UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington,
D.C. 20549
FORM 10-Q
(Mark One)
|
x
|
QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
|
|
For the quarterly period ended June 30,
2008
|
|
or
|
|
o
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TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
|
|
For the transition period
from to
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Commission
file number: 001-33437
KKR FINANCIAL HOLDINGS LLC
(Exact name of
registrant as specified in its charter)
Delaware
|
|
11-3801844
|
(State or other jurisdiction of
incorporation or organization)
|
|
(I.R.S. Employer
Identification No.)
|
|
|
|
555 California Street, 50
th
Floor
San Francisco, CA
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94104
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(Address of principal executive offices)
|
|
(Zip Code)
|
Registrants
telephone number, including area code:
(415) 315-3620
Indicate by check mark whether the registrant
(1) has filed all reports required to be filed by Section 13 or 15(d) of
the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the past
90 days.
x
Yes
o
No
Indicate by check mark whether the registrant
is a large accelerated filer, an accelerated filer, a non-accelerated filer, or
a smaller reporting company. See the definitions of large accelerated filer, accelerated
filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
(Check one):
Large accelerated filer
x
|
|
Accelerated filer
o
|
Non-accelerated filer
o
|
|
Smaller reporting company
o
|
(Do not check if a smaller reporting
company)
|
|
|
Indicate by check mark whether the registrant
is a shell company (as defined in Rule 12b-2 of the Act).
o
Yes
x
No
The number of shares of the registrants
common shares outstanding as of August 1, 2008 was 150,881,500.
PART I. FINANCIAL INFORMATION
Item
1. Financial Statements
KKR
Financial Holdings LLC and Subsidiaries
Condensed Consolidated Balance Sheets
(Unaudited)
(Amounts in thousands, except share information)
|
|
As of
June 30
, 2008
|
|
As of
December 31, 2007
|
|
Assets
|
|
|
|
|
|
Cash and cash equivalents
|
|
$
|
189,008
|
|
$
|
524,080
|
|
Restricted cash and cash equivalents
|
|
730,303
|
|
1,067,797
|
|
Securities available-for-sale, $1,087,747
and $1,346,247 pledged as collateral as of June 30, 2008 and December 31, 2007, respectively
|
|
1,117,788
|
|
1,359,541
|
|
Corporate loans, net of allowance for loan
losses of $35,000 and $25,000 as of June 30,
2008 and December 31, 2007, respectively
|
|
8,708,005
|
|
8,634,208
|
|
Residential mortgage-backed securities, at
estimated fair value, $72,668 and $117,833 pledged as collateral as of
June 30, 2008 and December 31, 2007, respectively
|
|
115,652
|
|
131,688
|
|
Residential mortgage loans, at estimated
fair value
|
|
3,394,996
|
|
3,921,323
|
|
Corporate loans held for sale
|
|
66,652
|
|
|
|
Derivative assets
|
|
28,436
|
|
18,737
|
|
Interest and principal receivable
|
|
111,038
|
|
162,465
|
|
Non-marketable equity securities
|
|
20,079
|
|
20,084
|
|
Reverse repurchase agreements
|
|
|
|
69,840
|
|
Other assets
|
|
78,459
|
|
86,504
|
|
Assets of discontinued operations
|
|
|
|
3,049,758
|
|
Total assets
|
|
$
|
14,560,416
|
|
$
|
19,046,025
|
|
Liabilities
|
|
|
|
|
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Repurchase agreements
|
|
$
|
|
|
$
|
2,808,066
|
|
Collateralized loan obligation senior
secured notes
|
|
7,549,318
|
|
5,948,610
|
|
Collateralized loan obligation junior
secured notes to affiliates
|
|
525,420
|
|
525,420
|
|
Secured revolving credit facility
|
|
378,306
|
|
167,024
|
|
Secured demand loan
|
|
|
|
24,151
|
|
Convertible senior notes
|
|
300,000
|
|
300,000
|
|
Junior subordinated notes
|
|
293,826
|
|
329,908
|
|
Subordinated notes to affiliates
|
|
80,000
|
|
152,574
|
|
Residential mortgage-backed securities
issued, at estimated fair value
|
|
3,204,392
|
|
3,169,353
|
|
Accounts payable, accrued expenses and
other liabilities
|
|
13,392
|
|
7,390
|
|
Accrued interest payable
|
|
97,749
|
|
114,035
|
|
Accrued interest payable to affiliates
|
|
55,375
|
|
44,121
|
|
Related party payable
|
|
5,439
|
|
9,694
|
|
Securities sold, not yet purchased
|
|
22,890
|
|
100,394
|
|
Derivative liabilities
|
|
116,880
|
|
56,663
|
|
Liabilities of discontinued operations
|
|
|
|
3,644,083
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|
Total liabilities
|
|
12,642,987
|
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17,401,486
|
|
Shareholders Equity
|
|
|
|
|
|
Preferred shares, no par value, 50,000,000
shares authorized and none issued and outstanding at June 30, 2008 and December 31, 2007
|
|
|
|
|
|
Common shares, no par value, 250,000,000
shares authorized, and 150,843,151 and 115,248,990 shares issued and
outstanding at June 30,
2008 and December 31, 2007, respectively
|
|
|
|
|
|
Paid-in-capital
|
|
2,551,800
|
|
2,167,156
|
|
Accumulated other comprehensive loss
|
|
(202,586
|
)
|
(157,245
|
)
|
Accumulated deficit
|
|
(431,785
|
)
|
(365,372
|
)
|
Total shareholders equity
|
|
1,917,429
|
|
1,644,539
|
|
Total liabilities and shareholders equity
|
|
$
|
14,560,416
|
|
$
|
19,046,025
|
|
See notes to
condensed consolidated financial statements.
3
KKR
Financial Holdings LLC and Subsidiaries
Condensed Consolidated Statements of Operations
(Unaudited)
(Amounts in thousands, except per share information)
|
|
For the three
|
|
For the three
|
|
For the six
|
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For the six
|
|
|
|
months ended
|
|
months ended
|
|
months ended
|
|
months ended
|
|
|
|
June 30, 2008
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|
June 30, 2007
|
|
June 30, 2008
|
|
June 30, 2007
|
|
Net investment income:
|
|
|
|
|
|
|
|
|
|
Securities interest income
|
|
$
|
34,788
|
|
$
|
27,262
|
|
$
|
74,597
|
|
$
|
49,935
|
|
Loan interest income
|
|
184,550
|
|
146,435
|
|
401,087
|
|
277,812
|
|
Dividend income
|
|
1,092
|
|
965
|
|
1,908
|
|
1,940
|
|
Other interest income
|
|
4,998
|
|
5,674
|
|
16,074
|
|
8,251
|
|
Total investment income
|
|
225,428
|
|
180,336
|
|
493,666
|
|
337,938
|
|
Interest expense
|
|
(128,037
|
)
|
(124,265
|
)
|
(282,102
|
)
|
(236,050
|
)
|
Interest expense to affiliates
|
|
(19,707
|
)
|
(8,256
|
)
|
(47,525
|
)
|
(8,256
|
)
|
Provision for loan losses
|
|
(10,000
|
)
|
|
|
(10,000
|
)
|
|
|
Net investment income
|
|
67,684
|
|
47,815
|
|
154,039
|
|
93,632
|
|
Other (loss) income:
|
|
|
|
|
|
|
|
|
|
Net realized and unrealized (loss) gain on
derivatives and foreign exchange
|
|
(5,918
|
)
|
6,481
|
|
(52,934
|
)
|
13,619
|
|
Net realized and unrealized (loss) gain on
investments
|
|
(17,217
|
)
|
26,739
|
|
(30,976
|
)
|
33,764
|
|
Net realized and unrealized (loss) gain on residential
mortgage-backed securities, residential mortgage loans, and residential
mortgage-backed securities issued, carried at estimated fair value
|
|
(5,594
|
)
|
1,526
|
|
(14,772
|
)
|
(1,691
|
)
|
Net realized and unrealized gain on
securities sold, not yet purchased
|
|
1,664
|
|
575
|
|
8,650
|
|
575
|
|
Gain on extinguishment of debt
|
|
17,225
|
|
|
|
17,225
|
|
|
|
Other income
|
|
513
|
|
2,540
|
|
5,469
|
|
4,588
|
|
Total other (loss) income
|
|
(9,327
|
)
|
37,861
|
|
(67,338
|
)
|
50,855
|
|
Non-investment expenses:
|
|
|
|
|
|
|
|
|
|
Related party management compensation
|
|
10,387
|
|
15,114
|
|
19,546
|
|
34,413
|
|
General, administrative and directors
expenses
|
|
5,752
|
|
3,991
|
|
10,274
|
|
10,252
|
|
Professional services
|
|
1,071
|
|
759
|
|
2,928
|
|
1,300
|
|
Loan servicing
|
|
2,391
|
|
2,939
|
|
4,960
|
|
6,023
|
|
Total non-investment expenses
|
|
19,601
|
|
22,803
|
|
37,708
|
|
51,988
|
|
Income from continuing operations before
equity in income of unconsolidated affiliate and income tax expense
|
|
38,756
|
|
62,873
|
|
48,993
|
|
92,499
|
|
Equity in income of unconsolidated
affiliate
|
|
|
|
5,725
|
|
|
|
12,706
|
|
Income from continuing operations before
income tax expense
|
|
38,756
|
|
68,598
|
|
48,993
|
|
105,205
|
|
Income tax expense
|
|
(116
|
)
|
(83
|
)
|
(116
|
)
|
(859
|
)
|
Income from continuing operations
|
|
38,640
|
|
68,515
|
|
48,877
|
|
104,346
|
|
(Loss) income from discontinued operations
|
|
(1,079
|
)
|
(15,544
|
)
|
2,668
|
|
(2,951
|
)
|
Net income
|
|
$
|
37,561
|
|
$
|
52,971
|
|
$
|
51,545
|
|
$
|
101,395
|
|
|
|
|
|
|
|
|
|
|
|
Net income per common share:
|
|
|
|
|
|
|
|
|
|
Basic
|
|
|
|
|
|
|
|
|
|
Income per share from continuing operations
|
|
$
|
0.26
|
|
$
|
0.85
|
|
$
|
0.38
|
|
$
|
1.30
|
|
(Loss) income per share from discontinued
operations
|
|
|
|
|
|
(0.19
|
)
|
|
0.02
|
|
|
(0.04
|
)
|
Net income per share
|
|
$
|
0.26
|
|
$
|
0.66
|
|
$
|
0.40
|
|
$
|
1.26
|
|
Diluted
|
|
|
|
|
|
|
|
|
|
Income per share from continuing operations
|
|
$
|
0.26
|
|
$
|
0.84
|
|
$
|
0.37
|
|
$
|
1.28
|
|
(Loss) income per share from discontinued
operations
|
|
|
|
|
|
(0.19
|
)
|
|
0.02
|
|
|
(0.04
|
)
|
Net income per share
|
|
$
|
0.26
|
|
$
|
0.65
|
|
$
|
0.39
|
|
$
|
1.24
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-average number of common shares
outstanding:
|
|
|
|
|
|
|
|
|
|
Basic
|
|
146,025
|
|
80,241
|
|
130,289
|
|
80,240
|
|
Diluted
|
|
146,749
|
|
81,933
|
|
130,964
|
|
81,805
|
|
|
|
|
|
|
|
|
|
|
|
Distributions declared per common share
|
|
$
|
0.40
|
|
$
|
0.56
|
|
$
|
0.90
|
|
$
|
1.10
|
|
See notes to
condensed consolidated financial statements.
4
KKR
Financial Holdings LLC and Subsidiaries
Condensed Consolidated Statement of Changes in Shareholders Equity
(Unaudited)
(Amounts in thousands)
|
|
Common
Shares
|
|
Paid-In
Capital
|
|
Accumulated Other
Comprehensive
Loss
|
|
Accumulated
Deficit
|
|
Comprehensive
Income
|
|
Total
Shareholders
Equity
|
|
Balance at January 1, 2008
|
|
115,249
|
|
$
|
2,167,156
|
|
$
|
(157,245
|
)
|
$
|
(365,372
|
)
|
|
|
$
|
1,644,539
|
|
Net income
|
|
|
|
|
|
|
|
51,545
|
|
$
|
51,545
|
|
51,545
|
|
Net change in unrealized gain on cash flow
hedges
|
|
|
|
|
|
839
|
|
|
|
839
|
|
839
|
|
Net change in unrealized loss on securities
available-for-sale
|
|
|
|
|
|
(46,180
|
)
|
|
|
(46,180
|
)
|
(46,180
|
)
|
Comprehensive income
|
|
|
|
|
|
|
|
|
|
$
|
6,204
|
|
|
|
Cash distributions on common shares
|
|
|
|
|
|
|
|
(117,958
|
)
|
|
|
(117,958
|
)
|
Cancellation of restricted common shares
|
|
(3
|
)
|
|
|
|
|
|
|
|
|
|
|
Grant of restricted common shares to the
Manager
|
|
1,097
|
|
|
|
|
|
|
|
|
|
|
|
Proceeds from issuance of common shares,
net of offering costs
|
|
34,500
|
|
383,631
|
|
|
|
|
|
|
|
383,631
|
|
Amortization of restricted common shares
|
|
|
|
1,013
|
|
|
|
|
|
|
|
1,013
|
|
Balance at June 30, 2008
|
|
150,843
|
|
$
|
2,551,800
|
|
$
|
(202,586
|
)
|
$
|
(431,785
|
)
|
|
|
$
|
1,917,429
|
|
See notes to
condensed consolidated financial statements.
5
KKR
Financial Holdings LLC and Subsidiaries
Condensed
Consolidated Statements of Cash Flows
(Unaudited)
(Amounts in thousands)
|
|
For the six
months ended
June 30, 2008
|
|
For the six
months ended
June 30, 2007
|
|
Cash flows from operating activities:
|
|
|
|
|
|
Net income
|
|
$
|
51,545
|
|
$
|
101,395
|
|
Adjustments to reconcile net income to net
cash provided by operating activities:
|
|
|
|
|
|
Net realized and unrealized loss (gain) on
derivatives, foreign exchange, and securities sold, not yet purchased
|
|
44,284
|
|
(14,194
|
)
|
Gain on extinguishment of debt
|
|
(17,225
|
)
|
|
|
Write-off of debt issuance costs
|
|
1,071
|
|
2,247
|
|
Lower of cost or estimated fair value
adjustment on corporate loans held for sale and provision for loan losses
|
|
12,637
|
|
|
|
Impairment of securities available-for-sale
|
|
9,688
|
|
|
|
Share-based compensation
|
|
1,013
|
|
6,692
|
|
Net unrealized loss (gain) on residential mortgage-backed
securities, residential mortgage loans, and liabilities at estimated fair
value
|
|
(4,824
|
)
|
14,491
|
|
Net realized loss (gain) on sales of
investments
|
|
20,150
|
|
(33,560
|
)
|
Depreciation and net amortization
|
|
(14,516
|
)
|
3,869
|
|
Equity in income of unconsolidated
affiliate
|
|
|
|
(12,706
|
)
|
Changes in assets and liabilities:
|
|
|
|
|
|
Interest receivable
|
|
41,049
|
|
(2,068
|
)
|
Other assets
|
|
(7,325
|
)
|
(38,332
|
)
|
Related party payable
|
|
(4,255
|
)
|
4,289
|
|
Accounts payable, accrued expenses and
other liabilities
|
|
(43,235
|
)
|
(1,843
|
)
|
Accrued interest payable
|
|
(16,808
|
)
|
(35,983
|
)
|
Accrued interest payable to affiliates
|
|
36,614
|
|
8,256
|
|
Income tax liability
|
|
12
|
|
(101
|
)
|
Net cash provided by operating activities
|
|
109,875
|
|
2,452
|
|
Cash flows from investing activities:
|
|
|
|
|
|
Principal payments from investments
|
|
966,000
|
|
2,264,015
|
|
Proceeds from sale of investments
|
|
823,721
|
|
1,119,841
|
|
Purchases of investments
|
|
(1,337,887
|
)
|
(1,756,054
|
)
|
Net proceeds, purchases, and settlements of
derivatives
|
|
18,131
|
|
4,140
|
|
Net change in reverse repurchase agreements
|
|
69,840
|
|
|
|
Net additions to restricted cash and cash
equivalents
|
|
337,847
|
|
(575,154
|
)
|
Restricted cash and cash equivalents
acquired due to consolidation of KKR Financial CLO 2007-1, Ltd.
|
|
|
|
57,104
|
|
Additions of leasehold improvements and
equipment
|
|
|
|
(232
|
)
|
Investment in unconsolidated affiliate
|
|
|
|
(60,327
|
)
|
Net cash provided by investing activities
|
|
877,652
|
|
1,053,333
|
|
Cash flows from financing activities:
|
|
|
|
|
|
Net change in repurchase agreements,
secured revolving credit facility, and secured demand loan
|
|
(2,620,935
|
)
|
(3,870,407
|
)
|
Net change in asset-backed secured
liquidity notes
|
|
(136,596
|
)
|
237,226
|
|
Repayment of residential mortgage-backed
securities issued
|
|
(363,500
|
)
|
|
|
Issuance of collateralized loan obligation
senior secured notes
|
|
1,600,000
|
|
2,368,500
|
|
Net change in subordinated notes to
affiliates
|
|
(47,880
|
)
|
262,103
|
|
Net change in junior subordinated notes
|
|
(18,857
|
)
|
70,000
|
|
Net proceeds from common share offering
|
|
383,631
|
|
|
|
Distributions on common shares
|
|
(117,958
|
)
|
(88,511
|
)
|
Other capitalized costs
|
|
(504
|
)
|
(16,340
|
)
|
Net cash used in financing activities
|
|
(1,322,599
|
)
|
(1,037,429
|
)
|
Net (decrease) increase in cash and cash
equivalents
|
|
(335,072
|
)
|
18,356
|
|
Cash and cash equivalents at beginning of
period
|
|
524,080
|
|
5,125
|
|
Cash and cash equivalents at end of period
|
|
$
|
189,008
|
|
$
|
23,481
|
|
Supplemental cash flow information:
|
|
|
|
|
|
Cash paid for interest
|
|
$
|
357,894
|
|
$
|
424,725
|
|
Cash paid for income taxes
|
|
$
|
99
|
|
$
|
1,590
|
|
Non-cash investing and financing
activities:
|
|
|
|
|
|
Net receivable for securities sold
|
|
$
|
(660
|
)
|
$
|
(312,553
|
)
|
Conversion from corporate loans to
corporate securities
|
|
$
|
228,350
|
|
$
|
|
|
Distributions of securities to the
asset-backed secured liquidity noteholders
|
|
$
|
3,623,049
|
|
$
|
|
|
Affiliate contributions for collateralized
loan obligation junior secured notes
|
|
$
|
|
|
$
|
169,209
|
|
See notes to
condensed consolidated financial statements.
6
KKR Financial Holdings LLC and Subsidiaries
Notes to Condensed Consolidated Financial
Statements (Unaudited)
Note 1. Organization
KKR Financial Holdings LLC together with
its subsidiaries (the Company or KKR Financial) is a specialty finance
company that uses leverage with the objective of generating competitive
risk-adjusted returns. The Company invests in financial assets primarily
consisting of corporate loans and securities, including senior secured and
unsecured loans, mezzanine loans, high yield corporate bonds, distressed and
stressed debt securities, marketable and non-marketable equity securities, and
credit default and total rate of return swaps. The Company also makes
opportunistic investments in other asset classes from time to time.
KKR Financial Holdings LLC is a Delaware
limited liability company and was organized on January 17, 2007. KKR
Financial Holdings LLC is the successor to KKR Financial Corp. (the REIT
Subsidiary), a Maryland corporation. The REIT Subsidiary was originally incorporated
in the State of Maryland in July 2004 and elected to be treated as a real
estate investment trust (REIT) for U.S. federal income tax purposes. On May 4,
2007, KKR Financial completed a restructuring transaction (the Restructuring
Transaction), pursuant to which the REIT Subsidiary became a subsidiary of KKR
Financial and each outstanding share of the REIT Subsidiarys common stock was
converted into one of KKR Financials common shares, which are publicly traded
on the New York Stock Exchange (NYSE) under the symbol KFN. KKR Financial
intends to continue to operate so as to qualify as a partnership, and not as an
association or publicly traded partnership that is taxable as a corporation,
for U.S. federal income tax purposes. The Restructuring Transaction has been
accounted for as a reorganization of entities under common control whereby the
consolidated assets and liabilities of the Company were recorded at the
historical cost of the REIT Subsidiary, as reflected on its condensed consolidated
financial statements. The Company is considered the REIT Subsidiarys successor
for accounting purposes, and the REIT Subsidiarys condensed consolidated
financial statements for prior periods are the Companys historical condensed
consolidated financial statements presented herein. On June 30, 2008, the Company completed
the sale of a controlling interest in the REIT Subsidiary to Rock Capital 2 LLC,
which did not result in a gain or loss.
KKR Financial Advisors LLC (the Manager),
a wholly-owned subsidiary of Kohlberg Kravis Roberts & Co.
(Fixed Income) LLC
(previously known as KKR Financial LLC ),
manages the Company pursuant to a management agreement (the Management
Agreement). In June 2008,
Kohlberg
Kravis Roberts & Co. (Fixed Income) LLC became a wholly-owned
subsidiary of Kohlberg Kravis Roberts &
Co. L.P. (KKR).
Note 2. Summary of Significant Accounting Policies
Basis of Presentation
The accompanying condensed consolidated
financial statements have been prepared in conformity with accounting
principles generally accepted in the United States of America (GAAP). The
condensed consolidated financial statements include the accounts of the
Company, consolidated residential mortgage loan securitization trusts where the
Company is the primary beneficiary, and entities established to complete
secured financing transactions that are considered to be variable interest
entities and for which the Company is the primary beneficiary. The REIT
Subsidiary, which was sold on June 30, 2008, is presented as discontinued
operations for financial statement purposes. Previously, the Companys
residential mortgage investment operations were also classified as discontinued
operations; however, the Company no longer deems a sale or transfer of its
remaining residential mortgage portfolio to be probable in the near term.
Accordingly, the Companys remaining residential mortgage investment operations
are presented as continuing operations and the associated prior period amounts
for existing residential mortgage assets and liabilities as of June 30,
2008 were reclassified as such for comparative purposes.
See Note 3 for
further discussion.
These financial statements should be read in
conjunction with the consolidated financial statements and notes thereto included
in the Companys Annual Report on Form 10-K for the year ended
December 31, 2007. The Companys results for any interim period are not
necessarily indicative of results for a full year or any other interim period.
In the opinion of management, all normal recurring adjustments have been
included for a fair statement of this interim financial information.
7
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 Companys condensed consolidated financial
statements and accompanying notes. Actual results could differ from managements
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 Entitiesan
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 VIEs expected losses, receives a majority of the VIEs
expected residual returns, or both.
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), KKR Financial CLO 2007-1, Ltd. (CLO
2007-1), KKR Financial CLO 2007-A, Ltd. (CLO 2007-A), and Wayzata Funding LLC (Wayzata),
are entities established to complete secured financing transactions. These
entities are VIEs and are not considered to be qualifying special-purpose
entities (QSPE) as defined by Statement of Financial Accounting
Standards (SFAS) 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 condensed consolidated
financial statements. Additionally, the Company is the primary beneficiary of
six residential mortgage loan securitization trusts that are not considered to
be QSPEs under SFAS No. 140 and the Company has therefore included the
accounts of these entities in these condensed consolidated financial
statements.
All inter-company balances and transactions
have been eliminated in consolidation.
Fair Value of Financial Instruments
Effective January 1, 2007, the Company
adopted SFAS No. 157,
Fair Value
Measurements
(SFAS No. 157), which requires additional
disclosures about the Companys assets and liabilities that are measured at
fair value.
As defined in SFAS No. 157, fair value
is the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the
measurement date. Where available, fair value is based on observable market
prices or parameters, or derived from such prices or parameters. Where
observable prices or inputs are not available, valuation models are applied.
These valuation techniques involve some level of management estimation and
judgment, the degree of which is dependent on the price transparency for the
instruments or market and the instruments complexity for disclosure purposes.
Beginning in January 2007, assets and liabilities recorded at fair value
in the consolidated balance sheets are categorized based upon the level of
judgment associated with the inputs used to measure their value. Hierarchical
levels, as defined in SFAS No. 157 and directly related to the amount of
subjectivity associated with the inputs to fair valuations of these assets and
liabilities, are as follows:
Level 1: Inputs are unadjusted, quoted
prices in active markets for identical assets or liabilities at the measurement
date.
The types of assets carried at level 1
fair value generally are equity securities listed in active markets.
Level 2: Inputs other than quoted prices
included in level 1 that are observable for the asset or liability, either
directly or indirectly. Level 2 inputs include quoted prices for similar
instruments in active markets, and inputs other than quoted prices that are
observable for the asset or liability.
Fair value assets and liabilities that are
generally included in this category are certain corporate debt securities and
certain financial instruments classified as derivatives where the fair value is
based on observable market inputs.
Level 3: Inputs are unobservable inputs
for the asset or liability, and include situations where there is little, if
any, market activity for the asset or liability. In certain cases, the inputs
used to measure fair value may fall into different levels of the fair value
hierarchy. In such cases, the level in the fair value hierarchy within which the
fair value measurement in its entirety falls has been determined based on the
lowest level input that is significant to the fair value measurement in its
entirety. The Companys assessment of the significance of a particular input to
the fair value measurement in its entirety requires judgment and the consideration
of factors specific to the asset.
Generally, assets and liabilities carried at
fair value and included in this category are certain corporate debt securities,
residential mortgage-backed securities, residential mortgage loans, residential
mortgage-backed securities issued and certain derivatives.
8
The availability of observable inputs can
vary depending on the financial asset or liability and is affected by a wide
variety of factors, including, for example, the type of product, whether the
product is new, whether the product is traded on an active exchange or in the
secondary market, and the current market condition. To the extent that
valuation is based on models or inputs that are less observable or unobservable
in the market, the determination of fair value requires more judgment.
Accordingly, the degree of judgment exercised by the Company in determining
fair value is greatest for instruments categorized in level 3. In certain
cases, the inputs used to measure fair value may fall into different levels of
the fair value hierarchy. In such cases, for disclosure purposes, the level in
the fair value hierarchy within which the fair value measurement in its
entirety falls is determined based on the lowest level input that is
significant to the fair value measurement in its entirety.
Fair value is a market-based measure
considered from the perspective of a market participant who holds the asset or
owes the liability rather than an entity-specific measure. Therefore, even when
market assumptions are not readily available, the Companys own assumptions are
set to reflect those that management believes market participants would use in
pricing the asset or liability at the measurement date.
Many financial assets and liabilities have
bid and ask prices that can be observed in the marketplace. Bid prices reflect
the highest price that the Company and others are willing to pay for an asset.
Ask prices represent the lowest price that the Company and others are willing
to accept for an asset. For financial assets and liabilities whose inputs are
based on bid-ask prices, the Company does not require that fair value always be
a predetermined point in the bid-ask range. The Companys policy is to allow
for mid-market pricing and adjusting to the point within the bid-ask range that
meets the Companys best estimate of fair value.
Assets and liabilities that are valued using
level 3 of the fair value hierarchy primarily consist of certain corporate debt
securities, residential mortgage-backed securities, residential mortgage loans,
residential mortgage-backed securities issued and certain over-the-counter (OTC)
derivative contracts. The valuation techniques used for these are described
below.
Residential
Mortgage-Backed Securities, Residential
Mortgage Loans, and Residential Mortgage-Backed
Securities Issued:
Residential mortgage-backed securities,
residential mortgage loans, and residential mortgage-backed securities issued
are initially valued at transaction price and are subsequently valued using
market data for similar instruments (e.g., recent transactions, nationally
recognized pricing services, or broker quotes), comparisons to benchmark
derivative indices or movements in underlying credit spreads.
Corporate Debt Securities:
Corporate debt securities are initially valued at transaction price and are
subsequently valued using market data for similar instruments (e.g., recent
transactions or broker quotes), comparisons to benchmark derivative indices or
movements in underlying credit spreads.
OTC Derivative Contracts:
OTC derivative contracts include forward, swap and option contracts related to
interest rates, foreign currencies, credit standing of reference entities, and
equity prices. The fair value of OTC derivative contracts can be modeled using
a series of techniques, including closed-form analytic formulae, such as the
Black-Scholes option-pricing model, and simulation models or a combination
thereof. Many pricing models do not entail material subjectivity because the
methodologies employed do not necessitate significant judgment, and the pricing
inputs are observed from actively quoted markets, as is the case for generic
interest rate swap and option contracts.
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 Companys
financing and derivative transactions. Interest income earned on restricted
cash and cash equivalents is recorded in other interest income.
Residential Mortgage-Backed Securities
Effective January 1, 2007, the Company
adopted SFAS No. 159,
The Fair Value Option for
Financial Assets and Financial Liabilities-Including an Amendment of Statement
115
(SFAS No. 159)
,
and elected
the option of carrying its
residential
mortgage-backed securities at estimated fair
value, with unrealized gains and losses reported in income. Estimated fair
values are based on estimates provided by independent
9
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
weighted-average cost basis.
Securities Available-for-Sale
The Company classifies its investments in corporate
debt securities and marketable equity 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 (loss). 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 weighted-average cost
basis. Purchases and sales of securities are recorded on the trade date.
The Company monitors its available-for-sale
securities 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 unaccreted discounts
on securities available-for-sale are recognized in interest income over the
contractual life, adjusted for actual prepayments, of the securities using the
effective interest method.
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 below the cost basis of the security to be
other-than-temporary.
Securities Sold, Not Yet Purchased
Securities sold, not yet purchased consist of
equity and debt securities that the Company has sold, but did not own prior to
the sale. In order to facilitate a short sale, the Company borrows the
securities from another party and delivers the securities to the buyer. The
Company will be required to cover its short sale in the future through the
purchase of the security in the market at the prevailing market price and
deliver it to the counterparty from which it borrowed. The Company is exposed
to a loss to the extent that the security price increases during the time from when
the Company borrowed the security to when the Company purchases it in the
market to cover the short sale. Changes in the value of these securities are
reflected in net realized and unrealized gain on securities sold, not yet purchased
on the Companys condensed consolidated statements of operations.
Corporate Loans
The Company purchases participations and
assignments in corporate leveraged 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 Companys expected return may decrease, the Company may elect
to sell a loan held for investment.
Interest income on loans includes interest at
stated coupon rates adjusted for accretion of purchase discounts and the
amortization of purchase premiums. Unamortized premiums and unaccreted
discounts are recognized in interest income over the contractual life, adjusted
for actual prepayments, of the loans using the effective interest method.
Residential Mortgage Loans
Effective January 1, 2007, the Company
adopted SFAS No. 159 and elected the option to carry its residential
mortgage loans at estimated fair value, with unrealized gains and losses
reported in income. Estimated fair values are based on estimates provided by
independent pricing sources or dealers who make markets in such securities.
10
Corporate Loans Held for Sale
Corporate loans held for sale consist of leveraged loans that the
Company has determined to no longer hold for investment. Corporate loans held
for sale are stated at lower of cost or estimated fair value.
Allowance for Loan Losses
The Companys allowance for estimated loan
losses represents its estimate of probable credit losses inherent in the loan
portfolio as of the balance sheet date. When determining the adequacy of the
allowance for loan losses, the Company considers historical and industry loss
experience, economic conditions and trends, the estimated fair values of its
loans, credit quality trends and other factors that it determines are relevant.
Additions to the allowance for loan losses are charged to current period
earnings through the provision for loan losses. The Companys allowance for
loan losses consists of two components, an allocated component and an
unallocated component. Amounts determined to be uncollectible are charged
directly to the allowance for loan losses.
The allocated component of the Companys
allowance for loan losses consists of individual loans that are impaired and
for which the estimated allowance for loan losses is determined in accordance
with SFAS No. 114,
Accounting by
Creditors for Impairment of a Loan.
The Company considers a loan to
be impaired when, based on current information and events, it believes it is
probable that it will be unable to collect all amounts due to it based on the
contractual terms of the loan. 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 may not be paid when
contractually due; (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 decreases below the Companys 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.
The unallocated component of the Companys
allowance for loan losses is determined in accordance with SFAS No. 5,
Accounting for Contingencies
. This
component of the allowance for loan losses represents the Companys estimate of
losses inherent, but unidentified, in its portfolio as of the balance sheet
date. The unallocated component of the allowance for loan losses is estimated
based upon a review of the Companys loan portfolios risk characteristics,
risk grouping of loans in the portfolio based upon estimated probability of
default and severity of loss based on loan type, and consideration of general
economic conditions and trends.
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 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, residential mortgage-backed securities, and securities
available-for-sale, primarily through the use of secured borrowings in the form
of securitization transactions structured as secured financings, repurchase
agreements, warehouse facilities, demand loans, and other secured and unsecured
borrowings. The Company recognizes interest expense on all borrowings on an
accrual basis.
Trust Preferred Securities
Trusts formed by the Company for the sole
purpose of issuing trust preferred securities are not consolidated by the
Company in accordance with FIN 46R as the Company has determined that it
is not the primary beneficiary of such trusts. The Companys investment in the
common securities of such trusts is included in other assets on the Companys
condensed consolidated financial statements.
Derivative Financial Instruments
The Company recognizes all derivatives at
estimated fair value. On the date the Company enters into a derivative
contract, 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 (fair value hedge); (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 (cash flow hedge); (iii) a
hedge of a net investment in a foreign operation; or (iv) a derivative
instrument not designated as a hedging instrument (free-standing derivative).
For a fair value hedge, the Company records changes in the estimated fair value
of the derivative and, to the extent that it is effective, changes in the fair
11
value of the hedged asset or liability attributable to the hedged risk,
in the current period earnings in the same financial statement category as the
hedged item. For a cash flow hedge, the Company records changes in the
estimated fair value of the derivative to the extent that it is effective in
other comprehensive (loss) income. The Company subsequently reclassifies these
changes in estimated fair value to net income in the same period(s) that
the hedged transaction affects earnings in the same financial statement
category as the hedged item. For free-standing derivatives, the Company reports
changes in the fair values in current period other income.
The Company formally documents at inception
its hedge relationships, including identification of the hedging instruments
and the hedged items, its risk management objectives, strategy for undertaking
the hedge transaction and the Companys evaluation of effectiveness of its
hedged transactions. Periodically, as required by SFAS No. 133,
Accounting for Derivative Instruments and Hedging
Activities
, as amended and interpreted (SFAS No. 133), the
Company also formally assesses whether the derivative it designated in each
hedging relationship is expected to be and has been highly effective in
offsetting changes in estimated fair values or cash flows of the hedged item
using either the dollar offset or the regression analysis method. If the
Company determines that a derivative is not highly effective as a hedge, it
discontinues hedge accounting.
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 a 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 a 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 condensed
consolidated statements of operations.
Manager Compensation
The Management Agreement provides for the
payment of a base management fee to the Manager, as well as an incentive fee if
the Companys financial performance exceeds certain benchmarks. Additionally,
the Management Agreement provides for the Manager to be reimbursed for certain
expenses incurred on the Companys behalf. See Note 14 for 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 Compensation
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 shares issued to the Companys
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 shares and common share 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 and
straight-line method pursuant to SFAS No. 123(R) to amortize
compensation expense for the restricted common shares and common share options
granted to the Manager.
Income Taxes
The Company is no longer treated as a REIT
for U.S. federal income tax purposes; however, the Company intends to continue
to operate so as to qualify as a partnership, and not as an association or
publicly traded partnership that is taxable as a corporation, for U.S. federal
income tax purposes. Therefore, the Company is not subject to U.S. federal
income tax at the entity level, but is subject to limited state income taxes.
Holders of the Companys shares will be required to take into account their
allocable share of each item of the Companys income, gain, loss, deduction,
and credit for the taxable year of the Company ending within or with their
taxable year.
KKR Financial Holdings II, LLC (KFH II), a
wholly-owned subsidiary of the Company which holds certain real estate
mortgage-backed securities, elected to be taxed as a REIT and is required to
comply with the provisions of the Internal Revenue Code of 1986, as amended
(the Code), with respect thereto. KFH II is not subject to federal income tax
to the extent that it currently distributes its income and satisfies certain
asset, income and ownership tests, and recordkeeping requirements. Even though
KFH II qualified for federal taxation as a REIT, it may be subject to some
amount of federal, state, local and foreign taxes based on their taxable
income.
KKR TRS Holdings, Ltd. (TRS Ltd.),
CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A, and Wayzata 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 KFN PEI
VII, LLC (PEI VII), a domestic
12
taxable corporate 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,
CLO 2007-1, and CLO 2007-A are foreign taxable corporate subsidiaries that were
established to facilitate securitization transactions, structured as secured
financing transactions, and TRS Ltd., is a foreign taxable corporate
subsidiary that was formed to make certain foreign investments from time to
time. 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. However, the Company will generally be
required to include their current taxable income in its calculation of its
taxable income allocable to shareholders.
Earnings Per Share
In accordance with SFAS No. 128,
Earnings per Share
(SFAS No. 128),
the Company presents both basic and diluted earnings per common share (EPS)
in its condensed consolidated financial statements and footnotes thereto. Basic
earnings per common share (Basic EPS) excludes dilution and is computed by
dividing net income or loss 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 share
options and unvested restricted common shares using the treasury method, and
the potential dilution of convertible senior notes using the if-converted
method, if they are not anti-dilutive. See Note 4 for earnings per common
share computations.
A rights offering whose exercise price at
issuance is less than the fair value of the stock is considered to have a bonus
element, resulting in an adjustment of the prior period number of shares
outstanding used to calculate basic and diluted earnings per share. As a result
of the $270.0 million common share rights offering that occurred during the
third quarter of 2007, prior period weighted-average number of shares and
earnings per share outstanding have been adjusted to reflect the issuance at
less than fair value.
Recent Accounting Pronouncements
In February 2008, the FASB
issued FASB Staff Position (FSP) SFAS 140-3,
Accounting
for Transfers of Financial Assets and Repurchase Financing Transactions
(FSP
SFAS No. 140-3). FSP SFAS No. 140-3 assumes that an initial transfer
of a financial asset and a repurchase financing are considered part of the same
arrangement, or a linked transaction. However, if certain criteria are met, the
initial transfer and repurchase financing shall not be evaluated as a linked
transaction and shall be evaluated separately under SFAS No. 140. FSP SFAS
No. 140-3 is effective for the Company for repurchase financings in which
the initial transfer is entered into after December 31, 2008
and early adoption is not permitted. The
Company does not expect the adoption of FSP SFAS No. 140-3 to have a
material impact on its financial statements.
In March 2008, the FASB
issued SFAS No. 161,
Disclosures about
Derivative Instruments and Hedging Activities, an Amendment of FASB Statement No. 133
(SFAS No. 161). SFAS No. 161 requires enhanced
qualitative disclosures about objectives and strategies for using derivatives,
quantitative disclosures about fair value amounts of gains and losses on
derivative instruments, and disclosures about credit-risk-related contingent
features in derivative agreements. The
additional disclosures required by SFAS No. 161 must be included in the
Companys consolidated financial statements beginning with the first quarter of
2009.
In May 2008, the FASB issued
FSP No. APB 14-1,
Accounting
for Convertible Debt Instruments That May Be Settled in Cash upon
Conversion (Including Partial Cash Settlement)
(FSP APB 14-1). This FSP requires that
issuers of convertible debt instruments that may be settled wholly or partly in
cash when converted should separately account for the liability and equity
(conversion feature) components of the instruments. As a result, interest
expense should be imputed and recognized based upon the entitys nonconvertible
debt borrowing rate, which will result in lower net income. Prior to the
adoption of FSP APB 14-1, APB No. 14,
Accounting for Convertible
Debt and Debt Issued with Stock Purchase Warrants
, provided that no
portion of the proceeds from the issuance of the instrument should be attributable
to the conversion feature. The 7.00% convertible senior notes issued by the
Company in July 2007 will be subject to FSP ABP 14-1. FSP APB 14-1 is
effective for the Company retroactively on January 1, 2009 and early
adoption is prohibited. The Company has determined that the adoption of FSP APB
14-1 does not have a material impact on its financial statements.
13
In May 2008,
FASB issued SFAS No. 163,
Accounting for Financial
Guarantee Insurance Contracts an interpretation of FASB Statement No. 60
(SFAS No. 163). SFAS No. 163 requires recognition of an
insurance claim liability prior to an event of default (insured event) when
there is evidence that credit deterioration has occurred in an insured
financial obligation. SFAS No. 163 is effective for financial statements
issued for fiscal years beginning after December 15, 2008 and all interim
periods within those fiscal years, and early application is not permitted. The
Company does not expect the adoption of SFAS No. 163 to have a material
impact on its financial statements.
Note 3. Discontinued Operations
In August 2007,
the Companys board of directors approved a plan to exit its residential
mortgage investment operations and sell the REIT Subsidiary. As of January 1,
2008, the REIT Subsidiarys assets and liabilities consisted solely of those
held by its two asset-backed commercial paper conduits (the Facilities). During March 2008, the Company entered
into an agreement with the holders of the secured liquidity notes (SLNs)
issued by the Facilities (the Noteholders) in order to terminate the
Facilities. With respect to the
agreement with the Noteholders, all of the residential mortgage-backed
securities (RMBS) funded by the SLNs have been returned to the Noteholders in
satisfaction of the SLNs and the Company has paid the Noteholders approximately
$42.0 million in conjunction with this resolution. The Company had previously
accrued $36.5 million for contingencies related to resolution of the Facilities
and as a consequence of this transaction, the Company recorded an incremental
charge during the quarter ended March 31, 2008 of $5.5 million. The
agreement with the Noteholders resulted in approximately $3.6 billion par
amount of RMBS being returned to the Noteholders in satisfaction of
approximately $3.5 billion par amount of SLNs held by the Noteholders.
Accordingly, the Company has removed the RMBS and SLNs that related to the
Facilities from its condensed consolidated financial statements as of March 31,
2008. Under the agreement with the Noteholders, the Company and its affiliates
have been released from any future obligations or liabilities to the
Noteholders.
As of June 30,
2008, the Company substantially completed its plan to exit its residential
mortgage investment operations through the sale of certain of its residential
mortgage-backed securities in the third quarter of 2007 and the agreement with
the Noteholders related to the Facilities described above. In addition, on June 30,
2008, the Company completed the sale of a controlling interest in the REIT
Subsidiary to Rock Capital 2 LLC, which did not result in a gain or loss.
Accordingly, t
he REIT Subsidiary is presented as discontinued
operations for financial statement purposes for all periods presented.
The Company no longer deems a sale or transfer of its remaining
residential mortgage portfolio to be probable in the near term. As such, the
Companys remaining residential mortgage investment operations, which were
previously presented as discontinued operations, are presented as continuing
operations and the associated prior period amounts presented in the Companys
condensed consolidated financial statements relating to the Companys existing
residential mortgage assets and liabilities as of June 30, 2008 have been
reclassified for comparative presentation.
As of June 30, 2008, the Companys remaining residential mortgage
portfolio consisted of $315.2 million of RMBS, of which $279.6 million was
rated investment grade or higher and $35.6 million was rated below investment
grade. Of the $315.2 million of RMBS, $199.5 million represented interests in
residential mortgage securitization trusts that were not structured as
QSPEs
. The
Company consolidated these trusts as it was the primary beneficiary of these
entities and therefore reported total assets of $3.4 billion and total
liabilities of $3.2 billion for these trusts in continuing operations as of June 30,
2008.
Summarized financial information for
discontinued operations is as follows (amounts in thousands):
|
|
As of
June 30, 2008
|
|
As of
December 31, 2007
|
|
Assets
|
|
|
|
|
|
Restricted cash and cash equivalents
|
|
$
|
|
|
$
|
353
|
|
Investments in securities and loans, at
fair value
|
|
|
|
3,043,193
|
|
Interest and principal receivable
|
|
|
|
3,734
|
|
Other assets
|
|
|
|
2,478
|
|
Assets of discontinued operations
|
|
$
|
|
|
$
|
3,049,758
|
|
14
|
|
As of
June 30, 2008
|
|
As of
December 31, 2007
|
|
Liabilities
|
|
|
|
|
|
Asset-backed secured liquidity notes, at
fair value
|
|
$
|
|
|
$
|
3,519,860
|
|
Accounts payable, accrued expenses and
other liabilities
|
|
|
|
123,701
|
|
Accrued interest payable
|
|
|
|
522
|
|
Liabilities of discontinued operations
|
|
$
|
|
|
$
|
3,644,083
|
|
The components of income from discontinued
operations are as follows (amounts in thousands):
|
|
Three months ended
|
|
Three months ended
|
|
Six months ended
|
|
Six months ended
|
|
|
|
June 30, 2008
|
|
June 30, 2007
|
|
June 30, 2008
|
|
June 30, 2007
|
|
Net investment income
|
|
$
|
|
|
$
|
3,841
|
|
$
|
16,795
|
|
$
|
10,969
|
|
Other loss
|
|
|
|
(18,909
|
)
|
(5,361
|
)
|
(13,004
|
)
|
Non-investment expenses
|
|
(1,079
|
)
|
(476
|
)
|
(8,766
|
)
|
(916
|
)
|
(Loss) income from discontinued operations
|
|
$
|
(1,079
|
)
|
$
|
(15,544
|
)
|
$
|
2,668
|
|
$
|
(2,951
|
)
|
Note 4. 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 shares outstanding for the period. Diluted net income per
common share is calculated by dividing net income by the weighted-average
number of common shares plus potentially dilutive common shares outstanding
during the period. Potentially dilutive common shares include the assumed
exercise of outstanding common share options and assumed vesting of outstanding
restricted common shares using the treasury stock method, as well as the
assumed conversion of convertible senior notes using the if-converted method,
if they are not anti-dilutive.
The following table presents a reconciliation
of basic and diluted net income per common share for the three and six months ended
June 30, 2008 and 2007 (amounts in thousands, except per share
information):
|
|
Three months ended June 30,
|
|
Six months ended June 30,
|
|
|
|
2008
|
|
2007
|
|
2008
|
|
2007
|
|
Income from continuing operations
|
|
$
|
38,640
|
|
$
|
68,515
|
|
$
|
48,877
|
|
$
|
104,346
|
|
(Loss) income from discontinued operations
|
|
(1,079
|
)
|
(15,544
|
)
|
2,668
|
|
(2,951
|
)
|
Net income
|
|
$
|
37,561
|
|
$
|
52,971
|
|
$
|
51,545
|
|
$
|
101,395
|
|
|
|
|
|
|
|
|
|
|
|
Basic:
|
|
|
|
|
|
|
|
|
|
Basic weighted-average shares outstanding
|
|
146,025
|
|
80,241
|
|
130,289
|
|
80,240
|
|
Income per share from continuing operations
|
|
$
|
0.26
|
|
$
|
0.85
|
|
$
|
0.38
|
|
$
|
1.30
|
|
(Loss) income per share from discontinued
operations
|
|
|
|
|
|
(0.19
|
)
|
|
0.02
|
|
|
(0.04
|
)
|
Net income per share
|
|
$
|
0.26
|
|
$
|
0.66
|
|
$
|
0.40
|
|
$
|
1.26
|
|
|
|
|
|
|
|
|
|
|
|
Diluted:
|
|
|
|
|
|
|
|
|
|
Basic weighted-average shares outstanding
|
|
146,025
|
|
80,241
|
|
130,289
|
|
80,240
|
|
Dilutive effect of share options and
restricted common shares using the treasury method
|
|
724
|
|
1,692
|
|
675
|
|
1,565
|
|
Diluted weighted-average shares outstanding
(1)
|
|
146,749
|
|
81,933
|
|
130,964
|
|
81,805
|
|
Income per share from continuing operations
|
|
$
|
0.26
|
|
$
|
0.84
|
|
$
|
0.37
|
|
$
|
1.28
|
|
(Loss) income per share from discontinued
operations
|
|
|
|
|
|
(0.19
|
)
|
|
0.02
|
|
|
(0.04
|
)
|
Net income per share
|
|
$
|
0.26
|
|
$
|
0.65
|
|
$
|
0.39
|
|
$
|
1.24
|
|
(1)
|
|
Potential anti-dilutive common shares excluded from diluted income
earnings per share for the three and six months ended June 30, 2008 were
9,677,430 and 4,825,458, respectively, related to convertible debt
securities, and 1,932,279 related to common share options. There were 1,932,279
of potential anti-dilutive common share options for the three and six months
ended June 30, 2007.
|
15
Note 5. Securities Sold, Not Yet Purchased
Securities sold, not yet purchased consist of equity and debt
securities that the Company has sold short. As of June 30, 2008, the
Company had securities sold, not yet purchased with a cost basis of
$27.2 million and accumulated net unrealized gain of $4.3 million. As
of December 31, 2007, the Company had securities sold, not yet purchased
with a cost basis of $103.1 million and accumulated net unrealized gain of
$2.7 million.
For the three and six months ended June 30, 2008, the Company had
net realized gains on securities sold, not yet purchased of $1.1 million
and $7.1 million, respectively, and net unrealized gains on securities sold,
not yet purchased of $0.6 million and $1.6 million, respectively. For the
three and six months ended June 30, 2007, the Company had net realized
gains on securities sold, not yet purchased of $0.1 million and net unrealized
gains on securities sold, not yet purchased of $0.4 million, respectively.
Note 6. Securities Available-for-Sale
The following table summarizes the Companys securities classified as
available-for-sale as of June 30, 2008, which are carried at estimated
fair value (amounts in thousands):
Description
|
|
Amortized Cost
|
|
Gross
Unrealized
Gains
|
|
Gross
Unrealized
Losses
|
|
Estimated Fair
Value
|
|
Corporate debt securities
|
|
$
|
1,272,932
|
|
$
|
5,977
|
|
$
|
(178,787
|
)
|
$
|
1,100,122
|
|
Marketable equity securities
|
|
28,155
|
|
|
|
(10,489
|
)
|
17,666
|
|
Total
|
|
$
|
1,301,087
|
|
$
|
5,977
|
|
$
|
(189,276
|
)
|
$
|
1,117,788
|
|
The following table shows the gross unrealized losses and estimated fair
value of the Companys available-for-sale securities, aggregated by length of
time that the individual securities have been in a continuous unrealized loss
position, as of June 30, 2008 (amounts in thousands):
|
|
Less Than 12 months
|
|
12 Months or More
|
|
Total
|
|
Description
|
|
Estimated Fair
Value
|
|
Unrealized
Losses
|
|
Estimated
Fair Value
|
|
Unrealized
Losses
|
|
Estimated
Fair Value
|
|
Unrealized
Losses
|
|
Corporate debt securities
|
|
$
|
398,514
|
|
$
|
(29,259
|
)
|
$
|
515,739
|
|
$
|
(149,528
|
)
|
$
|
914,253
|
|
$
|
(178,787
|
)
|
Marketable equity securities
|
|
17,666
|
|
(10,489
|
)
|
|
|
|
|
17,666
|
|
(10,489
|
)
|
Total
|
|
$
|
416,180
|
|
$
|
(39,748
|
)
|
$
|
515,739
|
|
$
|
(149,528
|
)
|
$
|
931,919
|
|
$
|
(189,276
|
)
|
The unrealized losses in
the above table exclude one investment in a preferred stock that is deemed to have
an other-than-temporary impairment of $9.7 million. This other-than-temporary
impairment was recognized in net realized and unrealized (loss) gain on
investments in the condensed consolidated statements of operations. When
evaluating whether an impairment is other-than-temporary, the Company performs
an analysis of the anticipated future cash flows and the ability and intent to
hold the investment for a sufficient amount of time to recover the unrealized losses.
Additionally, the Company considers the current events specific to the issuer
or industry including widening credit spreads and external credit ratings, as
well as interest rate volatility.
The unrealized losses in the above table are considered to be temporary
impairments due to market factors and are not reflective of credit
deterioration. The Company has performed credit analyses in relation to these
investments and believes the carrying value of these investments to be fully
recoverable over their expected holding period. Because the Company has the
intent and ability to hold these investments until recovery, the unrealized
losses are not considered to be other-than-temporary impairments.
The following table summarizes the Companys securities classified as
available-for-sale as of December 31, 2007, which are carried at estimated
fair value (amounts in thousands):
Description
|
|
Amortized Cost
|
|
Gross
Unrealized
Gains
|
|
Gross
Unrealized
Losses
|
|
Estimated Fair
Value
|
|
Corporate debt securities
|
|
$
|
1,438,027
|
|
$
|
8,706
|
|
$
|
(134,969
|
)
|
$
|
1,311,764
|
|
Marketable equity securities
|
|
58,529
|
|
24
|
|
(10,776
|
)
|
47,777
|
|
Total
|
|
$
|
1,496,556
|
|
$
|
8,730
|
|
$
|
(145,745
|
)
|
$
|
1,359,541
|
|
16
The following table shows the gross unrealized losses and estimated fair
value of the Companys available-for-sale securities, aggregated by length of
time that the individual securities have been in a continuous unrealized loss
position, as of December 31, 2007 (amounts in thousands):
|
|
Less Than 12 months
|
|
12 Months or More
|
|
Total
|
|
Description
|
|
Estimated
Fair Value
|
|
Unrealized
Losses
|
|
Estimated
Fair Value
|
|
Unrealized
Losses
|
|
Estimated
Fair Value
|
|
Unrealized
Losses
|
|
Corporate debt securities
|
|
$
|
1,075,296
|
|
$
|
(134,969
|
)
|
$
|
|
|
$
|
|
|
$
|
1,075,296
|
|
$
|
(134,969
|
)
|
Marketable equity securities
|
|
35,402
|
|
(7,664
|
)
|
9,321
|
|
(3,112
|
)
|
44,723
|
|
(10,776
|
)
|
Total
|
|
$
|
1,110,698
|
|
$
|
(142,633
|
)
|
$
|
9,321
|
|
$
|
(3,112
|
)
|
$
|
1,120,019
|
|
$
|
(145,745
|
)
|
The unrealized losses in the above table exclude one investment in a
corporate security that was deemed to be an other-than-temporary impairment of
$5.9 million. The decline in fair value was deemed to be
other-than-temporary in the fourth quarter of 2007 based on the Companys
intent to sell the security during 2008. This corporate security was sold
during the first quarter 2008 at approximately the same value it was carried at
as of December 31, 2007. When evaluating whether an impairment is
other-than-temporary, the Company performs an analysis of the anticipated
future cash flows and the ability and intent to hold the investment for a
sufficient amount of time to recover the unrealized losses. Additionally, the
Company considers the current events specific to the issuer or industry
including widening credit spreads and external credit ratings, as well as
interest rate volatility.
All other unrealized losses in the table above are considered to be
temporary impairments due to market factors and are not reflective of credit
deterioration. The Company has performed credit analyses in relation to these
investments and believes the carrying value of these investments to be fully
recoverable over their expected holding period. Because the Company has the
intent and ability to hold these investments until recovery, the related
unrealized losses are not considered to be other-than-temporary impairments.
During the three and six months ended June 30, 2008, the Company
had gross realized gains from the sales of securities available-for-sale of
$2.4 million and $4.6 million, respectively, and gross realized losses from the
sales of securities available-for-sale of $3.4 million and
$14.7 million, respectively. During the three and six months ended June 30,
2007, the Company had gross realized gains from the sales of securities
available-for-sale of $27.4 million and $32.1 million, respectively, and gross realized
losses from the sales of securities available-for-sale of $1.5 million and
$2.2 million, respectively. Note 10 to these condensed consolidated
financial statements describes the Companys borrowings under which the Company
has pledged securities available-for-sale for borrowings. The following table
summarizes the estimated fair value of securities available-for-sale pledged as
collateral for borrowings as of June 30, 2008 (amounts in thousands):
|
|
Corporate Debt
Securities
|
|
Marketable
Equity
Securities
|
|
Pledged as collateral for borrowings under secured revolving credit
facility
|
|
$
|
252,911
|
|
$
|
|
|
Pledged as collateral for collateralized loan obligation senior secured
notes and junior secured notes to affiliates
|
|
744,776
|
|
|
|
Pledged as collateral for subordinated notes to affiliates
|
|
90,060
|
|
|
|
Total
|
|
$
|
1,087,747
|
|
$
|
|
|
The following table summarizes the estimated fair value of securities
pledged as collateral for borrowings as of December 31, 2007 (amounts in
thousands):
|
|
Corporate Debt
Securities
|
|
Marketable
Equity
Securities
|
|
Pledged as collateral for borrowings under repurchase agreements
|
|
$
|
487,297
|
|
$
|
|
|
Pledged as collateral for borrowings under secured revolving credit
facility
|
|
43,878
|
|
|
|
Pledged as collateral for borrowings under secured demand loan
|
|
|
|
34,483
|
|
Pledged as collateral for collateralized loan obligation senior
secured notes and junior secured notes to affiliates
|
|
762,776
|
|
|
|
Pledged as collateral for subordinated notes to affiliates
|
|
17,813
|
|
|
|
Total
|
|
$
|
1,311,764
|
|
$
|
34,483
|
|
Note 7. Corporate Loans and Allowance for Loan
Losses
The following table summarizes the Companys corporate loans as of June 30,
2008 and December 31, 2007 (amounts in thousands):
|
|
As of June 30, 2008
|
|
As of December 31, 2007
|
|
Corporate loans, at net amortized cost
|
|
$
|
8,743,005
|
|
$
|
8,659,208
|
|
Less: Allowance for loan losses
|
|
(35,000
|
)
|
(25,000
|
)
|
Total
|
|
$
|
8,708,005
|
|
$
|
8,634,208
|
|
17
The following table summarizes the components of the net carrying value
of the Companys corporate loans as of June 30, 2008 and December 31,
2007 (amounts in thousands):
|
|
June 30, 2008
|
|
December 31, 2007
|
|
Description
|
|
Principal
|
|
Net
Unamortized
Discount
|
|
Estimated
Fair
Value
Adjustment
|
|
Net Carrying
Value
|
|
Principal
|
|
Net
Unamortized
Discount
|
|
Net Carrying
Value
|
|
Corporate loans held for investment (1)
|
|
$
|
8,981,931
|
|
$
|
(238,926
|
)
|
$
|
|
|
$
|
8,743,005
|
|
$
|
8,766,169
|
|
$
|
(106,961
|
)
|
$
|
8,659,208
|
|
Corporate loans held for sale
|
|
70,843
|
|
(1,554
|
)
|
(2,637
|
)
|
66,652
|
|
|
|
|
|
|
|
Total loans
|
|
$
|
9,052,774
|
|
$
|
(240,480
|
)
|
$
|
(2,637
|
)
|
$
|
8,809,657
|
|
$
|
8,766,169
|
|
$
|
(106,961
|
)
|
$
|
8,659,208
|
|
(1)
Excludes allowance for loan
losses of $35.0 million and $25.0 million as of June 30, 2008 and December 31,
2007, respectively.
As of June 30, 2008, approximately $66.7 million of corporate
loans were classified as held for sale.
The Company recorded a $2.6 million charge to earnings in net realized
and unrealized gain on investments related to these loans to adjust their
carrying value to the lower of cost or estimated fair value. The Company had no
loans held for sale as of December 31, 2007. Note 10 to these condensed consolidated
financial statements describes the Companys borrowings under which the Company
has pledged loans for borrowings. The following table summarizes the carrying
value of corporate loans, at net amortized cost, pledged as collateral for
borrowings as of June 30, 2008 and December 31, 2007 (amounts in
thousands):
|
|
As of June 30, 2008
|
|
As of December 31, 2007
|
|
Pledged as collateral for borrowings under repurchase agreements
|
|
$
|
|
|
$
|
1,994,999
|
|
Pledged as collateral for borrowings under secured revolving credit
facility
|
|
52,189
|
|
48,142
|
|
Pledged as collateral for collateralized loan obligation senior
secured notes and junior secured notes to affiliates
|
|
7,972,850
|
|
6,276,882
|
|
Pledged as collateral for subordinated notes to affiliates
|
|
602,265
|
|
27,886
|
|
Total
|
|
$
|
8,627,304
|
|
$
|
8,347,909
|
|
The following table
summarizes the changes in the allowance for loan losses for the Companys
corporate loan portfolio for the six months ended June 30, 2008 (amounts
in thousands):
Balance at January 1, 2008
|
|
$
|
25,000
|
|
Provision for loan losses
|
|
10,000
|
|
Charge-offs
|
|
|
|
Balance at June 30, 2008
|
|
$
|
35,000
|
|
The $35.0 million allowance for loan losses is unallocated as of June 30,
2008 because the Company has not deemed any individual loans as being impaired
as of that date. A provision for loan losses of $10.0 million was recorded
during the three and six months ended June 30, 2008. No provision for loan
losses was recorded during the three and six months ended June 30, 2007.
Note 8.
Residential
Mortgage-Backed Securities
Upon adoption of SFAS No. 159
as of January 1, 2007, the Company elected the option of carrying its
investments in residential mortgage-backed securities at estimated fair value.
As of June 30, 2008 and December 31, 2007, residential
mortgage-backed
securities totaled $115.7 million and
$131.7 million, respectively.
Note 10 to these
condensed consolidated financial statements describes the Companys borrowings
under which the Company has pledged residential
mortgage-backed
securities. T
he following
table summarizes the estimated fair value of
residential
mortgage-backed securities
pledged as collateral under repurchase agreements and a secured revolving
credit facility as of June 30, 2008 and December 31, 2007 (amounts in
thousands):
|
|
June 30, 2008
|
|
December 31, 2007
|
|
Pledged as collateral for borrowings under repurchase agreements
|
|
$
|
|
|
$
|
112,465
|
|
Pledged as collateral for borrowings under secured revolving credit
facility
|
|
72,668
|
|
5,368
|
|
Total
|
|
$
|
72,668
|
|
$
|
117,833
|
|
18
Note 9. Residential Mortgage Loans
The following table summarizes the Companys residential mortgage loans
as of June 30, 2008 and December 31, 2007 (amounts in thousands):
|
|
June 30, 2008
|
|
December 31, 2007
|
|
Residential mortgage loans, at estimated fair value (1)
|
|
$
|
3,394,996
|
|
$
|
3,921,323
|
|
|
|
|
|
|
|
|
|
(1)
Excludes real estate owned
(REO) by the Company as a result of foreclosure on delinquent loans of $8.9
million and $7.2 million as of June 30, 2008 and December 31, 2007, respectively.
REO is recorded within other assets on the Companys condensed consolidated
balance sheets.
The following table summarizes the estimated fair value of residential
mortgage loans pledged as collateral for borrowings as of June 30, 2008
and December 31, 2007 (amounts in thousands):
|
|
As of June 30, 2008
|
|
As of December 31, 2007
|
|
Pledged as collateral for borrowings under repurchase agreements
|
|
$
|
|
|
$
|
163,586
|
|
Pledged as collateral for borrowings under secured revolving credit
facility
|
|
153,181
|
|
25,162
|
|
Total
|
|
$
|
153,181
|
|
$
|
188,748
|
|
The following table summarizes the delinquency statistics of the
Companys residential mortgage loans as of June 30, 2008 and December 31,
2007 (dollar amounts in thousands):
|
|
June 30, 2008
|
|
December 31, 2007
|
|
Delinquency Status
|
|
Number of
Loans
|
|
Principal
Amount
|
|
Number of
Loans
|
|
Principal
Amount
|
|
30 to 59 days
|
|
58
|
|
$
|
18,510
|
|
96
|
|
$
|
30,163
|
|
60 to 89 days
|
|
23
|
|
8,921
|
|
18
|
|
6,151
|
|
90 days or more
|
|
54
|
|
20,146
|
|
43
|
|
14,045
|
|
In foreclosure
|
|
59
|
|
20,493
|
|
38
|
|
11,800
|
|
Total
|
|
194
|
|
$
|
68,070
|
|
195
|
|
$
|
62,159
|
|
As of June 30, 2008,
the loss exposure or uncollected principal amount related to the Companys
delinquent residential mortgage loans in the table above exceeded their fair
value by $5.0 million. As of June 30, 2008, 28 of the residential mortgage
loans owned by the Company with an outstanding balance of $8.9 million (not
included in the table above) were REO as a result of foreclosure on delinquent
loans. As of December 31, 2007, 25 of the residential mortgage loans owned
by the Company with an outstanding balance of $7.2 million (not included in the
table above) were REO as a result of foreclosure on delinquent loans.
Note 10. Borrowings
The Company leverages its portfolio of securities and loans through the
use of repurchase agreements, warehouse facilities, demand loans, and
securitization transactions structured as secured financings.
19
Certain information with respect to the Companys borrowings as of June 30,
2008 is summarized in the following table (dollar amounts in thousands):
|
|
Outstanding
Borrowings
|
|
Weighted-
Average
Borrowing
Rate
|
|
Weighted-
Average
Remaining
Maturity (in
days)
|
|
Estimated
Fair Value
of Collateral(1)
|
|
Secured revolving credit facility(2)
|
|
$
|
378,306
|
|
3.38
|
%
|
442
|
|
$
|
515,293
|
|
CLO 2005-1 senior secured notes
|
|
831,726
|
|
3.23
|
|
3,222
|
|
847,174
|
|
CLO 2005-2 senior secured notes
|
|
808,292
|
|
2.95
|
|
3,436
|
|
873,195
|
|
CLO 2006-1 senior secured notes
|
|
727,500
|
|
3.00
|
|
3,708
|
|
880,007
|
|
CLO 2007-1 senior secured notes
|
|
2,368,500
|
|
3.20
|
|
4,702
|
|
2,503,250
|
|
CLO 2007-1 junior secured notes to affiliates(3)
|
|
431,292
|
|
|
|
4,702
|
|
455,830
|
|
CLO 2007-A senior secured notes
|
|
1,213,300
|
|
5.59
|
|
3,394
|
|
1,225,797
|
|
CLO 2007-A junior secured notes to affiliates(4)
|
|
94,128
|
|
|
|
3,394
|
|
95,097
|
|
Wayzata senior secured notes
|
|
1,600,000
|
|
3.48
|
|
1,599
|
|
1,862,791
|
|
Convertible senior notes
|
|
300,000
|
|
7.00
|
|
1,476
|
|
|
|
Junior subordinated notes
|
|
293,826
|
|
6.56
|
|
10,308
|
|
|
|
Subordinated notes to affiliates(5)
|
|
80,000
|
|
|
|
1,599
|
|
93,140
|
|
Total
|
|
$
|
9,126,870
|
|
|
|
|
|
$
|
9,351,574
|
|
(1)
Collateral for
borrowings consists of
residential
mortgage-backed securities, securities available-for-sale, and
corporate and residential mortgage loans.
(2)
Includes
$133.3 million in borrowings collateralized by retained rated mezzanine
notes and unrated subordinated notes issued by the Companys CLO subsidiaries.
(3)
CLO 2007-1
junior secured notes to affiliates consist of (x) $244.7 million of mezzanine
notes with a weighted-average borrowing rate of 7.53% and (y) $186.6 million
of subordinated notes that do not have a contractual coupon rate, but instead
receive a pro rata amount of the net distributions from CLO 2007-1.
(4)
CLO 2007-A
junior secured notes to affiliates consist of (x) $79.0 million of mezzanine
notes with a weighted-average borrowing rate of 10.88% and (y) $15.1 million
of subordinated notes that do not have a contractual coupon rate, but instead
receive a pro rata amount of the net distributions from CLO 2007-A.
(5)
Subordinated
notes do not have a contractual coupon rate, but instead receive a pro rata
amount of the net distributions from Wayzata.
In the second quarter of 2008, the Company retired $35.0 million of junior
subordinated notes, which resulted in a gain on extinguishment of $17.2
million, partially offset by a $1.1 million write-off of debt issuance costs
and $0.7 million of other associated costs.
Certain information with respect to the Companys borrowings as of December 31,
2007 is summarized in the following table (dollar amounts in thousands):
|
|
Outstanding
Borrowings
|
|
Weighted-
Average
Borrowing
Rate
|
|
Weighted-
Average
Remaining
Maturity (in
days)
|
|
Estimated
Fair Value
of Collateral(1)
|
|
Repurchase agreements(2)
|
|
$
|
2,808,066
|
|
5.41
|
%
|
132
|
|
$
|
2,745,166
|
|
Secured revolving credit facility(3)
|
|
167,024
|
|
5.65
|
|
540
|
|
122,550
|
|
Secured demand loan
|
|
24,151
|
|
5.00
|
|
31
|
|
34,483
|
|
CLO 2005-1 senior secured notes
|
|
831,428
|
|
5.39
|
|
3,404
|
|
894,548
|
|
CLO 2005-2 senior secured notes
|
|
807,882
|
|
5.34
|
|
3,618
|
|
905,552
|
|
CLO 2006-1 senior secured notes
|
|
727,500
|
|
5.39
|
|
3,890
|
|
937,287
|
|
CLO 2007-1 senior secured notes
|
|
2,368,500
|
|
5.39
|
|
4,884
|
|
2,641,046
|
|
CLO 2007-1 junior secured notes to affiliates(4)
|
|
431,292
|
|
|
|
4,884
|
|
480,922
|
|
CLO 2007-A senior secured notes
|
|
1,213,300
|
|
5.57
|
|
3,576
|
|
1,095,328
|
|
CLO 2007-A junior secured notes to affiliates(5)
|
|
94,128
|
|
|
|
3,576
|
|
84,976
|
|
Convertible senior notes
|
|
300,000
|
|
7.00
|
|
1,658
|
|
|
|
Junior subordinated notes
|
|
329,908
|
|
7.54
|
|
10,524
|
|
|
|
Subordinated notes to affiliates(6)
|
|
152,574
|
|
|
|
|
|
163,437
|
|
Total
|
|
$
|
10,255,753
|
|
|
|
|
|
$
|
10,105,295
|
|
(1)
Collateral for
borrowings consists of
residential
mortgage-backed
securities, securities available-for-sale and corporate and residential
mortgage loans.
20
(2)
Includes
repurchase agreements of $544.5 million collateralized by retained rated
mezzanine notes and unrated subordinated notes issued by the Companys CLO
subsidiaries.
(3)
Includes
$100.0 million in borrowings collateralized by retained rated mezzanine
notes and unrated subordinated notes issued by the Companys CLO subsidiaries.
(4)
CLO 2007-1
junior secured notes to affiliates consist of (x) $244.7 million of mezzanine
notes with a weighted-average borrowing rate of 9.72% and (y) $186.6 million
of subordinated notes that do not have a contractual coupon rate, but instead
receive a pro rata amount of the net distributions from CLO 2007-1.
(5)
CLO 2007-A
junior secured notes to affiliates consist of (x) $79.0 million of mezzanine
notes with a weighted-average borrowing rate of 10.87% and (y) $15.1 million
of subordinated notes that do not have a contractual coupon rate, but instead
receive a pro rata amount of the net distributions from CLO 2007-A.
(6)
Subordinated
notes do not have a contractual coupon rate, but instead receive a pro rata
amount of the net distributions from KKR Financial CLO 2007-4, Ltd., KKR
Financial CLO 2008-1, Ltd., and Wayzata.
Note 11. Derivative Financial Instruments
The Company enters into derivative transactions in order to hedge its
interest rate risk exposure to the effects of interest rate changes.
Additionally, the Company enters into derivative transactions in the course of
its investing. The counterparties to the Companys derivative agreements 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. The counterparties to the
Companys derivative agreements have investment grade ratings and, as a result,
the Company does not anticipate that any of the counterparties will fail to
fulfill their obligations.
Cash Flow and Fair Value Hedges
The Company uses interest rate derivatives consisting of swaps to hedge
a portion of the interest rate risk associated with its borrowings under CLO
senior secured notes. The Company designates these financial instruments as
cash flow hedges. The Company also uses interest rate swaps to hedge all or a
portion of the interest rate risk associated with certain fixed interest rate
investments. The Company designates these financial instruments as fair value
hedges.
Free-Standing Derivatives
Free-standing derivatives are derivatives that the Company has entered
into in conjunction with its investment and risk management activities, but for
which the Company has not designated the derivative contract as a hedging instrument
for accounting purposes. Such derivative contracts may include credit default
swaps, foreign exchange contracts, and interest rate derivatives. Free-standing
derivatives also include investment financing arrangements (total rate of
return swaps) whereby the Company receives the sum of all interest, fees and
any positive change in fair value amounts from a reference asset with a
specified notional amount and pays interest on such notional amount plus any
negative change in fair value amounts from such reference asset.
The table below summarizes the aggregate notional amount and estimated
net fair value of the derivative instruments as of June 30, 2008 and December 31,
2007 (amounts in thousands):
|
|
As of
June 30, 2008
|
|
As of
December 31, 2007
|
|
|
|
Notional
|
|
Estimated
Fair Value
|
|
Notional
|
|
Estimated
Fair Value
|
|
Cash Flow Hedges:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
$
|
383,333
|
|
$
|
(19,282
|
)
|
$
|
383,333
|
|
$
|
(19,018
|
)
|
Fair Value Hedges:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
32,000
|
|
(1,219
|
)
|
32,000
|
|
(1,212
|
)
|
Free-Standing Derivatives:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
188,820
|
|
709
|
|
690,799
|
|
(7,959
|
)
|
Credit default swapslong
|
|
103,500
|
|
(1,733
|
)
|
66,000
|
|
(1,154
|
)
|
Credit default swapsshort
|
|
196,820
|
|
21,386
|
|
268,000
|
|
12,613
|
|
Total rate of return swaps
|
|
477,877
|
|
(88,256
|
)
|
442,204
|
|
(21,998
|
)
|
Foreign exchange contracts
|
|
26,702
|
|
(140
|
)
|
9,711
|
|
3
|
|
Common stock warrants
|
|
|
|
91
|
|
|
|
799
|
|
Total
|
|
$
|
1,409,052
|
|
$
|
(88,444
|
)
|
$
|
1,892,047
|
|
$
|
(37,926
|
)
|
21
For all hedges
where hedge accounting is being applied, effectiveness testing and other
procedures to ensure the ongoing validity of the hedges are performed at least
quarterly. During the three and six months ended June 30, 2008 and June 30,
2007, the Company recognized an immaterial amount of ineffectiveness in income
on the condensed consolidated statements of operations.
Note 12. Accumulated Other Comprehensive
Loss
The components
of accumulated other comprehensive loss were as follows (amounts in thousands):
|
|
As of
June 30, 2008
|
|
As of
December 31, 2007
|
|
Net unrealized losses on available-for-sale
securities
|
|
$
|
(184,407
|
)
|
$
|
(159,802
|
)
|
Net unrealized losses on cash flow hedges
|
|
(18,179
|
)
|
(19,018
|
)
|
Transition adjustment to accumulated
deficit in conjunction with fair value option election for residential
mortgage-backed securities
|
|
|
|
21,575
|
|
Accumulated other comprehensive loss
|
|
$
|
(202,586
|
)
|
$
|
(157,245
|
)
|
The components
of other comprehensive (loss) income were as follows (amounts in thousands):
|
|
Three months
|
|
Three months
|
|
Six months
|
|
Six months
|
|
|
|
ended
|
|
ended
|
|
ended
|
|
ended
|
|
|
|
June 30, 2008
|
|
June 30, 2007
|
|
June 30, 2008
|
|
June 30, 2007
|
|
Unrealized (losses) gains on securities
available-for-sale:
|
|
|
|
|
|
|
|
|
|
Unrealized holding gains (losses) arising
during period
|
|
$
|
18,131
|
|
$
|
(6,273
|
)
|
$
|
(65,977
|
)
|
$
|
641
|
|
Translation adjustment to accumulated
deficit in conjunction with fair value option election for residential
mortgage-backed securities
|
|
|
|
|
|
|
|
21,575
|
|
Reclassification adjustments for losses
(gains) realized in net income (1)
|
|
10,648
|
|
(25,340
|
)
|
19,797
|
|
(29,148
|
)
|
Unrealized losses on available-for-sale
securities from investment in unconsolidated affiliate
|
|
|
|
(8,810
|
)
|
|
|
(7,898
|
)
|
Unrealized (losses) gains on securities
available-for-sale
|
|
28,779
|
|
(40,423
|
)
|
(46,180
|
)
|
(14,830
|
)
|
Unrealized gains on cash flow hedges
arising during period
|
|
19,076
|
|
28,251
|
|
839
|
|
10,078
|
|
Other comprehensive (loss) income
|
|
$
|
47,855
|
|
$
|
(12,172
|
)
|
$
|
(45,341
|
)
|
$
|
(4,752
|
)
|
(1) 2008 amounts include an impairment of $9.7 million for one
investment in a preferred stock security which was determined to be
other-than-temporary.
Note 13. Share Options and Restricted
Shares
The Company
has adopted an amended and restated share incentive plan (the 2007 Share
Incentive Plan) that provides for the grant of qualified incentive common
share options that meet the requirements of Section 422 of the Code,
non-qualified common share options, share appreciation rights, restricted
common shares and other share-based awards. The 2007 Share Incentive Plan was
adopted on May 4, 2007. Prior to the 2007 Share Incentive Plan, the
Company had adopted the 2004 Stock Incentive Plan that provided for the grant
of qualified incentive common stock options that met 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. Share options and other share-based awards
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 share option granted under the 2007 Share Incentive Plan may not
be less than 100% of the fair market value of the common shares at the time the
common share option is granted. Each option to acquire a common share must
terminate no more than ten years from the date it is granted. As of June 30,
2008, the 2007 Share Incentive Plan authorizes a total of
22
8,339,625 shares that may be
used to satisfy awards under the 2007 Share Incentive Plan. On February 19,
2008, the Compensation Committee of the board of directors granted the Manager
1,097,000 restricted common shares that vest on February 19, 2011. The
following table summarizes restricted common share transactions:
|
|
Manager
|
|
Directors
|
|
Total
|
|
Unvested shares as of January 1, 2008
|
|
625,000
|
|
72,657
|
|
697,657
|
|
Issued
|
|
1,097,000
|
|
|
|
1,097,000
|
|
Vested
|
|
|
|
(16,120
|
)
|
(16,120
|
)
|
Cancelled
|
|
|
|
(2,839
|
)
|
(2,839
|
)
|
Forfeited
|
|
|
|
|
|
|
|
Unvested shares as of June 30, 2008
|
|
1,722,000
|
|
53,698
|
|
1,775,698
|
|
Pursuant to
SFAS No. 123(R), the Company is required to value any unvested restricted
common shares granted to the Manager at the current market price. The Company
valued the unvested restricted common shares granted to the Manager at $10.50
and $24.91 per share at June 30, 2008 and June 30, 2007,
respectively. There were $10.6 million and $6.4 million of total
unrecognized compensation costs related to unvested restricted common shares
granted as of June 30, 2008 and June 30, 2007, respectively.
The following
table summarizes common share option transactions:
|
|
Number of
Options
|
|
Weighted-Average
Exercise Price
|
|
Outstanding as of January 1, 2008
|
|
1,932,279
|
|
$
|
20.00
|
|
Granted
|
|
|
|
|
|
Exercised
|
|
|
|
|
|
Forfeited
|
|
|
|
|
|
Outstanding as of June 30, 2008
|
|
1,932,279
|
|
$
|
20.00
|
|
As of June 30,
2008 and December 31, 2007, 1,932,279 common share options were
exercisable. As of June 30, 2008 and December 31, 2007, the common
share options were fully vested and expire in August 2014. For the three
and six months ended June 30, 2008 and 2007, the components of share-based
compensation expense are as follows (amounts in thousands):
|
|
For the three
|
|
For the three
|
|
For the six
|
|
For the six
|
|
|
|
months ended
|
|
months ended
|
|
months ended
|
|
months ended
|
|
|
|
June 30, 2008
|
|
June 30, 2007
|
|
June 30, 2008
|
|
June 30, 2007
|
|
Options granted to Manager
|
|
$
|
|
|
$
|
(184
|
)
|
$
|
|
|
$
|
438
|
|
Restricted shares granted to Manager
|
|
196
|
|
930
|
|
658
|
|
6,040
|
|
Restricted shares granted to certain
directors
|
|
177
|
|
108
|
|
355
|
|
214
|
|
Total share-based compensation expense
|
|
$
|
373
|
|
$
|
854
|
|
$
|
1,013
|
|
$
|
6,692
|
|
Note 14. Management Agreement and
Related Party Transactions
The Manager
manages the Companys day-to-day operations, subject to the direction and
oversight of the Companys board of directors. The Management Agreement expires
on December 31 of each year, but is automatically renewed for a one-year
term each December 31 unless terminated upon the affirmative vote of at
least two-thirds of the Companys independent directors, or by a vote of the
holders of a majority of the Companys outstanding common shares, based upon (1) unsatisfactory
performance by the Manager that is materially detrimental to the Company or (2) a
determination that the management fee payable by the Manager is not fair,
subject to the Managers right to prevent such a termination under this
clause (2) by accepting a mutually acceptable reduction of management
fees. The Manager must 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.
23
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 condensed consolidated
financial statements and determined that they are not material.
For the three and six months
ended June 30, 2008, the Company incurred $8.9 million and $16.4
million, respectively, in base management fees. In addition, the Company
recognized share-based compensation expense related to common share options and
restricted common shares granted to the Manager of $0.2 million and $0.7
million, respectively, for the three and six months ended June 30, 2008
(see Note 13). The Company also reimbursed the Manager $2.6 million
and $5.1 million, respectively, for expenses for the three and six months ended
June 30, 2008. For the three and six months ended
June 30
, 2007, the Company incurred $7.1 million and
$14.3 million, respectively, 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 $0.7 million and $6.5
million, respectively, for the three
and six months ended June 30,
2007 (see Note 13). The Company also reimbursed the Manager $2.2 million and
$3.9 million, respectively, for
expenses for the three and six months ended June 30, 2007. Base management fees incurred
and share-based compensation expense relating to common share options and
restricted common shares granted to the Manager are included in related party
management compensation on the consolidated statements of operations. Expenses
incurred by the Manager and reimbursed by the Company are reflected in the
respective condensed consolidated statements of operations, non-investment
expense category based on the nature of the expense.
The Manager is
waiving base management fees related to the $230.4 million common share
offering and $270.0 million common share rights offering that occurred
during the third quarter of 2007 until such time as the Companys common share
closing price on the NYSE is $20.00 or more for five consecutive trading days.
Accordingly, the Manager permanently waived approximately $2.2 million and
$4.4 million of base management fees during the three and six months ended June 30,
2008, respectively.
No incentive
fees were earned by the Manager during the three and six months ended June 30,
2008, but $6.2 million and $12.6 million were earned by the Manager during
the three and six months ended June 30, 2007, respectively. An affiliate
of the Companys Manager has entered into separate management agreements with
the respective investment vehicles for CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO
2007-1, CLO 2007-A and Wayzata and is entitled to receive fees for the services
performed as collateral manager. The collateral manager has permanently waived
fees of approximately $22.5 million and $11.6 million as of June 30,
2008 and June 30, 2007, respectively. Beginning April 15, 2007, the
collateral manager ceased waiving fees for CLO 2005-1. The Company recorded an
expense of $1.2 million and $2.5 million for collateral management fees
for CLO 2005-1 for the three and six months ended June 30, 2008,
respectively. The collateral manager evaluates such waivers on a quarterly
basis and there are no assurances that the collateral manager will waive such
management fees subsequent to June 30, 2008.
The Company has invested in corporate loans and bonds of entities that
are affiliates of KKR. As of June 30, 2008, t
he aggregate par
amount of these affiliated investments totaled $3.9 billion, or approximately
36% of the total investment portfolio, consisting of twenty-two issuers. The
total $3.9 billion in investments were comprised of $2.9 billion of loans,
$636.8 million of corporate debt securities available for sale, and $306.5
million of loans financed under total rate of return swaps (included in
derivative assets and liabilities on the condensed consolidated balance sheet).
Note 15. Fair Value Disclosure
The following
table presents information about the Companys assets and liabilities
(including derivatives that are presented net) measured at fair value on a
recurring basis as of June 30, 2008, and indicates the fair value
hierarchy of the valuation techniques utilized by the Company to determine such
fair value (amounts in thousands):
|
|
Quoted Prices in
Active Markets
for Identical Assets
(Level 1)
|
|
Significant Other
Observable Inputs
(Level 2)
|
|
Significant
Unobservable Inputs
(Level 3)
|
|
Balance as of
June 30, 2008
|
|
Assets:
|
|
|
|
|
|
|
|
|
|
Securities available-for-sale
|
|
$
|
17,666
|
|
$
|
1,054,779
|
|
$
|
45,343
|
|
$
|
1,117,788
|
|
Residential mortgage-backed securities
|
|
|
|
|
|
115,652
|
|
115,652
|
|
Residential mortgage loans
|
|
|
|
|
|
3,394,996
|
|
3,394,996
|
|
REO
|
|
|
|
|
|
8,919
|
|
8,919
|
|
Corporate loans held for sale
|
|
|
|
66,652
|
|
|
|
66,652
|
|
Total
|
|
$
|
17,666
|
|
$
|
1,121,431
|
|
$
|
3,564,910
|
|
$
|
4,704,007
|
|
Liabilities:
|
|
|
|
|
|
|
|
|
|
Derivatives, net
|
|
$
|
|
|
$
|
(91,915
|
)
|
$
|
3,471
|
|
$
|
(88,444
|
)
|
Residential mortgage-backed securities
issued
|
|
|
|
|
|
(3,204,392
|
)
|
(3,204,392
|
)
|
Securities sold, not yet purchased
|
|
(22,890
|
)
|
|
|
|
|
(22,890
|
)
|
Total
|
|
$
|
(22,890
|
)
|
$
|
(91,915
|
)
|
$
|
(3,200,921
|
)
|
$
|
(3,315,726
|
)
|
24
The following
table presents information about the Companys assets and liabilities (including
derivatives that are presented net) measured at fair value on a recurring basis
as of December 31, 2007, and indicates the fair value hierarchy of the
valuation techniques utilized by the Company to determine such fair value
(amounts in thousands):
|
|
Quoted Prices in
Active Markets
for Identical Assets
(Level 1)
|
|
Significant Other
Observable Inputs
(Level 2)
|
|
Significant
Unobservable Inputs
(Level 3)
|
|
Balance as of
December 31, 2007
|
|
Assets:
|
|
|
|
|
|
|
|
|
|
Securities available-for-sale
|
|
$
|
47,777
|
|
$
|
1,212,266
|
|
$
|
99,498
|
|
$
|
1,359,541
|
|
Residential mortgage-backed securities
|
|
|
|
131,688
|
|
|
|
131,688
|
|
Residential mortgage loans
|
|
|
|
3,921,323
|
|
|
|
3,921,323
|
|
REO
|
|
|
|
7,200
|
|
|
|
7,200
|
|
Total
|
|
$
|
47,777
|
|
$
|
5,272,477
|
|
$
|
99,498
|
|
$
|
5,419,752
|
|
Liabilities:
|
|
|
|
|
|
|
|
|
|
Derivatives, net
|
|
$
|
|
|
$
|
(38,728
|
)
|
$
|
802
|
|
$
|
(37,926
|
)
|
Residential mortgage-backed securities
issued
|
|
|
|
(3,169,353
|
)
|
|
|
(3,169,353
|
)
|
Securities sold, not yet purchased
|
|
(32,704
|
)
|
(67,690
|
)
|
|
|
(100,394
|
)
|
Total
|
|
$
|
(32,704
|
)
|
$
|
(3,275,771
|
)
|
$
|
802
|
|
$
|
(3,307,673
|
)
|
The following
table presents additional information about assets, including derivatives, that
are measured at fair value on a recurring basis for which the Company has
utilized level 3 inputs to determine fair value, for the three months
ended June 30, 2008 and 2007 (amounts in thousands):
|
|
Three months ended June 30, 2008
|
|
Three months ended June
30, 2007
|
|
|
|
Securities
Available-
For-Sale
|
|
Residential
Mortgage-
Backed
Securities
|
|
Residential
Mortgage
Loans
|
|
REO
|
|
Derivatives,
net
|
|
Residential
Mortgage-
Backed
Securities
Issued
|
|
Securities
Available-
For-Sale
|
|
Derivatives,
net
|
|
Beginning balance as of April 1
|
|
$
|
78,654
|
|
$
|
121,324
|
|
$
|
3,605,233
|
|
$
|
8,046
|
|
$
|
1,049
|
|
$
|
(3,410,163
|
)
|
$
|
105,352
|
|
$
|
1,109
|
|
Total gains or losses (realized and
unrealized):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Included in earnings
|
|
|
|
(1,192
|
)
|
4,081
|
|
|
|
(297
|
)
|
(6,775
|
)
|
|
|
208
|
|
Included in other comprehensive loss
|
|
(586
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net transfers into (out of) level 3
|
|
(32,725
|
)
|
|
|
|
|
873
|
|
2,811
|
|
|
|
|
|
|
|
Purchases, sales, other settlements and
issuances, net
|
|
|
|
(4,480
|
)
|
(214,318
|
)
|
|
|
(92
|
)
|
212,546
|
|
(48,352
|
)
|
|
|
Ending balance as of June 30
|
|
$
|
45,343
|
|
$
|
115,652
|
|
$
|
3,394,996
|
|
$
|
8,919
|
|
$
|
3,471
|
|
$
|
(3,204,392
|
)
|
$
|
57,000
|
|
$
|
1,317
|
|
The amount of total gains or losses for the
period included in earnings attributable to the change in unrealized gains or
losses relating to assets still held at the reporting date (1)
|
|
$
|
|
|
$
|
(2,370
|
)
|
$
|
4,723
|
|
$
|
|
|
$
|
(297
|
)
|
$
|
(7,203
|
)
|
$
|
|
|
$
|
208
|
|
(1)
Amounts are included in net realized and
unrealized (loss) gain on derivatives and foreign exchange or net
realized and unrealized (loss) gain on residential mortgage-backed securities,
residential mortgage loans, and residential mortgage-backed securities issued,
carried at estimated fair value in the condensed consolidated statements of
operations.
25
The following
table presents additional information about assets, including derivatives that
are measured at fair value on a recurring basis for which the Company has
utilized level 3 inputs to determine fair value, for the six months ended June 30,
2008 and 2007 (amounts in thousands):
|
|
Six months ended June 30, 2008
|
|
Six months ended June 30,
2007
|
|
|
|
Securities
Available-
For-Sale
|
|
Residential
Mortgage-
Backed
Securities
|
|
Residential
Mortgage
Loans
|
|
REO
|
|
Derivatives,
net
|
|
Residential
Mortgage-
Backed
Securities
Issued
|
|
Securities
Available-
For-Sale
|
|
Derivatives,
net
|
|
Beginning balance as of January 1
|
|
$
|
99,498
|
|
$
|
|
|
$
|
|
|
$
|
|
|
$
|
802
|
|
$
|
|
|
$
|
104,498
|
|
$
|
|
|
Total gains or losses (realized and
unrealized):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Included in earnings
|
|
|
|
(7,137
|
)
|
(140,783
|
)
|
|
|
467
|
|
147,252
|
|
|
|
1,317
|
|
Included in other comprehensive loss
|
|
(4,090
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net transfers into (out of) level 3
|
|
(32,725
|
)
|
131,688
|
|
3,921,323
|
|
8,919
|
|
2,811
|
|
(3,169,353
|
)
|
|
|
|
|
Purchases, sales, other settlements and
issuances, net
|
|
(17,340
|
)
|
(8,899
|
)
|
(385,544
|
)
|
|
|
(609
|
)
|
(182,291
|
)
|
(47,498
|
)
|
|
|
Ending balance as of June 30
|
|
$
|
45,343
|
|
$
|
115,652
|
|
$
|
3,394,996
|
|
$
|
8,919
|
|
$
|
3,471
|
|
$
|
(3,204,392
|
)
|
$
|
57,000
|
|
$
|
1,317
|
|
The amount of total gains or losses for the
period included in earnings attributable to the change in unrealized gains or
losses relating to assets still held at the reporting date (1)
|
|
$
|
|
|
$
|
(9,250
|
)
|
$
|
(152,661
|
)
|
$
|
|
|
$
|
467
|
|
$
|
148,638
|
|
$
|
|
|
$
|
1,317
|
|
(1)
Amounts are included in net realized and
unrealized (loss) gain on derivatives and foreign exchange or net
realized and unrealized (loss) gain on residential mortgage-backed securities,
residential mortgage loans, and residential mortgage-backed securities issued,
carried at estimated fair value in the condensed consolidated statements of
operations.
As of June 30,
2008 and December 31, 2007, the Company did not have any assets or
liabilities measured at fair value on a non-recurring basis.
Note 16. Subsequent Events
On July 1, 2008, the
compensation committee of the board of directors granted 38,349 restricted
common shares and 29,720 of phantom common shares to the Companys directors
pursuant to the 2007 Share Incentive Plan.
On July 9,
2008, the Company retired $5.0 million of junior subordinated notes, which
resulted in a gain on extinguishment of $3.1 million, partially offset by a
$0.2 million write-off of debt issuance costs and $0.1 million of other associated
costs.
On August 7,
2008, the Companys board of directors declared a cash distribution for the
quarter ended June 30, 2008 on the Companys common shares of $0.40 per
share. The distribution is payable on August 29, 2008 to shareholders of
record as of the close of business on August 15, 2008.
26
Item 2.
Managements Discussion and Analysis of Financial Condition and Results
of Operations
Unless otherwise expressly stated or the context suggests
otherwise, the terms we, us and our refer, as of dates and for periods on
and after May 4, 2007 to KKR Financial Holdings LLC and its subsidiaries
and, as of dates and for periods prior to May 4, 2007, to our predecessor,
KKR Financial Corp., and its subsidiaries; Manager means KKR Financial
Advisors LLC; KKR means Kohlberg Kravis Roberts & Co. L.P. and its
affiliated companies (excluding portfolio companies that are minority or
majority owned or managed by funds associated with KKR); Management Agreement
means the amended and restated management agreement between KKR Financial
Holdings LLC and the Manager. The following managements discussion and
analysis (MD&A) is intended to assist the reader in understanding our
business. The MD&A is provided as a supplement to, and should be read in
conjunction with, our Condensed Consolidated Financial Statements and
accompanying notes included in this Quarterly Report on Form 10-Q and our
Consolidated Financial Statements and accompanying notes included in our Annual
Report on Form 10-K for the year ended December 31, 2007.
Forward Looking Statements
Certain
information contained in this Quarterly Report on Form 10-Q constitutes forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933
and Section 21E of the Securities Exchange Act of 1934 that are based on
our current expectations, estimates and projections. Pursuant to those
sections, we may obtain a safe harbor for forward-looking statements by
identifying those and by accompanying those statements with cautionary
statements, which identify factors that could cause actual results to differ
from those expressed in the forward-looking statements. Statements that are not
historical facts, including statements about our beliefs and expectations, are
forward-looking statements. The words believe, anticipate, intend, aim,
expect, strive, plan, estimate, and project, and similar words
identify forward-looking statements. Such statements are not guarantees of
future performance, events or results and involve potential risks and
uncertainties. Accordingly, actual results and the timing of certain events
could differ materially from those addressed in forward-looking statements due
to a number of factors including, but not limited to, changes in interest rates
and market values, changes in prepayment rates, general economic conditions,
and other factors not presently identified. Other factors that may impact our
actual results are discussed in our Annual Report on Form 10-K under the
section titled Risk Factors. We do not undertake, and specifically
disclaim, any obligation to publicly release the result of any revisions that
may be made to any forward-looking statements to reflect the occurrence of
anticipated or unanticipated events or circumstances after the date of such
statements.
Executive Overview
We are a
specialty finance company that uses leverage with the objective of generating
competitive risk-adjusted returns. We invest in financial assets primarily
consisting of corporate loans and securities, including senior secured and
unsecured loans, mezzanine loans, high yield corporate bonds, distressed and
stressed debt securities, marketable and non-marketable equity securities, and
credit default and total rate of return swaps. We also make opportunistic
investments in other asset classes from time to time.
Our objective
is to provide competitive returns to our investors through a combination of
distributions and capital appreciation. As part of our investment strategy, we
seek to invest opportunistically in those asset classes that can generate competitive
leveraged risk-adjusted returns, subject to maintaining our exemption from
regulation under the Investment Company Act of 1940, as amended (the Investment
Company Act).
Our income is
generated primarily from (i) net interest income and dividend income, (ii) realized
and unrealized gains and losses on our derivatives that are not accounted for
as hedges, (iii) realized gains and losses from the sales of investments, (iv) realized
and unrealized gains and losses on securities sold, not yet purchased, and (v) fee
income.
We are a
Delaware limited liability company and were organized on January 17, 2007.
We are the successor to KKR Financial Corp. (the REIT Subsidiary), a Maryland
corporation. The REIT Subsidiary was originally incorporated in the State of
Maryland on July 7, 2004 and elected to be treated as a real estate
investment trust (REIT) for U.S. federal income tax purposes. On May 4,
2007, we completed a restructuring transaction (the Restructuring Transaction),
pursuant to which the REIT Subsidiary became our subsidiary and each
outstanding share of the REIT Subsidiarys common stock was converted into one
of our common shares, which are publicly traded on the New York Stock Exchange
(NYSE) under the symbol KFN. Although we have not elected to be treated as
a REIT for U.S. federal income tax purposes, we intend to continue to operate
so as to qualify as a partnership, and not as an association or publicly traded
partnership taxable as a corporation, for U.S. federal income tax purposes.
On March 31, 2008, we entered into a
definitive agreement with Rock Capital 2 LLC pursuant to which Rock Capital 2
LLC would acquire a controlling interest in the REIT Subsidiary. This transaction
closed on June 30, 2008 and did not result in a gain or loss.
27
We manage our liquidity with
the intention of maintaining the continuing ability to fund our operations and
fulfill our commitments on a timely and cost-effective basis. Based on changes in our working capital, for
any given period, the cash flows provided by operating activities may be less
than the cumulative distributions paid on our shares for such period and such
shortfall, if any, may be funded through the issuance of unsecured indebtedness
or through the borrowing of additional amounts through the pledging of certain
of our assets. Our board of directors
considers available liquidity when declaring distributions to shareholders. As of June 30, 2008, we had unrestricted
cash and cash equivalents totaling $189.0 million.
Our Manager, a wholly owned subsidiary of Kohlberg
Kravis Roberts & Co. (Fixed Income) LLC
(previously known as
KKR Financial LLC), manages us pursuant to the Management Agreement. The
Manager is an affiliate of KKR. In June 2008,
Kohlberg Kravis Roberts & Co. (Fixed
Income) LLC became a wholly-owned subsidiary of KKR.
Discontinued Operations
In August 2007, our board of directors
approved a plan to exit our residential mortgage investment operations and sell
the REIT Subsidiary. As of January 1, 2008, the REIT Subsidiarys assets
and liabilities consisted solely of those held by our two asset-backed
commercial paper conduits (the Facilities).
During March 2008, we entered into an agreement with the holders of
the secured liquidity notes (SLNs) issued by the Facilities (the Noteholders)
in order to terminate the Facilities.
With respect to the agreement with the Noteholders, all of the
residential mortgage-backed securities (RMBS) funded by the SLNs have been returned
to the Noteholders in satisfaction of the SLNs and we have paid the Noteholders
approximately $42.0 million in conjunction with this resolution. We had
previously accrued $36.5 million for contingencies related to resolution of the
Facilities and as a consequence of this transaction, we recorded an incremental
charge during the quarter ended March 31, 2008 for $5.5 million. The
agreement with the Noteholders resulted in approximated $3.6 billion par amount
of RMBS being returned to the Noteholders in satisfaction of approximately $3.5
billion par amount of SLNs held by the Noteholders. Accordingly, we removed the
RMBS and SLNs that related to the Facilities from our condensed consolidated
financial statements as of March 31, 2008. Under the agreement with the
Noteholders, both we and our affiliates have been released from any future
obligations or liabilities to the Noteholders.
As of June 30, 2008, we substantially completed our plan to exit
our residential mortgage investment operations through the sale of certain of
our sale of residential mortgage-backed securities in the third quarter of 2007
and the agreement with the Noteholders related to the Facilities described
above. In addition, on June 30, 2008, we completed the sale of a
controlling interest in the REIT Subsidiary to Rock Capital 2 LLC, which did
not result in a gain or loss. Accordingly, the REIT Subsidiary is presented as
discontinued operations for financial statement purposes for all periods
presented.
We have determined that a sale or transfer of our remaining residential
mortgage portfolio to no longer be probable in the near term. As such, our
remaining residential mortgage investment operations, which were previously
presented as discounted operations, are presented as continuing operations and
the associated prior period amounts presented in our condensed consolidated
financial statements relating to our existing residential mortgage assets and
liabilities as of June 30, 2008 have been reclassified for comparative
presentation.
Extinguishment of Debt
During the
second quarter of 2008, we retired $35.0 million of junior subordinated notes,
which resulted in a gain on extinguishment of $17.2 million, partially
offset by a $1.1 million write-off of debt issuance costs and $0.7 million of other
associated costs. The net gain on extinguishment of debt is recorded on our
condensed consolidated statement of operations as other income.
Common Share Offering
On April 8, 2008, we
completed a public offering of 34.5 million common shares at a price of
$11.85 per common share. Net proceeds from the transaction before expenses
totaled $384.3 million, which we will use for general corporate purposes.
28
Cash Distributions to Shareholders
On August 7, 2008, our
board of directors declared a cash distribution for the quarter ended June 30,
2008 on our common shares of $0.40 per share. The distribution is payable on August 29,
2008 to shareholders of record as of the close of business on August 15,
2008.
Investment Portfolio
As of June 30, 2008, our investments in
corporate loans and debt securities totaled $9.9 billion, which represents a 0.6%
decrease from $10.0 billion as of December 31, 2007. Additionally, our
investments in RMBS totaled $315.2 million as of June 30, 2008, which
represents a decrease of 6.6% from $337.6 million as of December 31, 2007. As described under Discontinued Operations
above, we consolidate both the assets and liabilities of certain residential
mortgage-backed securitization trusts in accordance with accounting principles
generally accepted in the United States of America (GAAP) and as a result,
$199.5 million of our $315.2 million of RMBS investments are included in the
consolidation of these entities and the $199.5 million represents the net
difference between residential mortgage loans of $3.4 billion and residential
mortgage-backed securities issued of $3.2 billion, plus $8.9 million of real
estate owned (included in other assets on our condensed consolidated balance
sheet in our condensed consolidated financial statements).
Critical Accounting Policies
Our condensed
consolidated financial statements are prepared by management in conformity with
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.
Fair Value of Financial Instruments
Effective January 1,
2007, we adopted Statement of Financial Accounting Standards (SFAS) No. 157,
Fair Value Measurements
(SFAS No. 157),
which requires additional disclosures about our assets and liabilities that are
measured at fair value.
As defined in
SFAS No. 157, fair value is the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date. Where available, fair value is based on
observable market prices or parameters or derived from such prices or
parameters. Where observable prices or inputs are not available, valuation
models are applied. These valuation techniques involve some level of management
estimation and judgment, the degree of which is dependent on the price
transparency for the instruments or market and the instruments complexity for
disclosure purposes. Beginning in January 2007, assets and liabilities
recorded at fair value in the consolidated balance sheets are categorized based
upon the level of judgment associated with the inputs used to measure their
value. Hierarchical levels, as defined in SFAS No. 157 and directly
related to the amount of subjectivity associated with the inputs to fair
valuations of these assets and liabilities, are as follows:
Level 1:
Inputs are unadjusted, quoted prices in active markets for identical assets or
liabilities at the measurement date.
The types of
assets carried at level 1 fair value generally are equity securities listed
in active markets.
Level 2:
Inputs other than quoted prices included in level 1 that are observable
for the asset or liability, either directly or indirectly. Level 2 inputs
include quoted prices for similar instruments in active markets, and inputs
other than quoted prices that are observable for the asset or liability.
Fair value
assets and liabilities that are generally included in this category are certain
corporate debt securities and certain financial instruments classified as
derivatives where the fair value is based on observable market inputs.
Level 3:
Inputs are unobservable inputs for the asset or liability, and include
situations where there is little, if any, market activity for the asset or
liability. In certain cases, the inputs used to measure fair value may fall
into different
29
levels of the
fair value hierarchy. In such cases, the level in the fair value hierarchy
within which the fair value measurement in its entirety falls has been
determined based on the lowest level input that is significant to the fair
value measurement in its entirety. Our assessment of the significance of a
particular input to the fair value measurement in its entirety requires
judgment and the consideration of factors specific to the asset.
Generally,
assets and liabilities carried at fair value and included in this category are
certain corporate debt securities, residential mortgage-backed securities,
residential mortgage loans, residential mortgage-backed securities issued and
certain derivatives.
The
availability of observable inputs can vary depending on the financial asset or
liability and is affected by a wide variety of factors, including, for example,
the type of product, whether the product is new, whether the product is traded
on an active exchange or in the secondary market, and the current market
condition. To the extent that valuation is based on models or inputs that are
less observable or unobservable in the market, the determination of fair value
requires more judgment. Accordingly, the degree of judgment exercised by us in
determining fair value is greatest for instruments categorized in level 3.
In certain cases, the inputs used to measure fair value may fall into different
levels of the fair value hierarchy. In such cases, for disclosure purposes the
level in the fair value hierarchy within which the fair value measurement in
its entirety falls is determined based on the lowest level input that is
significant to the fair value measurement in its entirety.
Fair value is
a market-based measure considered from the perspective of a market participant
who holds the asset or owes the liability rather than an entity-specific
measure. Therefore, even when market assumptions are not readily available, our
own assumptions are set to reflect those that market participants would use in
pricing the asset or liability at the measurement date.
Many financial
assets and liabilities have bid and ask prices that can be observed in the
marketplace. Bid prices reflect the highest price that we and others are willing
to pay for an asset. Ask prices represent the lowest price that we and others
are willing to accept for an asset. For financial assets and liabilities whose
inputs are based on bid-ask prices, we do not require that fair value always be
a predetermined point in the bid-ask range. Our policy is to allow for
mid-market pricing and adjusting to the point within the bid-ask range that
meets our best estimate of fair value.
Assets and
liabilities that are valued using level 3 of the fair value hierarchy primarily
consist of certain corporate debt securities, residential mortgage-backed
securities, residential mortgage loans, residential mortgage-backed securities
issued and certain over-the-counter (OTC) derivative contracts. The valuation techniques used for these are
described below.
Residential Mortgage-Backed
Securities, Residential Mortgage Loans, and Residential Mortgage-Backed
Securities Issued:
Residential mortgage-backed
securities, residential mortgage loans, and residential mortgage-backed
securities issued are initially valued at transaction price and are
subsequently valued using market data for similar instruments (e.g., recent
transactions, nationally recognized pricing services, or broker quotes),
comparisons to benchmark derivative indices or movements in underlying credit
spreads.
Corporate
Debt Securities:
Corporate debt securities are
initially valued at transaction price and are subsequently valued using market
data for similar instruments (e.g., recent transactions or broker quotes),
comparisons to benchmark derivative indices or movements in underlying credit
spreads.
OTC
Derivative Contracts:
OTC derivative contracts include
forward, swap and option contracts related to interest rates, foreign
currencies, credit standing of reference entities, and equity prices. The fair
value of OTC derivative products can be modeled using a series of techniques,
including closed-form analytic formulae, such as the Black-Scholes
option-pricing model, and simulation models or a combination thereof. Many
pricing models do not entail material subjectivity because the methodologies
employed do not necessitate significant judgment, and the pricing inputs are
observed from actively quoted markets, as is the case for generic interest rate
swap and option contracts.
Share-Based Compensation
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),
Share-based Compensation
(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 shares 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 record compensation costs for restricted common shares
and common share 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 the awards have not vested. Unvested restricted common shares are
valued using observable secondary market prices. Unvested common share options
are valued using the Black-Scholes model and assumptions based on
30
observable market data for
comparable companies. We amortize compensation expense related to the
restricted common share and common share options that we granted to our Manager
using the graded vesting attribution and straight-line method in accordance
with SFAS No. 123(R). As of
June 30, 2008, the common share options were fully vested.
Because we
remeasure the amount of compensation costs associated with the unvested
restricted common shares and unvested common share options that we issued to
our Manager as of each reporting period, our share-based compensation expense
reported in our condensed consolidated financial statements will change based
on the estimated fair value of our common shares and this may result in
earnings volatility. For the three and six months ended
June 30, 2008, share-based
compensation totaled $0.4 million and $1.0 million, respectively. As of June 30, 2008, substantially all
of the non-vested restricted common shares issued that are subject to SFAS No. 123(R) are
subject to remeasurement. As of June 30,
2008, a $1 increase in the price of our common shares would have increased our
future share-based compensation expense by approximately $1.7 million and
this future share-based compensation expense would be recognized over the
remaining vesting periods of our outstanding restricted common shares and
common share options. As of June 30,
2008, future unamortized share-based compensation totaled $10.6 million, of
which $2.2 million, $4.0 million, and $4.4 million will be
recognized in 2008, 2009, and beyond, respectively.
Accounting for Derivative Instruments and
Hedging Activities
We recognize
all derivatives on our condensed consolidated balance sheets at estimated fair
value. On the date we enter into a derivative contract, we designate and
document each derivative contract as one of the following at the time the
contract is executed: (i) a hedge of a recognized asset or liability (fair
value hedge); (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 (cash flow hedge); (iii) a hedge of a net investment in a
foreign operation; or (iv) a derivative instrument not designated as a
hedging instrument (free-standing derivative). For a fair value hedge, we
record changes in the estimated fair value of the derivative and, to the extent
that it is effective, changes in the fair value of the hedged asset or
liability attributable to the hedged risk, in the current period earnings in
the same financial statement category as the hedged item. For a cash flow
hedge, we record changes in the estimated fair value of the derivative to the
extent that it is effective in other comprehensive income. We subsequently
reclassify these changes in estimated fair value to net income in the same
period(s) that the hedged transaction affects earnings in the same
financial statement category as the hedged item. For free-standing derivatives,
we report changes in the fair values in current period other (loss) income.
We formally
document at inception our hedge relationships, including identification of the
hedging instruments and the hedged items, our risk management objectives,
strategy for undertaking the hedge transaction and our evaluation of
effectiveness of its hedged transactions. Periodically, as required by SFAS No. 133,
Accounting for Derivative Instruments and
Hedging Activities
, as amended and interpreted (SFAS No. 133),
we also formally assesses whether the derivative designated in each hedging
relationship is expected to be and has been highly effective in offsetting
changes in estimated fair values or cash flows of the hedged item using either
the dollar offset or the regression analysis method. If we determine that a
derivative is not highly effective as a hedge, we discontinue hedge accounting.
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 June 30, 2008, the estimated fair
value of our net derivative liabilities totaled $88.4 million.
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. Evaluating whether the impairment
of an investment is other-than-temporary requires significant judgment and
requires us to make certain estimates and assumptions. 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
June 30,
2008, we had aggregate unrealized losses on our securities classified as
available-for-sale of approximately $189.3 million, which if not recovered
may result in the recognition of future losses. As of June 30, 2008, there was
31
an impairment of $9.7 million which was determined to be
other-than-temporary which has been recorded as a loss in the condensed consolidated
statements of operations.
Allowance for Loan Losses
Our allowance
for estimated loan losses represents our estimate of probable credit losses
inherent in the loan portfolio as of the balance sheet date. 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. Additions to the allowance for loan losses are charged to current
period earnings through the provision for loan losses. Amounts determined to be
uncollectible are charged directly to the allowance for loan losses. Our
allowance for loan losses consists of two components, an allocated component
and an unallocated component.
The allocated
component of our allowance for loan losses consists of individual loans that
are impaired and for which the estimated allowance for loan losses is
determined in accordance with SFAS No. 114,
Accounting by Creditors for Impairment of a Loan.
We
consider a loan to be impaired when, based on current information 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. An impaired loan may be left on
accrual status during the period we are pursuing repayment of the loan;
however, the loan is placed on non-accrual status at such time as: (i) we
believe that scheduled debt service payments may not be paid when contractually
due; (ii) the loan becomes 90 days delinquent; (iii) we determine 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 decreases below our 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.
The
unallocated component of our allowance for loan losses is determined in
accordance with SFAS No. 5,
Accounting
for Contingencies
. This component of the allowance for loan losses
represents our estimate of losses inherent, but unidentified, in our portfolio
as of the balance sheet date. The unallocated component of the allowance for
loan losses is estimated based upon a review of our loan portfolios risk
characteristics, risk grouping of loans in the portfolio based upon estimated
probability of default and severity of loss based on loan type, and
consideration of general economic conditions and trends. As of
June 30, 2008, our allowance for
loan losses totaled $35.0 million.
Recent Accounting Pronouncements
In February 2008, the FASB issued FSP FAS 140-3,
Accounting for Transfers of Financial Assets and Repurchase Financing
Transactions
(FSP SFAS No. 140-3). FSP SFAS No. 140-3
assumes that an initial transfer of a financial asset and a repurchase
financing are considered part of the same arrangement, or a linked transaction.
However, if certain criteria are met, the initial transfer and repurchase
financing shall not be evaluated as a linked transaction and shall be evaluated
separately under SFAS No. 140,
Accounting for Transfers
and Servicing of Financial Assets and Extinguishments of Liabilities
(SFAS No. 140). FSP SFAS No. 140-3 is effective for us for repurchase
financings in which the initial transfer is entered into after December 31,
2008
and early adoption is not permitted. We do not expect the adoption of FSP SFAS No. 140-3 to have a
material impact on our condensed
consolidated financial statements.
In March 2008, the FASB issued SFAS No. 161,
Disclosures about Derivative Instruments and Hedging Activities, an
Amendment of FASB Statement No. 133
(SFAS No. 161). SFAS
No. 161 requires enhanced qualitative disclosures about objectives and
strategies for using derivatives, quantitative disclosures about fair value
amounts of gains and losses on derivative instruments, and disclosures about
credit-risk-related contingent features in derivative agreements. The
additional disclosures required by SFAS No. 161 must be included in our
consolidated financial statements beginning with the first quarter of 2009.
In May 2008, the FASB issued
FSP No. APB 14-1,
Accounting
for Convertible Debt Instruments That May Be Settled in Cash upon
Conversion (Including Partial Cash Settlement)
(FSP APB 14-1). This FSP requires that
issuers of convertible debt instruments that may be settled wholly or partly in
cash when converted should separately account for the liability and equity
(conversion feature) components of the instruments. As a result, interest
expense should be imputed and recognized based upon the entitys nonconvertible
debt borrowing rate, which will result in lower net income. Prior to the
adoption of FSP APB 14-1, APB No. 14,
Accounting for Convertible
Debt and Debt Issued with Stock Purchase Warrants
, provided that no
portion of the proceeds from the issuance of the instrument should be
attributable to the conversion feature. The 7.00% convertible senior notes
issued by us in July 2007 will be subject to FSP ABP 14-1. FSP APB 14-1 is
effective for us retroactively on January 1, 2009 and early adoption is
prohibited. We have determined that the adoption of FSP APB 14-1 does not have
a material impact on our financial statements.
32
In May 2008, FASB issued SFAS No. 163,
Accounting for Financial Guarantee Insurance
Contracts an interpretation of FASB Statement No. 60
(SFAS No. 163).
SFAS No. 163 requires recognition of an insurance claim liability prior to
an event of default (insured event) when there is evidence that credit
deterioration has occurred in an insured financial obligation. SFAS No. 163
is effective for financial statements issued for fiscal years beginning after December 15,
2008 and all interim periods within those fiscal years, and early application
is not permitted. We do not expect the adoption of SFAS No. 163 to have a
material impact on our financial statements.
Results of Operations
Three and six months ended June 30, 2008
compared to three and six months ended June 30, 2007
Summary
Our net income
for the three and six months ended
June 30, 2008 totaled $37.6 million (or $0.26 per
diluted common share) and $51.5 million (or $0.39 per diluted common share),
respectively, as compared to net income of $53.0 million (or $0.65 per
diluted common share) and $101.4 million (or $1.24 per diluted common share),
respectively, for the three and six months ended June 30, 2007. Income from continuing operations for the
three and six months ended June 30,
2008 totaled $38.6 million (or $0.26 per diluted common share) and $48.9
million (or $0.37 per diluted common share), respectively, as compared to $68.5 million
(or $0.84 per diluted common share) and $104.3 million (or $1.28 per diluted
common share), respectively, for the three and six months ended June 30, 2007. The decrease in
income from continuing operations of $29.9 million, or 43.6%, and $55.5
million, or 53.2%, from the three and six months ended June 30, 2007 to
2008, respectively, is primarily attributable to a significant increase in net
realized and unrealized losses on investments, derivatives and foreign
exchange.
Net Investment Income
The following
table presents the components of our net investment income for the three and
six months ended
June 30,
2008 and 2007:
Comparative Net Investment Income Components
(Amounts in thousands)
|
|
For the three
months ended
June 30, 2008
|
|
For the three
months ended
June 30, 2007
|
|
For the six
months ended
June 30, 2008
|
|
For the six
months ended
June 30, 2007
|
|
Investment Income:
|
|
|
|
|
|
|
|
|
|
Corporate loans and securities interest
income
|
|
$
|
163,830
|
|
$
|
108,696
|
|
$
|
363,190
|
|
$
|
193,891
|
|
Residential mortgage loans and securities
interest income
|
|
44,643
|
|
64,504
|
|
92,847
|
|
132,693
|
|
Other interest income
|
|
4,998
|
|
5,674
|
|
16,074
|
|
8,251
|
|
Dividend income
|
|
1,092
|
|
965
|
|
1,908
|
|
1,940
|
|
Net discount accretion
|
|
10,865
|
|
497
|
|
19,647
|
|
1,163
|
|
Total investment income
|
|
225,428
|
|
180,336
|
|
493,666
|
|
337,938
|
|
Interest Expense:
|
|
|
|
|
|
|
|
|
|
Repurchase agreements
|
|
4,467
|
|
19,211
|
|
33,437
|
|
40,620
|
|
Collateralized loan obligation senior
secured notes
|
|
71,889
|
|
48,095
|
|
146,407
|
|
80,155
|
|
Secured revolving credit facility
|
|
3,140
|
|
2,402
|
|
5,773
|
|
3,390
|
|
Secured demand loan
|
|
25
|
|
611
|
|
348
|
|
1,215
|
|
Convertible senior notes
|
|
5,623
|
|
|
|
11,010
|
|
|
|
Junior subordinated notes
|
|
6,349
|
|
5,036
|
|
12,104
|
|
10,021
|
|
Residential mortgage-backed securities
issued
|
|
34,001
|
|
48,420
|
|
68,432
|
|
99,573
|
|
Other interest expense
|
|
272
|
|
634
|
|
1,022
|
|
1,267
|
|
Interest rate swap
|
|
2,271
|
|
(144
|
)
|
3,569
|
|
(191
|
)
|
Total interest expense
|
|
128,037
|
|
124,265
|
|
282,102
|
|
236,050
|
|
Interest expense to affiliates
|
|
19,707
|
|
8,256
|
|
47,525
|
|
8,256
|
|
Provision for loan losses
|
|
10,000
|
|
|
|
10,000
|
|
|
|
Net investment income
|
|
$
|
67,684
|
|
$
|
47,815
|
|
$
|
154,039
|
|
$
|
93,632
|
|
33
As presented in the table above, net
investment income increased $19.9 million, or 41.6%, and $60.4 million, or
64.5%, from the three and six months ended June 30, 2007 compared to the
three and six months ended June 30, 2008. The increase is primarily attributable
to the additional investments in our investment portfolio during 2008. As of June 30,
2008, we held $9.9 billion of investments in corporate loans and
securities, excluding the allowance for loan losses of $35.0 million. In
comparison, as of June 30, 2007, investments in corporate loans and
securities totaled $6.6 billion.
Net investment income in the table above does
not include equity in income of unconsolidated affiliate of nil for the three
and six months ended June 30, 2008 and $5.7 million and $12.7 million
for the three and six months ended June 30, 2007, respectively. Equity in
income of unconsolidated affiliate reflects our pro rata interest in the net
income of a limited partnership that was formed to hold the subordinated
interests in three entities formed to execute secured financing transactions in
the form of collateralized loan obligations (CLOs).
Other (Loss) Income
The following table presents the components
of other (loss) income for the three and six months ended June 30, 2008
and 2007:
Comparative Other (Loss) Income Components
(Amounts in thousands)
|
|
For the three
months ended
June 30, 2008
|
|
For the three
months ended
June 30, 2007
|
|
For the six
months ended
June 30, 2008
|
|
For the six
months ended
June 30, 2007
|
|
Net realized and unrealized (loss) gain on
derivatives and foreign exchange:
|
|
|
|
|
|
|
|
|
|
Interest rate swaptions
|
|
$
|
|
|
$
|
15
|
|
$
|
|
|
$
|
|
|
Interest rate swaps
|
|
(268
|
)
|
|
|
3,526
|
|
|
|
Credit default swaps
|
|
(2,955
|
)
|
1,015
|
|
10,334
|
|
973
|
|
Total rate of return swaps
|
|
(3,820
|
)
|
5,602
|
|
(66,445
|
)
|
12,369
|
|
Common stock warrants
|
|
(20
|
)
|
(144
|
)
|
(707
|
)
|
286
|
|
Foreign contract
|
|
(6
|
)
|
|
|
|
|
|
|
Foreign exchange translation
|
|
1,151
|
|
(7
|
)
|
358
|
|
(9
|
)
|
Total realized and unrealized (loss) gain
on derivatives and foreign exchange
|
|
(5,918
|
)
|
6,481
|
|
(52,934
|
)
|
13,619
|
|
Net realized loss on residential loans
carried at estimated fair value
|
|
(744
|
)
|
(124
|
)
|
(1,499
|
)
|
(201
|
)
|
Net unrealized (loss) gain on residential mortgage-backed
securities, residential mortgage loans, and residential mortgage-backed
securities issued, carried at estimated fair value
|
|
(4,850
|
)
|
1,650
|
|
(13,273
|
)
|
(1,490
|
)
|
Net realized (loss) gain on investments
|
|
(4,892
|
)
|
26,739
|
|
(18,651
|
)
|
33,764
|
|
Impairment of securities available for sale
|
|
(9,688
|
)
|
|
|
(9,688
|
)
|
|
|
Lower of cost or estimated fair value
adjustment to loans held for sale
|
|
(2,637
|
)
|
|
|
(2,637
|
)
|
|
|
Gain on extinguishment of debt
|
|
17,225
|
|
|
|
17,225
|
|
|
|
Net realized and unrealized gain on
securities sold, not yet purchased
|
|
1,664
|
|
575
|
|
8,650
|
|
575
|
|
Other income
|
|
513
|
|
2,540
|
|
5,469
|
|
4,588
|
|
Total other (loss) income
|
|
$
|
(9,327
|
)
|
$
|
37,861
|
|
$
|
(67,338
|
)
|
$
|
50,855
|
|
As presented in the table above, total other loss totaled
$9.3 million and $67.3 million for the three and six months ended June 30,
2008, respectively, as compared to other income of $37.9 million and $50.9
million for the three and six months ended June 30, 2007, respectively.
The change in total other (loss) income for the three months ended June 30,
2008 is primarily attributable to a $5.9 million net realized and
unrealized loss on derivatives and foreign exchange, of which $3.8 million
was related to total rate of return swaps, a $4.9 million unrealized loss on
the estimated fair value of our residential mortgage positions, an $5.6 million
realized loss on sales of investments, and a $9.7 million loss on the
impairment of a security available-for-sale, all partially offset by a $17.2
million gain on the extinguishment of junior subordinated notes. The change in
total other (loss) income for the six months ended June 30, 2008 is
primarily attributable to a $52.9 million net realized and unrealized loss
on derivatives and foreign exchange, of which $66.4 million was related to
total rate of return swaps, a $13.3 million unrealized loss on the estimated
fair value of our residential mortgage positions, a $20.2 million realized loss
on sales of investments, and $9.7 million loss on the impairment of a security
available-for-sale, all partially offset by a $17.2 million gain on the extinguishment
of junior subordinated notes.
34
Non-Investment Expenses
The following table presents the components
of non-investment expenses for the three and six months ended June 30,
2008 and 2007:
Comparative Non-Investment Expense Components
(Amounts
in thousands)
|
|
For the three
months ended
June 30, 2008
|
|
For the three
months ended
June 30, 2007
|
|
For the six
months ended
June 30, 2008
|
|
For the six
months ended
June 30, 2007
|
|
Related party management compensation:
|
|
|
|
|
|
|
|
|
|
Base management fees
|
|
$
|
8,927
|
|
$
|
7,077
|
|
$
|
16,360
|
|
$
|
14,273
|
|
Incentive fee
|
|
|
|
6,249
|
|
|
|
12,620
|
|
Share-based compensation
|
|
196
|
|
746
|
|
658
|
|
6,478
|
|
CLO management fees
|
|
1,264
|
|
1,042
|
|
2,528
|
|
1,042
|
|
Related party management compensation
|
|
10,387
|
|
15,114
|
|
19,546
|
|
34,413
|
|
Professional services
|
|
1,071
|
|
759
|
|
2,928
|
|
1,300
|
|
Loan servicing expense
|
|
2,391
|
|
2,939
|
|
4,960
|
|
6,023
|
|
Insurance expense
|
|
158
|
|
192
|
|
319
|
|
386
|
|
Directors expenses
|
|
315
|
|
285
|
|
716
|
|
605
|
|
General and administrative expenses
|
|
5,279
|
|
3,514
|
|
9,239
|
|
9,261
|
|
Total non-investment expenses
|
|
$
|
19,601
|
|
$
|
22,803
|
|
$
|
37,708
|
|
$
|
51,988
|
|
As presented in the table above, our
non-investment expenses decreased by $3.2 million and $14.3 million for
the three and six months ended June 30, 2008, respectively compared to June 30,
2007. 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, incentive fees, collateral management fees, and
share-based compensation related to restricted common shares and common share
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 our equity as defined in the Management Agreement. Our Manager is
also entitled to a quarterly incentive fee provided that our quarterly net
income, as defined in the Management Agreement, before the incentive fee
exceeds a defined return hurdle. The Manager did not earn an incentive fee
during the three and six months ended June 30, 2008, respectively. For the
three and six months ended June 30, 2007, incentive fees of $6.2 million
and $12.6 million were earned by the Manager.
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. Professional services expenses
consist of legal, accounting and other professional services. Directors
expenses represent share-based compensation, as well as expenses and
reimbursables due to the board of directors for their services. The decrease in
non-investment expense is primarily due to a decrease in share-based
compensation related to the vesting of restricted common shares and common
share options granted to our Manager, decline in estimated fair value of
restricted common shares granted to our Manager, and the absence of incentive
fees.
Income Tax Provision
After the Restructuring Transaction, we are no
longer treated as a REIT for U.S. federal income tax purposes; however, we
intend to continue to operate so as to qualify as a partnership, and not as an
association or publicly traded partnership that is taxable as a corporation,
for U.S. federal income tax purposes. Therefore, we generally are not subject
to U.S. federal income tax at the entity level, but are subject to limited
state income taxes. Holders of our shares are required to take into account
their allocable share of each item of our income, gain, loss, deduction, and
credit for our taxable year end ending within or with their taxable year.
KKR Financial Holdings II, LLC (KFH II), a
wholly-owned subsidiary of the Company which holds certain real estate
mortgage-backed securities, elected to be taxed as a REIT and we believe that
it has complied with the provisions of the Internal Revenue Code of 1986, as
amended, (the Code), with respect thereto. KFH II is not subject to federal
35
income tax to the extent that it currently distributes its income and
satisfies certain asset, income and ownership tests, and recordkeeping
requirements.
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), KKR Financial CLO 2007-1, Ltd. (CLO 2007-1), and KKR
Financial CLO 2007-A, Ltd. (CLO 2007-A) are foreign taxable corporate subsidiaries
that were established to facilitate securitization transactions, structured as
secured financing transactions, and KKR TRS Holdings, Ltd. (TRS Ltd.),
is a foreign taxable corporate subsidiary that was formed to make certain
foreign investments from time to time. They are organized as exempted companies
incorporated with limited liability under the laws of the Cayman Islands, and
are generally not subject to 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 corporate subsidiaries, they generally will not be subject to
corporate income tax in our financial statements on their earnings, and no
provisions for income taxes for the three months and six months ended June 30,
2008 and 2007 were recorded; however, we are generally required to include
their current taxable income in our calculation of taxable income allocable to
shareholders.
Investment Portfolio
Corporate Investment Summary
The tables below summarize the carrying
value, amortized cost, and estimated fair value of our corporate investment
portfolio as of June 30, 2008 and December 31, 2007, classified by
interest rate type. Carrying value is the value that investments are recorded
on our condensed consolidated balance sheets and is estimated fair value for
securities, amortized cost for loans held for investment, and the lower of cost
or estimated fair 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 corporate
investment portfolio as of June 30, 2008 classified by interest rate type:
Corporate Investment Portfolio
(Dollar
amounts in thousands)
|
|
Carrying
Value
|
|
Amortized
Cost
|
|
Estimated
Fair Value
|
|
Portfolio Mix
% by Fair Value
|
|
Floating Rate:
|
|
|
|
|
|
|
|
|
|
Corporate Loans
|
|
$
|
8,616,043
|
|
$
|
8,616,043
|
|
$
|
8,026,579
|
|
85.9
|
%
|
Corporate Debt Securities
|
|
200,051
|
|
236,240
|
|
200,051
|
|
2.1
|
|
Total Floating Rate
|
|
8,816,094
|
|
8,852,283
|
|
8,226,630
|
|
88.0
|
|
Fixed Rate:
|
|
|
|
|
|
|
|
|
|
Corporate Loans
|
|
193,614
|
|
193,614
|
|
187,298
|
|
2.0
|
|
Corporate Debt Securities
|
|
900,071
|
|
1,036,692
|
|
900,071
|
|
9.6
|
|
Total Fixed Rate
|
|
1,093,685
|
|
1,230,306
|
|
1,087,369
|
|
11.6
|
|
Marketable and Non-Marketable Equity
Securities:
|
|
|
|
|
|
|
|
|
|
Marketable Equity Securities
|
|
17,666
|
|
28,155
|
|
17,666
|
|
0.2
|
|
Non-Marketable Equity Securities
|
|
20,079
|
|
20,079
|
|
20,079
|
|
0.2
|
|
Total Marketable and Non-Marketable Equity
Securities
|
|
37,745
|
|
48,234
|
|
37,745
|
|
0.4
|
|
Total(1)
|
|
$
|
9,947,524
|
|
$
|
10,130,823
|
|
$
|
9,351,744
|
|
100.0
|
%
|
(1)
Total carrying value
excludes allowance for loan losses of $35.0 million and includes loans
held for sale.
The schedule above excludes equity securities
sold, not yet purchased, with a cost of $27.2 million and for which we had
accumulated net unrealized gains of $4.3 million as of June 30, 2008.
36
The table below summarizes our investment
portfolio as of December 31, 2007 classified by interest rate type:
Corporate Investment Portfolio
(Dollar
amounts in thousands)
|
|
Carrying
Value
|
|
Amortized
Cost
|
|
Estimated
Fair Value
|
|
Portfolio Mix
% by Fair Value
|
|
Floating Rate:
|
|
|
|
|
|
|
|
|
|
Corporate Loans
|
|
$
|
8,591,430
|
|
$
|
8,591,430
|
|
$
|
8,297,908
|
|
85.2
|
%
|
Corporate Debt Securities
|
|
200,341
|
|
218,722
|
|
200,341
|
|
2.0
|
|
Total Floating Rate
|
|
8,791,771
|
|
8,810,152
|
|
8,498,249
|
|
87.2
|
|
Fixed Rate:
|
|
|
|
|
|
|
|
|
|
Corporate Loans
|
|
67,778
|
|
67,778
|
|
65,688
|
|
0.7
|
|
Corporate Debt Securities
|
|
1,111,423
|
|
1,219,305
|
|
1,111,423
|
|
11.4
|
|
Total Fixed Rate
|
|
1,179,201
|
|
1,287,083
|
|
1,177,111
|
|
12.1
|
|
Marketable and Non-Marketable Equity
Securities:
|
|
|
|
|
|
|
|
|
|
Marketable equity securities
|
|
47,777
|
|
58,529
|
|
47,777
|
|
0.5
|
|
Non-Marketable Equity Securities
|
|
20,084
|
|
20,084
|
|
20,084
|
|
0.2
|
|
Total Marketable and Non-Marketable Equity
Securities
|
|
67,861
|
|
78,613
|
|
67,861
|
|
0.7
|
|
Total(1)
|
|
$
|
10,038,833
|
|
$
|
10,175,848
|
|
$
|
9,743,221
|
|
100.0
|
%
|
(1)
Total
carrying value excludes allowance for loan losses of $25.0 million.
The schedule above excludes equity securities
sold, not yet purchased, with a cost of $103.1 million and for which we
had accumulated net unrealized gains of $2.7 million as of December 31,
2007.
Corporate Loans
Our corporate loan portfolio totaled $8.8
billion as of June 30, 2008 and $8.7 billion as of December 31,
2007. 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 June 30, 2008, $8.6
billion, or 97.8%, of our corporate loan portfolio was floating rate and $0.2
billion, or 2.2%, was fixed rate. As of December 31,
2007, $8.6 billion, or 99.2%, our corporate loan portfolio was floating rate
and $0.1 billion, or 0.8%, was fixed rate.
All of our floating rate corporate loans have index reset frequencies
of less than twelve months with the majority resetting at least quarterly. The
weighted-average coupon on our floating rate corporate loans was 5.63% and
7.85% as of June 30, 2008 and December 31, 2007, respectively, and
the weighted-average coupon spread to London Interbank Offered Rates (LIBOR)
of our floating rate corporate loan portfolio was 2.88% and 2.87% as of June 30,
2008 and December 31, 2007, respectively. The weighted-average years to
maturity of our floating rate corporate loans was 5.3 years and 5.7 years as of
June 30, 2008 and December 31, 2007, respectively.
As of June 30, 2008, our fixed rate
corporate loans had a weighted-average coupon of 13.59% and a weighted-average
years to maturity of 5.9 years, as compared to 11.01% and 5.8 years,
respectively, as of December 31, 2007.
As of June 30, 2008 and December 31,
2007, there were no corporate loan balances placed on non-accrual status. We
evaluate and monitor the asset quality of our investment portfolio by
performing detailed credit reviews and by monitoring key credit statistics and
trends. The key credit statistics and trends we monitor to evaluate the quality
of our investments include credit ratings of both our investments and the
issuer, financial performance of the issuer including earnings trends, free
cash flows of the issuer, debt service coverage ratios of the issuer, financial
leverage of the issuer, and industry trends that have or may impact the
issuers current or future financial performance and debt service ability. As
of June 30, 2008, none of our corporate loan investments were delinquent
on principal or interest payments and none of the investments were in default
status. Our allowance for loan losses totaled $35.0 million and $25.0 million
as of June 30, 2008 and December 31, 2007, respectively. There were
no charge-offs and a $10.0 million provision for additional losses was recorded
during the quarter ended June 30, 2008.
We recorded a $2.6 million charge to earnings
during the quarter ended June 30, 2008 for the lower of cost or estimated
fair value adjustment for loans held for sale which had an estimated fair value
of $66.7 million as of June 30, 2008. We had no loans held for sale as of December 31,
2007.
37
The following table summarizes the par value
of our corporate loan portfolio stratified by Moodys Investors Service, Inc.
(Moodys) and Standard & Poors Ratings Services (Standard &
Poors) ratings category as of June 30, 2008 and December 31, 2007:
Corporate Loans
(Amounts
in thousands)
Ratings Category
|
|
As of
June 30, 2008
|
|
As of
December 31, 2007
|
|
Aaa/AAA
|
|
$
|
|
|
$
|
|
|
Aa1/AA+ through Aa3/AA
|
|
|
|
|
|
A1/A+ through A3/A
|
|
|
|
|
|
Baa1/BBB+ through Baa3/BBB
|
|
|
|
10,353
|
|
Ba1/BB+ through Ba3/BB
|
|
4,393,281
|
|
4,595,862
|
|
B1/B+ through B3/B
|
|
4,118,178
|
|
3,391,638
|
|
Caa1/CCC+ and lower
|
|
541,315
|
|
405,584
|
|
Non-rated
|
|
|
|
362,731
|
|
Total
|
|
$
|
9,052,774
|
|
$
|
8,766,168
|
|
Corporate Debt Securities
Our corporate debt securities portfolio
totaled $1.1 billion as of June 30, 2008 and $1.3 billion as of December 31,
2007. Our corporate debt securities portfolio consists of debt obligations of
corporations, partnerships and other entities in the form of senior secured and
subordinated notes. As of June 30, 2008, $0.9 billion, or 81.8%, of our
corporate debt securities portfolio was fixed rate and $0.2 billion, or 18.2%,
was floating rate. As of December 31,
2007, $1.1 billion, or 84.7%, of our corporate debt securities portfolio was
fixed rate and $0.2 billion, or 15.3%, was floating rate.
As of June 30, 2008, our fixed rate
corporate debt securities had a weighted-average coupon of 10.48% and a
weighted-average years to maturity of 7.3 years, as compared to 10.42% and 7.5
years, respectively, as of December 31, 2007.
All of our floating rate corporate debt securities
have index reset frequencies of less than twelve months. The weighted-average coupon on our floating
rate corporate debt securities was 6.00% and 8.39% as of June 30, 2008 and
December 31, 2007, respectively, and the weighted-average coupon spread to
LIBOR of our floating rate corporate debt securities was 3.29% and 3.28% as of June 30,
2008 and December 31, 2007, respectively. The weighted-average years to
maturity of our floating rate corporate debt securities was 5.2 years and 5.4
years as of June 30, 2008 and December 31, 2007, respectively.
We evaluate and monitor the asset quality of
our investment portfolio by performing detailed credit reviews and by
monitoring key credit statistics and trends. The key credit statistics and
trends we monitor to evaluate the quality of our investments include credit
ratings of both our investments and the issuer, financial performance of the
issuer including earnings trends, free cash flows of the issuer, debt service
coverage ratios of the issuer, financial leverage of the issuer, and industry
trends that have or may impact the issuers current or future financial
performance and debt service ability. As of June 30, 2008, none of our
investments in corporate debt securities were delinquent on principal or interest
payments and none of the investments were in default status.
The following table summarizes the par value
of our corporate debt securities portfolio stratified by Moodys and Standard &
Poors ratings category as of June 30, 2008 and December 31, 2007:
Corporate Debt Securities
(Amounts
in thousands)
Ratings Category
|
|
As of
June 30, 2008
|
|
As of
December 31, 2007
|
|
Aaa/AAA
|
|
$
|
|
|
$
|
|
|
Aa1/AA+ through Aa3/AA
|
|
|
|
|
|
A1/A+ through A3/A
|
|
|
|
|
|
Baa1/BBB+ through Baa3/BBB
|
|
|
|
|
|
Ba1/BB+ through Ba3/BB
|
|
206,500
|
|
236,553
|
|
B1/B+ through B3/B
|
|
490,531
|
|
431,478
|
|
Caa1/CCC+ and lower
|
|
595,747
|
|
772,315
|
|
Non-Rated
|
|
7,143
|
|
30,000
|
|
Total
|
|
$
|
1,299,921
|
|
$
|
1,470,346
|
|
Residential Mortgage Investment
Summary
Our residential mortgage investment portfolio
consists of investments in RMBS with an estimated fair value of $315.2 million
as of June 30, 2008. The $315.2 million of RMBS is comprised of $279.6 million
of RMBS that are rated investment grade or higher and $35.6 million of RMBS
that are related below investment grade. Of the $315.2 million of RMBS
investments we hold, $199.5 million are in six residential mortgage-backed
securitization trusts that are not structured as qualifying special-purpose
entities as defined by SFAS No. 140. Accordingly, as we own the first loss
securities in these trusts, we are deemed to be the primary beneficiary of
these entities and as such, consolidate these trusts in accordance with GAAP. This
results in us reflecting the financial position and results of these trusts in
our condensed consolidated financial statements. Consolidation of these six
entities does not impact our net assets or net income; however, it does result
in us showing the consolidated assets, liabilities, revenues and expenses on
our condensed consolidated financial statements. On our condensed consolidated
balance sheet as of June 30, 2008, the $315.2 million of RMBS is computed as
our investments in RMBS of $115.7 million, plus $199.5 million, which
represents the difference between residential mortgage loans of $3.4 billion
less residential mortgage-backed securities issued of $3.2 billion plus $8.9
million of real estate owned that is included in other assets on our condensed
consolidated balance sheet. The $315.2 million of RMBS as of June 30, 2008
represents a decrease of 6.6% from $337.6 million as of December 31, 2007.
38
As our condensed consolidated financial statements included in this
Form 10-Q are presented to reflect the consolidation of the aforementioned
residential mortgage securitization trusts, the information contained in this
Managements Discussion and Analysis of Financial Condition and Results of
Operations reflects our residential mortgage portfolio presented on a consolidated
basis consistent with the disclosures in our condensed consolidated financial
statements.
The tables below summarize the carrying
value, amortized cost, and estimated fair value of our residential mortgage
investments as of June 30, 2008 and December 31, 2007, classified by
interest rate type. Carrying value is the value that investments are recorded
on our condensed consolidated balance sheets and is estimated fair value for
residential mortgage-backed securities and residential mortgage loans.
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 residential
mortgage investment portfolio as of June 30, 2008 classified by interest
rate type:
Residential Mortgage Investment Portfolio
(Dollar
amounts in thousands)
|
|
Carrying
Value
|
|
Amortized
Cost
|
|
Estimated
Fair Value
|
|
Portfolio Mix
% by Fair Value
|
|
Floating Rate:
|
|
|
|
|
|
|
|
|
|
Residential Adjustable Rate Mortgage
(ARM) Loans
|
|
$
|
512,647
|
|
$
|
606,107
|
|
$
|
512,647
|
|
14.6
|
%
|
Residential ARM Securities
|
|
41,346
|
|
51,350
|
|
41,346
|
|
1.2
|
|
Total Floating Rate
|
|
553,993
|
|
657,457
|
|
553,993
|
|
15.8
|
|
Hybrid Rate:
|
|
|
|
|
|
|
|
|
|
Residential Hybrid ARM Loans
|
|
2,882,349
|
|
3,048,678
|
|
2,882,349
|
|
82.1
|
|
Residential Hybrid ARM Securities
|
|
74,306
|
|
83,186
|
|
74,306
|
|
2.1
|
|
Total Hybrid Rate
|
|
2,956,655
|
|
3,131,864
|
|
2,956,655
|
|
84.2
|
|
Total
|
|
$
|
3,510,648
|
|
$
|
3,789,321
|
|
$
|
3,510,648
|
|
100.0
|
%
|
The table below summarizes our residential
mortgage investment portfolio as of December 31, 2007 classified by
interest rate type:
Residential Mortgage Investment Portfolio
(Dollar amounts in thousands)
|
|
Carrying
Value
|
|
Amortized
Cost
|
|
Estimated
Fair Value
|
|
Portfolio Mix
% by Fair Value
|
|
Floating Rate:
|
|
|
|
|
|
|
|
|
|
Residential ARM Loans
|
|
$
|
628,745
|
|
$
|
667,000
|
|
$
|
628,745
|
|
15.5
|
%
|
Residential ARM Securities
|
|
51,964
|
|
55,930
|
|
51,964
|
|
1.3
|
|
Total Floating Rate
|
|
680,709
|
|
722,930
|
|
680,709
|
|
16.8
|
|
Hybrid Rate:
|
|
|
|
|
|
|
|
|
|
Residential Hybrid ARM Loans
|
|
3,292,578
|
|
3,374,696
|
|
3,292,578
|
|
81.2
|
|
Residential Hybrid ARM Securities
|
|
79,724
|
|
85,391
|
|
79,724
|
|
2.0
|
|
Total Hybrid Rate
|
|
3,372,302
|
|
3,460,087
|
|
3,372,302
|
|
83.2
|
|
Total
|
|
$
|
4,053,011
|
|
$
|
4,183,017
|
|
$
|
4,053,011
|
|
100.0
|
%
|
Residential
ARM Securities
Our residential ARM securities portfolio
totaled $41.3 million as of June 30, 2008 and $52.0 million as of December 31,
2007. As of June 30, 2008 and December 31,
2007, 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 11.35% and 11.36%,
respectively, which was materially above the then current weighted-average net
coupon of 6.27% and 7.03%, respectively.
Residential ARM Securities
(Amounts
in thousands)
Ratings Category
|
|
As of
June 30, 2008
|
|
As of
December 31, 2007
|
|
Aaa/AAA
|
|
$
|
26,935
|
|
$
|
34,960
|
|
Aa1/AA+ through Aa3/AA
|
|
|
|
|
|
A1/A+ through A3/A
|
|
6,169
|
|
7,326
|
|
Baa1/BBB+ through Baa3/BBB
|
|
4,177
|
|
4,466
|
|
Ba1/BB+ through Ba3/BB
|
|
1,780
|
|
2,049
|
|
B1/B+ through B3/B
|
|
1,156
|
|
1,196
|
|
Caa1/CCC+ and lower
|
|
|
|
|
|
Non-Rated
|
|
1,129
|
|
1,967
|
|
Total
|
|
$
|
41,346
|
|
$
|
51,964
|
|
39
Residential Hybrid ARM
Securities
Our residential hybrid ARM
securities portfolio totaled $74.3 million as of June 30, 2008 and
$79.7 million as of December 31, 2007. As of June 30, 2008 and December 31,
2007, all of our residential hybrid ARM securities had underlying mortgage
loans that were originated as 5/1 hybrid ARM loans. The weighted-average coupon
on the portfolio of residential hybrid securities was 4.19% and 4.18% as of June 30,
2008 and December 31, 2007, respectively. As of June 30, 2008 and December 31,
2007, our weighted-average months until roll date for the mortgage loans
underlying our residential hybrid ARM securities was 6 and 12, respectively.
Residential
Hybrid ARM Securities
(Amounts in
thousands)
Ratings Category
|
|
As of
June 30, 2008
|
|
As of
December 31, 2007
|
|
Aaa/AAA
|
|
$
|
20,715
|
|
$
|
23,083
|
|
Aa1/AA+ through Aa3/AA
|
|
25,624
|
|
26,756
|
|
A1/A+ through A3/A
|
|
14,760
|
|
14,898
|
|
Baa1/BBB+ through Baa3/BBB
|
|
6,127
|
|
9,002
|
|
Ba1/BB+ through Ba3/BB
|
|
3,022
|
|
2,915
|
|
B1/B+ through B3/B
|
|
1,520
|
|
1,356
|
|
Caa1/CCC+ and lower
|
|
|
|
|
|
Non-Rated
|
|
2,538
|
|
1,714
|
|
Total
|
|
$
|
74,306
|
|
$
|
79,724
|
|
Residential
ARM Loans
Our residential ARM loans portfolio totaled
$512.6 million as of June 30, 2008 and $628.7 million as of December 31,
2007. As of June 30, 2008 and December 31, 2007, 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 11.93% which was well above the then current weighted-average
net coupon of 3.98% and 6.19%, respectively.
Residential
Hybrid ARM Loans
Our residential hybrid ARM loans portfolio
totaled $2.9 billion as of June 30, 2008 and $3.3 billion as of December 31,
2007. As of June 30, 2008 and December 31, 2007, all of our
residential hybrid ARM loans were originated as either 3/1 or 5/1 hybrid ARM
loans. The weighted-average net coupon on the portfolio of residential hybrid
loans was 4.88% as of June 30, 2008 and December 31,
40
2007. As of June 30, 2008 and December 31, 2007, the weighted-average
months until roll date for the mortgage loans underlying our residential hybrid
ARM securities was 18 and 22, respectively.
Portfolio Purchases
We purchased $0.6 billion and
$1.3 billion par amount of investments during the three and six months
ended June 30, 2008, compared
to $2.6 billion and $2.9 billion for the three and six months ended June 30, 2007, respectively.
The table below summarizes our investment
portfolio purchases for the periods indicated and includes the par amount of
the securities and loans that were purchased:
Investment
Portfolio Purchases
(Dollar
amounts in thousands)
|
|
Three months ended
June 30, 2008
|
|
Three months ended
June 30, 2007
|
|
Six months ended
June 30, 2008
|
|
Six months ended
June 30, 2007
|
|
|
|
Par Amount
|
|
%
|
|
Par Amount
|
|
%
|
|
Par Amount
|
|
%
|
|
Par Amount
|
|
%
|
|
Securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporate Debt Securities
|
|
$
|
83,747
|
|
14.8
|
%
|
$
|
724,000
|
|
28.3
|
%
|
$
|
126,747
|
|
9.7
|
%
|
$
|
758,000
|
|
26.1
|
%
|
Marketable Equity Securities
|
|
4,969
|
|
0.9
|
|
22,906
|
|
0.9
|
|
6,496
|
|
0.5
|
|
40,634
|
|
1.4
|
|
Non-Marketable Equity Securities
|
|
|
|
|
|
|
|
|
|
|
|
|
|
7,500
|
|
0.2
|
|
Total Securities Principal Balance
|
|
88,716
|
|
15.7
|
|
746,906
|
|
29.2
|
|
133,243
|
|
10.2
|
|
806,134
|
|
27.7
|
|
Loans:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporate Loans
|
|
476,680
|
|
84.3
|
|
1,814,145
|
|
70.8
|
|
1,171,253
|
|
89.8
|
|
2,101,831
|
|
72.3
|
|
Grand Total Principal Balance
|
|
$
|
565,396
|
|
100.0
|
%
|
$
|
2,561,051
|
|
100.0
|
%
|
$
|
1,304,496
|
|
100.0
|
%
|
$
|
2,907,965
|
|
100.0
|
%
|
The schedule above excludes equity securities
sold, not yet purchased, with a cost of $27.2 million as of June 30, 2008.
There were no equity securities sold, not yet purchased as of June 30,
2007.
Discontinued Operations
Summarized financial information for
discontinued operations is as follows (amounts in thousands):
|
|
As of
June 30, 2008
|
|
As of
December 31, 2007
|
|
Assets of discontinued operations
|
|
$
|
|
|
$
|
3,049,758
|
|
Liabilities of discontinued operations
|
|
$
|
|
|
$
|
3,644,083
|
|
(Loss) income from discontinued operations is
as follows (amounts in thousands):
|
|
Three months ended
|
|
Three months ended
|
|
Six months ended
|
|
Six months ended
|
|
|
|
June 30, 2008
|
|
June 30, 2007
|
|
June 30, 2008
|
|
June 30, 2007
|
|
(Loss) income from discontinued operations
|
|
$
|
(1,079
|
)
|
$
|
(15,544
|
)
|
$
|
2,668
|
|
$
|
(2,951
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Shareholders Equity
Our shareholders equity at June 30, 2008 and December 31,
2007 totaled $1.9 billion and $1.6 billion, respectively. Included in our
shareholders equity as of June 30,
2008 and December 31, 2007, was accumulated other comprehensive loss
totaling $202.6 million and $157.2 million, respectively.
41
Our average shareholders equity and return
on average shareholders equity for the three and six months ended June 30, 2008 was $1.9 billion
and 8.0% and $1.7 billion and 6.0%, respectively. Our average shareholders
equity and return on average shareholders equity for the three and six months
ended June 30, 2007 was $1.7 billion and 12.4% and $1.7 billion and 11.9%,
respectively. Return on average shareholders equity is defined as net income
divided by weighted-average shareholders equity. Our book value per share as
of June 30, 2008 and December 31,
2007 was $12.71 and $14.27, respectively, and is computed based on 150,843,151
and 115,248,990 shares issued and outstanding as of June 30, 2008 and December 31, 2007, respectively.
On August 7, 2008, our board of
directors declared a cash distribution for the quarter ended June 30, 2008 on our common shares
of $0.40 per share. The distribution is payable on August 29, 2008 to
shareholders of record as of the close of business on August 15, 2008.
Liquidity and Capital Resources
We manage our liquidity with the intention of
maintaining the continuing ability to fund our operations and fulfill our
commitments on a timely and cost-effective basis. Based on changes in our
working capital, for any given period the cash flows provided by operating
activities may be less than the cumulative distributions paid on our shares for
such period and such shortfall, if any, may be funded through the issuance of
unsecured indebtedness or through the borrowing of additional amounts through
the pledging of certain of our assets. Our board of directors considers available
liquidity when declaring distributions to shareholders. As of June 30, 2008, we had unrestricted
cash and cash equivalents totaling $189.0 million.
We believe that our liquidity level and
access to additional financing are 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, distributions to our
shareholders and implementing our long-term business strategy, although there
can be no assurance in this regard. As of June 30, 2008, we owed our
Manager $5.4 million for the payment of management fees, collateral
management fees and reimbursable expenses pursuant to the Management Agreement.
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
shares and one or more classes of preferred shares), 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 acceptable terms, it may have an
adverse effect on our business and results of operations and our ability to
make distributions to shareholders. Upon liquidation, holders of our debt
securities and lenders with respect to other borrowings will receive, and any
holders of preferred shares that we may issue in the future may receive, a
distribution of our available assets prior to holders of our common shares. 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.
Sources of Funds
Common Share Offering
On April 8, 2008, we completed a public offering of
34.5 million common shares at a price of $11.85 per common share. Net
proceeds from the transaction before expenses totaled $384.3 million,
which we will use for general corporate purposes.
Repurchase Agreements
As of June 30,
2008, we had nil outstanding on repurchase facilities. Because we borrow under
repurchase agreements based on the estimated fair value of our pledged
investments and 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.
42
Secured Credit Facility
On December 14, 2007, we amended our
Second Amended and Restated Credit Agreement, dated May 4, 2007, with Bank
of America, N.A., as Administrative Agent and the lender parties thereto, and
TRS Ltd., KFH II, KFH III, KKR Financial Holdings, Inc. and KKR
Financial Holdings, Ltd. The amendment decreased the size of the credit
facility from $800.0 million to $500.0 million. Outstanding
borrowings under the credit facility bear interest at either (a) an
interest rate per annum equal to the LIBOR rate for the applicable interest
period plus 0.825% for borrowings under tranche A of the facility and
1.075% for borrowings under tranche B of the facility or (b) an
alternate base rate per annum equal to the greater of (i) the prime rate
in effect on such day and (ii) the federal funds rate in effect on such
day plus 0.50%. In addition, pursuant to this amendment our financial covenants
were amended to now require that we:
·
maintain adjusted
consolidated tangible net worth of at least $1.437 billion plus an amount
equal to 85% of the net proceeds, subject to certain exceptions, from the
issuance of equity interests (as defined in the amendment) subsequent to September 30,
2007;
·
not permit our adjusted net
income from continuing operations (as defined in the amendment) to be less than
$1.00 for any quarter; and
·
not exceed a leverage ratio
(as defined in the amendment) of 4.75 to 1.0, computed on a basis that
generally excludes debt of discontinued operations.
Junior
Subordinated Notes
In the second quarter of 2008, we retired
$35.0 million of junior subordinated notes, which resulted in a gain on
extinguishment of $17.2 million, partially offset by a $1.1 million write-off
of debt issuance costs and $0.7 million of other associated costs.
Capital Utilization and Leverage
As of June 30,
2008 and December 31, 2007, we had shareholders equity totaling $1.9
billion and $1.6 billion, respectively and our leverage was 4.8 times and
6.2 times equity, respectively.
Off-Balance Sheet Commitments
As of June 30,
2008, we had committed to purchase corporate loans with aggregate commitments
totaling $253.5 million. In a typical 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.
We participate in certain financing
arrangements, including revolvers and delayed draw facilities, whereby we are
committed to provide funding at the discretion of the borrower up to a specific
predetermined amount. As of June 30,
2008, we had unfunded financing commitments totaling $128.3 million.
Partnership
Tax
Matters
As
of
June
30,
2008, we believe that the
Company continued to qualify as a partnership,
and
not
as
an association
or publicly traded partnership taxable as
a
corporation,
for U.S. federal income
tax purposes. In general, if a partnership is
publicly traded
(as
defined in the Code), it
will
be
treated as a
corporation
for
U.S.
federal income tax purposes.
A
publicly traded partnership will,
however, be taxed as
a
partnership,
and not as a corporation, for
U.S.
federal income tax
purposes
,
so
long
as
it
is
not required to
register under the Investment Company Act and at least
90%
of its gross
income for each taxable year constitutes qualifying income within the meaning
of
Section 7704(d)
of
the Code. We
refer to this exception
as
the qualifying income
exception.
Qualifying income generally
includes rents, dividends, interest (to the extent such interest is
neither
derived
from
the conduct
of a
financial or
insurance business nor based, directly or
indirectly
,
upon income or profits of
any person), and capital gains
from
the sale or
other
disposition
of stocks, bonds and real property. Qualifying income
also includes other income
derived
from
the business of
investing in, among other things, stocks and securities. However,
the
sections
of
the
Code and the
corresponding
U.S.
Treasury Regulations that
relate to the
qualifying income exception are highly
technical and complex, and the Companys satisfaction
of
the qualifying
income exception will depend upon its actual annual operating results.
Accordingly, no assurance
can be given that the
Company
has operated, or will continue to
operate, in
a
manner
so
as to satisfy
the
qualifying
income exception.
43
Exemption from Regulation under the Investment Company
Act
We intend to conduct our operations so that
we are not required to register as an investment company under the Investment
Company Act. Section 3(a)(l)(C) of the Investment Company Act defines
as an investment company any issuer that is engaged or proposes to engage in
the business of investing, reinvesting, owning, holding or trading in
securities and owns or proposes to acquire investment securities having a value
exceeding 40% of the value of the issuers total assets (exclusive of U.S.
government securities and cash items) on an unconsolidated basis. Excluded from
the term investment securities, among other things, are securities issued by
majority-owned subsidiaries that are not themselves investment companies and
are not relying on the exception from the definition of an investment company
set forth in Section 3(c)(l) or Section 3(c)(7) of the
Investment Company Act.
After the Restructuring Transaction, we were
organized as a holding company that conducts its businesses primarily through
majority-owned subsidiaries. As a result, the securities issued to us by our
subsidiaries that are excepted from the definition of an investment company
by Section 3(c)(l) or 3(c)(7) of the Investment Company Act,
together with any other investment securities we may own, may not have a
combined value in excess of 40% of the value of our total assets on an
unconsolidated basis. The determination of whether an entity is a
majority-owned subsidiary of ours is made by us. The Investment Company Act
defines a majority-owned subsidiary of a person as a company 50% or more of the
outstanding voting securities of which are owned by such person, or by another
company which is a majority-owned subsidiary of such person. The Investment
Company Act further defines voting securities as any security presently
entitling the owner or holder thereof to vote for the election of directors of
a company. We treat companies, including CLO issuers, in which we own at least
a majority of the outstanding voting securities as majority-owned subsidiaries
for purposes of the 40% test.
Our subsidiaries that issue CLOs generally
will rely on Rule 3a-7, an exemption from the Investment Company Act
provided for certain structured financing vehicles. Accordingly, each of our
CLO subsidiaries that rely on Rule 3a-7 is subject to specific guidelines
and restrictions, including a prohibition on the CLO issuers from acquiring and
disposing of assets primarily for the purposes of recognizing gains or
decreasing losses resulting from market value changes. Certain sales and
purchases of assets may be made so long as the CLOs do not violate our
guidelines and are not based primarily on the changes in market value. We can,
however, sell assets without limitation if we believe the credit profile of the
obligor will deteriorate. The proceeds of permitted dispositions may be
reinvested in collateral that is consistent with the credit profile of the CLO
under specific and predetermined guidelines.
In addition, the combined value of the
investment securities issued by our subsidiaries that are excepted by Section 3(c)(1) or
3(c)(7) of the Investment Company Act, together with any other investment
securities we may own, may not exceed 40% of the value of our total assets on
an unconsolidated basis. This requirement limits the types of businesses in
which we may engage through these subsidiaries.
To the extent that the SEC provides more
specific or different guidance regarding the application of Rule 3a-7 of
the Investment Company Act, we may be required to adjust our investment
strategy accordingly. Any additional guidance from the SEC could provide
additional flexibility to us, or it could further inhibit our ability to pursue
the investment strategy we have chosen, which could have a material adverse
effect on our operations.
Quantitative and Qualitative Disclosures About Market
Risk
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.
Liquidity Risk
Liquidity risk is defined as the risk that we
will be unable to fulfill our obligations on a timely basis, continuously
borrow funds in the market on a cost-effective basis to fund actual or proposed
commitments, or liquidate assets when needed at a reasonable price.
44
A material event that impacts capital markets
participants may 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
shares and one or more classes of preferred shares), 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 acceptable terms, it may have an
adverse effect on our business and results of operations and our ability to
make distributions to shareholders. Upon liquidation, holders of our debt
securities and lenders with respect to other borrowings will receive, and any
holders of preferred shares that we may issue in the future may receive, a
distribution of our available assets prior to holders of our common shares. 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.
We have established a formal liquidity
contingency plan which provides guidelines for liquidity management. We determine
our current liquidity position and forecast liquidity based on anticipated
changes in the balance sheet. We also stress test our liquidity position under
several different stress scenarios. A stress test aims at capturing the impact
of extreme (but rare) market rate changes on the market value of equity and net
interest income. This scenario is applied on a daily basis to our balance sheet
and the resulting loss in cash is evaluated. Besides providing a measure of the
potential loss under the extreme scenario, this technique enables us to
identify the nature of the changes in market risk factors to which it is the
most sensitive, allowing us to take appropriate action to address those risk
factors.
Credit Spread Exposure
Our investments are subject to spread risk.
Our investments in floating rate loans and securities are valued based on a
market credit spread over LIBOR and are affected similarly by changes in LIBOR
spreads. Our investments in fixed rate loans and securities are valued based on
a market credit spread over the rate payable on fixed rate U.S. Treasuries of
like maturity. Increased credit spreads, or credit spread widening, will have
an adverse impact on the value of our investments while decreased credit
spreads, or credit spread tightening, will have a positive impact on the value
of our investments.
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. Interest rates on 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. 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 generally 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.
45
The following table summarizes the estimated
net fair value of our derivative instruments held at June 30, 2008 and December 31, 2007 (amounts in
thousands):
Derivative
Fair Value
|
|
As of
June 30, 2008
|
|
As of
December 31, 2007
|
|
|
|
Notional
|
|
Estimated
Fair Value
|
|
Notional
|
|
Estimated
Fair Value
|
|
Cash Flow Hedges:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
$
|
383,333
|
|
$
|
(19,282
|
)
|
$
|
383,333
|
|
$
|
(19,018
|
)
|
Fair Value Hedges:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
32,000
|
|
(1,219
|
)
|
32,000
|
|
(1,212
|
)
|
Free-Standing Derivatives:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
188,820
|
|
709
|
|
690,799
|
|
(7,959
|
)
|
Credit default swapslong
|
|
103,500
|
|
(1,733
|
)
|
66,000
|
|
(1,154
|
)
|
Credit default swapsshort
|
|
196,820
|
|
21,386
|
|
268,000
|
|
12,613
|
|
Total rate of return swaps
|
|
477,877
|
|
(88,256
|
)
|
442,204
|
|
(21,998
|
)
|
Foreign exchange contracts
|
|
26,702
|
|
(140
|
)
|
9,711
|
|
3
|
|
Common stock warrants
|
|
|
|
91
|
|
|
|
799
|
|
Total
|
|
$
|
1,409,052
|
|
$
|
(88,444
|
)
|
$
|
1,892,047
|
|
$
|
(37,926
|
)
|
Item 3.
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 Managements Discussion and Analysis of Financial
Condition and Results of Operations.
Item 4.
Controls and Procedures
The Companys management
evaluated, with the participation of the Companys principal executive and
principal financial officer, the effectiveness of the Companys disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under
the Securities Exchange Act of 1934, as amended (the Exchange Act)) as of June 30,
2008. Based on their evaluation, the Companys principal executive and
principal financial officer concluded that the Companys disclosure controls
and procedures as of
June 30,
2008 were designed and were functioning
effectively to provide reasonable assurance that the information required to be
disclosed by the Company in reports filed under the Exchange Act is (i) recorded,
processed, summarized, and reported within the time periods specified in the
SECs rules and forms, and (ii) accumulated and communicated to
management, including the principal executive and principal financial officers,
as appropriate, to allow timely decisions regarding disclosure.
There has been no change in the
Companys internal control over financial reporting (as defined in Rules 13a-15(f) and
15d-15(f) under the Exchange Act) that occurred during the Companys three
and six months ending June 30, 2008, that has materially affected, or is
reasonably likely to materially affect, the Companys internal control over
financial reporting.
PART II.
OTHER INFORMATION
Item 1.
Legal
Proceedings
None.
Item 1A.
Risk
Factors
There have been no material
changes in our risk factors from those disclosed in our Annual Report on Form 10-K
for the year ended December 31, 2007.
Item 2
.
Unregistered Sales of Equity
Securities and Use of Proceeds
None.
Item 3.
Defaults
Upon Senior Securities
None.
Item 4.
Submission
of Matters to a Vote of Security Holders
46
Our 2008 annual
meeting of the shareholders was held on May 1, 2008. A total of 94,530,468
of our shares were present or voted by proxy at the meeting. This represented
more than 81% of the total number of voting rights outstanding and entitled to
vote at the annual meeting. The following matters were voted upon and received
the votes as set forth below:
1. Shareholders elected
eleven directors to one-year terms that will expire at the annual meeting of
the shareholders in 2009.
The vote tabulation for
individual directors was:
DIRECTOR
|
|
FOR
|
|
WITHHELD
|
|
William F. Aldinger
|
|
91,759,391
|
|
2,771,077
|
|
Tracy L. Collins
|
|
92,712,122
|
|
1,818,346
|
|
Saturnino S. Fanlo
|
|
92,907,037
|
|
1,623,431
|
|
V. Paul Finigan
|
|
93,013,334
|
|
1,517,134
|
|
Paul M. Hazen
|
|
93,029,341
|
|
1,501,127
|
|
R. Glenn Hubbard
|
|
91,755,960
|
|
2,774,508
|
|
Ross J. Kari
|
|
93,030,529
|
|
1,499,939
|
|
Ely L. Licht
|
|
91,858,135
|
|
2,672,333
|
|
Deborah H. McAneny
|
|
93,022,422
|
|
1,508,046
|
|
Scott C. Nuttall
|
|
92,925,000
|
|
1,605,468
|
|
Willy R. Strothotte
|
|
93,009,872
|
|
1,520,596
|
|
2. The election of
Deloitte & Touche LLP as our independent registered public accounting
firm for the year ending December 31, 2008 was ratified with 93,068,524
shares voting for, 734,030 shares voting against, 727,914 shares abstaining and
no broker non-votes.
Item 5.
Other
Information
None.
Item 6.
Exhibits
31.1
|
|
Chief Executive Officer Certification
|
31.2
|
|
Chief Financial Officer Certification
|
32
|
|
Certification Pursuant to 18 U.S.C. Section 1350
|
47
SIGNATURES
Pursuant
to the requirements of the Securities Exchange Act of 1934, KKR Financial
Holdings LLC has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
|
|
KKR Financial Holdings LLC
|
|
|
|
Signature
|
|
Title
|
|
|
|
/s/ SATURNINO S. FANLO
|
|
Chief Executive Officer (Principal Executive Officer)
|
Saturnino S. Fanlo
|
|
|
|
|
|
/s/
JEFFREY B. VAN HORN
|
|
Chief Financial Officer (Principal Financial and Accounting Officer)
|
Jeffrey B. Van Horn
|
|
|
|
|
|
Date: August 7, 2008
|
|
|
48
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