short term borrowings we may enter into in order to finance the purchase of these investments.

Our assets include leveraged loans, high yield securities and common and preferred equity securities, each of which has greater risks of loss than secured senior loans and, if those losses are realized, it could adversely affect our earnings, which could adversely affect our cash available for distribution to our stockholders.

Our assets include leveraged loans, high yield securities and marketable and non-marketable common and preferred equity securities, each of which involves a higher degree of risk than senior secured loans. First, the leveraged loans and high yield securities may not be secured by mortgages or liens on assets. Even if secured, these leveraged loans and high yield securities may have higher loan-to-value ratios than a senior secured loan. Furthermore, our right to payment and the security interest may be subordinated to the payment rights and security interests of the senior lender. Therefore, we may be limited in our ability to enforce our rights to collect these loans and to recover any of the loan balance through a foreclosure of collateral.

Certain of these leveraged loans and high yield securities may have an interest-only payment schedule, with the principal amount remaining outstanding and at risk until the maturity of the loan. In this case, a borrower’s ability to repay its loan may be dependent upon a liquidity event that will enable the repayment of the loan.

In addition to the above, numerous other factors may affect a company’s ability to repay its loan, including the failure to meet its business plan, a downturn in its industry or negative economic conditions. A deterioration in a company’s financial condition and prospects may be accompanied by deterioration in the collateral for the high yield securities and leveraged loans. Losses on our high yield securities and leveraged loans could adversely affect our earnings, which could adversely affect cash available for distribution to our stockholders.

In addition, marketable and non-marketable common and preferred equity securities may also have a greater risk of loss than senior secured loans since such investments are subordinate to debt of the issuer and are not secured by property underlying the investment.

Prepayments can adversely affect the yields on our investments.

In the case of residential mortgage loans, there are seldom any restrictions on borrowers’ abilities to prepay their loans. Homeowners tend to prepay mortgage loans faster when interest rates decline. Consequently, owners of the loans have to reinvest the money received from the prepayments at the lower prevailing interest rates. Conversely, homeowners tend not to prepay mortgage loans when interest rates increase. Consequently, owners of the loans are unable to reinvest money that would have otherwise been received from prepayments at the higher prevailing interest rates. This volatility in prepayment rates may affect our ability to maintain targeted amounts of leverage on our mortgage-backed securities portfolio and may result in reduced earnings or losses for us and negatively affect the cash available for distribution to our stockholders.

The yield of our other assets may be affected by the rate of prepayments differing from our projections. Prepayments on debt instruments, where permitted under the debt documents, are influenced

by changes in current interest rates and a variety of economic, geographic and other factors beyond our control, and consequently, such prepayment rates cannot be predicted with certainty. If we are unable to invest the proceeds of such prepayments received, the yield on our portfolio will decline. In addition, we may acquire assets at a discount or premium and if the asset does not repay when expected, our anticipated yield may be impacted. Under certain interest rate and prepayment scenarios we may fail to recoup fully our cost of acquisition of certain investments.

The mortgage loans we invest in and the mortgage loans underlying the mortgage and asset-backed securities we invest in are subject to delinquency, foreclosure and loss, which could result in losses to us.

Commercial real estate loans are secured by multifamily or commercial property and are subject to risks of delinquency and foreclosure, and risks of loss that are greater than similar risks associated with loans made on the security of single-family residential property. The ability of a borrower to repay a loan secured by an income-producing property typically is dependent primarily upon the successful operation of such property rather than upon the existence of independent income or assets of the borrower. If the net operating income of the property is reduced, the borrower’s ability to repay the loan may be impaired. Net operating income of an income-producing property can be affected by, among other things: tenant mix, success of tenant businesses, property management decisions, property location and condition, competition from comparable types of properties, changes in laws that increase operating expense or limit rents that may be charged, any need to address environmental contamination at the property, the occurrence of any uninsured casualty at the property, changes in national, regional or local economic conditions and/or specific industry segments, declines in regional or local real estate values, declines in regional or local rental or occupancy rates, increases in interest rates, real estate tax rates and other operating expenses, changes in governmental rules, regulations and fiscal policies, including environmental legislation, acts of God, terrorism, social unrest and civil disturbances.

Residential mortgage loans are secured by single-family residential property and are subject to risks of delinquency, foreclosure and risks of loss. The ability of a borrower to repay a loan secured by a residential property is dependent upon the income or assets of the borrower. A number of factors, including a general economic downturn, acts of God, terrorism, social unrest and civil disturbances, may impair borrowers’ abilities to repay their loans. Asset-backed securities are bonds or notes backed by loans and/or other financial assets. The ability of borrowers to repay these loans or other financial assets is dependent upon the income or assets of these borrowers.

In the event of any default under a mortgage loan held directly by us, we will bear a risk of loss of principal to the extent of any deficiency between the value of the collateral and the principal and accrued interest of the mortgage loan, which could have a material adverse effect on our cash flow from operations. In the event of the bankruptcy of a mortgage loan borrower, the mortgage loan to such borrower will be deemed to be secured only to the extent of the value of the underlying collateral at the time of bankruptcy (as determined by the bankruptcy court), and the lien securing the mortgage loan will be subject to the avoidance powers of the bankruptcy trustee or debtor-in-possession to the extent the lien is unenforceable under state law.

Foreclosure of a mortgage loan can be an expensive and lengthy process that could have a substantial negative effect on our anticipated return on the foreclosed mortgage loan. RMBS evidence interests in or are secured by pools of residential mortgage loans and CMBS evidence interests in or are secured by a single commercial mortgage loan or a pool of commercial real estate loans. Accordingly, the mortgage-backed securities we invest in are subject to all of the risks of the underlying mortgage loans.

In the future we may invest in RMBS backed by non-prime or sub-prime residential mortgage loans which are subject to higher delinquency, foreclosure and loss rates than prime residential mortgage loans which could result in losses to us.

Non-prime and sub-prime residential mortgage loans are made to borrowers who have poor or limited credit histories and as a result they do not qualify for traditional mortgage products. Because of the poor, or lack of, credit history, non-prime and sub-prime borrowers have a materially higher rate of delinquencies and foreclosure and loss rates compared to prime credit quality borrowers. There is limited history with respect to the performance of RMBS backed by residential mortgage loans over various economic cycles. Investments in non-prime and sub-prime RMBS backed by sub-prime or non-prime residential mortgage loans have higher risk than investments in RMBS backed by prime residential mortgage loans. We may realize credit losses if we invest in RMBS backed by sub-prime and non-prime residential mortgage loans because such RMBS are subject to all of the risks of the underlying sub-prime and non-prime residential mortgage loans.

All, or a significant portion, of our investment portfolio is invested in non-agency RMBS and non-conforming residential mortgage loans.

A significant portion of our investment portfolio consists of non-agency RMBS and non-conforming residential mortgage loans. Agency backed securities include RMBS which represent the entire ownership interest in pools of residential mortgage loans secured by residential real property and are guaranteed as to principal and interest by federally chartered entities such as Fannie Mae and Freddie Mac and, in the case of Ginnie Mae, by the U.S. government. Non-agency RMBS are not guaranteed by Fannie Mae, Freddie Mac, Ginnie Mae, or the U.S. government; rather their ratings are assigned by nationally recognized rating agencies such as Moody’s and Standard & Poor’s. Non-agency RMBS have a higher risk of loss than do agency RMBS. We may realize credit losses on our investment in non-agency RMBS.

We expect that a material portion of our investment portfolio of residential mortgage loans and RMBS will consist of, or in the case of RMBS be backed by, non-conforming residential mortgage loans. We expect that the residential mortgage loans will be non-conforming due to non-credit factors including, but not limited to, the fact that the (i) mortgage loan amounts exceed the maximum amount for such mortgage loan to qualify as a conforming mortgage loan, and (ii) underwriting documentation for the mortgage loan does not meet the criteria for qualification as a conforming mortgage loan. Non-conforming residential mortgage loans may have higher risk of delinquency and foreclosure and losses than conforming mortgage loans. We may realize credit losses on our investment in non-conforming residential mortgage loans and RMBS backed by non-conforming residential mortgage loans.

Our investment portfolio of residential mortgage loans, residential mortgage-backed securities, commercial real estate loans, and commercial real estate mortgage-backed securities may have material geographic concentrations.

We have material geographic concentrations related to investments in residential mortgage loans and RMBS. We expect that over 60% of our investment portfolio of residential mortgage loans and RMBS will consist of properties located in California, New York, New Jersey, Florida, Virginia and Texas. We have material geographic concentrations related to investments in commercial real estate loans and CMBS. We expect that over 60% of our investment portfolio of commercial real estate loans and CMBS will consist of properties located in New York, California, Arizona, Florida and Hawaii. The risk of foreclosure and losses are likely to be correlated between our residential and our commercial real estate investments and the correlation may be exacerbated by our geographic concentrations. We may realize credit losses on our residential and commercial real estate mortgage loan and mortgage-backed securities because of our geographic concentrations and the correlation of foreclosure and losses between our residential and commercial real estate investments.

Our investments in subordinated commercial mortgage-backed securities are generally in the “second loss” position and therefore subject to losses.

In general, losses on an asset securing a mortgage loan included in a securitization will be borne first by the equity holder of the property, then by a cash reserve fund or letter of credit, if any, and then by the “first loss” subordinated security holder and then by the “second loss” subordinated security holder. In the event of default and the exhaustion of any equity support, reserve fund, letter of credit and any classes of securities junior to those in which we invest, we will not be able to recover all of our investment in the securities we purchase. In addition, if the underlying mortgage portfolio has been overvalued by the originator, or if the values subsequently decline and, as a result, less collateral is available to satisfy interest and principal payments due on the related mortgage-backed securities, the securities in which we invest may effectively become the “first loss” position behind the more senior securities, which may result in significant losses to us. The prices of lower credit quality securities are generally less sensitive to interest rate changes than more highly rated investments, but more sensitive to economic downturns or individual issuer developments. A projection of an economic downturn, for example, could cause a decline in the price of lower credit quality securities because the ability of obligors of mortgages underlying mortgage-backed securities to make principal and interest payments may be impaired. In such event, existing credit support in the securitization structure may be insufficient to protect us against loss of our principal on these securities.

Our investments in senior unsecured REIT securities are subject to specific risks relating to the particular REIT issuer of the securities and to the general risks of investing in subordinated real estate related securities, which may result in losses to us.

Our investments in REIT securities involve special risks relating to the particular REIT issuer of the securities, including the financial condition and business outlook of the issuer. REITs generally are required to invest substantially in operating real estate or real estate-related assets and are subject to the inherent risks associated with real estate-related investments discussed in this Annual Report on Form 10-K. Our investments in REIT securities are also subject to the risks described above with respect to mortgage loans and mortgage-backed securities and similar risks, including (i) risks of delinquency and foreclosure, and risks of loss in the event thereof, (ii) the dependence upon the successful operation of and net income from real property, (iii) risks generally incident to interests in real property, and (iv) risks that may be presented by the type and use of a particular commercial property. REIT securities are generally unsecured and may also be subordinated to other obligations of the issuer.

We may also invest in REIT securities that are rated below investment grade. As a result, investments in REIT securities are also subject to risks of: (i) limited liquidity in the secondary trading market, (ii) substantial market price volatility resulting from changes in prevailing interest rates, (iii) subordination to the prior claims of banks and other senior lenders to the issuer, (iv) the operation of mandatory sinking fund or call/redemption provisions during periods of declining interest rates that could cause the issuer to reinvest premature redemption proceeds in lower yielding assets, (v) the possibility that earnings of the REIT issuer may be insufficient to meet its debt service and dividend obligations and (vi) the declining creditworthiness and potential for insolvency of the issuer of such REIT securities during periods of rising interest rates and economic downturn. These risks may adversely affect the value of outstanding REIT securities and the ability of the issuers thereof to repay principal and interest or make distributions to our stockholders.

With respect to our ability to make distributions to our stockholders, the credit facility limits the amount of distributions we may make to 100% of our taxable income (which, as defined, is expected at all times to exceed our calculation of taxable income for REIT compliance purposes, as it is computed without giving effect to net operating loss carryforwards and nonrecurring items, including, but not limited to, stock-based compensation expense and bad debt write-offs). The facility also prohibits distributions in the event of certain defaults under that agreement, including: failure to pay principal or interest under the facility and other material indebtedness as and when due; breaches of representations, warranties and covenants; defaults under other material indebtedness; events of insolvency; unpaid judgments in excess of $25 million; certain events relating to benefit plans subject to ERISA; the failure of our Manager to continue as our Manager and remain affiliated with KKR; our failure to maintain our status as a REIT; and any change in control (such defaults subject in certain cases to grace periods). As a result, these limitations, and limitations imposed by any future financing agreements, may adversely affect our ability to make future distributions to our stockholders or may reduce the amount of such distributions. No assurance can be given as to our ability to make distributions to our stockholders.

In addition, the operating and financial restrictions in our credit facility and any future financing agreements may adversely affect our ability to engage in our current and future operations. Specifically, these restrictions may limit our ability to incur additional indebtedness, including indebtedness that may be required to meet our short-term liquidity needs such as for the payment of distributions. A breach of any of the restrictive covenants in our credit facility could result in a default under the facility. If any such default occurs, in addition to the limitations on distributions described above, the lenders under the facility may elect to declare all outstanding borrowings, together with accrued interest and other fees, to be immediately due and payable, enforce their security interest or require us to apply all of our available cash to repay these borrowings. Those lenders will also have the right in these circumstances to terminate any commitments they have to provide further borrowings.

Our Investment Company Act exemption limits our investment discretion and loss of the exemption would adversely affect us and negatively affect the market price of shares of our common stock and the ability to make distributions to our stockholders.

We believe that we currently are not, and we intend to operate our company so that we will not be regulated as, an investment company under the Investment Company Act because we are “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” Specifically, we are required to invest at least 55% of our assets in “qualifying real estate assets”; (that is, mortgage loans, RMBS and CMBS that represent the entire ownership in a pool of mortgage loans and other qualifying interests in real estate), and at least an additional 25% of our assets in RMBS, CMBS and other “real estate-related assets” or additional qualifying real estate assets.

We will need to monitor our assets to ensure that we continue to satisfy the percentage tests. Although we believe that it should not be difficult to maintain at least 80% of our assets in real estate-related assets, the requirement that at least 55% of our assets constitute qualifying real estate assets is more limiting. For example, our ability to invest in privately issued mortgage-backed securities for which we do not own all of the securities issued and with respect to which we do not obtain the right to foreclose on the related mortgage loans is limited because these securities do not constitute qualifying investments for the 55% test, even if they are treated more favorably under the REIT tax rules. Maintaining our exemption from regulation as an investment company under the Investment Company Act limits our ability to invest in assets that otherwise would meet our investment strategies.

If we fail to qualify for this exemption, we could not operate our business efficiently under the regulatory scheme imposed on investment companies under the Investment Company Act. Accordingly, we could be required to restructure our activities. For example, if the market value of our investments in equity securities were to increase by an amount that resulted in less than 55% of our assets being invested

in mortgage loans or other qualifying real estate assets, we might have to sell equity securities in order to qualify for exemption under the Investment Company Act. The sale could occur under adverse market conditions. In addition, our Manager may terminate its management agreement with us if we fail to qualify for this exemption.

Rapid changes in the values of our mortgage-backed securities and other real estate related investments may make it more difficult for us to maintain our REIT status or exemption from the Investment Company Act.

If the market value or income potential of our mortgage-backed securities and other real estate related investments declines as a result of increased interest rates, prepayment rates or other factors, we may need to increase our real estate investments and income and/or liquidate our non-qualifying assets in order to maintain our REIT status or exemption from the Investment Company Act. If the decline in real estate asset values and /or income occurs quickly, this may be especially difficult to accomplish. This difficulty may be exacerbated by the illiquid nature of many of our non-real estate assets. We may have to make investment decisions that we otherwise would not make absent the REIT and Investment Company Act considerations.

Maryland takeover statutes may prevent or make difficult a change of control of our company that could be in the interests of our stockholders.

Certain provisions of the Maryland General Corporation Law, or MGCL, may have the effect of inhibiting a third party from making a proposal to acquire us or of impeding a change in control under circumstances that otherwise could provide the holders of shares of our common stock with the opportunity to realize a premium over the then-prevailing market price of such shares. We are subject to the “business combination” provisions of the MGCL that, subject to limitations, prohibit certain business combinations between us and an “interested stockholder” (defined generally as any person who beneficially owns 10% or more of the voting power of our shares or an affiliate or associate of ours who, at any time within the two-year period prior to the date in question, was the beneficial owner of 10% or more of our then outstanding voting shares, or an affiliate thereof) for five years after the most recent date on which the stockholder becomes an interested stockholder, and thereafter imposes special appraisal rights and special stockholder voting requirements on these combinations. We have, by resolution, however, exempted business combinations between us and any person, provided that such business combination is first approved by our board of directors, from the provisions of the Maryland Business Combination Act. Consequently, the five-year prohibition and the supermajority vote requirements will not apply to business combinations between us and any person described above if approved by our board of directors. We have determined to opt out of the so-called “control share” provisions of the MGCL that provide that “control shares” of a Maryland corporation (defined as shares which, when aggregated with other shares controlled by the stockholder, entitle the stockholder to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition” (defined as the direct or indirect acquisition of ownership or control of “control shares”) have no voting rights except to the extent approved by our stockholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding all interested shares. We may in the future, however, elect to become subject to the control share provisions of the MGCL. The “unsolicited takeover” provisions of the MGCL permit our board of directors, without stockholder approval and regardless of what is currently provided in our charter or bylaws, to implement takeover defenses, some of which (for example, a classified board) we do not yet have. These provisions may have the effect of inhibiting a third party from making an acquisition proposal for us or of delaying, deferring or preventing a change in control of our company under the circumstances that otherwise could provide the holders of our common stock with the opportunity to realize a premium over the then-current market price. We have no present plans to classify our board.

Our charter and bylaws contain provisions that may inhibit potential acquisition bids that our stockholders may consider favorable, and the market price of our common stock may be lower as a result.

Our charter and bylaws contain provisions that may have an anti-takeover effect and inhibit a change in our board of directors. These provisions include the following:

· There are ownership limits and restrictions on transferability and ownership in our charter. In order to qualify as a REIT for each taxable year after 2004, not more than 50% of the value of our outstanding stock may be owned, directly or constructively, by five or fewer individuals during the second half of any calendar year and our shares must be beneficially owned by 100 or more persons during at least 335 days of a taxable year of 12 months or during a proportionate part of a shorter taxable year. To assist us in satisfying these tests, subject to some exceptions, our charter generally prohibits any stockholder from beneficially or constructively owning more than 9.8% in value or number of shares, whichever is more restrictive, of any class or series of our outstanding capital stock. This restriction may:

· discourage a tender offer or other transactions or a change in the composition of our board of directors or control that might involve a premium price for our shares or otherwise be in the best interests of our stockholders; and

· result in shares issued or transferred in violation of such restrictions being automatically transferred to a trust for a charitable beneficiary and thereby resulting in a forfeiture of owning the additional shares.

· Our charter permits our board of directors to issue preferred stock with terms that may discourage a third party from acquiring us. Our charter permits our board of directors to amend the charter to increase the total number of authorized shares of stock or the number of shares of any class or series and to issue preferred stock, and to classify or reclassify authorized but unissued shares of our stock having preferences, conversion or other rights, voting powers, restrictions, limitations as to distributions, qualifications, or terms or conditions of redemption as determined by our board. Thus, our board could authorize the issuance of preferred stock with terms and conditions that could have the effect of discouraging a takeover or other transaction in which holders of some or a majority of our shares might receive a premium for their shares over the then-prevailing market price of our shares.

· Our charter and bylaws contain other possible anti-takeover provisions that may have the effect of delaying, deferring or preventing a change in control of us or the removal of existing directors and, as a result, could prevent our stockholders from being paid a premium for their common stock over the then-prevailing market price.

Our rights and the rights of our stockholders to take action against our directors and officers are limited, which could limit their recourse in the event of actions not in their best interests.

Our charter limits the liability of our directors and officers to us and our stockholders for money damages, except for liability resulting from:

· actual receipt of an improper benefit or profit in money, property or services; or

· a final judgment based upon a finding of active and deliberate dishonesty by the director or officer that was material to the cause of action adjudicated.

In addition, our charter authorizes us to obligate our company to indemnify our present and former directors and officers for actions taken by them in those capacities to the maximum extent permitted by Maryland law. Our bylaws require us to indemnify each present or former director or officer, to the maximum extent permitted by Maryland law, in the defense of any proceeding to which he or she is made,

or threatened to be made, a party by reason of his or her service to us. In addition, we may be obligated to fund the defense costs incurred by our directors and officers.

Tax Risks

Complying with REIT requirements may cause us to forgo otherwise attractive opportunities or engage in marginal investment opportunities.

To qualify as a REIT for federal income tax purposes, we must continually satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets, the amounts we distribute to our stockholders and the ownership of our stock. In order to meet these tests, we may be required to forgo attractive business or investment opportunities or engage in marginal investment opportunities. Thus, compliance with the REIT requirements may hinder our ability to operate solely on the basis of maximizing profits.

The prohibited transactions tax will limit our ability to engage in transactions, including certain methods of securitizing mortgage loans, that would be treated as sales for federal income tax purposes.

A REIT’s net income from prohibited transactions is subject to a 100% tax. In general, prohibited transactions are sales or other dispositions of property, other than foreclosure property, but including loans, held primarily for sale to customers in the ordinary course of business. We might be subject to this tax if we were able to sell or securitize loans in a manner that was treated as a sale of the loans for federal income tax purposes. Therefore, in order to avoid the prohibited transactions tax, we may choose not to engage in certain sales of loans and may limit the structures we utilize for our securitization transactions even though such sales or structures might otherwise be beneficial to us.

It may be possible to reduce the impact of the prohibited transaction tax and the holding of assets not qualifying as real estate assets for purposes of the REIT asset tests by conducting certain activities, holding non-qualifying REIT assets or engaging in CDO or CLO transactions through our subsidiaries that are taxable REIT subsidiaries, subject to certain limitations as described below. To the extent that we engage in such activities through taxable REIT subsidiaries, the income associated with such activities may be subject to full corporate income tax.

We may be subject to the prohibited transactions tax on the loans we sold or will sell to our CLO issuers if the Internal Revenue Service challenges our characterization of those transactions.

We have sold certain loans to our CLO issuers, including KKR Financial CLO 2005-1, Ltd. and KKR Financial CLO 2005-2, Ltd. We believe that such loans have not been held by us primarily for sale to customers in the ordinary course of our trade or business, and we do not believe that the prohibited transactions tax applies to the sales of such loans. There can be no complete assurance, however, that the Internal Revenue Service, or IRS, will not successfully assert a contrary position, in which case we would be subject to the prohibited transactions tax on the gain from the sale of such loans, which would reduce our distributions to you.

Certain of our financing activities may subject us to U.S. federal income tax.

It is possible that certain of our financing activities, such as securitizations, may result in treatment of us or a portion of our assets as a “taxable mortgage pool” for U.S. federal income tax purposes. As a result, although the law on the matter is unclear, we might be taxable at the highest corporate income tax rate on a portion of the income arising from a taxable mortgage pool that is allocable to the percentage of our stock held by “disqualified organizations,” which are generally certain cooperatives, governmental entities and tax-exempt organizations that are exempt from unrelated business taxable income. We expect that disqualified organizations will own our stock. Because this tax would be imposed on us, all of our investors,

including investors that are not disqualified organizations, would bear a portion of the tax cost associated with the classification of us or a portion of our assets as a taxable mortgage pool. We may, in our discretion, elect to conduct financing activities that otherwise would result in our treatment as a taxable mortgage pool through KKR TRS Holdings, Inc., our domestic taxable REIT subsidiary. In such case, we would not be subject to the special REIT rules regarding taxable mortgage pools but taxable income associated with such financing activities would be subject to federal, state and local income tax.

Failure to qualify as a REIT would subject us to U.S. federal income tax, which would reduce the cash available for distribution to our stockholders.

We operate, and intend to continue to operate, in a manner that is intended to cause us to qualify as a REIT for U.S. federal income tax purposes commencing with our short taxable year ended on December 31, 2004. The U.S. federal income tax laws governing REITs are extremely complex, however, and interpretations of the U.S. federal income tax laws governing qualification as a REIT are limited. Qualifying as a REIT requires us to meet various tests regarding the nature of our assets and our income, the ownership of our outstanding stock, and the amount of our distributions on an ongoing basis. While we have operated and intend to continue to operate so that we will qualify as a REIT, given the highly complex nature of the rules governing REITs, the ongoing importance of factual determinations and the possibility of future changes in our circumstances, no assurance can be given that we will so qualify for any particular year.

If we fail to qualify as a REIT in any calendar year, we would be required to pay U.S. federal income tax on our taxable income. We might need to borrow money or sell assets in order to pay that tax. Our payment of income tax would decrease the amount of our income available for distribution to our stockholders. Furthermore, if we fail to maintain our qualification as a REIT, we no longer would be required to distribute substantially all of our REIT taxable income to our stockholders. Unless our failure to qualify as a REIT were excused under federal tax laws, we could not re-elect REIT status until the fifth calendar year following the year in which we failed to qualify.

Failure to make required distributions would subject us to tax, which would reduce the cash available for distribution to our stockholders.

In order to qualify as a REIT, an entity must distribute annually to its stockholders, each calendar year, at least 90% of its REIT taxable income, determined without regard to the deduction for dividends paid and excluding net capital gain. To the extent that a REIT satisfies the 90% distribution requirement, but distributes less than 100% of its taxable income, it will be subject to federal corporate income tax on its undistributed income. In addition, a REIT will incur a 4% nondeductible excise tax on the amount, if any, by which its distributions in any calendar year are less than the sum of:

· 85% of its REIT ordinary income for that year;

· 95% of its REIT capital gain net income for that year; and

· 100% of its undistributed taxable income from prior years.

We intend to pay out our REIT taxable income to our stockholders in a manner intended to satisfy the 90% distribution requirement and to avoid both corporate income tax and the 4% nondeductible excise tax. There is, however, no requirement that domestic taxable REIT subsidiaries distribute their after-tax net income to their parent REIT or their stockholders, and our domestic taxable REIT subsidiary may determine not to make any distributions to us.

PART II

Item 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information

Our common stock is traded on the NYSE under the symbol “KFN.” On March 24, 2006, the closing price of our common stock, as reported on the NYSE, was $22.50. The following table sets forth the high and low sale prices for our common stock for the period indicated as reported on the NYSE:

	Sales Price
Quarter Ended	High	Low
June 30, 2005 (from June 24, 2005)	25.07	24.00
September 30, 2005	25.01	21.55
December 31, 2005	24.18	20.71

As of March 24, 2006, we had 80,374,061 issued and outstanding shares of common stock that were held by 19 holders of record. The 19 holders of record include Cede & Co., which holds shares as nominee for The Depository Trust Company, which itself holds shares on behalf of the beneficial owners of our common stock.

Distributions

We generally need to distribute at least 90% of our net taxable income each year (subject to certain adjustments) so that we can qualify as a REIT under the Internal Revenue Code. Up to 20% of the value of a REIT’s assets may consist of investments in the securities of one or more taxable REIT subsidiaries. A domestic taxable REIT subsidiary, such as KKR TRS Holdings, Inc., may retain its taxable income, and its earnings are subject to the 90% distribution requirement only to the extent the domestic taxable REIT subsidiary actually distributes its earnings to the REIT. However, a foreign taxable REIT subsidiary, such as KKR Financial CLO 2005-1, Ltd., KKR Financial CLO 2005-2, Ltd., KKR Financial CDO 2005-1, Ltd., and KKR Financial CLO 2006-1, Ltd., generally is deemed to distribute its earnings to the REIT on an annual basis for federal income tax purposes, and its earnings are subject to the 90% distribution requirement, regardless of whether it actually distributes its earnings.

Subject to the distribution requirements referred to above, we intend, to the extent practicable, to invest substantially all of the proceeds from repayments, sales and refinancings of our assets in real estate-related assets and other assets. We may, however, under certain circumstances, make a distribution of capital or of assets. Such distributions, if any, will be made at the discretion of our board of directors. Distributions will be made in cash to the extent that cash is available for distribution.

The actual amount and timing of distributions will be at the discretion of our board of directors and may not be in even amounts throughout our fiscal year.

The following table shows the distributions relating to our 2005 fiscal year:

	Record Date		Payment Date		Cash Distribution Declared per Share
April 5, 2005		April 18, 2005		$0.25
June 21, 2005		August 2, 2005		$0.40
November 16, 2005		November 30, 2005		$0.32
February 15, 2006		February 28, 2006		$0.40

Item 6. SELECTED CONSOLIDATED FINANCIAL DATA

The following selected financial data is derived from our audited consolidated financial statements for the year ended December 31, 2005 and for the period ended December 31, 2004. You should read the selected financial data together with the more detailed information contained in the consolidated financial statements and associated notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Annual Report on Form 10-K.

	Year Ended December 31, 2005				Period from August 12, 2004 (inception) through December 31, 2004
	(in thousands, except per share data)
Consolidated Statement of Operations Data:
Net Investment Income:
Total investment income		$	399,929			$	8,122
Interest expense		(279,718		)		(975		)
Provision for loan losses		(1,500		)		—
Net investment income		118,711				7,147
Other income (loss):
Total other income (loss)		7,560				(488		)
Non-investment expenses:
Related party management compensation		50,791				11,222
Professional services		4,121				901
Loan servicing expense		5,143				—
Insurance expenses		975				335
Directors expenses		1,071				341
Other general and administrative expenses		5,945				797
Total non-investment expenses		68,046				13,596
Net income (loss) before income tax expense (benefit)		58,225				(6,937		)
Income tax expense (benefit)		3,144				(228		)
Net income (loss)		$ 55,081				$ (6,709		)
Net income (loss) per common share:
Basic		$ 0.93				$ (0.17		)
Diluted		$ 0.92				$ (0.17		)
Weighted-average number of common shares outstanding:
Basic		58,998				39,796
Diluted		60,087				39,796
Distributions declared per common share		$ 0.97				—

	As of December 31, 2005			As of December 31, 2004
	(in thousands, except per share data)
Consolidated Balance Sheet Data:
Cash and cash equivalents		$	16,110		$	7,219
Restricted cash and cash equivalents		80,223			1,321
Securities available-for-sale, $5,910,399 and $1,484,222 pledged as collateral as of December 31, 2005 and 2004, respectively		6,149,506			1,651,280
Loans, net of allowance for loan losses of $1,500 and 0 as of December 31, 2005 and 2004, respectively		8,846,341			682,757
Total assets		15,290,540			2,347,340
Total borrowings		13,363,838			1,586,149
Total liabilities		13,635,394			1,590,592
Total stockholders’ equity		1,655,146			756,748
Book value per share		$	20.59		$	18.46

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Except where the context suggests otherwise, the terms “we,” “us” and “our” refer to KKR Financial Corp. and its subsidiaries.

Executive Overview

We are a specialty finance company that invests in multiple asset classes and uses leverage to generate competitive leveraged risk-adjusted returns subject to maintaining our status as a REIT, and our exemption from regulation under the Investment Company Act of 1940, as amended (the “Investment Company Act”). Our objective is to provide competitive returns to our investors through a combination of dividends and capital appreciation. As part of our multi-asset class strategy, we seek to invest opportunistically in those asset classes that can generate competitive leveraged risk-adjusted returns. Investing in multiple asset classes does not, however, reduce or eliminate many of the risks associated with our investment portfolio such as geographic concentration risk, asset class concentration risk, market risk and credit risk. We currently make investments in the following asset classes: (i) residential mortgage loans and mortgage-backed securities; (ii) corporate loans and debt securities; (iii) commercial real estate loans and debt securities; (iv) asset-backed securities; and (v) marketable and non-marketable equity securities. We also make opportunistic investments in other asset classes from time to time. Our investment guidelines do not impose any limitations on the amount of our investments in any specific asset class, industry, or investment. Our income is generated primarily from the difference between the interest and dividend income earned on our investments and the cost of our borrowings, plus (i) realized and unrealized gains and losses our free-standing derivatives, (ii) realized gains and losses from the sales of investments, and (iii) fee income.

We were organized as a Maryland corporation on July 7, 2004 and commenced operations on August 12, 2004 (“Inception”). We are managed by KKR Financial Advisors LLC (the “Manager”) pursuant to a management agreement (the “Management Agreement”). The Manager is an affiliate of Kohlberg Kravis Roberts & Co. L.P. The Company is taxed as a real estate investment trust (“REIT”) and is required to comply with the provisions of the Internal Revenue Code of 1986, as amended (the “Code”) with respect thereto.

We completed our initial private placement of shares of our common stock on August 12, 2004, which generated net proceeds of approximately $755.5 million. We completed our initial public offering (“IPO”) of our common stock on June 29, 2005, which generated net proceeds of approximately $848.8 million. In the IPO we sold 37,500,000 shares of common stock at $24.00 per share. The IPO included 28,750 shares of common stock that were sold by existing stockholders. Our stock is listed on the New York Stock Exchange under the symbol “KFN” and began trading on June 24, 2005. On June 23, 2005 we effected a reverse stock split of our common stock at a ratio of one share of common stock for every two shares of common stock then outstanding. The accompanying consolidated financial statements have been adjusted to give effect to the reverse stock split for all periods presented.

We commenced our investment activities by funding our first investment on September 30, 2004. Assuming no material changes in market conditions or our business strategy, our objective is to have fully deployed our capital on a fully leveraged basis by the end of the second quarter of 2006. We used the proceeds from our IPO to reduce short-term borrowings and intend to fund future investments principally through borrowings until such time that we fully deploy our capital on a fully leveraged basis. Provided that market conditions and market opportunities are favorable, we may undertake to raise additional equity capital subsequent to the deployment of our existing capital and leverage.

Cash Distributions to Stockholders

Our total distributions for 2005, including a distribution for the fourth quarter that was declared on February 1, 2006, totaled $84.5 million.

Investment Portfolio

As of December 31, 2005, our investment portfolio totaled $15.0 billion, representing an increase of 552.2% from $2.3 billion as of December 31, 2004. As of December 31, 2005, our investment portfolio primarily consisted of residential mortgage loans and securities totaling $12.0 billion, corporate loans and securities totaling $2.4 billion, commercial real estate loans and securities totaling $604.0 million, and marketable equity securities consisting of preferred and common stock totaling $47.0 million. In addition, our investment portfolio includes investments in non-marketable equity securities totaling $52.5 million as of December 31, 2005.

Funding Activities

We have expanded our sources of funding during 2005. During 2005 we completed our IPO which generated net proceeds of $848.8 million. Consistent with 2004, our primary source of borrowed funding continues to be from repurchase agreements which totaled $9.8 billion, or 73% of our totaling borrowings as of December 31, 2005. Additionally, we closed two separate $1 billion collateralized loan transactions during 2005 from which $1.5 billion of senior secured notes were issued. We also closed our first asset-backed commercial paper conduit during 2005, from which we had $2.0 billion of secured liquidity notes outstanding as of December 31, 2005. We also entered into a $275 million 364-day secured revolving credit facility from which we had borrowed $54.0 million as of December 31, 2005.

Critical Accounting Policies

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

Revenue Recognition

We account for interest income on our investments using the effective yield method. For investments purchased at par, the effective yield is the contractual coupon rate on the investment. Unamortized premiums and discounts on non-residential mortgage-backed securities are recognized in interest income over the contractual life, adjusted for actual prepayments, of the securities using the effective interest method. For securities representing beneficial interests in securitizations (i.e., residential mortgage-backed securities), unamortized premiums and discounts are recognized over the contractual life, adjusted for estimated prepayments and estimated credit losses of the securities using the effective interest method. Actual prepayment and credit loss experience is reviewed quarterly and effective yields are recalculated when differences arise between prepayments and credit losses originally anticipated compared to amounts actually received plus anticipated future prepayments.

for actual prepayments, of the loans using the effective interest method. For residential mortgage loans, unamortized premiums and discounts are recognized over the contractual life, adjusted for estimated prepayments using the effective interest method.

As of December 31, 2005, unamortized purchase premiums and unaccreted purchase discounts on our investment portfolio totaled $42.8 million and $49.5 million, respectively.

Share-Based Payment

We account for share-based compensation issued to members of our board of directors and our Manager using the fair value based methodology in accordance with SFAS No. 123(R). We do not have any employees, although we believe that members of our board of directors are deemed to be employees for purposes of interpreting and applying accounting principles relating to share-based compensation. We record as compensation costs the restricted common stock that we issued to members of our board of directors at estimated fair value as of the grant date and we amortize the cost into expense over the three-year vesting period using the straight-line method. We recorded compensation costs for restricted common stock and common stock options that we issued to our Manager at estimated fair value as of the grant date and we remeasure the amount on subsequent reporting dates to the extent that the restricted common stock and/or common stock options have not vested. Unvested restricted common stock is valued using observable secondary market prices. Unvested common stock options are valued using the Black-Scholes model and assumptions based on observable market data for comparable companies. We amortize compensation expense related to the restricted common stock and common stock options that we granted to our Manager using the graded vesting attribution method in accordance with SFAS No. 123(R).

Because we remeasure the amount of compensation costs associated with the unvested restricted common stock and unvested common stock options that we issued to our Manager as of each reporting period, our share-based compensation expense reported in our consolidated financial statements will change based on the estimated fair value of our common stock and this may result in earnings volatility. For the year ended December 31, 2005, share-based compensation totaled $30.2 million. As of December 31, 2005, substantially all of the non-vested common stock options and restricted common stock issued that is subject to SFAS No. 123(R) is subject to remeasurement. As of December 31, 2005, a $1 increase in the price of our common stock increases our future share-based compensation expense by approximately $3.0 million and this future share-based compensation expense would be recognized over the remaining vesting periods of our outstanding restricted common stock and common stock options. As of December 31, 2005, future unamortized share-based compensation totaled $41.7 million, of which $27.8 million, $11.2 million, and $2.7 million will be recognized in 2006, 2007, and 2008.

Classifications of Investment Securities

Our investments in securities are classified as “available-for-sale” and are recorded and reported on our consolidated balance sheet at estimated fair value with unrealized gains and losses reported in accumulated other comprehensive income (loss) on our consolidated balance sheet. We designate and classify our investments in securities as available-for-sale because we may sell them prior to their maturity date. We do not designate and classify our investments in securities as trading securities because we do not intend to trade them or sell them in the near term. We determine the estimated fair value of our investments in securities using quoted market prices, dealers who make markets in the securities, and third-party pricing services. When we sell an investment security, the realized net gain or loss on the sale of the security is included in our consolidated statements of operations and we specifically identify the security that was sold and its specific cost basis when we compute the net realized gain or loss.

Accounting for Derivative Instruments and Hedging Activities

Our policies permit us to enter into derivative contracts, including interest rate swaps, interest rate corridors, interest rate swaptions, interest rate straddles, and credit and currency derivatives. We use interest rate derivatives to manage interest rate risk. We formally document relationships between our hedging instruments and our hedged transactions as of the inception date of the hedge, including (i) our risk management objective and hedge strategy, (ii) the risk that we are hedging, (iii) the hedging instruments, consisting of the derivative instruments that comprise the hedge, (iv) the hedged transaction, consisting of the recognized or forecasted transaction that we are hedging, (v) the method that we used to assess the hedge’s effectiveness on a retrospective and prospective basis, and (vi) the methodology that we will use to measure hedge ineffectiveness. On the date that we enter into an interest rate derivative transaction we designate the interest rate derivative as (i) a hedge of a forecasted transaction or of the variability of cash flows related to a recognized liability (“cash flow hedge”) or (ii) held for trading (“trading instrument”). Our interest rate swaptions are undesignated derivative contracts and accounted for as trading instruments, and our interest rate swap and interest rate corridor contracts are designated and accounted for as cash flow hedges. As of December 31, 2005, we have not entered into any interest rate derivative transactions that are designated as a hedge of the estimated fair value of a recognized asset or liability or of an unrecognized firm commitment (“fair value hedge”).

For our cash flow hedges, we record and report our hedge instruments at estimated fair value on our balance sheet and record the changes in their estimated fair value in accumulated other comprehensive income (loss). Changes in these amounts are reclassified to our statements of operations over the effective hedge period as the hedged item affects earnings. Our cash flow hedge instrument must be “highly effective,” as defined in SFAS No. 133, in achieving offsetting changes in the hedged item attributable to the risk that we are hedging in order to qualify for initial and recurring hedge accounting treatment. We recognize any hedge ineffectiveness related to our cash flow hedges as a component of interest expense during the period in which it occurs. Prior to the end of the specified cash flow hedge period, the effective portion of our hedge instrument gains and losses is recorded in other accumulated comprehensive income (loss). The estimated fair values of our hedge instruments are based on market prices provided by dealers that make markets in such hedging instruments. For our cash flow hedges, we are required to discontinue hedge accounting prospectively when we determine that (i) the hedging instruments are no longer effective in offsetting changes in the cash flows of a hedged transaction, (ii) we determine that it is no longer probable that the forecasted transaction will occur, or (iii) the designation of the hedging instruments as hedges is no longer permitted or appropriate.

We are not required to account for our derivative contracts using hedge accounting as described above. If we decide not to designate the derivative contracts as hedges or if we fail to fulfill the criteria necessary to qualify for hedge accounting, then the changes in the estimated fair values of our derivative contracts would affect periodic earnings immediately potentially resulting in the increased volatility of our earnings. The qualification requirements for hedge accounting are complex and as a result we must evaluate, designate, and thoroughly document each hedge transaction at inception and perform ineffectiveness analysis and prepare related documentation at inception and on a recurring basis thereafter. As of December 31, 2005, the estimated fair value of our derivatives totaled $57.4 million. As of December 31, 2005, the estimated fair value of interest rate derivatives accounted for as cash flow hedges totaled approximately $55.6 million and the net change in unrealized gain on such cash flow hedges totaled approximately $45.6 million, which amount is recorded in accumulated other comprehensive income in the consolidated statements of changes in stockholders’ equity. During 2005 we purchased an interest rate corridor for a cost of $10.0 million which has an effective date of March 25, 2006 and a maturity date of January 25, 2009. The purchase price of the corridor will be amortized in accordance with SFAS No. 133 Implementation Issue No. G20, Cash Flow Hedges: Assessing and Measuring the Effectiveness of a Purchase Option Used in a Cash Flow Hedge, and will result in an increase in interest expense of $2.2 million, $3.8

million, and $4.0 million in 2006, 2007, and 2008, respectively, exclusive of any payments we receive in connection with the corridor, if any.

Impairments

We evaluate our investment portfolio for impairment as of each quarter end or more frequently if we become aware of any material information that would lead us to believe that an investment may be impaired. We evaluate whether the investment is considered impaired and whether the impairment is other-than-temporary. If we make a determination that the impairment is other-than-temporary, we recognize an impairment loss equal to the difference between the amortized cost basis and the estimated fair value of the investment. We consider many factors in determining whether the impairment of an investment is other-than-temporary, including but not limited to the length of time the security has had a decline in estimated fair value below its amortized cost, the amount of the loss, the intent and our financial ability to hold the investment for a period of time sufficient for a recovery in its estimated fair value, recent events specific to the issuer or industry, external credit ratings and recent downgrades in such ratings. As of December 31, 2005, we had aggregate unrealized losses on our securities classified as available-for-sale of approximately $45.3 million, which if not recovered may result in the recognition of future losses. As of December 31, 2005, $36.9 million of the aggregate unrealized losses were associated with investments rated Aaa by Moody’s and AAA by Standard and Poor’s.

Allowance for Loan Losses

We maintain an allowance for loan losses at a level that we believe is adequate based on an evaluation of known and inherent risks related to our loan investments. When determining the adequacy of the allowance for loan losses we consider historical and industry loss experience, economic conditions and trends, the estimated fair values of our loans, credit quality trends and other factors that we determine are relevant. To estimate the allowance for loan losses, we first identify impaired loans. Loans are generally evaluated for impairment individually, but loans purchased on a pooled basis with relatively smaller balances and substantially similar characteristics may be evaluated collectively for impairment. We consider a loan to be impaired when, based on current information and events, we believe it is probable that we will be unable to collect all amounts due to us based on the contractual terms of the loan. When a loan is impaired, the allowance for loan losses is increased by the amount of the excess of the amortized cost basis of the loan over its estimated fair value. Increases in the allowance for loan losses are recognized in our results of operations as a provision for loan losses. When we make a determination that some or all of a loan is uncollectible, we charge-off or write-down the loan and the allowance for loan losses is reduced.

Currently, our residential mortgage loans are relatively homogeneous and the adequacy of the allowance for loan losses is based on a review of relevant factors including, but not limited to, estimated fair values, industry statistics, current economic conditions, loan portfolio composition, delinquency trends and credit losses realized to-date on underlying loans. Because our mortgage loan portfolio is not seasoned, we review these factors for similar portfolios of mortgage loans that have comparable FICO® scores, loan-to-value ratios (“LTV”), loan balances, and geographical diversity and that were originated through similar mortgage banking channels, and we use this information when assessing the adequacy of the allowance for loan losses. Our investments in commercial real estate mortgage loans and corporate loans are not homogeneous and we individually review each of the loans for impairments and use relevant information in our analysis, including current estimated fair values, current valuation multiples, projected operating cash flow and projected liquidation cash flows.

Recent Accounting Pronouncements

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, which replaces APB Opinion No. 20, Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements—An Amendment of APB Opinion No. 28. SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an error. SFAS No. 154 is required to be adopted by the Company in the first quarter of 2006. We do not expect that the adoption of SFAS No. 154 will have a material effect on our consolidated financial statements.

In November 2005, the FASB issued FASB Staff Position FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (“FSP 115-1”), which provides guidance on determining when investments in certain debt and equity securities are considered impaired, whether that impairment is other-than-temporary, and on measuring such impairment loss. FSP 115-1 also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. FSP 115-1 is required to be adopted by the Company in the first quarter of 2006. We do not expect that the adoption of FSP 115-1 will have a material effect on our consolidated financial statements.

In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments. Key provisions of SFAS No. 155 include: (1) a broad fair value measurement option for certain hybrid financial instruments that contain an embedded derivative that would otherwise require bifurcation; (2) clarification that only the simplest separations of interest payments and principal payments qualify for the exception afforded to interest-only strips and principal-only strips from derivative accounting under paragraph 14 of SFAS No. 133 (thereby narrowing such exception); (3) a requirement that beneficial interests in securitized financial assets be analyzed to determine whether they are freestanding derivatives or whether they are hybrid instruments that contain embedded derivatives requiring bifurcation; (4) clarification that concentrations of credit risk in the form of subordination are not embedded derivatives; and (5) elimination of the prohibition on a QSPE holding passive derivative financial instruments that pertain to beneficial interests that are or contain a derivative financial instrument. In general, these changes will reduce the operational complexity associated with bifurcating embedded derivatives, and increase the number of beneficial interests in securitization transactions, including interest-only strips and principal-only strips, required to be accounted for in accordance with SFAS No. 133. We do not expect that the adoption of SFAS No. 155 will have a material effect on our consolidated financial statements.

Results of Operations

Year ended December 31, 2005 compared to period from August 12, 2004 (Inception) through December 31, 2004

Summary

Our net income for the year ended December 31, 2005 totaled $55.1 million (or $0.92 per diluted share) as compared to a net loss of $6.7 million (or $0.17 per diluted share) for the period from inception through December 31, 2004. During the year ended December 31, 2005, our investment portfolio increased by 552.2% from $2.3 billion as of December 31, 2004 to $15.0 billion as of December 31, 2005.

Net Investment Income

The following table presents the components of our net investment income for the year ended December 31, 2005 and for period from August 12, 2004 (inception) through December 31, 2004:

Comparative Net Investment Income Components
(Amounts in thousands)

	For the year ended December 31, 2005				For the period from August 12, 2004 (inception) through December 31, 2004
Investment Income:
Residential mortgage loans and securities interest income		$	281,985			$	2,041
Corporate loans and securities interest income		95,852				1,895
Commercial real estate loans and securities interest income		19,284				689
Other interest income		3,335				3,197
Common and preferred stock dividend income		3,421				296
Net premium/discount (amortization) accretion		(3,948		)		4
Total investment income		399,929				8,122
Interest Expense:
Repurchase agreements interest expense		237,985				975
Collateralized loan obligation senior secured notes interest expense		28,269				—
Asset-backed secured liquidity notes interest expense		8,065				—
Secured revolving credit facility interest expense		245				—
Demand loan interest expense		1,430				—
Other interest expense		803				—
Interest rate swaps interest expense, net		2,921				—
Total interest expense		(279,718		)		(975		)
Provision for loan losses		(1,500		)		—
Net investment income		$	118,711			$	7,147

As presented in the table above, our net investment income increased by $111.6 million in 2005 compared to 2004. The change from 2004 to 2005 is primarily attributable to the increase in our investment portfolio during 2005. As of December 31, 2005, we held $15.0 billion in investments in loans and securities available-for-sale and had borrowings outstanding totaling $13.4 billion. Additionally, we recorded a provision for loans losses of $1.5 million during the year ended December 31, 2005. In comparison, as of December 31, 2004, investments in loans and securities available-for-sale totaled $2.3 billion and borrowings outstanding totaled $1.6 billion. In addition, the results for 2004 reflect less than a full year since we commenced operations on August 12, 2004.

Other Income

The following table presents the components of other income for the year ended December 31, 2005 and the period from August 12, 2004 (inception) through December 31, 2004:

Comparative Other Income Components
(Amounts in thousands)

	For the year ended December 31, 2005				For the period from August 12, 2004 (inception) through December 31, 2004
Net realized and unrealized gain (loss) on derivatives and foreign exchange:
Interest rate swaptions		$	(424	)		$	(28	)
Interest rate swaps		758				—
Credit default swaps		(259		)		(417		)
Total rate of return swaps		755				—
Foreign exchange contracts		2,211				(125		)
Foreign exchange translation		(2,928		)		—
Total realized and unrealized gain (loss) on derivatives and foreign exchange		113				(570		)
Net realized gain on investments		4,117				75
Fee and other income		3,330				7
Total other income (loss)		$	7,560			$	(488	)

As presented in the table above, other income totaled $7.6 million for the year ended December 31, 2005 as compared to a loss of $0.5 million for the period from August 12, 2004 (inception) through December 31, 2004. The increase in total other income from prior period is primarily attributable to increased investment activity in 2005 and as previously noted, since we commenced operations on August 12, 2004, 2004 results reflect less than a full year.

Non-Investment Expenses

The following table presents the components of non-investment expenses for the year ended December 31, 2005 and for period from August 12, 2004 (inception) through December 31, 2004:

Comparative Non-Investment Expense Components
(Amounts in thousands)

	For the year ended December 31, 2005			For the period from August 12, 2004 (inception) through December 31, 2004
Related party management compensation:
Base management fees		$	20,982		$	5,112
Share-based compensation		29,809			6,110
Related party management compensation		50,791			11,222
Professional services		4,121			901
Loan servicing expense		5,143			—
Insurance expense		975			335
Directors expenses		1,071			341
General and administrative expenses		5,945			797
Total non-investment expenses		$	68,046		$	13,596

As presented in the table above, our non-investment expenses increased by $54.5 million for the year ended December 31, 2005 compared to the period from August 12, 2004 (inception) through December 31, 2004. The increase in non-investment expenses from prior period is primarily attributable to our growth in 2005 and as previously noted; we commenced operations on August 12, 2004 and therefore 2004 results reflect less than a full year of operations. The significant components of non-investment expense are described below.

Management compensation to related parties consists of base management fees payable to our Manager pursuant to the Management Agreement, and share-based compensation related to restricted common stock and common stock options granted to our Manager. The base management fee payable was calculated in accordance with the Management Agreement and is based on an annual rate of 1.75% times “equity” as defined in the Management Agreement. Our Manager is also entitled to an incentive fee provided that our quarterly “net income,” as defined in the Management Agreement, before the incentive fee exceeds a defined return hurdle. We did not exceed the applicable hurdle during either the year ended December 31, 2005 or the period from August 12, 2004 (inception) through December 31, 2004; accordingly, no incentive fee was earned or paid.

General and administrative expenses consist of expenses incurred by our Manager on our behalf that are reimbursable to our Manager pursuant to the Management Agreement. We expect that our general and administrative expenses will continue to increase as our investment portfolio continues to increase. Professional services expenses consist of legal, accounting and other professional services. We expect that our recurring professional services expenses will continue to increase as our investment portfolio continues to increase. Loan servicing expense consists of fixed servicing fees paid to third-party servicers. We expect that loan servicing expense will continue to increase as our residential loan portfolio continues to increase.

Income Tax Provision

We have elected to be taxed as a REIT and intend to continue to comply with the provisions of the Code with respect thereto. Accordingly, we are not subject to federal income tax to the extent that our distributions to stockholders satisfy the REIT requirements and certain asset, income and ownership tests,

and recordkeeping requirements are fulfilled. Even though we qualify for federal taxation as a REIT, we may be subject to some amount of federal, state, local and foreign taxes based on our taxable income and we have provided for such taxes in the amount of $0.5 million for the year ended December 31, 2005.

KKR TRS Holdings, Inc., our domestic taxable REIT subsidiary, is taxed as a regular subchapter C corporation under the provisions of the Code. KKR TRS Holdings, Inc. was formed to make, from time to time, certain investments that would not be REIT qualifying investments if made directly by us, and to earn income that would not be REIT qualifying income if earned directly by us. For the year ended December 31, 2005, KKR TRS Holdings, Inc. had pre-tax net income of $6.0 million and the provision for income taxes totaled $2.6 million. As of December 31, 2005, KKR TRS Holdings, Inc. had an income tax liability of $2.4 million.

KKR Financial CLO 2005-1, Ltd., KKR Financial CLO 2005-2, Ltd., KKR Financial CDO 2005-1, Ltd., and KKR Financial CLO 2006-1, Ltd., are foreign taxable REIT subsidiaries that were established to facilitate securitization transactions structured as secured financing transactions. They are organized as exempted companies incorporated with limited liability under the laws of the Cayman Islands, and are generally exempt from federal and state income tax at the corporate entity level because they restrict their activities in the United States to trading in stock and securities for their own account. Therefore, despite their status as taxable REIT subsidiaries, they generally will not be subject to corporate income tax on their earnings, and no provisions for income taxes for the year ended December 31, 2005 were recorded; however, we will generally be required to include their current taxable income in our calculation of REIT taxable income.

Financial Condition

Summary

The tables below summarize the carrying value, amortized cost, and estimated fair value of our investment portfolio as of December 31, 2005 and 2004, classified by interest rate type. Carrying value is the value that investments are recorded on our consolidated balance sheets and is estimated fair value for securities and amortized cost for loans held for investment and the lower of amortized cost or market value for loans held for sale. Estimated fair values set forth in the tables below are based on dealer quotes and/or nationally recognized pricing services.

The table below summarizes our investment portfolio as of December 31, 2005 classified by interest rate type:

Investment Portfolio
(Amounts in thousands)

	Carrying Value			Amortized Cost			Estimated Fair Value		Portfolio Mix % by Fair Value
Floating Rate:
Residential ARM Loans		$	2,175,929		$	2,175,929	$	2,163,932		14.5	%
Residential ARM Securities		3,375,434			3,369,763		3,375,434			22.6
Corporate Loans		1,872,277			1,872,277		1,886,372			12.6
Corporate Debt Securities		279,280			277,030		279,280			1.9
Commercial Real Estate Loans		486,096			486,096		485,775			3.3
Commercial Real Estate Debt Securities		63,032			63,168		63,032			0.4
Total Floating Rate		8,252,048			8,244,263		8,253,825			55.3
Hybrid Rate:
Residential Hybrid ARM Loans		4,252,893			4,252,893		4,224,234			28.3
Residential Hybrid ARM Securities		2,162,404			2,197,020		2,162,404			14.5
Total Hybrid Rate		6,415,297			6,449,913		6,386,638			42.8
Fixed Rate:
Corporate Loans		25,000			25,000		25,000			0.2
Corporate Debt Securities		202,474			202,748		202,474			1.4
Commercial Real Estate Loans		35,646			35,646		35,657			0.2
Commercial Real Estate Debt Securities		19,880			19,833		19,880			0.1
Total Fixed Rate		283,000			283,227		283,011			1.9
Total		$	14,950,345		$	14,977,403	$	14,923,474		100.0	%

The table above excludes marketable equity securities with a fair value of $47.0 million and amortized cost of $47.2 million, and non-marketable equity securities with a fair value of $52.5 million and amortized cost of $52.5 million as of December 31, 2005. As of December 31, 2005, the aggregate amortized cost value of the Company’s investment portfolio exceeded the aggregate fair value of its portfolio by $54.1 million and, as of the same date, the Company had unrealized gains totaling $45.6 million related to its cash flow hedges, as defined under SFAS No. 133. As of December 31, 2005, the aggregate net unamortized purchase discount related to the Company’s investment portfolio was $6.7 million.

The table below summarizes our investment portfolio as of December 31, 2004, classified by interest rate type:

Investment Portfolio
(Amounts in thousands)

	Carrying Value			Amortized Cost			Estimated Fair Value		Portfolio Mix % by Fair Value
Floating Rate:
Residential ARM Loans		$	233,120		$	233,120	$	233,877		10.1	%
Residential ARM Securities		1,582,711			1,581,824		1,582,711			68.7
Corporate Loans		394,387			394,387		396,873			17.2
Corporate Debt Securities		16,814			16,578		16,814			0.7
Commercial Real Estate Loans		50,000			50,000		50,250			2.2
Commercial Real Estate Debt Securities		12,007			12,000		12,007			0.5
Total Floating Rate		2,289,039			2,287,909		2,292,532			99.4
Hybrid Rate:
Residential Hybrid ARM Loans		—			—		—			—
Residential Hybrid ARM Securities		—			—		—			—
Total Hybrid Rate		—			—		—			—
Fixed Rate:
Corporate Loans		5,250			5,250		5,289			0.2
Corporate Debt Securities		8,086			8,000		8,086			0.4
Total Fixed Rate		13,336			13,250		13,375			0.6
Total		$	2,302,375		$	2,301,159	$	2,305,907		100.0	%

The table above excludes preferred stock with an estimated fair value of $31.7 million and an amortized cost of $31.1 million as of December 31, 2004. As of December 31, 2004, the aggregate net unamortized purchase discount related to our investment portfolio was $5.2 million.

Asset Quality

2005 Hurricanes

During the third quarter of 2005, the Gulf Coast region of the United States was severely impacted by Hurricanes Katrina and Rita. Our principal source of exposure to the hurricanes is through properties collateralizing our residential mortgage loans. As of December 31, 2005, no losses have been realized from the effects of the hurricanes. Based on our expectation that losses will be realized from the hurricanes, we have recorded a provision for loan losses of $1.3 million related to our residential mortgage loan portfolio. We do not believe that the hurricanes have had a material impact on our corporate or commercial real estate loan portfolio.

Asset Quality Review

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

credit ratings of our investment portfolio. For residential mortgage loans and residential mortgage-backed securities we monitor the credit quality of the underlying borrowers by monitoring trends and changes in the underlying borrowers’ FICO® scores. Borrowers with lower FICO® scores default more frequently than borrowers with higher FICO® scores. For residential and commercial real estate mortgage loans and mortgage-backed securities we monitor trends and changes in LTV ratios. Increases in LTV ratios are likely to result in higher realized credit losses when borrowers default.

Securities Available-for-Sale

The following table summarizes the amortized cost of our debt investment securities portfolio by investment class stratified by Moody’s and Standard & Poor’s ratings category as of December 31, 2005:

Investment Securities
(Amounts in thousands)

Ratings Category	Residential ARM Securities			Residential Hybrid ARM Securities		Corporate Debt Securities		Commercial Real Estate Debt Securities			Total
Aaa/AAA		$	3,310,370	$	2,134,333	$	—		$	—	$	5,444,703
Aa1/AA+ through Aa3/AA-		21,497		28,274		—			—		49,771
A1/A+ through A3/A-		15,498		17,916		—			—		33,414
Baa1/BBB+ through Baa3/BBB-		10,998		8,566		41,537			38,491		99,592
Ba1/BB+ through Ba3/BB-		4,714		3,622		150,719			25,000		184,055
B1/B+ through B3/B-		2,856		2,064		153,483			—		158,403
Caa1/CCC+ and lower		—		—		107,357			8,337		115,694
Non-Rated		3,830		2,245		26,682			11,173		43,930
Total		$	3,369,763	$	2,197,020	$	479,778		$	83,001	$	6,129,562

The following table shows the amortized cost of our debt investment securities portfolio by investment class stratified by Moody’s and Standard & Poor’s ratings category as of December 31, 2004:

Investment Securities
(Amounts in thousands)

Ratings Category	Residential ARM Securities			Residential Hybrid ARM Securities			Corporate Debt Securities			Commercial Real Estate Debt Securities			Total
Aaa/AAA		$	1,522,749		$	—		$	—		$	—	$	1,522,749
Aa1/AA+ through Aa3/AA-		21,500			—			—			—		21,500
A1/A+ through A3/A-		15,500			—			—			—		15,500
Baa1/BBB+ through Baa3/BBB-		11,000			—			5,000			12,000		28,000
Ba1/BB+ through Ba3/BB-		4,579			—			7,000			—		11,579
B1/B+ through B3/B-		2,695			—			7,578			—		10,273
Caa1/CCC+ and lower		—			—			5,000			—		5,000
Non-Rated		3,801			—			—			—		3,801
Total		$	1,581,824		$	—		$	24,578		$	12,000	$	1,618,402

Loans

Our residential mortgage loan portfolio totaled $6.4 billion as of December 31, 2005 and $0.2 billion as of December 31, 2004. As of December 31, 2005 and December 31, 2004, we did not own any real estate properties that we had acquired through foreclosure. The weighted average original FICO® score and

weighted average original LTV ratio of our residential ARM loan portfolio were 737 and 67.2%, respectively, as of December 31, 2005. As of December 31, 2004, the weighted average original FICO® score and weighted average LTV ratio of our residential ARM loan portfolio were 744 and 63.5%, respectively. As of December 31, 2005, our residential ARM loan investment portfolio did not have any material concentrations in investor owned properties, multi-unit housing properties, condominium properties and/or cooperative properties. A material portion of our residential ARM loans are non-conforming mortgage loans, not due to credit quality, but because the mortgage loans have balances that exceed the maximum balances necessary to qualify as a conforming mortgage loan.

During the year ended December 31, 2005, we recorded a provision for loan losses of $1.5 million related to our residential mortgage loan portfolio. For the year ended December 31, 2005 we had no charge-offs and none of our residential mortgage loans were in foreclosure. Of the $1.5 million provision for loan losses recorded during the year ended December 31, 2005, $1.3 million was recorded during the third quarter of 2005 in response to Hurricanes Katrina and Rita. As of December 31, 2005, no losses have been realized on mortgage loans located in the regions affected by the hurricanes. As of December 31, 2005, we believe that we are adequately reserved for losses inherent in our residential mortgage loan portfolio as of that date. As of December 31, 2004, we had not recorded an allowance for loan losses for our residential mortgage loan portfolio.

The following table summarizes the delinquency statistics of residential mortgage loans as of December 31, 2005 (dollar amounts in thousands):

Delinquency Status	Number of Loans		Principal Amount
30 to 59 days		82		$	31,049
60 to 89 days		11		3,427
90 days or more		6		1,589
In foreclosure		—		—
Total		99		$	36,065

No residential mortgage loans were delinquent as of December 31, 2004.

Our corporate loan portfolio totaled $1.9 billion as of December 31, 2005 and $0.4 billion as of December 31, 2004. Our corporate 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. As of December 31, 2005 and December 31, 2004, none of the corporate loans in our investment portfolio were delinquent. We performed an allowance for loan losses analysis as of December 31, 2005 and December 31, 2004, and we have made the determination that no allowance for loan losses was required for our corporate loan portfolio as of December 31, 2005 or December 31, 2004.

The following table summarizes the amortized cost of our corporate loans portfolio stratified by Moody’s and Standard & Poor’s ratings category as of December 31, 2005 and December 31, 2004:

Corporate Loans
(Amounts in thousands)

Ratings Category	As of December 31, 2005			As of December 31, 2004
Aaa/AAA		$	—		$	—
Aa1/AA+ through Aa3/AA-		—			—
A1/A+ through A3/A-		—			—
Baa1/BBB+ through Baa3/BBB-		2,000			—
Ba1/BB+ through Ba3/BB-		638,693			216,822
B1/B+ through B3/B-		1,127,400			182,815
Caa1/CCC+ and lower		21,410			—
Non-Rated		107,774			—
Total		$	1,897,277		$	399,637

Our commercial real estate loan portfolio totaled $521.7 million and $50.0 million as of December 31, 2005 and December 31, 2004, respectively. Our commercial real estate loan portfolio consists of senior, mezzanine, and bridge loans that are secured by commercial real estate. As of December 31, 2005 none of the commercial real estate loans in our investment portfolio were delinquent.

We performed an allowance for loan losses analysis as of December 31, 2005 and December 31, 2004, and we have made the determination that no allowance for loan losses was required for our commercial real estate loan portfolio as of December 31, 2005 or December 31, 2004.

The following table summarizes the amortized cost of our commercial real estate loans portfolio stratified by Moody’s and Standard & Poor’s ratings category as of December 31, 2005 and December 31, 2004:

Commercial Real Estate Loans
(Amounts in thousands)

Ratings Category	As of December 31, 2005			As of December 31, 2004
Aaa/AAA		$	—		$	—
Aa1/AA+ through Aa3/AA-		—			—
A1/A+ through A3/A-		—			—
Baa1/BBB+ through Baa3/BBB-		—			—
Ba1/BB+ through Ba3/BB-		60,929			—
B1/B+ through B3/B-		74,853			—
Caa1/CCC+ and lower		50,000			50,000
Non-Rated		335,960			—
Total		$	521,742		$	50,000

Asset Repricing Characteristics

Summary

The table below summarizes the repricing characteristics of our investment portfolio as of December 31, 2005 and December 31, 2004, and is classified by interest rate type:

Investment Portfolio
(Amounts in thousands)

	As of December 31, 2005						As of December 31, 2004
	Amortized Cost			Portfolio Mix			Amortized Cost			Portfolio Mix
Floating Rate:
Residential ARM Loans		$	2,175,929		14.5	%		$	233,120		10.1	%
Residential ARM Securities		3,369,763			22.5			1,581,824			68.8
Corporate Loans		1,872,277			12.5			394,387			17.1
Corporate Debt Securities		277,030			1.9			16,578			0.7
Commercial Real Estate Loans		486,096			3.2			50,000			2.2
Commercial Real Estate Debt Securities		63,168			0.4			12,000			0.5
Total Floating Rate		8,244,263			55.0			2,287,909			99.4
Hybrid Rate:
Residential Hybrid ARM Loans		4,252,893			28.4			—			—
Residential Hybrid ARM Securities		2,197,020			14.7			—			—
Total Hybrid Rate		6,449,913			43.1			—			—
Fixed Rate:
Corporate Loans		25,000			0.2			5,250			0.2
Corporate Debt Securities		202,748			1.4			8,000			0.4
Commercial Real Estate Loans		35,646			0.2			—			—
Commercial Real Estate Debt Securities		19,833			0.1			—			—
Total Fixed Rate		283,227			1.9			13,250			0.6
Total		$	14,977,403		100.0	%		$	2,301,159		100.0	%

Residential ARM Securities

As of December 31, 2005, substantially all of our residential ARM securities were comprised of one-month LIBOR floating rate securities that reprice monthly and were subject to a weighted average maximum net interest rate of 11.63% which is materially above the then current weighted average net coupon of 4.62%. Our repricing risk on our portfolio of residential ARM securities increases materially if interest rates continue to increase to a level where the weighted average coupon rate approaches the weighted average maximum net interest rate of 11.63% because the weighted average coupon is subject to a maximum rate, or cap, which is approximately equal to the weighted average maximum interest rate of 11.63%.

Residential Hybrid ARM Securities

As of December 31, 2005, all of our residential hybrid ARM securities had underlying mortgage loans that were originated as 5/1 hybrid ARM loans. As of December 31, 2005, we owned 100% of the securities that represent 100% of the beneficial interest in the 5/1 hybrid ARM loans underlying our portfolio of

hybrid ARM securities. When the underlying residential hybrid mortgage loans convert from fixed rate to floating rate, the underlying mortgage loans will have an interest rate based on one-year LIBOR or one-year constant maturity treasury index, or CMT, depending upon if the underlying mortgage loan is a LIBOR- or CMT-based mortgage loan. On the date that the residential hybrid ARM loans convert from a fixed rate to a floating rate loan, which we refer to as the roll date, our portfolio of residential hybrid ARM loans will have a weighted average coupon that is the sum of (i) the post-roll date index, and (ii) the weighted average post-roll date net margin. As of December 31, 2005 all of the mortgage loans underlying our residential hybrid ARM securities had a post-roll date index reset frequency of one year with 35% based on six-month or one-year LIBOR and 65% based on one-year CMT. Our repricing risk on our portfolio of residential hybrid ARM loans increases materially if interest rates continue to increase to a level where, subsequent to the roll date, the weighted average net coupon rate approaches the weighted average post roll date maximum net interest rate of 9.43% because the post roll date weighted average net coupon is subject to a maximum rate, or cap, which is approximately equal to the weighted average post roll date maximum net interest rate or 9.43%. The weighted average coupon on the portfolio of residential hybrid securities is 4.13% as of December 31, 2005. As of December 31, 2005, the weighted average months until roll date for the mortgage loans underlying our residential hybrid ARM securities was 36. We did not own any residential hybrid ARM securities as of December 31, 2004.

Residential ARM Loans

As of December 31, 2005, all of our residential ARM loans were comprised of one-month LIBOR floating rate loans that reprice monthly and were subject to a weighted average maximum net interest rate of 11.9%, which is well above the then current weighted average net coupon of 5.05%. Our repricing risk on our portfolio of residential ARM loans increases materially if interest rates continue to increase to a level where the weighted average net coupon rate approaches the weighted average maximum interest rate of 11.9% because the weighted average coupon is subject to a maximum rate, or cap, which is approximately equal to the weighted average maximum interest rate of 11.9%.

Residential Hybrid ARM Loans

As of December 31, 2005, all of our residential hybrid ARM loans were originated as either 3/1 or 5/1 hybrid ARM loans. When the loans convert from fixed rate to floating rate, the underlying mortgage loans will have an interest rate based on one-year LIBOR or one-year CMT. On the date that the residential hybrid ARM loans convert from a fixed rate to a floating rate loan, which we refer to as the roll date, our portfolio of residential hybrid ARM loans will have a weighted average coupon that is the sum of (i) the post-roll date index, and (ii) the weighted average post-roll date net margin. As of December 31, 2005 all of our residential hybrid ARM loans had a post-roll date index reset frequency of one-year with 43% based on six-month or one-year LIBOR and 57% based on one-year CMT. Our repricing risk on our portfolio of residential hybrid ARM loans increases materially if interest rates continue to increase to a level where, subsequent to the roll date, the weighted average net coupon rate approaches the weighted average post-roll date maximum net interest rate of 10.1% because the post-roll date weighted average net coupon is subject to a maximum rate, or cap, which is approximately equal to the weighted average post-roll date maximum net interest rate or 10.13%. The weighted average net coupon on the portfolio of residential hybrid loans is 4.85% as of December 31, 2005. As of December 31, 2005, the weighted average months until roll date for the mortgage loans underlying our residential hybrid ARM securities was 44. We did not own any residential hybrid ARM loans as of December 31, 2004.

Corporate Loans and Securities

All of our floating rate corporate loans and securities have index reset frequencies of less than twelve months with the majority of the loans resetting at least quarterly. The weighted average coupon on our

floating rate corporate loans and securities was 7.12% and 4.93% as of December 31, 2005 and December 31, 2004, respectively. As of December 31, 2005 and December 31, 2004, the weighted average years to maturity of our floating rate corporate loans and securities was 6.3 years and 6.0 years, respectively.

As of December 31, 2005, our fixed rate corporate debt securities had a weighted average coupon of 10.58% and a weighted average years to maturity of 8.7 years, as compared to 7.49% and 7.3 years, respectively, as of December 31, 2004.

Commercial Real Estate Loans and Securities

All of our floating rate commercial real estate loans and securities have index reset frequencies of less than twelve months. The weighted average coupon on our floating rate commercial real estate loans and securities was 8.70% and 5.60% as of December 31, 2005 and December 31, 2004, respectively. As of December 31, 2005 and December 31, 2004, the weighted average years to maturity of our floating rate commercial real estate loans and securities was 3.7 years and 5.7 years, respectively.

As of December 31, 2005, our fixed rate commercial real estate loans and securities had a weighted average coupon of 7.95% and a weighted average years to maturity of 7.7 years. We had no investments in fixed rate commercial real estate loans or securities as of December 31, 2004.

Portfolio Purchases

We purchased $15.6 billion par amount of investments during the year ended December 31, 2005. For the period from August 12, 2004 (inception) through December 31, 2004 we purchased $2.3 billion par amount of investments.

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

Investment Portfolio Purchases
(Amounts in thousands)

	Year ended December 31, 2005				Period from August 12, 2004 (inception) through December 31, 2004
	Par Amount		%		Par Amount		%
Securities:
Residential ARM Securities	$	2,918,325	18.7	%	$	1,604,594	69.1	%
Residential Hybrid ARM Securities	2,935,532		18.8		—		—
Corporate Debt Securities	557,820		3.6		24,500		1.1
Commercial Real Estate Debt Securities	85,671		0.6		12,000		0.5
Total Securities Principal Balance	6,497,348		41.7		1,641,094		70.7
Loans:
Residential ARM Loans	2,172,771		13.9		229,855		9.9
Residential Hybrid ARM Loans	4,547,632		29.2		—		—
Corporate Loans	1,870,849		12.0		400,774		17.3
Commercial Real Estate Loans	493,129		3.2		50,000		2.1
Total Loans Principal Balance	9,084,381		58.3		680,629		29.3
Grand Total Principal Balance	$	15,581,729	100.0	%	$	2,321,723	100.0	%

The table above excludes purchases of $28.3 million (purchase cost) of marketable equity securities during the year ended December 31, 2005 and $31.2 million during the period from August 12, 2004 (inception) through December 31, 2004. Purchases of $52.5 million of non-marketable equity securities are

also excluded from the table above. The investments in non-marketable securities consist of four private equity transactions where we co-invested with one or more private equity funds affiliated with KKR on a pari passu basis.

During the year ended December 31, 2005, we purchased $5.9 billion of securities in connection with five securitization transactions backed by $4.5 billion of residential hybrid ARM loans and $1.4 billion of residential ARM loans. In each of the five securitization transactions, we purchased all of the securities issued, including the subordinate classes. Included in the $5.9 billion of securities purchased, were $0.4 billion of loans we contributed to the securitization transactions, resulting in a net purchase of $5.5 billion of securities. Of the $5.9 billion of securities purchased, approximately 96% were rated AAA by Standard & Poor’s. Each of the special-purpose entities that issued the securities are not considered qualifying special-purpose entities as defined by SFAS No. 140 and are treated as variable interest entities under FIN 46R. We have determined that we are the primary beneficiary of each of the special purpose entities that issued the securities; accordingly, we have recorded these investments as loans and not securities on our Consolidated Balance Sheet.

In addition to the five securitization transactions previously described, during September 2005, we securitized $959.2 million of residential ARM loans and retained all of the securities issued in the securitization transaction, including the subordinate classes. While we retained all of the securities from this transaction, the loans transferred in this securitization are owned by a special purpose entity and the loans are not available to us, our creditors or our stockholders. Of the $959.2 million of securities issued, approximately $908.8 million, or 95%, were rated AAA by Standard & Poor’s. Even though we transferred the loans to a separate bankruptcy-remote legal entity, we did not account for the transaction as a sale as the securitization transaction did not meet the criteria for sales treatment under SFAS No. 140. Accordingly, we did not record a gain or loss in connection with the securitization transaction and have accounted for the transferred assets as loans on our Consolidated Balance Sheet.

During January 2006, we invested $40 million in a series of corporate floating rate notes which were rated BB by Standard and Poor’s and were issued by an unaffiliated third party. KKR Financial Advisors II, LLC (“KFA II”), a wholly-owned subsidiary of our Manager, is the collateral manager for the unaffiliated third party in connection with this corporate floating rate note transaction.

Stockholders’ Equity

Our stockholders’ equity at December 31, 2005 and December 31, 2004 totaled $1.7 billion and $756.7 million, respectively. Included in our stockholders’ equity as of December 31, 2005 and December 31, 2004, is accumulated other comprehensive income totaling $18.3 million and $1.7 million, respectively.

Our average stockholders’ equity and return on average stockholders’ equity for the year ended December 31, 2005 were $1.3 billion and 4.5%, respectively. Return on average stockholders’ equity is defined as net income divided by weighted average stockholders’ equity. Our weighted average stockholders’ equity and return on average equity for the period from August 12, 2004, the date we commenced operations, through December 31, 2004, were $756.1 million and (2.3%), respectively. Our weighted average stockholders’ equity for the period from July 7, 2004 (date of incorporation) through December 31, 2004, is not considered meaningful, as substantive operations did not begin until August 12, 2004.

Our book value per fully diluted share as of December 31, 2005 and December 31, 2004 was $20.59 and $18.46, respectively, and is computed based on 80,374,061 and 41,004,492 shares issued and outstanding as December 31, 2005 and December 31, 2004, respectively.

On April 5, 2005, our board of directors authorized a cash distribution of $0.25 per share to stockholders of record on April 5, 2005. This distribution was paid on April 18, 2005. The aggregate amount of the distribution, $10.3 million, exceeded net income for the quarter by $4.2 million.

On June 21, 2005, our board of directors declared a cash distribution for the quarter ended June 30, 2005 on our common stock to stockholders of record on June 21, 2005. On July 21, 2005, our board of directors set the amount of the cash distribution at $0.40 per share, paid on August 2, 2005. The aggregate amount of the distribution, $16.4 million, exceeded net income for the quarter by $7.9 million.

On November 2, 2005, our board of directors declared a cash distribution of $0.32 per share for the quarter ended September 30, 2005 to stockholders of record on November 16, 2005. The distribution was paid on November 30, 2005. The aggregate amount of the distribution, $25.7 million, exceeded net income for the quarter by $7.3 million.

On February 1, 2006, our board of directors declared a cash distribution of $0.40 per share for the quarter ended December 31, 2005 to stockholders of record on February 15, 2006. The distribution was paid on February 28, 2006. The aggregate amount of the distribution, $32.1 million, exceeded net income for the quarter by $10.1 million.

Liquidity and Capital Resources

We manage our liquidity with the intention of providing the continuing ability to fund our operations and fulfill our commitments on a timely and cost-effective basis. As of December 31, 2005 and December 31, 2004, we had unencumbered assets totaling $810.4 million and $580.0 million, respectively, consisting of unpledged investments, cash and cash equivalents, and other assets. We also have the ability to borrow additional amounts related to certain of our encumbered assets.

We believe that our liquidity level is in excess of that necessary to sufficiently enable us to meet our anticipated liquidity requirements including, but not limited to, funding our purchases of investments, required cash payments and additional collateral under our borrowings and our derivative transactions, required periodic cash payments related to our derivative transactions, payment of fees and expenses related to our Management Agreement, payment of general corporate expenses and general corporate capital expenditures and distributions to our stockholders. As of December 31, 2005, we owed our Manager $3.7 million for the payment of management fees and reimbursable expenses pursuant to the Management Agreement.

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

Our ability to meet our long-term liquidity and capital resource requirements may be subject to our ability to obtain additional debt financing and equity capital. We may increase our capital resources through offerings of equity securities (possibly including common stock and one or more classes of preferred stock), commercial paper, medium-term notes, securitization transactions structured as secured financings, and senior or subordinated notes. If we are unable to renew, replace or expand our sources of financing on substantially similar terms, it may have an adverse effect on our business and results of operations. Upon liquidation, holders of our debt securities and lenders with respect to other borrowings, as well as any holders of preferred stock that we may issue in the future, will receive a distribution of our available assets prior to holders of our common stock.

The decisions by investors and lenders to enter into equity and financing transactions with us will depend upon a number of factors, including our historical and projected financial performance, compliance with the terms of our current credit arrangements, industry and market trends, the availability of capital and our investors’ and lenders’ policies and rates applicable thereto, and the relative attractiveness of alternative investment or lending opportunities.

Any material event that impacts capital markets participants may also impair our ability to access additional liquidity and we may therefore be required to sell some or all of our portfolio investments in order to maintain sufficient liquidity. Such sales may be at prices lower than the carrying value of our pledged investments, which would result in our recognition of such losses and reduced income.

In order to continue to qualify as a REIT and to eliminate corporate income taxes on the income we distribute to our stockholders, we are required to distribute 90% to 100% of our ordinary taxable income and short-term capital gains on an annual basis.

Sources of Funds

Our sources of funding have consisted of the net proceeds from our August 2004 private placement of common stock and our June 2005 IPO of common stock of $755.5 million and $848.8 million, respectively. During the period from August 12, 2004 (Inception) through December 31, 2004, our primary source of funding after our August 2004 private placement consisted of borrowings under repurchase agreements. During the year ended December 31, 2005, our sources of borrowed funding consisted of borrowings under repurchase agreements and securitization transactions structured as secured financings. Our securitization transactions are accounted for as secured borrowings under SFAS No. 140. The securitization transactions we have utilized for secured financings have consisted of CLOs and asset-backed secured liquidity notes.

Equity Transactions

On August 12, 2004, we completed our initial private placement of our common stock at $20.00 per share that generated net proceeds of approximately $755.5 million. On June 29, 2005, we completed our IPO of 37,500,000 shares of common stock that generated net proceeds of approximately $848.8 million. We sold 37,471,250 common shares at a price of $24.00 per share and selling stockholders sold 28,750 shares. Our stock is listed on the New York Stock Exchange under the symbol “KFN” and began trading on June 24, 2005. On June 23, 2005, we effected a reverse stock split of our common stock at a ratio of one share of common stock for every two shares of common stock then outstanding.

Securitization Transactions

On March 30, 2005, we closed KKR Financial CLO 2005-1, Ltd. (“CLO 2005-1”), a $1.0 billion collateralized loan obligation transaction that provides us with secured financing for investments consisting of corporate loans and certain other loans and securities. The investments that are owned by CLO 2005-1 secure the CLO 2005-1 senior, mezzanine, and subordinate notes payable, and as a result, those investments are not available to us, our creditors or stockholders. CLO 2005-1 issued a total of $773.0 million of senior secured notes at par to investors and we retained $148.0 million of rated mezzanine notes and $85.5 million of unrated subordinated notes. The rated mezzanine notes consist of $64.0 million rated A2/A, $64.0 million rated Baa3/BBB-, $15.0 million rated Ba2/BB-, and $5.0 million rated B2/B-. All of the notes issued mature on April 26, 2017; however, we have the right to call the notes at par any time after April 2008.

The manager for CLO 2005-1 is KFA II. As compensation for the performance of its obligations under the collateral management agreement, KFA II is entitled to receive a senior collateral management fee of 0.15% per annum based on the aggregate principal amount of certain collateral, as calculated on a quarterly basis pursuant to the terms of the indenture. KFA II, in its sole and absolute discretion, may elect to defer or permanently waive payment of all or any portion of the foregoing fees on any related payment

date. KFA II has elected to permanently waive the senior collateral management fees from March 30, 2005 through April 26, 2006 and has advised us that it intends, but is not legally obligated, to waive such fees in the future until such time that our capital is fully deployed. There can be no assurances that KFA II will waive the senior collateral management fees for any period(s) subsequent to April 26, 2006.

On September 30, 2005, we closed a $5.0 billion asset-backed secured liquidity note facility. This facility provides us with an alternative source of funding our residential mortgage-backed securities by issuing asset-backed secured liquidity notes that are rated A-1+, P-1, and F1+, by Standard and Poor’s, Moody’s and Fitch Inc, respectively. Issuances of asset-backed secured liquidity notes are recorded as borrowings on our Consolidated Balance Sheet. At December 31, 2005, we had $2.0 billion of asset-backed secured liquidity notes outstanding.

On November 3, 2005, we closed KKR Financial CLO 2005-2, Ltd. (“CLO 2005-2”) our second $1.0 billion collateralized loan obligation transaction that provides us with secured financing for investments consisting of corporate loans and certain other loans and securities. The investments that are owned by CLO 2005-2 collateralize the CLO 2005-2 debt, and as a result, those investments are not available to us, our creditors or stockholders. CLO 2005-2 issued a total of $752.0 million of senior secured notes, including $150.0 million of senior delayed draw notes, at par to investors and we retained $168.0 million of rated mezzanine notes and $98.5 million of unrated subordinate notes. The rated mezzanine notes consist of $64.0 million rated A2/A, $64.0 million rated Baa2/BBB-, $30.0 million rated Ba2/BB-, and $10.0 million rated B2/B-. All of the notes issued mature on November 26, 2017; however, we have the right to call the notes at par any time after November 2009.

The manager for CLO 2005-2 is KFA II. As compensation for the performance of its obligations under the collateral management agreement, KFA II is entitled to receive a senior collateral management fee of 0.15% per annum based on the aggregate principal amount of certain collateral, as calculated on a quarterly basis pursuant to the terms of the indenture. KFA II, in its sole and absolute discretion, may elect to defer or permanently waive payment of all or any portion of the foregoing fees on any related payment date. KFA II has elected to permanently waive the senior collateral management fees from November 3, 2005 through May 26, 2006 and has advised us that it intends, but is not legally obligated, to waive such fees in the future until such time that our capital is fully deployed. There can be no assurances that KFA II will waive the senior collateral management fees for any period(s) subsequent to May 26, 2006.

In preparation for future securitization transactions, during the year ended December 31, 2005 we formed KKR Financial CDO 2005-1, Ltd. (“CDO 2005-1”), KKR Financial CLO 2006-1, Ltd. (“CLO 2006-1”), and KKR Financial CLO 2006-2, Ltd. (“CLO 2006-2”). These entities will be used to provide secured financing principally for the purchase of corporate and commercial real estate loans and securities. CLO 2006-1 has executed a $500.0 million warehouse facility, in the form of a repurchase agreement. At December 31, 2005, there was $117.7 million outstanding under the repurchase facility that bears interest at a rate of 30-day LIBOR plus 0.65%. Additionally, CLO 2006-1 had $76.1 million outstanding under a separate repurchase agreement from the repurchase facility as of December 31, 2005. CDO 2005-1 has executed a $300.0 million warehouse facility, in the form of a repurchase agreement. At December 31, 2005 there was $263.8 million outstanding under this facility that bears interest at a rate of 30-day LIBOR plus 1.10%. CLO 2006-2 has executed a $450.0 million warehouse facility, in the form of a repurchase agreement. At December 31, 2005 there were no borrowings outstanding under this facility, any borrowings would bear interest at a rate of 30-day LIBOR plus 0.65%.

Repurchase Agreements

As of December 31, 2005, we had $9.8 billion outstanding on repurchase facilities with ten counterparties with a weighted average effective rate of 4.47% and a weighted average remaining term to maturity of 24 days. Because we borrow under repurchase agreements based on the estimated fair value of its pledged investments, and because changes in interest rates can negatively impact the valuation of our

pledged investments, our ongoing ability to borrow under our repurchase facilities may be limited and our lenders may initiate margin calls in the event interest rates change or the value of our pledged securities decline as a result of adverse changes in interest rates or credit spreads.

At December 31, 2005, we had repurchase agreements with the following counterparties (amounts in thousands):

Counterparty(2)	Amount At Risk(1)		Weighted Average Maturity (Days)		Weighted Average Interest Rate
Banc of America Securities LLC.	$	4,122		25		4.44	%
Bear Stearns & Co. Inc.	191,755			24		4.46
Citigroup Global Markets Ltd	63,773			25		4.44
Credit Suisse First Boston LLC.	27,325			27		4.43
Deutsche Bank AG.	126,994			18		5.47
J. P. Morgan Chase Bank, N.A	61,461			25		4.43
Lehman Brothers Holdings Inc.	22,317			25		4.43
Merrill Lynch, Pierce, Fenner & Smith Inc.	45,461			30		4.43
Morgan Stanley & Co. Inc.	255,534			22		4.52
UBS Financial Services Inc.	14,314			3		4.34
Total	$	813,056

Notes:

(1) Computed as an amount equal to the estimated fair value of securities or loans sold, plus accrued interest income, minus the sum of repurchase agreement liabilities plus accrued interest expense.

(2) Counterparty includes subsidiaries and affiliates of each counterparty listed.

Secured Credit Facility

During June 2005, we entered into a $275 million secured credit facility that matures on June 15, 2006, with affiliates of J.P. Morgan Securities Inc. and Citigroup Global Markets Inc. as agents, joint bookrunners, arrangers and lenders under that facility. Participants in the secured credit facility include J.P. Morgan Chase Bank, N.A., Citicorp North America, Inc., and Bank of America, N.A. Among other things, the facility limits the amount of distributions we may make to 100% of our taxable income computed without giving effect to net operating loss carryforwards and nonrecurring items (including, but not limited to, stock- based compensation expense and bad debt write-offs), prohibits distributions in the event of certain defaults under the credit facility and specifies negative covenants as to our leverage and net worth. Outstanding borrowings under our new credit facility will bear interest at either (i) an alternate base rate per annum equal to the greater of (a) the prime rate in effect on such day, and (b) the federal funds effective rate in effect on such day plus 1¤2 of 1% or (ii) an interest rate per annum equal to the rate of 30-day LIBOR for such interest period multiplied by a Statutory Reserve Rate (as defined in such credit facility), plus 1%. As of December 31, 2005, we had $54.0 million of borrowings outstanding under this facility.

Capital Utilization and Leverage

As of December 31, 2005 and December 31, 2004, we had stockholders’ equity totaling $1.7 billion and $756.7 million, respectively, and our leverage was 8.1 times and 2.1 times, respectively.

As of December 31, 2005, we believe that we have sufficient capital to increase borrowings significantly before becoming capital or leverage constrained.

Off-Balance Sheet Commitments

As of December 31, 2005, we had committed to purchase corporate loans with aggregate commitments totaling $61.5 million. In a typical corporate loan or commercial real estate loan syndication, there is a delay between the time we are informed of our allocable portion of such loan and the actual funding of such loan.

As of December 31, 2005, we had purchased or participated in corporate loan delayed draw transactions with aggregate commitments totaling $72.9 million. In a delayed draw transaction, we have made available to the borrower a stated amount to be drawn as needed within a specified future period of time.

Contractual Obligations

The table below summarizes our contractual obligations as of December 31, 2005. The table below excludes accrued interest expenses, contractual commitments related to our derivatives, and the Management Agreement that we have with our Manager because those contracts do not have fixed and determinable payments:

Contractual Obligations
(Amounts in thousands)

	Payments Due by Period
	Total		Less than 1 year		1-3 years			3-5 Years			More than 5 years
Repurchase agreements	$	9,303,622	$	9,303,622		$	—		$	—	$	—
CLO 2005-1 senior secured notes	773,000		—			—			—		773,000
CLO 2005-2 senior secured notes	727,000		—			—			—		727,000
CDO 2005-1 repurchase agreements	263,801		263,801			—			—		—
CLO 2006-1 repurchase agreements	193,835		193,835			—			—		—
Demand loan	40,511		40,511			—			—		—
Secured revolving credit facility	54,000		54,000			—			—		—
Asset-backed secured liquidity notes	2,008,069		2,008,069			—			—		—
Operating leases	15,408		1,132			3,102			2,817		8,357
Total	$	13,379,246	$	11,864,970		$	3,102		$	2,817	$	1,508,357

REIT Matters

As of December 31, 2005, we believe that we qualified as a REIT under the provisions of the Code. The Code requires that at the end of each calendar quarter at least 75% of our total assets must be “real estate assets” as defined in the Code. The Code also requires that each year at least 75% of our gross income come from real estate sources and 95% of our gross income come from real estate sources and certain other passive sources itemized in the Code, such as dividends and interest. As of December 31, 2005, we believe that we were in compliance with such requirements. As of December 31, 2005, we also believe that we met all of the REIT requirements regarding the ownership of our common stock and the distributions of our taxable income.

To maintain our status as a REIT for federal income tax purposes, we are required to declare dividends amounting to at least 90% of our taxable income for each year. In addition, for each taxable year, to avoid certain federal excise taxes, we are required to declare and pay dividends amounting to certain designated percentages of our taxable income by the end of such taxable year. For the period covered by our calendar year 2005 federal tax return, we met all of the distribution requirements of a REIT. Because we expect to make distributions based on taxable income, we expect that our distributions may at times be more or less than our reported earnings computed in accordance with GAAP.

Total taxable income and REIT taxable income are non-GAAP financial measurements, and do not purport to be an alternative to reported net income (loss) determined in accordance with GAAP as a measure of operating performance or to cash flows from operating activities determined in accordance with GAAP as a measure of liquidity. Total taxable income is the aggregate amount of taxable income generated by us and by our domestic and foreign taxable REIT subsidiaries. REIT taxable income excludes the undistributed taxable income of our domestic taxable REIT subsidiary, which is not included in REIT taxable income until distributed to us. There is no requirement that our domestic taxable REIT subsidiary distribute its earnings to us. REIT taxable income, however, includes the taxable income of our foreign taxable REIT subsidiaries because we will generally be required to recognize and report their taxable income on a current basis. These non-GAAP financial measurements are important because we are structured as a REIT and the Code requires that we pay substantially all of our taxable income in the form of distributions to our stockholders. The non-GAAP financial measurements of total taxable income and REIT taxable income are critical in the determination of the amount of the minimum distributions that we must pay to our stockholders so as to comply with the rules set forth in the Code. Because not all companies use identical calculations, this presentation of total taxable income and REIT taxable income may not be comparable to other similarly titled measures prepared and reported by other companies. The table below reconciles the differences between reported net income and total taxable income and REIT taxable income for the year ended December 31, 2005 and the period from August 12, 2004 (Inception) through December 31, 2004:

Reconciliation of Reported GAAP Net Income (Loss) to Total Taxable Income
and REIT Taxable Income (Loss)
(Amounts in thousands, except per share amounts)

	Estimated For the Year Ended December 31, 2005						For the period from August 12, 2004 (inception) through December 31, 2004
	Amount			Per Share			Amount			Per Share
Reported net income (loss)	$	55,081		$	0.92		$	(6,709	)	$	(0.17	)
Interest income and expense	194			—			11			—
Share-based compensation	30,007			0.50			(17,651		)	(0.43		)
Depreciation of leasehold improvements and equipment	421			0.01			63			—
Lease abandonment expense	795			0.01			—			—
Provision for loan losses	1,500			0.02			—			—
Losses on sales of assets to third parties	(571		)	(0.01		)	—			—
Gains on sales of assets to affiliates	5,687			0.09			—			—
Realized and unrealized derivative gains and (losses)	(1,895		)	(0.03		)	378			0.01
Book/tax year end difference adjustment for CLOs/CDOs	(8,168		)	(0.13		)	—			—
Other	8			—			4			—
Income tax expense (benefit)	3,144			0.05			(228		)	(0.01		)
Total taxable income (loss)	86,203			1.43			(24,132		)	(0.60		)
Undistributed taxable income of domestic taxable REIT subsidiary	(4,077		)	(0.06		)	193			—
REIT taxable income (loss)	$	82,126		$	1.37		$	(23,939	)	$	(0.60	)
Number of common shares outstanding:
Weighted-average diluted common shares outstanding during the period	60,087						39,796

Our board of directors has adopted a policy to distribute to our stockholders amounts required to maintain our status as a REIT and to avoid federal excise taxes, in each case as discussed above. This distribution policy takes into account a number of factors, including, but not limited to, our actual results

of operations, our financial condition and our total taxable income and REIT taxable income. The actual amount and timing of distributions, if any, will be at the discretion of our Board of Directors and may not be in even amounts throughout our fiscal year. Pursuant to this policy, on April 5, 2005, our Board of Directors authorized a cash distribution of $0.25 per common share to our stockholders of record on April 5, 2005. This distribution was paid on April 18, 2005. The aggregate amount of the distribution was $10.3 million. On June 21, 2005, our Board of Directors declared a cash distribution for the quarter ended June 30, 2005 to stockholders of record on June 21, 2005. On July 21, 2005 our Board of Directors set the amount of the cash distribution at $0.40 per share. The aggregate amount of the distribution was $16.4 million and was paid on August 2, 2005. On November 2, 2005, our Board of Directors declared a cash distribution for the quarter ended September 30, 2005 on our common stock of $0.32 per share. This distribution was paid on November 30, 2005 to stockholders of record as of the close of business on November 16, 2005. The aggregate amount of the distribution was $25.7 million. The aggregate amount of distributions paid to common stockholders during the year ended December 31, 2005, totaled $52.4 million, which is less than our estimated total taxable income for the year ended December 31, 2005, of $86.2 million, as well as the estimated REIT taxable income for the year ended December 31, 2005 of $82.1 million. On February 1, 2006, our Board of Directors declared a cash distribution for the quarter ended December 31, 2005 of $0.40 per share. The aggregate amount of the distribution was $32.1 million, which was paid on February 28, 2006. Neither the payment of these distributions nor the existence of our distribution policy guarantees that we will make future distributions to our stockholders of any particular level, or at all. In addition, the amounts of these distributions do not constitute any kind of projection as to the amount of future distributions, if any.

Tax Treatment of Distributions

Dividend Income

For federal income tax purposes, distributions declared and paid in 2005 on our common stock total $0.97 per share. No portion of the distributions is considered a return of capital or long term capital gain. All distributions are fully (100%) taxable as dividend income at ordinary rates to stockholders and no portion of the dividends are eligible for the 15% dividend rate or the corporate dividends received deduction.

Excess Inclusion Income

Stockholders that are tax-exempt, or non-U.S. corporations or residents, or U.S. taxpayers, will be required to report 3.22% of our dividends to the IRS as “Excess Inclusion Income.”

· Tax-exempt stockholders will be required to treat excess inclusion income as unrelated business taxable income (commonly referred to as “UBTI”);

· Non-U.S. stockholders will be subject to the 30 percent U.S. federal withholding tax on this excess inclusion income without reduction under any otherwise applicable income tax treaty; and

· U.S. stockholders, including taxpaying entities, must report taxable income that in no event will be less than the amount of excess inclusion income.

AMT Adjustments and Tax Preference Items

There are special rules regarding the applicability of the alternative minimum tax (“AMT”) to REITs. Under these rules, items that are treated differently for regular tax and AMT purposes, namely the “AMT Adjustments and Tax Preference Items,” should be apportioned between the REIT and its stockholders. As a result of these special rules, stockholders are required to report as AMT adjustments and tax preference items an amount equal to 3.84% of the 2005 dividends that they received.

We recommend that stockholders discuss the tax consequences of their investment, including the proper tax treatment of any excess inclusion income and AMT adjustments and tax preference items, with their tax advisor.

Exemption from Regulation under the Investment Company Act

We intend to operate our business so as to be excluded from regulation under the Investment Company Act. Because we conduct some of our business through wholly-owned subsidiaries, we must ensure not only that we qualify for an exclusion or exemption from regulation under the Investment Company Act, but also that each of our subsidiaries so qualifies.

For KKR Financial Corp. itself, we will be relying on a provision designed for companies that do not issue redeemable securities and are primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.

The Securities and Exchange Commission (“SEC”) has not promulgated rules to address precisely what is required for a company to be considered “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” A series of no-action letters issued by the Division of Investment Management (the “Division”) of the SEC, however, reflects the view that at least 55% of a company’s assets must consist of mortgage loans and other assets that are considered the functional equivalent of mortgage loans for purposes of the Investment Company Act (collectively, “qualifying real estate assets”), and an additional 25% of a company’s assets must consist of real estate-related assets, leaving no more than 20% of the company’s assets in miscellaneous assets. These no-action letters also indicate what types of assets can be considered qualifying real estate assets. No-action letters issued by the Division are not binding except as they relate to the companies to whom they are addressed, so investors should be aware that the Division may change its position regarding what assets might constitute qualifying real estate assets at any time. If the Division were to change its position, we might be required to change our investment strategy to comply with any new guidance provided by the Division. We cannot predict whether such a change would be adverse to us.

Based on the no-action letters issued by the Division, we classify our investment in residential mortgage loans as qualifying real estate assets, as long as the loans are “fully secured” by an interest in real estate. That is, if the loan-to-value ratio of the loan is equal to or less than 100%, then we consider the mortgage loan a qualifying real estate asset. We do not consider loans with loan-to-value ratios in excess of 100% to be qualifying real estate assets for the 55% test, but only real estate-related assets for the 25% test.

We also consider agency whole pool certificates to be qualifying real estate assets. An agency whole pool certificate is a certificate issued or guaranteed as to principal and interest by federally chartered entities such as the Federal National Mortgage Association, better known as “Fannie Mae,” the Federal Home Loan Mortgage Corporation, better known as “Freddie Mac,” and, in the case of the Government National Mortgage Association, better known as “Ginnie Mae,” by the U.S. government, that represents the entire beneficial interest in the underlying pool of mortgage loans. By contrast, an agency certificate that represents less than the entire beneficial interest in the underlying mortgage loans is not considered to be a qualifying real estate asset for purpose of the 55% test, but constitutes a real estate-related asset for purposes of the 25% test.

Most non-agency mortgage-backed securities do not constitute qualifying real estate assets for purposes of the 55% test, because they represent less than the entire beneficial interest in the related pool of mortgage loans. The Division, however, has indicated in a series of no-action letters that in certain circumstances a company’s investment in non-agency mortgage- backed securities is the “functional equivalent” of owning the underlying mortgage loans. We own mortgage-backed securities that we classify as qualifying real estate assets because we believe that we own the functional equivalent of the underlying mortgage loans.

In several such instances, we own all of the securities issued by the related securitization trust. There are no other owners of the securities, and thus we view our investment, economically, as an investment in mortgage loans rather than an investment in mortgage-backed securities. For these transactions, we classify our entire investment as an investment in qualifying real estate assets for purposes of the 55% test.

In another instance, we own the most subordinate class of securities issued in the securitization, designated Class B-6, the class that is most likely to absorb losses on the related pool of mortgage loans, and we have the right to decide whether to foreclose upon defaulted mortgage loans. Thus, based on a series of no-action letters, we classify this investment as an investment in qualifying real estate assets for purposes of the 55% test. In addition to our ownership of Class B-6 in this securitization, we also own all of the other subordinated classes in the securitization: Classes B-5, B-4, B-3, B-2, B-1 and M. All of the subordinate classes could have been issued as a single subordinate class, but to obtain varying ratings on the classes and to increase the liquidity of our holdings, our subordinate interest was divided into separate classes. Losses on the mortgage loans, to the extent they exceed the principal balance of the Class B-6, are allocated to Class B-6, B-5, B-4, B-3, B-2, B-1 and M, in that order. If losses are so great that the principal balance of Class B-6 is reduced to zero, then we, as the owner of the Class B-5 securities, would have the right to decide whether to foreclose on defaulted mortgage loans. This right continues throughout the subordinate classes, such that the owner of the most subordinate class that is outstanding at any time has foreclosure rights. Because we own 100% of each class of subordinate securities in this structure, and each such class carries with it the right to foreclose if it ever becomes the most subordinate class in the structure, we classify all of these subordinate securities as qualifying real estate assets for purposes of the 55% test. If we were to sell all or a portion of any of those subordinated classes, we would recharacterize the remaining portion of that class, together with any classes senior to that class, as real estate-related assets for the 25% test, rather than qualifying real estate assets for the 55% test. We own a portion of a senior class issued in this same securitization, but because it is not a subordinated class, we do not consider it a qualifying real estate asset for purposes of the 55% test, but merely a real estate-related asset for purposes of the 25% test.

We will use this same analysis to determine whether to classify investments we make in the future as qualifying real estate assets. If we acquire securities that, collectively, are expected to receive all of the principal and interest paid on the related pool of underlying mortgage loans (less fees, such as servicing and trustee fees, and expenses of the securitization), and we have foreclosure rights with respect to those mortgage loans, then we will consider those securities, collectively, to be qualifying real estate assets. If another entity acquires any of the securities that are expected to receive cash flow from the underlying mortgage loans, then we will consider whether we have the unilateral right to foreclose on the underlying loans and whether our investment is a first loss position to decide whether it should be classified as a qualifying real estate asset. If we own more than one subordinate class, then, to determine the classification of the subordinate classes that we own other than the first loss class, we would consider whether such classes are contiguous with the first loss class (with no other classes absorbing losses after the first loss class and before any other subordinate classes that we own), whether we own the entire amount of each such class and whether we would continue to have the unilateral right to foreclose in connection with each such class if the more subordinate classes were no longer outstanding. If the answers to any of these questions is no, then we would not classify that particular class, or classes senior to that class, as a qualifying real estate asset.

To the extent that our investments in mortgage-backed securities do not constitute qualifying real estate assets for the 55% test, they will be classified as real estate-related assets for purposes of the 25% test. We do not expect that our investments in corporate leveraged loans or high yield corporate bonds will constitute qualifying real estate or real estate-related assets. Instead, they will constitute miscellaneous assets, which can constitute no more than 20% of our assets.

We believe that we have satisfied the tests with respect to our assets, measured on an unconsolidated basis, since the first anniversary of our initial private placement of our common stock in August 2004. It is

not entirely settled, however, that the tests are to be measured on an unconsolidated basis. To the extent the SEC provides further guidance on how to measure assets for these tests, we will adjust our measurement techniques.

In addition to monitoring our assets to qualify for the exclusion from regulation as an investment company, we also must ensure that each of our subsidiaries qualifies for its own exclusion or exemption. Some of our subsidiaries rely on the exemption provided if (i) the securities of the subsidiary are owned exclusively by persons who at the time of acquisition of the securities are “qualified purchasers” as that term is defined in the Investment Company Act and (ii) none of the non-real estate subsidiaries is making or proposing to make a public offering of its securities. Other subsidiaries may qualify, on their own, for the exclusion designed for companies primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate, the same exclusion from regulation that we rely upon for our exclusion from regulation. To the extent that we form subsidiaries in the future, we must ensure that they qualify for their own separate exclusion from regulation as an investment company.

We have not received a no-action letter from the Division regarding how our investment strategy fits within the exclusion from regulation under the Investment Company Act that we are using. To the extent that the Division provides more specific or different guidance regarding the treatment of assets as qualifying real estate assets or real estate-related assets, we may be required to adjust our investment strategy accordingly. Any additional guidance from the Division could provide additional flexibility to us, or it could further inhibit our ability to pursue the investment strategy we have chosen.

Quantitative and Qualitative Disclosures About Market Risk

Market Risks

Currency Risks

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

Inflation Risks

Our investment portfolio comprises the majority of our assets and our investments are financial in nature. Changes in interest rates and credit spreads may have a material adverse impact on our financial condition, results of operations and liquidity. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates.

Interest Rate Risk

We believe that our primary market risk is interest rate risk. Interest rate risk is defined as the sensitivity of our current and future earnings to interest rate volatility, variability of spread relationships, the difference in repricing intervals between our assets and liabilities and the effect that interest rates may have on our cash flows and the prepayment rates experienced on our investments that have imbedded borrower optionality. The objective of interest rate risk management is to achieve earnings, preserve capital and achieve liquidity by minimizing the negative impacts of changing interest rates, asset and liability mix, and prepayment activity.

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

Interest rate risk impacts our interest income, interest expense, prepayments, and the fair value of our investments, interest rate derivatives, and liabilities. We manage interest rate risk and make interest rate risk decisions by evaluating our projected earnings under selected interest rate scenarios. We also use static measures of interest rate risk including duration. During periods of increasing interest rates we are biased to purchase investments that are floating rate and we have had that bias since our inception. We manage our interest rate risk using various techniques ranging from the purchase of floating rate investments to the use of interest rate derivatives. We generally fund our variable rate investments with variable rate borrowings with similar interest rate reset frequencies. We fund our fixed rate and our hybrid investments with short-term variable rate borrowings and we may use interest rate derivatives to hedge the variability of the cash flows associated with our existing or forecasted variable rate borrowings. Hedging activities are complex and accounting for interest rate derivatives as fair value or cash flow hedges in accordance with SFAS No. 133 is difficult. We may not be able to execute certain hedging strategies because we are a REIT and there are complex rules regarding how our hedges impact our compliance with the REIT requirements.

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

The periodic and lifetime interest rate caps contained in our residential ARM loans and securities may limit the repricing of our residential ARM loans and securities and, as a result, we are exposed to the risk that repricing of our investments is limited by the respective caps and our variable rate borrowings do not have any similar such caps. As a result our income on the investments that are subject to the periodic and lifetime cap would remain constant while our cost of financing using variable rate debt would increase. The periodic and lifetime interest rate caps may negatively impact future net interest margins and the fair values of our residential ARM loan and security investments.

The table below presents an approximation of the sensitivity of the market value of our residential mortgage loan and security portfolio using BondStudio®. Application of this method results in an estimation of the percentage change in the market value of our residential mortgage assets and interest rate derivatives per 50 basis point shift in interest rates expressed in a measure commonly referred to as effective duration. Positive portfolio effective duration indicates that the market value of the total portfolio will decline if interest rates rise and increase if interest rates decline. Negative portfolio effective duration indicates that the market value of the total portfolio will decline if interest rates decline and increase if interest rates rise. The closer effective duration is to zero, the less interest rate changes are expected to affect the market value of our residential mortgage loan and security portfolio and our investments. Included in the table is a base case effective duration calculation for an interest rate scenario that assumes future rates are those implied by the yield curve as of February 28, 2006. The other four scenarios assume interest rates are instantaneously 50 and 100 basis points lower and 50 and 100 basis points higher than those implied by the yield curve as of February 28, 2006.

Net Portfolio Effective Duration
December 31, 2005

	Base Case			Parallel -50 bps			Parallel -100 bps			Parallel +50 bps			Parallel +100 bps
Residential mortgage assets:
ARM loans and securities		0.28			0.18			0.08			0.39			0.54
Hybrid loans and securities		1.99			1.76			1.32			2.12			2.20
Total residential assets		1.22			1.06			0.81			1.33			1.43
Interest rate swaptions and corridor		(0.23	)		(0.22	)		(0.16	)		(0.20	)		(0.12	)
Amortizing interest rate swaps		(1.72	)		(1.75	)		(1.78	)		(1.70	)		(1.67	)
Net portfolio effective duration		0.14			(0.03	)		(0.26	)		0.26			0.41

Based on the assumptions used, the model output suggests a low degree of portfolio price change given the decreases and increases in interest rates. The table above excludes corporate loans and securities and commercial rate loans and securities totaling $2.4 billion and $604.7 million, respectively, as of December 31, 2005. Changes in assumptions including, but not limited to, volatility, mortgage spreads, prepayment behavior and defaults, as well as the timing and level of interest rate changes, will affect the results of the model. Therefore, actual results are likely to vary from modeled results.

Although market value sensitivity analysis is widely accepted in identifying interest rate risk, it does not take into consideration changes that may occur such as, but not limited to, changes in investment and financing strategies, changes in market spreads, and changes in business volumes.

The use of interest rate derivatives is a critical part of our interest risk management strategy. The table below summarizes the contractual notional balance of our amortizing interest rate swaps and interest rate corridor as of December 31, 2005, and for each of the following five years then ended.

Hedge Instruments Notional Amounts
(Amounts in millions)

	As of December 31, 2005
	2005	2006	2007	2008	2009
Interest rate swaps	$ 4,308	$ 4,525	$ 3,348	$ 2,022	$ 1,017
Interest rate corridors	—	691	755	720	—
Total	$ 4,308	$ 5,216	$ 4,103	$ 2,742	$ 1,017

The following table summarizes the estimated net fair value of our derivative instruments held at December 31, 2005 and December 31, 2004 (amounts in thousands):

Derivative Fair Value

	As of December 31, 2005		As of December 31, 2004
Cash Flow Hedges:
Interest rate corridors		$ 14,762		$ —
Interest rate swaps		40,796		—
Free-Standing Derivatives:
Interest rate swaptions		879		223
Interest rate swaps		198		—
Credit default swaps		71		(625	)
Total rate of return swaps		727		—
Foreign exchange contracts		—		(125	)
Net fair value		$ 57,433		$ (527	)

Risk Management

To the extent consistent with maintaining our REIT status, we seek to manage our interest rate risk exposure to protect our investment portfolio and related borrowings against the effects of major interest rate changes. We generally seek to manage our interest rate risk by:

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

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

· Attempting to structure our borrowing agreements to have a range of different maturities, terms, amortizations and interest rate adjustment periods; and

· Using interest rate derivatives to adjust the interest rate sensitivity of our investment portfolio and our borrowings.

Item 7A. Quantitative and Qualitative Disclosures about Market Risk

See discussion of quantitative and qualitative disclosures about market risk in “Quantitative and Qualitative Disclosures About Market Risk” section of Item 7 of this Annual Report on Form 10-K.

Item 8. Financial Statements and Supplementary Data

The consolidated financial statements of the Company and the related notes to the consolidated financial statements, together with the Report of Independent Registered Public Accounting Firm thereon, are set forth on pages F-1 through F-33 in this Annual Report on Form 10-K.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

Item 9A. Controls and Procedures

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e)

and 15d-15(e) under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this report (the “Evaluation Date”). Based on this evaluation, our principal executive officer and principal financial officer concluded as of the Evaluation Date that our disclosure controls and procedures were effective such that the information relating to us, including our consolidated subsidiaries, required to be disclosed in our Securities and Exchange Commission (“SEC”) reports (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to our management, including our principal executive and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

As previously disclosed in our registration statement on Form S-11 (Registration No. 333-124103), in connection with its audit of our consolidated financial statements for the period ended December 31, 2004, our independent registered public accounting firm on March 8, 2005 identified to us three matters involving our internal controls over financial reporting that it considered to be reportable conditions under standards established by the American Institute of Certified Public Accountants, which reportable conditions in its judgment constituted material weaknesses. Under these standards, in each of these areas the design or operation of our internal controls did not reduce to a relatively low level the risk that misstatements caused by error or fraud in amounts that would be material may occur and not be detected within a timely period.

We are actively remediating the identified reportable conditions. Specifically, subsequent to March 8, 2005 our Chief Operating Officer became our Chief Financial Officer and we hired individuals to fill the positions of Controller; Assistant Controller; Treasurer; Chief Accounting Officer; and Financial Analysis Manager. We are also enhancing our internal control structure to ensure proper segregation of duties and the timely recording of transactions and timely preparation of reconciliations as we continue to prepare for compliance with Section 404 of the Sarbanes-Oxley Act of 2002. We will be required to issue a management report on our assessment of internal controls over financial reporting in our Annual Report on Form 10-K for the year ended December 31, 2006.

There were no other changes in our internal control over financial reporting identified in connection with the foregoing evaluation that occurred during the quarter ended December 31, 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Item 9B. Other Information

None.

PART III

Item 10. Directors and Executive Officers of the Registrant

The information required by Item 10 is incorporated herein by reference to the Proxy Statement to be filed with the SEC pursuant to Regulation 14A within 120 days after December 31, 2005.

Item 11. Executive Compensation

The information required by Item 11 is incorporated herein by reference to the Proxy Statement to be filed with the SEC pursuant to Regulation 14A within 120 days after December 31, 2005.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters

The information required by Item 12 is incorporated herein by reference to the Proxy Statement to be filed with the SEC pursuant to Regulation 14A within 120 days after December 31, 2005.

Item 13. Certain Relationships and Related Transactions

The information required by Item 13 is incorporated herein by reference to the Proxy Statement to be filed with the SEC pursuant to Regulation 14A within 120 days after December 31, 2005.

Item 14. Principal Accountants Fees and Services

The information required by Item 14 is incorporated herein by reference to the Proxy Statement to be filed with the SEC Pursuant to Regulation 14A within 120 days after December 31, 2005.

PART IV

Item 15. Exhibits and Financial Statement Schedules

(a)1. and (a)2. Documents filed as part of this report:

1. and 2.

All financial statement schedules are omitted because of the absence of conditions under which they are required or because the required information is included in our consolidated financial statements or notes thereto, included in Part II, Item 8, of this Annual Report on Form 10-K.

3. Exhibit Index:

Exhibit Number		Description
3.1*		Articles of Amendment and Restatement of the Registrant, dated August 10, 2004
3.2*		Form of Articles of Amendment, dated June 23, 2005
3.3*		Form of Articles of Amendment, dated June 23, 2005
3.4*		Amended and Restated Bylaws of the Registrant
4.1*		Form of Certificate for Common Stock
4.2*		Registration Rights Agreement, dated as of August 12, 2004 between the Registrant and Friedman, Billings, Ramsey & Co., Inc.

10.1*		Management Agreement, dated as of August 12, 2004, between Registrant and KKR Financial Advisors LLC
10.2*		Amended and Restated 2004 Stock Incentive Plan
10.3*		Form of Nonqualified Stock Option Agreement
10.4*		Form of Restricted Stock Award Agreement
10.5*		Form of Restricted Stock Award Agreement for Non-Employee Directors
10.6*		Indenture, dated as of March 30, 2005, by and among KKR Financial CLO 2005-1, Ltd., KKR Financial 2005-1, Corp. and JPMorgan Chase Bank, National Association
10.7*		License Agreement, dated as of August 12, 2004, between the Registrant and Kohlberg Kravis Roberts & Co. L.P.
10.8*		Letter Agreement, dated as of August 12, 2004, between the Registrant and KKR Financial Advisors LLC
10.9*		Credit Agreement, dated as of June 16, 2005, among the Registrant, KKR TRS Holdings, Inc., the Lenders party thereto, and JPMorgan Chase Bank, N.A., as Administrative Agent
10.10*		First Amendment to Credit Agreement, dated as of June 17, 2005, among the Registrant, KKR TRS Holdings, Inc., the Existing Lenders party thereto, JPMorgan Chase Bank, N.A., as Administrative Agent, and Bank of America, N.A.
10.11*		Collateral Management Agreement, dated as of March 30, 2005, between KKR Financial CLO 2005-1, Ltd. and KKR Financial Advisors II, LLC
10.12*		Fee Waiver Letter, dated April 15, 2005, between KKR Financial CLO 2005-1, Ltd., KKR Financial Advisors II, LLC and JPMorgan Chase Bank, N.A.
21.1**		List of Subsidiaries of the Registrant
31.1**		Certification Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as amended
31.2**		Certification Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as amended.
32**		Certification Pursuant to 18 U.S.C. Section 1350

* Incorporated by reference to the Registrant’s Registration Statement on Form S-11 (Registration No. 333-124103), as amended. Such registration statement was originally filed with the Securities and Exchange Commission on April 15, 2005.

** Filed herewith.

KKR Financial Corp. and Subsidiaries
Consolidated Balance Sheets
(Amounts in thousands, except share information)

	December 31, 2005			December 31, 2004
Assets
Cash and cash equivalents	$	16,110			$	7,219
Restricted cash and cash equivalents	80,223				1,321
Securities available-for-sale, $5,910,399 and $1,484,222 pledged as collateral as of December 31, 2005 and December 31, 2004, respectively	6,149,506				1,651,280
Loans, net of allowance for loan losses of $1,500 and $0 as of December 31, 2005 and December 31, 2004, respectively	8,846,341				682,757
Derivative assets	58,898				223
Interest receivable	59,993				2,694
Principal receivable	7,108				—
Non-marketable equity securities	52,500				—
Deferred tax asset	—				228
Other assets	19,861				1,618
Total assets	$	15,290,540			$	2,347,340
Liabilities
Repurchase agreements	$	9,761,258			$	1,558,274
Collateralized loan obligation senior secured notes	1,500,000				—
Asset-backed secured liquidity notes	2,008,069				—
Secured revolving credit facility	54,000
Secured demand loan	40,511				27,875
Payable for securities purchases	196,315				—
Accounts payable, accrued expenses and other liabilities	45,925				1,157
Accrued interest payable	21,415				771
Related party payable	3,673				1,765
Income tax liability	2,763				—
Derivative liabilities	1,465				750
Total liabilities	13,635,394				1,590,592
Stockholders’ Equity
Preferred stock, $0.01 par value, 50,000,000 shares authorized and none issued and outstanding at December 31, 2005 and December 31, 2004	—				—
Common stock, $0.01 par value, 250,000,000 shares authorized and 80,374,061 shares issued and outstanding at December 31, 2005 and 41,004,492 shares issued and outstanding at December 31, 2004	804				410
Additional paid-in-capital	1,639,996				761,327
Accumulated other comprehensive income	18,344				1,720
Accumulated deficit	(3,998		)		(6,709		)
Total stockholders’ equity	1,655,146				756,748
Total liabilities and stockholders’ equity	$	15,290,540			$	2,347,340

See notes to consolidated financial statements.

F-4

KKR Financial Corp. and Subsidiaries
Consolidated Statements of Operations
(Amounts in thousands, except per share information)

	Year ended December 31, 2005				For the Period from August 12, 2004 (Inception) through December 31, 2004
Net investment income:
Securities interest income		$	186,510			$	2,715
Loan interest income		206,663				1,914
Dividend income		3,421				296
Other interest income		3,335				3,197
Total investment income		399,929				8,122
Interest expense		(279,718		)		(975		)
Provision for loan losses		(1,500		)		—
Net investment income		118,711				7,147
Other income:
Net realized and unrealized gain (loss) on derivatives and foreign exchange		113				(570		)
Net realized gain on investments		4,117				75
Fee and other income		3,330				7
Total other income (loss)		7,560				(488		)
Non-investment expenses:
Related party management compensation		50,791				11,222
Professional services		4,121				901
Loan servicing expense		5,143				—
Insurance expense		975				335
Directors expenses		1,071				341
General and administrative expenses		5,945				797
Total non-investment expenses		68,046				13,596
Income (loss) before income tax expense (benefit)		58,225				(6,937		)
Income tax expense (benefit)		3,144				(228		)
Net income (loss)		$	55,081			$	(6,709	)
Net income (loss) per common share:
Basic		$	0.93			$	(0.17	)
Diluted		$	0.92			$	(0.17	)
Weighted-average number of common shares outstanding:
Basic		58,998				39,796
Diluted		60,087				39,796
Distributions declared per common share		$	0.97			$	—

See notes to consolidated financial statements.

F-5

KKR Financial Corp. and Subsidiaries
Consolidated Statements of Changes in Stockholders’ Equity
(Amounts in thousands)

	Shares of Common Stock			Common Stock at Par Value			Additional Paid-In Capital			Accumulated Other Comprehensive Income				Accumulated Deficit				Comprehensive Income (Loss)				Total Stockholders’ Equity
Balance at August 12, 2004		—			$	—	$	1			$	—			$	—			$	—			$	1
Net loss		—			—		—				—				(6,709		)		(6,709		)		(6,709		)
Net change in unrealized gain on securities available-for-sale		—			—		—				1,720				—				1,720				1,720
Comprehensive loss																			$	(4,989	)
Issuance of common stock, net of expenses		41,004			410		760,865				—				—								761,275
Amortization of common stock options		—			—		461				—				—								461
Balance at December 31, 2004		41,004			410		761,327				1,720				(6,709		)						756,748
Net income															55,081				55,081				55,081
Net change in unrealized gain on cash flow hedges		—			—		—				45,559				—				45,559				45,559
Net change in unrealized loss on securities available-for-sale		—			—		—				(28,935		)		—				(28,935		)		(28,935		)
Comprehensive income		—			—		—				—				—				$	71,705
Cash distributions on common stock		—			—		—				—				(52,370		)						(52,370		)
Issuance of common stock, net of expenses		39,375			394		848,423				—				—								848,817
Amortization of restricted common stock		—			—		28,104				—				—								28,104
Forfeiture of restricted common stock		(5	)		—		(13		)		—				—								(13		)
Amortization of common stock options		—			—		2,155				—				—								2,155
Balance at December 31, 2005		80,374			$	804	$	1,639,996			$	18,344			$	(3,998	)						$	1,655,146

See notes to consolidated financial statements.

F-6

KKR Financial Corp. and Subsidiaries
Consolidated Statements of Cash Flows
(Amounts in thousands)

	Year ended December 31, 2005				For the Period from August 12, 2004 (Inception) through December 31, 2004
Cash flows from operating activities:
Net income (loss)		$	55,081			$	(6,709	)
Adjustments to reconcile net income (loss) to cash provided by operating activities:
Unrealized gain (loss) on derivatives		(851		)		527
Realized gain on foreign exchange		(68		)		—
Provision for loan losses		1,500				—
Share-based compensation		30,246				6,226
Net gain on sale of securities available-for-sale		(2,667		)		—
Net gain on sale of loans		(1,450		)		—
Depreciation and amortization		10,634				81
Deferred income tax expense (benefit)		925				(228		)
Changes in assets and liabilities:
Interest receivable		(57,621		)		(2,694		)
Other assets		(10,047		)		(710		)
Related party payable		1,908				1,765
Accounts payable, accrued expenses and other liabilities		46,833				1,157
Accrued interest payable		20,644				771
Net cash provided by operating activities		95,067				186
Cash flows from investing activities:
Purchase of securities available-for-sale		(6,279,068		)		(1,664,369		)
Principal payments on securities available-for-sale		1,561,034				14,813
Proceeds from sale of securities available-for-sale		381,134				—
Purchase of loans		(9,219,553		)		(683,377		)
Principal payments on loans		846,504				620
Proceeds from sale of loans		207,160				—
Purchases of non-marketable equity securities		(52,500		)		—
Purchase of derivatives		(1,477		)		—
Net additions to restricted cash and cash equivalents		(78,902		)		(1,321		)
Purchase of leasehold improvements and equipment		(1,716		)		(993		)
Net cash used in investing activities		(12,637,384		)		(2,334,627		)
Cash flows from financing activities:
Net proceeds from issuance of common shares		848,817				755,510
Proceeds from borrowings:
Repurchase agreements		116,764,832				2,285,274
Asset-backed secured liquidity notes		3,265,145				—
Collateralized loan obligation senior secured notes		1,500,000				—
Secured revolving credit facility		87,000				—
Secured demand loan		12,636				27,875
Other capitalized costs		(8,288		)		—
Purchase of interest rate derivatives		(10,072		)		—
Repayments of borrowings:
Repurchase agreements		(108,561,848		)		(727,000		)
Asset-backed secured liquidity notes		(1,261,644		)		—
Secured revolving credit facility		(33,000		)		—
Distributions on common stock		(52,370		)		—
Net cash provided by financing activities		12,551,208				2,341,659
Net increase in cash and cash equivalents		8,891				7,218
Cash and cash equivalents at beginning of period		7,219				1
Cash and cash equivalents at end of period		$	16,110			$	7,219
Supplemental cash flow information:
Cash paid for interest		$	259,074			$	230
Cash paid for taxes		$	152			$	—
Non-cash investing and financing activities:
Unsettled securities trades		$	196,315			$	—
Issuance of restricted common stock		$	42,405			$	24,178

See notes to consolidated financial statements.

F-7

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements

Note 1. Organization

KKR Financial Corp. (the “Company” or “KKR Financial”) is a specialty finance company that invests in multiple asset classes and uses leverage to generate competitive leveraged risk-adjusted returns. The Company currently makes investments in the following asset classes: (i) residential mortgage loans and mortgage-backed securities; (ii) corporate loans and debt securities; (iii) commercial real estate loans and debt securities; (iv) asset-backed securities; and (v) marketable and non-marketable equity securities. The Company also makes opportunistic investments in other asset classes from time to time.

The Company was organized as a Maryland corporation on July 7, 2004, and commenced operations on August 12, 2004 (“Inception”). KKR Financial Advisors LLC (the “Manager”) manages the Company pursuant to a management agreement (the “Management Agreement”). The Manager is an affiliate of Kohlberg Kravis Roberts & Co. L.P. The Company is taxed as a real estate investment trust (“REIT”) and is required to comply with the provisions of the Internal Revenue Code of 1986, as amended (the “Code”), with respect thereto.

On August 12, 2004, the Company completed its initial private placement of shares of its common stock at $20.00 per share that generated net proceeds of approximately $755.5 million. On June 29, 2005, the Company completed its initial public offering (the “IPO”) of 37,500,000 shares of common stock that generated net proceeds of approximately $848.8 million. The Company sold 37,471,250 common shares at a price of $24.00 per share and selling stockholders sold 28,750 shares. The Company’s stock is listed on the New York Stock Exchange under the symbol “KFN” and began trading on June 24, 2005. On June 23, 2005 the Company effectuated a reverse stock split of its common stock at a ratio of one share of common stock for every two shares of common stock then outstanding. The accompanying consolidated financial statements have been adjusted to give effect to the reverse stock split for all periods presented.

Note 2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”). The consolidated financial statements include the accounts of the Company and its taxable REIT subsidiaries: KKR TRS Holdings, Inc. (“KKR TRS”); KKR Financial CLO 2005-1, Ltd. (“CLO 2005-1”); KKR Financial CLO 2005-2, Ltd. (“CLO 2005-2”); KKR Financial CLO 2006-1, Ltd. (“CLO 2006-1”), and KKR Financial CDO 2005-1, Ltd. (“CDO 2005-1”). The Company intends to make a taxable REIT subsidiary election with respect to KKR Financial CLO 2006-2, Ltd. (“CLO 2006-2”) in the future. KKR TRS was formed to make, from time to time, certain investments that would not be REIT qualifying investments if made directly by the Company, and to earn income that would not be REIT qualifying income if earned directly by the Company. CLO 2005-1, CLO 2005-2, CLO 2006-1, and CLO 2006-2 are entities established to execute collateralized loan obligation (“CLO”) secured financing transactions. CDO 2005-1 is an entity established to complete a collateralized debt obligation (“CDO”) secured financing transaction. The consolidated financial statements also include the accounts of the Company’s qualified REIT subsidiaries: KKR Financial Mortgage Corp. (“KKR Mortgage”); KKR QRS #1, Inc. (“KKR QRS”); and KKR Pacific Funding Trust and KKR Pacific Funding Depositor Corporation (collectively, “KKR Pacific”). KKR Mortgage was formed to sell, from time to time, the Company’s whole loan mortgage pools in residential mortgage-backed securitization (“RMBS”) transactions. KKR QRS was formed to hold the residual interests in RMBS transactions structured as real estate mortgage investment conduits (“REMICs”) for tax

F-8

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 2. Summary of Significant Accounting Policies (Continued)

purposes. KKR Pacific was formed to finance the Company’s RMBS investments through the issuance of asset-backed secured liquidity notes. The term “Company” refers to these entities collectively, unless otherwise noted. The entities consolidated by the Company are either wholly-owned subsidiaries or entities established to complete secured financing transactions that are considered to be variable interest entities and for which the Company is the primary beneficiary. For additional information, see “Consolidation” below. Certain amounts for prior periods have been reclassified to conform to the December 31, 2005 presentation.

Use of Estimates

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

Consolidation

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

CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2006-2, and CDO 2005-1 are VIEs and are not considered to be qualifying special-purpose entities (“QSPE”) as defined by Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (“SFAS No. 140”). The Company has determined it is the primary beneficiary of these entities and has included the accounts of these entities in these consolidated financial statements.

All inter-company balances and transactions have been eliminated in consolidation.

Cash and Cash Equivalents

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

Restricted Cash and Cash Equivalents

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

F-9

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 2. Summary of Significant Accounting Policies (Continued)

Securities Available-for-Sale

The Company classifies its investments in securities as available-for-sale as the Company may sell them prior to maturity and does not hold them principally for the purpose of selling them in the near term. These investments are carried at estimated fair value, with unrealized gains and losses reported in accumulated other comprehensive income. Estimated fair values are based on quoted market prices, when available, or on estimates provided by independent pricing sources or dealers who make markets in such securities. Upon the sale of a security, the realized net gain or loss is computed on a specific identification basis.

The Company monitors its available-for-sale investment portfolio for impairments. A loss is recognized when it is determined that a decline in the estimated fair value of a security below its amortized cost is other-than-temporary. The Company considers many factors in determining whether 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 a decline in estimated fair value below its amortized cost, the amount of the unrealized loss, the intent and ability of the Company to hold the security for a period of time sufficient for a recovery in value, recent events specific to the issuer or industry, external credit ratings and recent changes in such ratings.

Unamortized premiums and discounts on non-residential mortgage-backed securities are recognized in interest income over the contractual life, adjusted for actual prepayments, of the securities using the effective interest method. For securities representing beneficial interests in securitizations (i.e., residential mortgage-backed securities), unamortized premiums and discounts are recognized over the contractual life, adjusted for estimated prepayments and estimated credit losses of the securities using the effective interest method. Actual prepayment and credit loss experience is reviewed quarterly and effective yields are recalculated when differences arise between prepayments and credit losses originally anticipated compared to amounts actually received plus anticipated future prepayments.

Non-marketable Equity Securities

Non-marketable equity securities consist primarily of private equity investments. These investments are accounted for under the cost method. The Company reviews these investments quarterly for possible other-than-temporary impairment. The Company reduces the carrying value of the investment and recognizes a loss when the Company considers a decline in estimated fair value to be other-than-temporary.

Loans

The Company purchases pools of residential mortgage whole loans and participations in corporate leveraged loans and commercial real estate loans in the primary and secondary market. Loans are held for investment and the Company initially records loans at their purchase prices. The Company subsequently accounts for loans based on their outstanding principal plus or minus unaccreted purchase discounts and unamortized purchase premiums. In certain instances, where the credit fundamentals underlying a particular loan have materially changed in such a manner that the Company’s expected return may decrease, the Company may elect to sell a loan held for investment due to adverse changes in credit

F-10

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 2. Summary of Significant Accounting Policies (Continued)

fundamentals. Once the determination has been made by the Company that it will no longer hold the loan for investment, the Company accounts for the loan at the lower of amortized cost or estimated fair value.

Interest income on loans includes interest at stated coupon rates adjusted for accretion of purchase discounts and the amortization of purchase premiums. For corporate and commercial real estate loans, unamortized premiums and discounts are recognized in interest income over the contractual life, adjusted for actual prepayments, of the loans using the effective interest method. For residential mortgage loans, unamortized premiums and discounts are recognized over the contractual life, adjusted for estimated prepayments using the effective interest method.

Allowance and Provision for Loan Losses

The Company maintains an allowance for loan losses at a level that management considers adequate based on an evaluation of known and inherent risks in the loan portfolio, including historical and industry loss experience, economic conditions and trends, estimated fair values and the quality of collateral, estimated fair values of the loans and other relevant factors.

To estimate the allowance for loan losses, the Company first identifies impaired loans. Loans are generally evaluated for impairment individually, but loans purchased on a pooled basis with relatively smaller balances and substantially similar characteristics may be evaluated collectively for impairment. The Company considers a loan to be impaired when, based on current information and events, management believes it is probable that the Company will be unable to collect all amounts due pursuant to the contractual terms of the loan agreement. When a loan is impaired, the allowance for loan losses is increased by the amount of the excess of the amortized cost basis of the loan over its estimated fair value. Estimated fair value may be determined based on (i) observable market quotes; (ii) the estimated sales price of the collateral less estimated disposition costs; or (iii) the present value of projected future net cash flows. Increases in the allowance for loan losses are recognized in the statements of operations as a provision for loan losses. A charge-off or write-down of a loan is recorded, and the allowance for loan losses is reduced, when the loan or a portion thereof is considered uncollectible and of such little value that further pursuit of collection is not warranted.

An impaired loan may be left on accrual status during the period the Company is pursuing repayment of the loan; however, the loan is placed on non-accrual status at such time as: (i) management believes that scheduled debt service payments will not be met within the coming 12 months; (ii) the loan becomes 90 days delinquent; (iii) management determines the borrower is incapable of, or has ceased efforts toward, curing the cause of the impairment; or (iv) the net realizable value of the underlying collateral securing the loan approximates the Company’s carrying value of such loan. While on non-accrual status, previously recognized accrued interest is reversed and interest income is recognized only upon actual receipt.

Leasehold Improvements and Equipment

Leasehold improvements and equipment are carried at cost less depreciation and amortization and reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets might not be recoverable. Equipment is depreciated using the straight-line method over the estimated useful lives of the respective assets of three years. Leasehold improvements are amortized on a

F-11

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 2. Summary of Significant Accounting Policies (Continued)

straight-line basis over the shorter of their estimated useful lives or lease terms. Leasehold improvements and equipment, net of accumulated depreciation and amortization, are included in other assets.

Borrowings

The Company finances the acquisition of its investments, including loans and securities available-for-sale, primarily through the use of secured borrowings in the form of securitization transactions structured as secured financings, repurchase agreements, asset-backed secured liquidity notes, warehouse facilities, demand loans, and other secured and unsecured borrowings. The Company recognizes interest expense on all borrowings on an accrual basis.

Derivative Financial Instruments

The Company recognizes all derivatives on the consolidated balance sheet at estimated fair value. In accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended and interpreted (“SFAS No. 133”), the Company designates and documents each derivative contract as one of the following at the time the contract is executed: (i) a hedge of a recognized asset or liability or an unrecognized firm commitment; (ii) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability; (iii) a hedge of a net investment in a foreign operation; or (iv) a derivative instrument not designated as a hedging instrument.

In accordance with SFAS No. 133, the Company designates certain of its derivative instruments as cash flow hedges and formally documents its hedge relationships, including identification of the hedging instruments and the hedged items, as well as its risk management objectives and strategies for undertaking the hedge transaction, prior to the execution of the derivative contract. The Company assesses the effectiveness of the hedge both at inception and on an on-going basis and determines whether the hedge is highly effective in offsetting changes in cash flows of the hedged item. The Company records the effective portion of changes in the estimated fair value of the cash flow hedges in accumulated other comprehensive income and subsequently reclassifies the related amount of accumulated other comprehensive income to earnings in the consolidated statements of operations when the hedging relationship is terminated. If it is determined that a derivative has ceased to be a highly effective hedge, the Company will discontinue hedge accounting for such transaction. For derivatives that are not designated as hedges (“free-standing derivatives”), all changes in estimated fair value are recognized in the consolidated statements of operations.

Foreign Currency

The Company makes investments in non-U.S. dollar denominated securities and loans. As a result, the Company is subject to the risk of fluctuation in the exchange rate between the U.S. dollar and the foreign currency in which it makes an investment. In order to reduce the currency risk, the Company may hedge the applicable foreign currency. All investments denominated in foreign currency are converted to the U.S. dollar using prevailing exchange rates on the balance sheet date. Income, expenses, gains and losses on investments denominated in foreign currency are converted to the U.S. dollar using the prevailing exchange rates on the dates when they are recorded. Foreign exchange gains and losses are recorded in the consolidated statements of operations.

F-12

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 2. Summary of Significant Accounting Policies (Continued)

Manager Compensation

The Company’s Management Agreement provides for the payment of a base management fee to the Manager, as well as an incentive fee if the Company’s financial performance exceeds certain benchmarks. See Note 11 for further discussion of the specific terms of the computation and payment of the incentive fee. The base management fee and the incentive fee are accrued and expensed during the period for which they are earned by the Manager.

Share-Based Payments

The Company accounts for share-based compensation issued to its Directors and to its Manager using the fair value based methodology prescribed by SFAS No. 123(R), Share-Based Payment (“SFAS No. 123(R)”). Compensation cost related to restricted common stock issued to the Company’s Directors is measured at its estimated fair value at the grant date, and is amortized and expensed over the vesting period on a straight-line basis. Compensation cost related to restricted common stock and common stock options issued to the Manager is initially measured at estimated fair value at the grant date, and is remeasured on subsequent dates to the extent the awards are unvested. The Company has elected to use the graded vesting attribution method pursuant to SFAS No. 123(R) to amortize compensation expense for the restricted common shares and common stock options granted to the Manager.

Income Taxes

The Company has elected to be taxed as a REIT and is required to comply with the provisions of the Code with respect thereto. Accordingly, the Company is not subject to federal income tax to the extent that its distributions to stockholders satisfy the REIT requirements and certain asset, income and ownership tests and recordkeeping requirements are fulfilled. Even though the Company qualifies for federal taxation as a REIT, it may be subject to some amount of federal, state, local and foreign taxes based on the Company’s taxable income.

KKR TRS, CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2006-2 and CDO 2005-1 are not consolidated for federal income tax return purposes. For financial reporting purposes, current and deferred taxes are provided for on the portion of earnings recognized by the Company with respect to its interest in KKR TRS, a domestic taxable REIT subsidiary, because it is taxed as a regular subchapter C corporation under the provisions of the Code. Deferred income tax assets and liabilities are computed based on temporary differences between the GAAP consolidated financial statements and the federal income tax basis of assets and liabilities as of each consolidated balance sheet date. CLO 2005-1, CLO 2005-2, CLO 2006-1 and CDO 2005-1, the Company’s foreign taxable REIT subsidiaries, and CLO 2006-2, which will elect to be a taxable REIT subsidiary in the future, are organized as exempted companies incorporated with limited liability under the laws of the Cayman Islands, and are generally exempt from federal and state income tax at the corporate entity level because they restrict their activities in the United States to trading in stock and securities for their own account. Therefore, despite their status as taxable REIT subsidiaries, they generally will not be subject to corporate income tax on their earnings, and no provision for income taxes for the year ended December 31, 2005 is required; however, the Company will generally be required to include their current taxable income in its calculation of REIT taxable income.

F-13

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 2. Summary of Significant Accounting Policies (Continued)

Earnings Per Share

In accordance with SFAS No. 128, Earnings per Share, the Company presents both basic and diluted earnings (loss) per common share (“EPS”) in its consolidated financial statements and footnotes thereto. Basic earnings (loss) per common share (“Basic EPS”) excludes dilution and is computed by dividing net income or loss allocable to common stockholders by the weighted average number of common shares, including vested restricted common shares, outstanding for the period. Diluted earnings per share (“Diluted EPS”) reflects the potential dilution of common stock options and unvested restricted common stock, if they are not anti-dilutive. See Note 3 for earnings per common share computations.

Recent Accounting Pronouncements

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, which replaces APB Opinion No. 20, Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements—An Amendment of APB Opinion No. 28. SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an error. SFAS No. 154 is required to be adopted by the Company in the first quarter of 2006. The Company does not expect that the adoption of SFAS No. 154 will have a material impact on its consolidated financial statements.

In November 2005, the FASB issued FASB Staff Position FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (“FSP 115-1”), which provides guidance on determining when investments in certain debt and equity securities are considered impaired, whether that impairment is other-than-temporary, and on measuring such impairment loss. FSP 115-1 also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. FSP 115-1 is required to be adopted by the Company in the first quarter of 2006. The Company does not expect that the adoption of FSP 115-1 will have a material impact on its consolidated financial statements.

F-14

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 2. Summary of Significant Accounting Policies (Continued)

including interest-only strips and principal-only strips, required to be accounted for in accordance with SFAS No. 133. The Company does not expect that the adoption of SFAS No. 155 will have a material effect on its consolidated financial statements.

Note 3. Earnings per Share

The Company calculates basic net income per common share by dividing net income for the period by the weighted-average shares of its common stock outstanding for the period. Diluted net income per common share takes into account the effect of dilutive instruments, such as common stock options and unvested restricted common stock, but uses the average share price for the period in determining the number of incremental shares that are to be added to the weighted-average number of shares of its common stock outstanding. The following table presents a reconciliation of basic and diluted net income per common share for the year ended December 31, 2005 (amounts in thousands, except per share information):

	Year ended December 31, 2005
Basic:
Net income		$	55,081
Weighted-average number of common shares outstanding		58,998
Basic net income per common share		$	0.93
Diluted:
Net income		$	55,081
Weighted-average number of common shares outstanding		58,998
Plus: Incremental shares from assumed conversion of dilutive instruments		1,089
Adjusted weighted-average number of common shares outstanding		60,087
Diluted net income per common share		$	0.92

For the period from Inception through December 31, 2004, the Company incurred a net loss of $0.17 per common share. Inclusion of common stock options and unvested restricted common stock in the diluted loss per common share calculation would reduce the net loss per common share amount; therefore, they are considered anti-dilutive. As a result, the Company’s diluted loss per common share is equal to its basic loss per common share for such period.

F-15

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 4. Securities Available-for-Sale

The following table summarizes the Company’s securities classified as available-for-sale as of December 31, 2005, which are carried at estimated fair value (amounts in thousands):

Description	Amortized Cost		Gross Unrealized Gains			Gross Unrealized (Losses)				Estimated Fair Value
Residential mortgage-backed securities	$	5,566,783		$	9,893		$	(38,838	)	$	5,537,838
Commercial mortgage-backed securities	83,001			94			(183		)	82,912
Asset-backed securities	21,846			73			—			21,919
Corporate securities	457,932			7,829			(5,926		)	459,835
Common and preferred stock	47,158			232			(388		)	47,002
Total	$	6,176,720		$	18,121		$	(45,335	)	$	6,149,506

The following table summarizes the Company’s securities classified as available-for-sale as of December 31, 2004, which are carried at estimated fair value (amounts in thousands):

Description	Amortized Cost		Gross Unrealized Gains			Gross Unrealized (Losses)				Estimated Fair Value
Residential mortgage-backed securities	$	1,581,824		$	911		$	(24	)	$	1,582,711
Commercial mortgage-backed securities	12,000			7			—			12,007
Asset-backed securities	5,000			—			—			5,000
Corporate securities	19,578			477			(155		)	19,900
Common and preferred stock	31,158			504			—			31,662
Total	$	1,649,560		$	1,899		$	(179	)	$	1,651,280

All securities in an unrealized loss position at December 31, 2005 and December 31, 2004 have been in an unrealized loss position for less than one year. The Company’s review of such securities indicates that the decrease in estimated fair value was not due to permanent changes in the underlying credit fundamentals or in the amount of principal and interest expected to be received. In addition, the Company has the financial wherewithal and management has the intent to hold the securities for a period of time sufficient for a recovery in the estimated fair value. Therefore, management does not believe any of the securities held are other-than-temporarily impaired at December 31, 2005 or December 31, 2004.

During the year ended December 31, 2005, the Company’s gross realized gains from the sales of securities were $2.8 million. The Company had gross realized losses from the sales of securities during the year ended December 31, 2005 of $0.1 million and did not sell any securities during the period from Inception through December 31, 2004.

F-16

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 4. Securities Available-for-Sale (Continued)

The following table summarizes the estimated fair value of debt securities by contractual maturity as of December 31, 2005 (dollars in thousands):

Description	Estimated Fair Value			Weighted Average Coupon
Due within one year		$	—		—	%
One to five years		73,991			7.39
Five to ten years		370,563			9.15
Greater than ten years		5,657,950			4.50
Total		$	6,102,504

Mortgage-backed and asset-backed securities included in the table above were allocated based on contractual principal maturities assuming no prepayments.

Note 6 to these consolidated financial statements describes the Company’s borrowings under which the Company has pledged securities available-for-sale for borrowings under repurchase agreements, asset-backed secured liquidity notes, and all other secured financing transactions. The following table summarizes the estimated fair value of securities pledged as collateral under repurchase agreements, asset-backed secured liquidity notes, and all other secured financing transactions as of December 31, 2005:

	Residential Mortgage-Backed Securities			Commercial Mortgage-Backed Securities			Corporate Securities(1)
Pledged as collateral for borrowings under repurchase agreements		$	4,534,257		$	65,352		$	286,365
Pledged as collateral for asset-backed secured liquidity notes		720,370			—			—
Pledged as collateral for borrowings under secured revolving credit facility		—			—			82,888
Pledged as collateral for borrowings under secured demand loan		—			45,057			—
Pledged as collateral for collateralized loan obligation senior secured notes		—			5,021			171,089
Total		$	5,254,627		$	115,430		$	540,342

(1) Includes asset-backed securities.

F-17

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 5. Loans

The following table summarizes the Company’s loans as of December 31, 2005 (amounts in thousands):

	Principal			Unamortized Premium/(Discount)				Net Amortized Cost
Residential mortgage loans	$	6,405,701			$	23,121		$	6,428,822
Corporate loans	1,900,385				(3,108		)	1,897,277
Commercial real estate loans	522,750				(1,008		)	521,742
Allowance for loan losses for residential mortgage loans	(1,500		)		—			(1,500		)
Total loans held for investment	8,827,336				19,005			8,846,341
Loans held for sale	—				—			—
Total loans, net of allowance for loan losses	$	8,827,336			$	19,005		$	8,846,341

The following table summarizes of the Company’s loans as of December 31, 2004 (amounts in thousands):

	Principal		Unamortized Premium/(Discount)				Net Amortized Cost
Corporate loans	$	400,218		$	(581	)	$	399,637
Residential mortgage loans	229,855			3,265			233,120
Commercial real estate loans	50,000			—			50,000
Total loans held for investment	$	680,073		$	2,684		$	682,757

The following is a reconciliation of carrying amounts of residential mortgage loans for the year ended December 31, 2005 (amount in thousands):

Balance at January 1, 2005	$	229,855
Loan purchases (principal)	6,720,923
Principal payments	(545,077		)
Net unamortized premium	23,121
Balance at December 31, 2005	$	6,428,822

During the year ended December 31, 2005, the Company purchased $5.9 billion of securities in connection with five securitization transactions backed by $4.5 billion of residential hybrid ARM loans and $1.4 billion of residential ARM loans. In each of the five securitization transactions, the Company purchased all of the securities issued, including the subordinate classes. Included in the $5.9 billion of securities purchased, were $0.4 billion of loans contributed to the securitization transactions by the Company, resulting in a net purchase by the Company of $5.5 billion of securities. Of the $5.9 billion of securities purchased, approximately 96% were rated AAA by Standard & Poor’s. Each of the special-purpose entities that issued the securities are not considered qualifying special-purpose entities as defined by SFAS No. 140 and are treated as VIEs under FIN 46R. The Company has determined that it is the primary beneficiary of each of the special-purpose entities that issued the securities; accordingly, the Company recorded its investments as loans and not securities.

F-18

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 5. Loans (Continued)

During September 2005, the Company securitized $959.2 million of residential ARM loans and retained all of the securities issued in the securitization transaction, including the subordinate classes. While the Company retained all of the securities, which are legal assets of the Company, the loans transferred in this securitization are owned by a special purpose entity and the loans are not available to the Company, its creditors or stockholders. Of the $959.2 million of securities issued, approximately $908.8 million, or 95%, were rated AAA by Standard & Poor’s. While the Company transferred the loans to a separate bankruptcy-remote legal entity, the Company did not account for the transaction as a sale as the securitization transaction did not meet the criteria for sales treatment under SFAS No. 140. Accordingly, the Company did not record a gain or loss in connection with the securitization transaction and accounts for the transferred assets as loans on its consolidated balance sheet.

The following table summarizes the geographic distribution of the Company’s residential mortgage loan portfolio as of December 31, 2005 (dollar amounts in thousands):

State or Territory	Number of Loans		Principal Amount			% of Principal Amount
California		4,123		$	2,411,737		37.7	%
Florida		1,141		537,735			8.4
New York		598		384,853			6.0
New Jersey		538		284,718			4.4
Virginia		564		261,646			4.1
Other		5,804		2,525,012			39.4
Total		12,768		$	6,405,701		100.0	%

The following table summarizes the delinquency statistics of residential mortgage loans as of December 31, 2005 (dollar amounts in thousands):

Delinquency Status	Number of Loans		Principal Amount
30 to 59 days		82		$	31,049
60 to 89 days		11		3,427
90 days or more		6		1,589
In foreclosure		—		—
Total		99		$	36,065

No residential mortgage loans were delinquent as of December 31, 2004. Additionally, no corporate loans or commercial real estate loans were delinquent as of December 31, 2005 or December 31, 2004.

The following table summarizes the changes in the allowance for loan losses for the Company’s residential mortgage loan portfolio during the year ended December 31, 2005 (amounts in thousands):

Balance, beginning of year	$	—
Provision for loan losses	1,500
Charge-offs	—
Balance, end of year	$	1,500

F-19

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 5. Loans (Continued)

As of December 31, 2004, the Company had not recorded an allowance for loan losses for the Company’s residential mortgage loan portfolio. Additionally, as of December 31, 2005 and December 31, 2004, the Company had not recorded an allowance for loan losses for its commercial real estate or corporate loan portfolios. In reviewing the Company’s portfolio of commercial real estate loans and corporate loans, the Company determined that no loans were impaired as of December 31, 2005 or December 31, 2004.

Note 6 to these consolidated financial statements describes the Company’s borrowings under which the Company has pledged loans for borrowings under repurchase agreements, asset-backed secured liquidity notes, and all other secured financing transactions. The following table summarizes the carrying value of loans pledged as collateral under repurchase agreements, asset-backed secured liquidity notes, and all other secured financing transactions as of December 31, 2005:

	Residential Mortgage Loans			Corporate Loans			Commercial Real Estate Loans
Pledged as collateral for borrowings under repurchase agreements		$	4,904,779		$	145,217		$	380,090
Pledged as collateral for asset-backed secured liquidity notes		1,366,300			—			—
Pledged as collateral for borrowings under secured revolving credit facility		—			59,965			10,000
Pledged as collateral for collateralized loan obligation senior secured notes		—			1,715,100			40,000
Total		$	6,271,079		$	1,920,282		$	430,900

Note 6. Borrowings

The Company leverages its portfolio of securities and loans through the use of repurchase agreements, asset-backed secured liquidity notes, warehouse facilities, demand loans, and securitization transactions structured as secured financings. Each of the borrowing vehicles used by the Company bears interest at floating rates based on a spread above the London InterBank Offered Rate (“LIBOR”) or asset-backed secured liquidity note interest rates.

F-20

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 6. Borrowings (Continued)

Certain information with respect to the Company’s borrowings as of December 31, 2005 is summarized in the following table (amounts in thousands):

	Outstanding Borrowings		Weighted Average Borrowing Rate			Weighted Average Remaining Maturity (in days)		Fair Value of Collateral (1)
Repurchase agreements	$	9,303,622		4.33	%		24		$	9,472,231
Demand loan	40,511			4.63			13		45,057
Secured revolving credit facility	54,000			5.38			13		152,241
Asset-backed secured liquidity notes	2,008,069			4.42			14		2,080,072
CLO 2005-1 senior secured notes	773,000			4.49			4,134		996,681
CLO 2005-2 senior secured notes	727,000			4.59			4,348		946,969
CLO 2006-1 repurchase agreements	193,835			4.86			5		436,756
CDO 2005-1 repurchase agreements	263,801			5.47			18		388,783
Total	$	13,363,838							$	14,518,790

(1) Collateral for borrowings consists of securities available-for-sale, loans, and non-marketable equity investments.

Certain information with respect to the Company’s borrowings as of December 31, 2004 is summarized in the following table (amounts in thousands):

	Outstanding Borrowings		Weighted Average Borrowing Rate			Weighted Average Remaining Maturity (in days)		Fair Value of Collateral
Repurchase agreements	$	1,558,274		2.51	%		20	$	1,736,687
Demand loan	27,875			2.79	%		1	31,662
Total	$	1,586,149						$	1,768,349

As of December 31, 2005, the Company had $9.8 billion outstanding on repurchase facilities with ten counterparties with a weighted average effective borrowing rate of 4.47% and a weighted average remaining term to maturity of 24 days. Because the Company borrows under repurchase agreements based on the estimated fair value of its pledged investments, and because changes in interest rates can negatively impact the valuation of its pledged investments, the Company’s ongoing ability to borrow under its repurchase facilities may be limited and its lenders may initiate margin calls in the event interest rates change or the value of its pledged securities decline as a result of adverse changes in interest rates or credit spreads.

F-21

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 6. Borrowings (Continued)

At December 31, 2005, the Company had repurchase agreements with the following counterparties (amounts in thousands):

Counterparty(2)	Amount At Risk(1)		Weighted Average Maturity (Days)		Weighted Average Interest Rate
Banc of America Securities LLC.	$	4,122		25		4.44	%
Bear Stearns & Co. Inc.	191,755			24		4.46
Citigroup Global Markets Ltd	63,773			25		4.44
Credit Suisse First Boston LLC.	27,325			27		4.43
Deutsche Bank AG.	126,994			18		5.47
J. P. Morgan Chase Bank, N.A	61,461			25		4.43
Lehman Brothers Holdings Inc.	22,317			25		4.43
Merrill Lynch, Pierce, Fenner & Smith Inc.	45,461			30		4.43
Morgan Stanley & Co. Inc.	255,534			22		4.52
UBS Financial Services Inc.	14,314			3		4.34
Total	$	813,056

Notes:

(1) Computed as an amount equal to the estimated fair value of securities or loans sold, plus accrued interest income, minus the sum of repurchase agreement liabilities plus accrued interest expense.

(2) Counterparty includes subsidiaries and affiliates of each counterparty listed.

At December 31, 2004, the Company had repurchase agreements with the following counterparties (amounts in thousands):

Repurchase Agreements

Counterparty(2)	Amount At Risk(1)		Weighted Average Maturity (Days)		Weighted Average Interest Rate
Credit Suisse First Boston LLC	$	48,619		20		2.48	%
Bear, Stearns & Co. Inc.	106,695			31		2.84	%
J.P. Morgan Securities Inc	23,942			18		2.55	%
Total	$	179,256

Notes:

(1) Computed as an amount equal to the estimated fair value of securities or loans sold, plus accrued interest income, minus the sum of repurchase agreement liabilities plus accrued interest expense.

(2) Counterparty includes subsidiaries and affiliates of each counterparty listed.

On March 30, 2005, the Company closed CLO 2005-1, a $1.0 billion CLO transaction that provides financing for investments consisting of corporate loans and certain other loans and securities. The investments that are owned by CLO 2005-1 collateralize the CLO 2005-1 debt, and as a result, those

F-22

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 6. Borrowings (Continued)

investments are not available to the Company, its creditors or stockholders. CLO 2005-1 issued a total of $773.0 million of senior secured notes at par to investors. In addition, the Company retained $148.0 million of rated mezzanine notes and $85.5 million of unrated subordinated notes issued by CLO 2005-1.

The senior notes issued to investors by CLO 2005-1 consist of three classes of notes as follows: (i) $615.0 million of class A-1 notes bearing interest at three-month LIBOR plus 0.27%; (ii) $58.0 million of class B notes bearing interest at three-month LIBOR plus 0.45%; and (iii) $100.0 million of class A-2 Delayed Draw notes bearing interest on the drawn amount at three-month LIBOR plus 0.27%. All of the notes issued mature on April 26, 2017, though the Company has the right to call the notes at par any time after April 2008.

During April 2005 the Company formed CDO 2005-1 and began borrowing on a $300.0 million warehouse facility, in the form of a repurchase agreement, to purchase commercial real estate obligations. The repurchase facility bears interest at a rate of 30-day LIBOR plus 1.10% and as of December 31, 2005, there was $263.8 million outstanding.

During June 2005, the Company entered into a $275.0 million secured revolving credit facility. This revolving credit facility matures on June 30, 2006, and, as of December 31, 2005, the Company had $54.0 million of borrowings outstanding. The revolving credit facility bears interest at 30-day LIBOR plus 1.00%.

On September 30, 2005, the Company closed a $5.0 billion asset-backed secured liquidity note facility. This facility provides the Company with an alternative source of funding its residential mortgage-backed securities by issuing asset-backed secured liquidity notes that are rated A-1+, P-1, and F1+, by Standard and Poor’s, Moody’s Investors Service, or Moody’s, and Fitch Inc, respectively. Issuances of asset-backed secured liquidity notes are recorded as borrowings on the Company’s consolidated balance sheet. At December 31, 2005, the Company had $2.0 billion of asset-backed secured liquidity notes outstanding.

On November 3, 2005, the Company closed CLO 2005-2, its second $1.0 billion CLO transaction that provides financing for investments consisting of corporate loans and certain other loans and securities. The investments that are owned by CLO 2005-2 collateralize the CLO 2005-2 debt, and as a result, those investments are not available to the Company, its creditors or stockholders. CLO 2005-2 issued a total of $752.0 million of senior secured notes at par to investors. In addition, the Company retained $168.0 million of rated mezzanine notes and $98.5 million o f unrated subordinate notes issued by CLO 2005-2.

The senior notes issued to investors by CLO 2005-2 consist of three classes of notes as follows: (i) $545.0 million of class A-1 notes bearing interest at three-month LIBOR plus 0.26%; (ii) $57.0 million of class B notes bearing interest at three-month LIBOR plus 0.43%; and (iii) $150.0 million of class A-2 Delayed Draw notes bearing interest on the drawn amount at three-month LIBOR plus 0.26% (at December 31, 2005, $125.0 million of the delayed draw notes were drawn). All of the notes issued mature on November 26, 2017, though the Company has the right to call the notes at par any time after November 2009.

During 2005, the Company formed CLO 2006-1 and during December 2005 executed a $500.0 million warehouse facility, in the form of a repurchase agreement, to finance the purchase of corporate

F-23

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 6. Borrowings (Continued)

loans and certain other loans and securities. The repurchase facility bears interest at a rate of 30-day LIBOR plus 0.65% and as of December 31, 2005, there was $117.7 million outstanding. Additionally, CLO 2006-1 had $76.1 million outstanding under a separate repurchase agreement from the repurchase facility as of December 31, 2005. Also during December 2005, the Company formed CLO 2006-2 and executed a $450.0 million warehouse facility, in the form of a repurchase agreement, to finance the purchase of corporate loans and certain other loans and securities. The repurchase facility bears interest at a rate of 30-day LIBOR plus 0.65% and as of December 31, 2005, there were no borrowings outstanding.

The table below summarizes our contractual obligations (excluding interest) under our borrowing agreements as of December 31, 2005 (amounts in thousands):

	Payments Due by Period
	Total		Less than 1 year			1-3 years			3-5 Years			More than 5 years
Repurchase agreements	$	9,303,622		$	9,303,622		$	—		$	—	$	—
CLO 2005-1 senior secured notes	773,000			—			—			—		773,000
CLO 2005-2 senior secured notes	727,000			—			—			—		727,000
CDO 2005-1 repurchase agreements	263,801			263,801			—			—		—
CLO 2006-1 repurchase facilities	193,835			193,835			—			—		—
Demand loan	40,511			40,511			—			—		—
Secured revolving credit facility	54,000			54,000			—			—		—
Asset-backed secured liquidity notes	2,008,069			2,008,069			—			—		—
Total	$	13,363,838		$	11,863,838		$	—		$	—	$	1,500,000

Note 7. Derivative Financial Instruments

The Company uses derivative financial instruments to hedge all or a portion of the interest rate risk associated with its borrowings under repurchase agreements and asset-backed secured liquidity notes. Certain of the techniques used to hedge exposure to interest rate fluctuations may also be used to protect against declines in the market value of assets that result from general trends in debt markets or from fluctuations in currency values, to the extent the Company makes non-U.S. dollar-denominated investments. The principal objective of such arrangements is to minimize the risks and/or costs associated with the Company’s operating and financial structure as well as to hedge specific anticipated transactions. The counterparties to these contractual arrangements are major financial institutions with which the Company and its affiliates may also have other financial relationships. In the event of nonperformance by the counterparties, the Company is potentially exposed to losses. However, because of the high credit ratings of the counterparties with which the Company has entered into derivative transactions, the Company does not anticipate that any of the counterparties will fail to fulfill their obligations.

F-24

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 7. Derivative Financial Instruments (Continued)

The table below summarizes the estimated net fair value of the derivative instruments as of December 31, 2005 and December 31, 2004 (amounts in thousands):

	As of December 31, 2005			As of December 31, 2004
Cash Flow Hedges:
Interest rate corridors		$	14,762		$	—
Interest rate swaps		40,796			—
Free-Standing Derivatives:
Interest rate swaptions		879			223
Interest rate swaps		198			—
Credit default swaps		71			(625		)
Total rate of return swaps		727			—
Foreign exchange contracts		—			(125		)
Net fair value		$	57,433		$	(527	)

During the year ended December 31, 2005 and the period ended December 31, 2004, the terms of the Company’s derivatives designated as cash flow hedges matched the related hedged items and, as a result, the Company recognized zero ineffectiveness from cash flow hedges in income. The following table summarizes by derivative instrument type the effect on income from free-standing derivatives for the periods:

Free-Standing Derivatives:	For the year ended December 31, 2005				For the period from August 12, 2004 (inception) through December 31, 2004
Interest rate swaptions		$	(424	)		$	(28	)
Interest rate swaps		499				—
Credit default swaps		(259		)		(283		)
Total rate of return swaps		755				—
Foreign exchange contracts		2,211				(125		)
Net realized and unrealized gains (losses) on freestanding derivatives		$	2,782			$	(436	)

Note 8. Accumulated Other Comprehensive Income

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

	As of December 31, 2005				As of December 31, 2004
Net unrealized (losses) gains on available-for-sale securities		$	(27,215	)		$	1,720
Net unrealized gains on cash flow hedges		45,559				—
Accumulated other comprehensive income		$	18,344			$	1,720

F-25

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 8. Accumulated Other Comprehensive Income (Continued)

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

	Year ended December 31, 2005				Year ended December 31, 2004
Unrealized gains on securities available-for-sale:
Unrealized holding gains (losses) arising during period		$	(26,268	)		$	1,720
Reclassification adjustments for gains realized in net income		(2,667		)		—
Unrealized gains (losses) on securities available-for-sale		(28,935		)		1,720
Unrealized gains on cash flow hedges		45,559				—
Other comprehensive income		$	16,624			$	1,720

Note 9. Commitments

Operating Lease

As of December 31, 2005, the Company was obligated under two non-cancelable operating leases with terms of ten years and two years, respectively. The majority of the future lease payments are related to a ten-year operating lease for executive offices that the Company will relocate to in 2006. The total lease payments to be made over the ten-year period, including certain free rent periods, are being recognized as office lease expense on a straight-line basis over the ten-year period. This expense is included in general and administrative expense on the Consolidated Statements of Operations. Total rent expense under operating leases for the years ended December 31, 2005 and 2004 was $0.7 million and $0.2 million, respectively. Minimum future obligations on leases in effect at December 31, 2005, are approximately as follows (amounts in thousands):

Year	Amount
2006	$	1,132
2007	1,723
2008	1,379
2009	1,388
2010	1,429
2011 and thereafter	8,357
Total	$	15,408

Loan Commitments

As part of its strategy of investing in corporate loans and commercial real estate loans, the Company commits to purchase interests in primary market loan syndications, which obligate the Company to acquire a predetermined interest in such loans at a specified price on a to-be-determined settlement date. Consistent with standard industry practices, once the Company has been informed of the amount of its syndication allocation in a particular loan by the syndication agent, the Company bears the risks and

F-26

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 9. Commitments (Continued)

benefits of changes in the fair value of the syndicated loan from that date forward. As of December 31, 2005, the Company had committed to purchase or participate in approximately $61.5 million of corporate loans at December 31, 2005. In addition, the Company had an obligation to fund delayed draw commitments, upon request, totaling $72.9 million at December 31, 2005. Under the terms of the delayed draw commitments the Company receives a commitment fee of between 1.38% and 2.13% per annum for the period from the date of its commitment to the date that the delayed draw is funded.

Note 10. Stock Options and Restricted Stock

The Company has adopted a stock incentive plan (the “2004 Stock Incentive Plan”) that provides for the grant of qualified incentive common stock options that meet the requirements of Section 422 of the Code, non-qualified common stock options, stock appreciation rights, restricted common stock and other share-based awards. The 2004 Stock Incentive Plan was amended on May 26, 2005. The Compensation Committee of the Board of Directors administers the plan. Stock options may be granted to the Manager, Directors, officers and any key employees of the Manager and to any other individual or entity performing services for the Company.

The exercise price for any stock option granted under the 2004 Stock Incentive Plan may not be less than 100% of the fair market value of the shares of common stock at the time the common stock option is granted. Each common stock option must terminate no more than ten years from the date it is granted. The 2004 Stock Incentive Plan, as amended, authorizes that a total of 7,964,625 shares may be used to satisfy awards under the plan. The Company made its initial grants under the 2004 Stock Incentive Plan on August 12, 2004, and August 19, 2004, the dates that the Company closed its initial private placement of common stock and the date that the over-allotment option was exercised, respectively.

The following table summarizes restricted common stock transactions:

	Manager		Directors			Total
Unvested shares as of August 19, 2004	1,193,867			15,000		1,208,867
Issued	—			—		—
Vested	—			—		—
Forfeited	—			—		—
Unvested shares as of December 31, 2004	1,193,867			15,000		1,208,867
Issued	1,875,000			28,321		1,903,321
Vested	(397,956	)		(10,000	)	(407,956	)
Forfeited	—			(5,000	)	(5,000	)
Unvested shares as of December 31, 2005	2,670,911			28,321		2,699,232

The shares of restricted common stock granted to the directors were valued using the fair market value at the time of grant, which was $24.90 and $20.00 per share, for the shares of restricted common stock granted in 2005 and 2004, respectively. Pursuant to SFAS No. 123(R), the Company is required to value any unvested shares of restricted common stock granted to the Manager at the current market price. The Company valued the unvested restricted common stock at $23.99 and $20.00 per share at December 31, 2005 and December 31, 2004, respectively.

F-27

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 10. Stock Options and Restricted Stock (Continued)

The following table summarizes common stock option transactions:

	Number of Options	Weighted Average Exercise Price
Outstanding as of August 19, 2004	1,989,779		$	20.00
Granted	—		—
Exercised	—		—
Forfeited	—		—
Outstanding as of December 31, 2004	1,989,779		$	20.00
Granted	—		—
Exercised	—		—
Forfeited	—		—
Outstanding as of December 31, 2005	1,989,779		$	20.00

None of the common stock options outstanding were exercised at December 31, 2005 and December 31, 2004, respectively. As of December 31, 2005, 663,260 common stock options were exercisable, and no common stock options were exercisable as of December 31, 2004. The common stock options are valued using the Black-Scholes model using the following assumptions:

	As of December 31, 2005		As of December 31, 2004
Expected life		8.6 years		9.6 years
Discount rate		4.50%		4.44%
Volatility		20%		20%
Dividend yield		9%		9%

The estimated fair value of the common stock options was $1.90 and $0.98 at December 31, 2005 and December 31, 2004, respectively. For the year ended December 31, 2005 and the period from August 12, 2004 (Inception) through December 31, 2004, the components of share-based compensation expense are as follows (amounts in thousands):

	Year ended December 31, 2005			Period from August 12, 2004 (Inception) through December 31, 2004
Options granted to Manager		$	2,155		$	461
Restricted shares granted to Manager		27,654			5,649
Restricted shares granted to certain directors		437			116
Total share-based compensation expense		$	30,246		$	6,226

Note 11. Management Agreement and Related Party Transactions

The Manager manages the Company’s day-to-day operations, subject to the direction and oversight of the Company’s Board of Directors. The Management Agreement was executed on August 12, 2004. The initial term expires on December 31, 2006 and shall be automatically renewed for a one-year term on each

F-28

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 11. Management Agreement and Related Party Transactions (Continued)

anniversary date thereafter. Following the initial term, the Management Agreement may be terminated upon the affirmative vote of at least two-thirds of the Company’s independent directors, or by a vote of the holders of a majority of the outstanding shares of the Company’s common stock.

The Management Agreement provides, among other things, that the Company pays to the Manager, in exchange for managing the day-to-day operations of the Company, certain fees and reimbursements, consisting of a base management fee, an incentive fee, and reimbursement for out-of-pocket and certain other costs incurred by the Manager and on behalf of the Company. All rent incurred by the Manager is paid by the Company and the Company is a party to the lease.

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

For the year ended December 31, 2005, the Company incurred $21.0 million in base management fees. In addition, the Company recognized share-based compensation expense related to common stock options and restricted common stock granted to the Manager of $29.8 million for the year ended December 31, 2005 (see Note 10). The Company also reimbursed the Manager $4.9 million for expenses for the year ended December 31, 2005. The Company incurred base management fees and reimbursed the Manager for expenses of $5.1 million and $1.8 million, respectively, for the period from Inception through December 31, 2004. In addition, the Company recognized share-based compensation expense related to common stock options and restricted common stock granted to the Manager of $6.1 million for the period from Inception through December 31, 2004. Base management fees incurred and share-based compensation expense relating to common stock options and restricted common stock granted to the Manager are included in management compensation to related party on the Consolidated Statements of Operations. Expenses incurred by the Manager and reimbursed by the Company are reflected in the respective consolidated statement of operations non-investment expense category based on the nature of the expense.

No incentive fees were earned or paid to the Manager during the year ended December 31, 2005 or during the period from Inception to December 31, 2004.

An affiliate of the Company’s Manager has entered into separate management agreements with the respective investment vehicles for CLO 2005-1 and CLO 2005-2 and is entitled to receive fees for the services performed as collateral manager. To date, the collateral manager has waived approximately $1.5 million of management fees payable to it from CLO 2005-1, which covers the period commencing in March 2005 and ending in April 2006 and has waived approximately $0.8 million of management fees payable to it from CLO 2005-2, which covers the period commencing November 2005 and ending in May 2006. The waivers for CLO 2005-1 and CLO 2005-2 expire in April 2006 and May 2006, respectively, and there is no guarantee that the collateral manager will waive such management fees subsequent to those dates.

During the fourth quarter of 2005, the Company co-invested $52.5 million on a pari passu basis with KKR in four separate private equity transactions.

F-29

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 12. Income Taxes

Even though the Company qualifies for federal taxation as a REIT, it may be subject to some amount of federal, state, local and foreign taxes based on the Company’s taxable income. KKR TRS, however, is taxed as a regular subchapter C corporation under the Code. The income tax provision for the Company (REIT) and KKR TRS (TRS) for the year ended December 31, 2005 and the period from August 12, 2004 (inception) through to December 31, 2004 consisted of the following components (amounts in thousands):

	Year ended December 31, 2005			Period from August 12, 2004 (inception) through December 31, 2004
Current provision:
Federal—TRS		$	1,473		$	—
Federal—REIT		352			—
State—TRS		242			—
Foreign—REIT		152			—
Total current provision		2,219			—
Deferred provision (benefit):
Federal—TRS		788			(190		)
State—TRS		137			(38		)
Total deferred provision (benefit)		925			(228		)
Total provision for income taxes		$	3,144		$	(228	)

The above tax expense (benefit) was based on KKR TRS’s effective tax rate of 40.75% at December 31, 2005 and 42.02% at December 31, 2004. It was equivalent to the combined rate of the Federal statutory income tax rate and the State statutory income tax rate, net of Federal benefit.

The components of the deferred tax assets and liabilities as of December 31, 2005 and December 31, 2004 are as follows (amounts in thousands):

	December 31, 2005				December 31, 2004
Deferred tax assets:
Unrealized loss—derivatives		$	—			$	147
Net operating loss carryforward		—				81
Gross deferred tax asset		$	—			$	228
Deferred tax liabilities:
Unrealized gain—derivatives		$	697			$	—
Net operating loss carryforward		—				—
Gross deferred tax liabilities		$	697			$	—
Net deferred tax asset (liability)		$	(697	)		$	228
Valuation allowance		—				—
Total deferred tax asset (liability)		$	(697	)		$	228

F-30

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 12. Income Taxes (Continued)

For federal income tax purposes, the distributions declared and paid during 2005 on the Company’s common stock are 100% taxable as dividend income at ordinary rates and no portion of the dividends is eligible for the 15% dividend tax rate or the corporate dividends received deduction.

Note 13. Leasehold Improvements and Equipment

The following is a summary of the Company’s leasehold improvements and equipment, which are included in other assets in the consolidated balance sheet at December 31, 2005 and 2004 (dollars in thousands):

	December 31, 2005				December 31, 2004
Leasehold improvements		$	1,274			$	385
Furniture and equipment		1,435				608
		2,709				993
Accumulated depreciation and amortization		(641		)		(85		)
Total property and equipment, net		$	2,068			$	908

Depreciation and amortization expense was $0.6 million and $0.1 million for the years ended December 31, 2005 and 2004, respectively.

Note 14. Fair Value of Financial Instruments

SFAS No. 107, Disclosure About Fair Value of Financial Instruments, requires disclosure of the fair value of financial instruments for which it is practicable to estimate that value. The fair value of securities available-for-sale, loans, derivatives, and loan commitments is based on quoted market prices or estimates provided by independent pricing sources. The fair value of cash and cash equivalents, interest payable, repurchase agreements, collateralized loan obligation senior secured notes, asset-backed secured liquidity notes, secured revolving credit facility, secured demand loan and interest payable, approximates cost as of December 31, 2005 and December 31, 2004, due to the short-term nature of these instruments.

F-31

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 14. Fair Value of Financial Instruments (Continued)

The table below discloses the carrying value and the fair value of the Company’s financial instruments as of December 31, 2005 (dollars in thousands):

	Carrying Amount		Estimated Fair Value
Financial Assets:
Cash and cash equivalents	$	96,333		$	96,333
Securities available-for-sale	6,149,506			6,149,506
Loans, net of allowance for loan losses of $1,500	8,846,341			8,820,970
Non-marketable equity securities	52,500			52,500
Interest receivable	59,993			59,993
Derivatives	58,898			58,898
Financial Liabilities:
Repurchase agreements	$	9,761,258		$	9,761,258
Collateralized loan obligation senior secured notes	1,500,000			1,500,000
Asset-backed secured liquidity notes	2,008,069			2,008,069
Secured revolving credit facility	54,000			54,000
Secured demand loan	40,511			40,511
Interest payable	21,415			21,415
Derivatives	1,465			1,465
Off-Balance Sheet Items:
Loan commitments	$	—		$	346

The table below discloses the carrying value and the fair value of the Company’s financial instruments as of December 31, 2004 (dollars in thousands):

	Carrying Amount		Estimated Fair Value
Financial Assets:
Cash and cash equivalents	$	8,540		$	8,540
Securities available-for-sale	1,651,280			1,651,280
Loans	682,757			686,290
Interest receivable	2,694			2,694
Derivatives	223			223
Financial Liabilities:
Repurchase agreements	$	1,558,274		$	1,558,274
Demand loan	27,875			27,875
Interest payable	771			771
Derivatives	750			750
Off-Balance Sheet Items:
Loan commitments	$	—		$	642

F-32

KKR Financial Corp. and Subsidiaries
Notes to Consolidated Financial Statements (Continued)

Note 15. Summary of Quarterly Information (Unaudited)

The following is a presentation of the quarterly results of operations (amounts in thousands, except per share information):

	2005												2004
	Fourth Quarter			Third Quarter			Second Quarter			First Quarter			Fourth Quarter			Period from August 12, 2004 (inception) to September 30, 2004
Net investment income:
Total investment income	$	178,770		$	116,587		$	69,026		$	35,546		$	6,656			$	1,466
Interest expense	(133,456		)	(77,532		)	(48,281		)	(20,449		)	(975		)		—
Provision for loan losses	(200		)	(1,300		)	—			—
Net investment income	45,114			37,755			20,745			15,097			5,681				1,466
Other income:
Total other income (loss)	2,984			1,879			1,859			838			(488		)		—
Non-investment expenses:
Related party management compensation	17,721			14,331			10,731			8,008			7,421				3,801
Professional services	1,504			1,432			788			397			680				221
Loan servicing expense	3,144			1,369			363			267			—				—
Insurance expense	267			275			216			217			216				119
Directors expenses	352			368			152			199			242				99
General and administrative expenses	1,838			2,630			858			619			141				656
Total non-investment expenses	24,826			20,405			13,108			9,707			8,700				4,896
Income (loss) before income tax expense (benefit)	23,272			19,229			9,496			6,228			(3,507		)		(3,430		)
Income tax expense (benefit)	1,263			775			994			112			(228		)		—
Net income (loss)	$	22,009		$	18,454		$	8,502		$	6,116		$	(3,279	)		$	(3,430	)
Net income (loss) per common share:
Basic	$	0.28		$	0.24		$	0.21		$	0.15		$	(0.08	)		$	(0.09	)
Diluted	$	0.28		$	0.24		$	0.21		$	0.15		$	(0.08	)		$	(0.09	)
Weighted-average number of common shares outstanding:
Basic	77,675			77,486			40,212			39,796			39,796				39,796
Diluted	78,787			78,492			40,994			40,301			39,796				39,796
Distributions declared per common share	$	0.32		$	—		$	0.40		$	0.25		$	—			$	—

Note 16. Subsequent Events

On February 1, 2006, the Company’s Board of Directors declared a cash distribution for the quarter ended December 31, 2005 on the Company’s common stock of $0.40 per share. The distribution was paid on February 28, 2006 to stockholders of record as of the close of business on February 15, 2006.

During January 2006, the Company invested $40 million in a series of corporate floating rate notes which were rated BB by Standard and Poor’s and were issued by an unaffiliated third party. KKR Financial Advisors II, LLC, a wholly-owned subsidiary of the Company’s Manager, is the collateral manager for the unaffiliated third party in connection with this corporate floating rate note transaction.

F-33

(Mark One)
x	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2005
or
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to

Maryland		20-1426618
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)
Four Embarcadero Center, Suite 2050
San Francisco, CA		94111
(Address of principal executive offices)		(Zip Code)

Title of each class		Name of each exchange on which registered
Common Stock ($.01 par value)		New York Stock Exchange

KKR FINANCIAL CORP.
(Registrant)
By:	/s/ SATURNINO S. FANLO
	Name:	Saturnino S. Fanlo
	Title:	Chief Executive Officer

	Signature		Title		Date
s/ SATURNINO S. FANLO		Chief Executive Officer and Director		March 29, 2006
Saturnino S. Fanlo		(Principal Executive Officer)
/s/ DAVID A. NETJES		Chief Financial Officer and		March 29, 2006
David A. Netjes		Chief Operating Officer (Principal Financial and Accounting Officer)
/s/ PAUL M. HAZEN		Chairman and Director		March 29, 2006
Paul M. Hazen
/s/ WILLIAM F. ALDINGER		Director		March 29, 2006
William F. Aldinger
/s/ PATRICK COWELL		Director		March 29, 2006
Patrick Cowell
/s/ KENNETH M. DEREGT		Director		March 29, 2006
Kenneth M. deRegt
/s/ VINCENT PAUL FINIGAN		Director		March 29, 2006
Vincent Paul Finigan
/s/ R. GLENN HUBBARD		Director		March 29, 2006
R. Glenn Hubbard
/s/ ROSS J. KARI		Director		March 29, 2006
Ross J. Kari
/s/ ELY L. LICHT		Director		March 29, 2006
Ely L. Licht
/s/ DEBORAH H. MCANENY		Director		March 29, 2006
Deborah H. McAneny
/s/ SCOTT C. NUTTALL		Director		March 29, 2006
Scott C. Nuttall

		Page
	Part I
Item 1.	Business	1
Item 1A.	Risk Factors	12
Item 1B.	Unresolved Staff Comments	37
Item 2.	Properties	37
Item 3.	Legal Proceedings	37
Item 4.	Submission of Matters to a Vote of Security Holders	37
	Part II
Item 5.	Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities	38
Item 6.	Selected Consolidated Financial Data	39
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	41
Item 7A.	Quantitative and Qualitative Disclosures about Market Risk	72
Item 8.	Financial Statements and Supplementary Data	72
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	72
Item 9A.	Controls and Procedures	72
Item 9B.	Other Information	74
	Part III
Item 10.	Directors and Executive Officers of the Registrant	74
Item 11.	Executive Compensation	74
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters	74
Item 13.	Certain Relationships and Related Transactions	74
Item 14.	Principal Accountants Fees and Services	74
	Part IV
Item 15.	Exhibits and Financial Statement Schedules	74

		Page
Report of Independent Registered Public Accounting Firm		F-3
Consolidated Balance Sheets		F-4
Consolidated Statements of Operations		F-5
Consolidated Statements of Changes in Stockholders’ Equity		F-6
Consolidated Statements of Cash Flows		F-7
Notes to Consolidated Financial Statements		F-8

Company				Jurisdiction of Incorporation or Formation
KKR TRS Holdings, Inc.				Delaware
KKR Financial CLO 2005-1, Ltd.				Cayman Islands
KKR Financial CLO 2005-2, Ltd.				Cayman Islands
KKR Financial CLO 2006-1, Ltd.				Cayman Islands
KKR Financial CLO 2006-2, Ltd.				Cayman Islands
KKR Financial CDO 2005-1, Ltd.				Cayman Islands
KKR Financial Mortgage Corp.				Maryland
KKR QRS #1, Inc.				Delaware
KKR Pacific Funding Trust				Delaware
KKR Pacific Funding Depositor Corporation				Delaware
KFN PEI I, LLC				Delaware
KFN PEI II, LLC				Delaware
KFN PEI III, LLC				Delaware
KFN PEI IV, LLC				Delaware

	/s/ SATURNINO S. FANLO
	Saturnino S. Fanlo Chief Executive Officer (Principal Executive Officer)

Date: March 29, 2006
	/s/ DAVID A. NETJES
	David A. Netjes Chief Financial Officer and Chief Operating Officer (Principal Financial and Accounting Officer)