Table of Contents
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 September 30,
2008
|
|
or
|
|
o
|
TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
|
|
For the transition period
from to
|
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
|
|
94104
|
(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 October 21, 2008 was 150,881,500.
Table of Contents
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
September
30
, 2008
|
|
As of
December 31, 2007
|
|
Assets
|
|
|
|
|
|
Cash and cash equivalents
|
|
$
|
196,526
|
|
$
|
524,080
|
|
Restricted cash and cash equivalents
|
|
855,791
|
|
1,067,797
|
|
Securities available-for-sale, $1,008,104
and $1,346,247 pledged as collateral as of September 30, 2008 and December 31, 2007, respectively
|
|
1,023,276
|
|
1,359,541
|
|
Corporate loans, net of allowance for loan
losses of $35,000 and $25,000 as of September
30, 2008 and December 31, 2007, respectively
|
|
8,458,531
|
|
8,634,208
|
|
Residential mortgage-backed securities, at
estimated fair value, $71,509 and $117,833 pledged as collateral as of September
30, 2008 and December 31, 2007, respectively
|
|
112,980
|
|
131,688
|
|
Residential mortgage loans, at estimated
fair value
|
|
3,054,756
|
|
3,921,323
|
|
Corporate loans held for sale
|
|
28,201
|
|
|
|
Derivative assets
|
|
51,235
|
|
18,737
|
|
Interest and principal receivable
|
|
115,005
|
|
162,465
|
|
Non-marketable equity securities
|
|
17,505
|
|
20,084
|
|
Reverse repurchase agreements
|
|
27,645
|
|
69,840
|
|
Other assets
|
|
75,998
|
|
86,504
|
|
Assets of discontinued operations
|
|
|
|
3,049,758
|
|
Total assets
|
|
$
|
14,017,449
|
|
$
|
19,046,025
|
|
Liabilities
|
|
|
|
|
|
Repurchase agreements
|
|
$
|
|
|
$
|
2,808,066
|
|
Collateralized loan obligation senior
secured notes
|
|
7,549,672
|
|
5,948,610
|
|
Collateralized loan obligation junior
secured notes to affiliates
|
|
525,420
|
|
525,420
|
|
Secured revolving credit facility
|
|
378,306
|
|
167,024
|
|
Secured demand loan
|
|
|
|
24,151
|
|
Convertible senior notes
|
|
300,000
|
|
300,000
|
|
Junior subordinated notes
|
|
288,671
|
|
329,908
|
|
Subordinated notes to affiliates
|
|
84,000
|
|
152,574
|
|
Residential mortgage-backed securities
issued, at estimated fair value
|
|
2,868,232
|
|
3,169,353
|
|
Accounts payable, accrued expenses and
other liabilities
|
|
27,821
|
|
7,390
|
|
Accrued interest payable
|
|
56,901
|
|
114,035
|
|
Accrued interest payable to affiliates
|
|
36,317
|
|
44,121
|
|
Related party payable
|
|
5,071
|
|
9,694
|
|
Securities sold, not yet purchased
|
|
83,507
|
|
100,394
|
|
Derivative liabilities
|
|
82,968
|
|
56,663
|
|
Liabilities of discontinued operations
|
|
|
|
3,644,083
|
|
Total liabilities
|
|
12,286,886
|
|
17,401,486
|
|
Shareholders Equity
|
|
|
|
|
|
Preferred shares, no par value, 50,000,000
shares authorized and none issued and outstanding at September 30, 2008 and December 31, 2007
|
|
|
|
|
|
Common shares, no par value, 250,000,000
shares authorized, and 150,881,500 and 115,248,990 shares issued and
outstanding at September 30,
2008 and December 31, 2007, respectively
|
|
|
|
|
|
Paid-in-capital
|
|
2,551,634
|
|
2,167,156
|
|
Accumulated other comprehensive loss
|
|
(377,924
|
)
|
(157,245
|
)
|
Accumulated deficit
|
|
(443,147
|
)
|
(365,372
|
)
|
Total shareholders equity
|
|
1,730,563
|
|
1,644,539
|
|
Total liabilities and shareholders equity
|
|
$
|
14,017,449
|
|
$
|
19,046,025
|
|
See notes to
condensed consolidated financial statements.
3
Table of Contents
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 nine
|
|
For the nine
|
|
|
|
months ended
|
|
months ended
|
|
months ended
|
|
months ended
|
|
|
|
September 30, 2008
|
|
September 30, 2007
|
|
September 30, 2008
|
|
September 30, 2007
|
|
Net investment income:
|
|
|
|
|
|
|
|
|
|
Securities interest income
|
|
$
|
34,507
|
|
$
|
37,725
|
|
$
|
109,104
|
|
$
|
87,661
|
|
Loan interest income
|
|
187,756
|
|
190,471
|
|
588,843
|
|
468,283
|
|
Dividend income
|
|
358
|
|
782
|
|
2,266
|
|
2,722
|
|
Other interest income
|
|
4,431
|
|
11,850
|
|
20,505
|
|
20,100
|
|
Total investment income
|
|
227,052
|
|
240,828
|
|
720,718
|
|
578,766
|
|
Interest expense
|
|
(118,105
|
)
|
(145,058
|
)
|
(400,207
|
)
|
(381,107
|
)
|
Interest expense to affiliates
|
|
(18,794
|
)
|
(21,148
|
)
|
(66,319
|
)
|
(29,404
|
)
|
Provision for loan losses
|
|
|
|
(25,000
|
)
|
(10,000
|
)
|
(25,000
|
)
|
Net investment income
|
|
90,153
|
|
49,622
|
|
244,192
|
|
143,255
|
|
Other (loss) income:
|
|
|
|
|
|
|
|
|
|
Net realized and unrealized loss on
derivatives and foreign exchange
|
|
(15,534
|
)
|
(16,042
|
)
|
(68,468
|
)
|
(2,422
|
)
|
Net realized and unrealized (loss) gain on
investments
|
|
(28,278
|
)
|
53,400
|
|
(59,254
|
)
|
87,164
|
|
Net realized and unrealized gain (loss) on residential
mortgage-backed securities, residential mortgage loans, and residential
mortgage-backed securities issued, carried at estimated fair value
|
|
121
|
|
(39,286
|
)
|
(14,651
|
)
|
(40,978
|
)
|
Net realized and unrealized gain on securities
sold, not yet purchased
|
|
14,242
|
|
2,220
|
|
22,892
|
|
2,795
|
|
Gain on extinguishment of debt
|
|
3,056
|
|
|
|
20,281
|
|
|
|
Other income
|
|
2,470
|
|
2,760
|
|
7,939
|
|
7,347
|
|
Total other (loss) income
|
|
(23,923
|
)
|
3,052
|
|
(91,261
|
)
|
53,906
|
|
Non-investment expenses:
|
|
|
|
|
|
|
|
|
|
Related party management compensation
|
|
9,811
|
|
4,925
|
|
29,357
|
|
39,338
|
|
General, administrative and directors
expenses
|
|
3,820
|
|
3,842
|
|
14,094
|
|
14,095
|
|
Professional services
|
|
1,335
|
|
2,194
|
|
4,263
|
|
3,495
|
|
Loan servicing
|
|
2,274
|
|
2,729
|
|
7,234
|
|
8,751
|
|
Total non-investment expenses
|
|
17,240
|
|
13,690
|
|
54,948
|
|
65,679
|
|
Income from continuing operations before
equity in income of unconsolidated affiliate and income tax expense
|
|
48,990
|
|
38,984
|
|
97,983
|
|
131,482
|
|
Equity in income of unconsolidated
affiliate
|
|
|
|
|
|
|
|
12,706
|
|
Income from continuing operations before
income tax expense
|
|
48,990
|
|
38,984
|
|
97,983
|
|
144,188
|
|
Income tax expense
|
|
|
|
(386
|
)
|
(116
|
)
|
(1,245
|
)
|
Income from continuing operations
|
|
48,990
|
|
38,598
|
|
97,867
|
|
142,943
|
|
Income (loss) from discontinued operations
|
|
|
|
(300,105
|
)
|
2,668
|
|
(303,055
|
)
|
Net income (loss)
|
|
$
|
48,990
|
|
$
|
(261,507
|
)
|
$
|
100,535
|
|
$
|
(160,112
|
)
|
|
|
|
|
|
|
|
|
|
|
Net income per common share:
|
|
|
|
|
|
|
|
|
|
Basic
|
|
|
|
|
|
|
|
|
|
Income per share from continuing operations
|
|
$
|
0.33
|
|
$
|
0.44
|
|
$
|
0.72
|
|
$
|
1.75
|
|
Income (loss) per share from discontinued
operations
|
|
|
|
|
|
(3.43
|
)
|
|
0.02
|
|
|
(3.71
|
)
|
Net income (loss) per share
|
|
$
|
0.33
|
|
$
|
(2.99
|
)
|
$
|
0.74
|
|
$
|
(1.96
|
)
|
Diluted
|
|
|
|
|
|
|
|
|
|
Income per share from continuing operations
|
|
$
|
0.33
|
|
$
|
0.44
|
|
$
|
0.71
|
|
$
|
1.73
|
|
Income (loss) per share from discontinued
operations
|
|
|
|
|
|
(3.42
|
)
|
|
0.02
|
|
|
(3.66
|
)
|
Net income (loss) per share
|
|
$
|
0.33
|
|
$
|
(2.98
|
)
|
$
|
0.73
|
|
$
|
(1.93
|
)
|
|
|
|
|
|
|
|
|
|
|
Weighted-average number of common shares
outstanding:
|
|
|
|
|
|
|
|
|
|
Basic
|
|
149,612
|
|
87,443
|
|
136,777
|
|
81,692
|
|
Diluted
|
|
149,883
|
|
87,696
|
|
137,319
|
|
82,747
|
|
|
|
|
|
|
|
|
|
|
|
Distributions declared per common share
|
|
$
|
0.40
|
|
$
|
0.56
|
|
$
|
1.30
|
|
$
|
1.66
|
|
See notes to
condensed consolidated financial statements.
4
Table
of Contents
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
Loss
|
|
Total
Shareholders
Equity
|
|
Balance at January 1, 2008
|
|
115,249
|
|
$
|
2,167,156
|
|
$
|
(157,245
|
)
|
$
|
(365,372
|
)
|
|
|
$
|
1,644,539
|
|
Net income
|
|
|
|
|
|
|
|
100,535
|
|
$
|
100,535
|
|
100,535
|
|
Net change in unrealized loss on cash flow
hedges
|
|
|
|
|
|
(4,101
|
)
|
|
|
(4,101
|
)
|
(4,101
|
)
|
Net change in unrealized loss on securities
available-for-sale
|
|
|
|
|
|
(216,578
|
)
|
|
|
(216,578
|
)
|
(216,578
|
)
|
Comprehensive loss
|
|
|
|
|
|
|
|
|
|
$
|
(120,144
|
)
|
|
|
Cash distributions on common shares
|
|
|
|
|
|
|
|
(178,310
|
)
|
|
|
(178,310
|
)
|
Cancellation of restricted common shares
|
|
(3
|
)
|
|
|
|
|
|
|
|
|
|
|
Grant of restricted common shares
|
|
1,135
|
|
|
|
|
|
|
|
|
|
|
|
Proceeds from issuance of common shares,
net of offering costs
|
|
34,500
|
|
383,519
|
|
|
|
|
|
|
|
383,519
|
|
Amortization of restricted common shares
|
|
|
|
959
|
|
|
|
|
|
|
|
959
|
|
Balance at September 30, 2008
|
|
150,881
|
|
$
|
2,551,634
|
|
$
|
(377,924
|
)
|
$
|
(443,147
|
)
|
|
|
$
|
1,730,563
|
|
See notes to condensed
consolidated financial statements.
5
Table
of Contents
KKR Financial Holdings LLC and Subsidiaries
Condensed
Consolidated Statements of Cash Flows
(Unaudited)
(Amounts in thousands)
|
|
For the nine
months ended
September 30, 2008
|
|
For the nine
months ended
September 30, 2007
|
|
Cash flows from operating activities:
|
|
|
|
|
|
Net income
(loss)
|
|
$
|
100,535
|
|
|
(160,112
|
)
|
Adjustments to reconcile net income (loss)
to net cash provided by operating activities:
|
|
|
|
|
|
Net realized and unrealized loss (gain) on
derivatives, foreign exchange, and securities sold, not yet purchased
|
|
45,576
|
|
(24,722
|
)
|
Gain on extinguishment of debt
|
|
(20,281
|
)
|
|
|
Write-off of unamortized debt issuance
costs
|
|
1,224
|
|
2,247
|
|
Lower of cost or estimated fair value
adjustment on corporate loans held for sale and provision for loan losses
|
|
12,353
|
|
25,000
|
|
Impairment of securities available-for-sale
|
|
20,254
|
|
|
|
Share-based compensation
|
|
959
|
|
2,289
|
|
Net unrealized (gain) loss on residential mortgage-backed
securities, residential mortgage loans, and liabilities at estimated fair
value
|
|
(7,568
|
)
|
183,011
|
|
Net realized loss (gain) on sales of
investments
|
|
39,735
|
|
(43,565
|
)
|
Depreciation and net amortization
|
|
(26,043
|
)
|
3,948
|
|
Equity in income of unconsolidated
affiliate
|
|
|
|
(12,706
|
)
|
Changes in assets and liabilities:
|
|
|
|
|
|
Interest receivable
|
|
32,617
|
|
(31,785
|
)
|
Other assets
|
|
(11,897
|
)
|
(16,237
|
)
|
Related party payable
|
|
(4,623
|
)
|
(1,923
|
)
|
Accounts payable, accrued expenses and
other liabilities
|
|
(27,965
|
)
|
116,136
|
|
Accrued interest payable
|
|
(57,656
|
)
|
29,404
|
|
Accrued interest payable to affiliates
|
|
17,556
|
|
29,004
|
|
Income tax liability
|
|
12
|
|
|
|
Net cash provided by operating activities
|
|
114,788
|
|
99,989
|
|
Cash flows from investing activities:
|
|
|
|
|
|
Principal payments from investments
|
|
1,307,765
|
|
2,973,566
|
|
Proceeds from sale of investments
|
|
1,415,574
|
|
3,125,000
|
|
Purchases of investments
|
|
(1,818,037
|
)
|
(4,342,073
|
)
|
Net proceeds, purchases, and settlements of
derivatives
|
|
(52,811
|
)
|
40,570
|
|
Net change in reverse repurchase agreements
|
|
42,195
|
|
(34,660
|
)
|
Net additions (reductions) to restricted
cash and cash equivalents
|
|
212,359
|
|
(502,324
|
)
|
Restricted cash and cash equivalents
acquired due to consolidation of KKR Financial CLO 2007-1, Ltd.
|
|
|
|
57,104
|
|
Additions of leasehold improvements and
equipment
|
|
|
|
(244
|
)
|
Investment in unconsolidated affiliate
|
|
|
|
(60,327
|
)
|
Net cash provided by investing activities
|
|
1,107,045
|
|
1,256,612
|
|
Cash flows from financing activities:
|
|
|
|
|
|
Net change in repurchase agreements,
secured revolving credit facility, and secured demand loan
|
|
(2,620,935
|
)
|
(3,675,629
|
)
|
Net change in asset-backed secured
liquidity notes
|
|
(136,596
|
)
|
(3,736,390
|
)
|
Proceeds from issuance of residential
mortgage-backed securities issued
|
|
|
|
3,319,547
|
|
Repayment of residential mortgage-backed
securities issued
|
|
(531,601
|
)
|
(99,323
|
)
|
Issuance of collateralized loan obligation
senior secured notes
|
|
1,600,000
|
|
2,426,778
|
|
Net change in collateralized loan
obligation junior secured notes to affiliates
|
|
|
|
262,103
|
|
Issuance of convertible senior notes
|
|
|
|
300,000
|
|
Net change in junior subordinated notes
|
|
(20,956
|
)
|
70,000
|
|
Net change
in subordinated notes to affiliates
|
|
(43,880
|
)
|
131,417
|
|
Net proceeds from common share offering
|
|
383,519
|
|
437,675
|
|
Distributions on common shares
|
|
(178,310
|
)
|
(133,590
|
)
|
Other capitalized costs
|
|
(628
|
)
|
(19,911
|
)
|
Net cash used in financing activities
|
|
(1,549,387
|
)
|
(717,323
|
)
|
Net (decrease) increase in cash and cash
equivalents
|
|
(327,554
|
)
|
639,278
|
|
Cash and cash equivalents at beginning of
period
|
|
524,080
|
|
5,125
|
|
Cash and cash equivalents at end of period
|
|
$
|
196,526
|
|
$
|
644,403
|
|
Supplemental cash flow information:
|
|
|
|
|
|
Cash paid for interest
|
|
$
|
547,266
|
|
$
|
656,197
|
|
Cash paid for income taxes
|
|
$
|
100
|
|
$
|
1,775
|
|
Non-cash investing and financing
activities:
|
|
|
|
|
|
Net payable for securities purchased
|
|
$
|
|
|
$
|
(180,689
|
)
|
Conversion from corporate loans to
corporate securities
|
|
$
|
331,725
|
|
$
|
|
|
Distributions of securities to the
asset-backed secured liquidity noteholders
|
|
$
|
3,623,049
|
|
$
|
|
|
Affiliate contributions for collateralized
loan obligation junior secured notes
|
|
$
|
|
|
$
|
169,209
|
|
|
|
|
|
|
|
|
|
|
See notes to
condensed consolidated financial statements.
6
Table
of Contents
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 is a Delaware limited liability
company and was organized on January 17, 2007. KKR Financial 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 September 30,
2008 were reclassified as such for comparative purposes.
See Note 3 for
further discussion.
These
condensed consolidated
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
Table
of Contents
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,
corporate loans held for sale 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
8
Table of Contents
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.
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 conditions. 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.
Depending on the relative liquidity in the
markets for certain assets, the Company may transfer assets to level 3 if it
determines that observable quoted prices, obtained directly or indirectly, are
not available. 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) 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.
9
Table of Contents
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.
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 short. 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 minus or plus unaccreted purchase discounts and
unamortized purchase premiums. In certain instances, including 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. Unaccreted discounts and unamortized
premiums are recognized in interest income over the contractual life, adjusted
for actual prepayments, of the loans using the effective interest method.
10
Table
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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.
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 if it is determined that
such amounts are not collectible 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 are 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 and other secured and unsecured borrowings. The Company
recognizes interest expense on all borrowings on an accrual basis.
Residential Mortgage-Backed Securities Issued
Effective
January 1, 2007, the Company adopted SFAS No. 159 and elected the
option to carry its residential mortgage-backed securities issued at estimated
fair value, with unrealized gains and losses reported in income.
11
Table
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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 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
12
Table
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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 U.S. 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 its taxable
income.
KKR TRS Holdings, Ltd. (TRS Ltd.)
and KKR Financial Holdings, Ltd. (KFH Ltd.) are not consolidated for U.S. federal
income tax 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
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 U.S. 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
subsidiaries treated as disregarded entities or partnerships for U.S. federal
income tax purposes that were established to facilitate securitization
transactions, structured as secured financing transactions, and TRS Ltd.
and KFH Ltd. are foreign taxable corporate subsidiaries that were formed to
make certain foreign and domestic investments from time to time. TRS Ltd. and
KFH Ltd. are organized as exempted companies incorporated with limited
liability under the laws of the Cayman Islands, and are generally exempt from
U.S. federal and state income tax at the corporate entity level because they
restrict their activities in the U.S. 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 No. 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
13
Table of Contents
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 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 will not have a material impact on its financial statements.
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.
In October 2008, FASB issued FSP SFAS No.
157-3,
Determining the Fair Value of a Financial Asset
when the Market for that Asset is Not Active
(FSP SFAS No. 157-3).
FSP SFAS No. 157-3 is intended to enhance the comparability and consistency in
fair value measurements of financial assets that trade in inactive markets and
includes illustrative examples addressing how assumptions should be considered
when measuring fair value when relevant observable inputs do not exist, as well
as how market quotes and available observable inputs in an inactive market should
be considered when assessing and measuring fair value. FSP SFAS No. 157-3 is
effective upon issuance and includes prior periods for which financial
statements have not been issued. The Company has taken FSP SFAS No. 157-3 into
consideration when measuring the fair value of its assets and liabilities.
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 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.
14
Table of Contents
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 September 30, 2008 have been reclassified for comparative
presentation.
As of September 30, 2008, the Companys remaining residential mortgage
portfolio consisted of $310.4 million of RMBS, of which $277.2 million was
rated investment grade or higher and $33.2 million was rated below investment
grade. Of the $310.4 million of RMBS, $197.4 million represented interests in
residential mortgage securitization trusts that were not structured as
QSPEs
. The
Company consolidates these trusts because it is the primary beneficiary of
these entities and therefore reported total assets of $3.1 billion and total
liabilities of $2.9 billion for these trusts in continuing operations as of September
30, 2008.
Summarized financial information for
discontinued operations is as follows (amounts in thousands):
|
|
As of
September 30, 2008
|
|
As of
December 31,
2007
|
|
Assets
|
|
|
|
|
|
Restricted cash and cash equivalents
|
|
$
|
|
|
$
|
353
|
|
Investments in securities and loans, at
fair value
|
|
|
|
3,043,193
|
|
Interest and principal receivable
|
|
|
|
3,734
|
|
Other assets
|
|
|
|
2,478
|
|
Assets of discontinued operations
|
|
$
|
|
|
$
|
3,049,758
|
|
|
|
As of
September 30, 2008
|
|
As of
December 31, 2007
|
|
Liabilities
|
|
|
|
|
|
Asset-backed secured liquidity notes, at
fair value
|
|
$
|
|
|
$
|
3,519,860
|
|
Accounts payable, accrued expenses and
other liabilities
|
|
|
|
123,701
|
|
Accrued interest payable
|
|
|
|
522
|
|
Liabilities of discontinued operations
|
|
$
|
|
|
$
|
3,644,083
|
|
The components of income from discontinued
operations are as follows (amounts in thousands):
|
|
Three months ended
|
|
Three months ended
|
|
Nine months ended
|
|
Nine months ended
|
|
|
|
September 30, 2008
|
|
September 30, 2007
|
|
September 30, 2008
|
|
September 30, 2007
|
|
Net investment (loss) income
|
|
$
|
|
|
$
|
(14,480
|
)
|
$
|
16,795
|
|
$
|
(3,512
|
)
|
Other loss
|
|
|
|
(148,250
|
)
|
(5,361
|
)
|
(161,252
|
)
|
Non-investment expenses
|
|
|
|
(137,375
|
)
|
(8,766
|
)
|
(138,291
|
)
|
(Loss) income from discontinued operations
|
|
$
|
|
|
$
|
(300,105
|
)
|
$
|
2,668
|
|
$
|
(303,055
|
)
|
Note 4. Earnings per Share
The Company calculates basic net income per
common share by dividing net income for the period by the weighted-average number
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.
15
Table of Contents
The following table presents a reconciliation
of basic and diluted net income per common share for the three and nine months
ended September 30, 2008 and 2007 (amounts in thousands, except per share
information):
|
|
Three months ended
September 30,
|
|
Nine months ended
September 30,
|
|
|
|
2008
|
|
2007
|
|
2008
|
|
2007
|
|
Income from continuing operations
|
|
$
|
48,990
|
|
$
|
38,598
|
|
$
|
97,867
|
|
$
|
142,943
|
|
(Loss) income from discontinued operations
|
|
|
|
(300,105
|
)
|
2,668
|
|
(303,055
|
)
|
Net income (loss)
|
|
$
|
48,990
|
|
$
|
(261,507
|
)
|
$
|
100,535
|
|
$
|
(160,112
|
)
|
|
|
|
|
|
|
|
|
|
|
Basic:
|
|
|
|
|
|
|
|
|
|
Basic weighted-average shares outstanding
|
|
149,612
|
|
87,443
|
|
136,777
|
|
81,692
|
|
Income per share from continuing operations
|
|
$
|
0.33
|
|
$
|
0.44
|
|
$
|
0.72
|
|
$
|
1.75
|
|
(Loss) income per share from discontinued
operations
|
|
|
|
|
|
(3.43
|
)
|
|
0.02
|
|
|
(3.71
|
)
|
Net income (loss) per share
|
|
$
|
0.33
|
|
$
|
(2.99
|
)
|
$
|
0.74
|
|
$
|
(1.96
|
)
|
|
|
|
|
|
|
|
|
|
|
Diluted:
|
|
|
|
|
|
|
|
|
|
Basic weighted-average shares outstanding
|
|
149,612
|
|
87,443
|
|
136,777
|
|
81,692
|
|
Dilutive effect of share options and
restricted common shares using the treasury method
|
|
271
|
|
253
|
|
542
|
|
1,055
|
|
Diluted weighted-average shares outstanding
(1)
|
|
149,883
|
|
87,696
|
|
137,319
|
|
82,747
|
|
Income per share from continuing operations
|
|
$
|
0.33
|
|
$
|
0.44
|
|
$
|
0.71
|
|
$
|
1.73
|
|
(Loss) income per share from discontinued
operations
|
|
|
|
|
|
(3.42
|
)
|
|
0.02
|
|
|
(3.66
|
)
|
Net income (loss) per share
|
|
$
|
0.33
|
|
$
|
(2.98
|
)
|
$
|
0.73
|
|
$
|
(1.93
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(1)
|
|
Potential anti-dilutive common shares excluded from diluted net
income per share for the three and nine months ended September 30, 2008 were
9,677,430 related to convertible debt securities and 1,932,279 related to
common share options. There were 1,932,279 of potential anti-dilutive common
share options for the three and nine months ended September 30, 2007.
|
Note 5. Securities Sold, Not Yet
Purchased
Securities sold, not yet purchased consist of
equity and debt securities that the Company has sold short. As of September 30,
2008, the Company had securities sold, not yet purchased with a cost basis of
$101.3 million and accumulated net unrealized gain of $17.8 million.
As of December 31, 2007, the Company had securities sold, not yet
purchased with a cost basis of $103.1 million and accumulated net
unrealized gain of $2.7 million.
For the three and nine months ended September
30, 2008, the Company had net realized gains on securities sold, not yet
purchased of $0.7 million and $7.8 million, respectively, and net
unrealized gains on securities sold, not yet purchased of $13.5 million
and $15.1 million, respectively. For the three and nine months ended September
30, 2007, the Company had net realized gains on securities sold, not yet
purchased of $5.2 million and $5.3 million, and net unrealized losses on
securities sold, not yet purchased of $2.9 million and $2.5 million,
respectively.
Note 6. Securities Available-for-Sale
The following table summarizes the Companys
securities classified as available-for-sale as of September 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
|
|
$
|
1,359,501
|
|
$
|
2,296
|
|
$
|
(344,098
|
)
|
$
|
1,017,699
|
|
Marketable equity securities
|
|
17,322
|
|
115
|
|
(11,860
|
)
|
5,577
|
|
Total
|
|
$
|
1,376,823
|
|
$
|
2,411
|
|
$
|
(355,958
|
)
|
$
|
1,023,276
|
|
The following table shows the 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 September 30, 2008
(amounts in thousands):
|
|
Less Than 12 months
|
|
12 Months or More
|
|
Total
|
|
Description
|
|
Estimated Fair
Value
|
|
Unrealized
Losses
|
|
Estimated
Fair Value
|
|
Unrealized
Losses
|
|
Estimated
Fair Value
|
|
Unrealized
Losses
|
|
Corporate debt securities
|
|
$
|
512,393
|
|
$
|
(63,530
|
)
|
$
|
407,058
|
|
$
|
(280,568
|
)
|
$
|
919,451
|
|
$
|
(344,098
|
)
|
Marketable equity securities
|
|
1,282
|
|
(1,379
|
)
|
3,711
|
|
(10,481
|
)
|
4,993
|
|
(11,860
|
)
|
Total
|
|
$
|
513,675
|
|
$
|
(64,909
|
)
|
$
|
410,769
|
|
$
|
(291,049
|
)
|
$
|
924,444
|
|
$
|
(355,958
|
)
|
16
Table of Contents
The
unrealized losses in the above table exclude investments in common and
preferred stock that are deemed to be other-than-temporarily impaired by $20.3
million. This amount consists of impairment charges that the Company recognized
during the third quarter of 2008 totaling $10.6 million for certain publicly
traded preferred and common stock investments. The remainder of the $20.3
million relates to an impairment charge recorded during the second quarter of
2008 totaling $9.7 million for a preferred stock investment. The charges
relating to the impairment of these securities were 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 Companys 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
|
|
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.
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 nine months ended
September 30, 2008, the Company had gross realized gains from the sales of
securities available-for-sale of $0.6 million and $5.2 million, respectively,
and gross realized losses from the sales of securities available-for-sale of
$7.7 million and $22.4 million, respectively. During the three and
nine months ended September 30, 2007, the Company had gross realized gains from
the sales of securities available-for-sale of $3.8 million and $35.7 million,
respectively, and gross realized losses from the sales of securities
available-for-sale of $2.6 million and $4.8 million,
17
Table of Contents
respectively. Note 10 to these condensed consolidated financial
statements describes the Companys borrowings under which the Company has
pledged securities available-for-sale. The following table summarizes the
estimated fair value of securities available-for-sale pledged as collateral for
borrowings as of September 30, 2008 (amounts in thousands):
|
|
Corporate Debt
Securities
|
|
Marketable
Equity
Securities
|
|
Pledged as collateral for borrowings under
secured revolving credit facility
|
|
$
|
222,733
|
|
$
|
|
|
Pledged as collateral for collateralized
loan obligation senior secured notes and junior secured notes to affiliates
|
|
705,464
|
|
|
|
Pledged as collateral for subordinated
notes to affiliates
|
|
79,907
|
|
|
|
Total
|
|
$
|
1,008,104
|
|
$
|
|
|
The following table summarizes the 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 September 30, 2008 and December 31, 2007 (amounts in
thousands):
|
|
As of September 30, 2008
|
|
As of December 31, 2007
|
|
Corporate loans, at net amortized cost
|
|
$
|
8,493,531
|
|
$
|
8,659,208
|
|
Less: allowance for loan losses
|
|
(35,000
|
)
|
(25,000
|
)
|
Total
|
|
$
|
8,458,531
|
|
$
|
8,634,208
|
|
The following table summarizes the components
of the net carrying value of the Companys corporate loans as of September 30,
2008 and December 31, 2007 (amounts in thousands):
|
|
September 30, 2008
|
|
December 31, 2007
|
|
Description
|
|
Principal
|
|
Net
Unamortized
Discount
|
|
Estimated
Fair
Value
Adjustment
|
|
Net Carrying
Value
|
|
Principal
|
|
Net
Unamortized
Discount
|
|
Net Carrying
Value
|
|
Corporate loans held for investment (1)
|
|
$
|
8,752,586
|
|
$
|
(259,055
|
)
|
$
|
|
|
$
|
8,493,531
|
|
$
|
8,766,169
|
|
$
|
(106,961
|
)
|
$
|
8,659,208
|
|
Corporate loans held for sale
|
|
31,151
|
|
(597
|
)
|
(2,353
|
)
|
28,201
|
|
|
|
|
|
|
|
Total loans
|
|
$
|
8,783,737
|
|
$
|
(259,652
|
)
|
$
|
(2,353
|
)
|
$
|
8,521,732
|
|
$
|
8,766,169
|
|
$
|
(106,961
|
)
|
$
|
8,659,208
|
|
(1)
Excludes allowance
for loan losses of $35.0 million and $25.0 million as of September 30, 2008 and
December 31, 2007, respectively.
As of September 30, 2008, approximately $28.2
million of corporate loans were classified as held for sale. The Company recorded a $2.4 million charge to
earnings in net realized and unrealized (loss) 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 corporate loans held for sale as of
December 31, 2007. Note 10 to
these condensed consolidated financial statements describes the Companys
borrowings under
18
Table of Contents
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 September 30, 2008 and
December 31, 2007 (amounts in thousands):
|
|
As of September 30, 2008
|
|
As of December 31, 2007
|
|
Pledged as collateral for borrowings under
repurchase agreements
|
|
$
|
|
|
$
|
1,994,999
|
|
Pledged as collateral for borrowings under
secured revolving credit facility
|
|
41,480
|
|
48,142
|
|
Pledged as collateral for collateralized
loan obligation senior secured notes and junior secured notes to affiliates
|
|
6,568,571
|
|
6,276,882
|
|
Pledged as collateral for subordinated
notes to affiliates
|
|
493,959
|
|
27,886
|
|
Total
|
|
$
|
7,104,010
|
|
$
|
8,347,909
|
|
The following table
summarizes the changes in the allowance for loan losses for the Companys
corporate loan portfolio for the nine months ended September 30, 2008 (amounts
in thousands):
Balance at January 1, 2008
|
|
$
|
25,000
|
|
Provision for loan losses
|
|
10,000
|
|
Charge-offs
|
|
|
|
Balance at September 30, 2008
|
|
$
|
35,000
|
|
The $35.0 million allowance for loan losses
is unallocated as of September 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 and $25.0 million was recorded during the nine months ended
September 30, 2008 and 2007, respectively.
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 RMBS at estimated fair value.
As of September 30, 2008 and December 31, 2007, RMBS totaled $113.0
million and $131.7 million, respectively.
Note
10 to these condensed consolidated financial statements describes the Companys
borrowings under which the Company has pledged RMBS. T
he following
table summarizes the estimated fair value of
RMBS pledged as collateral under repurchase agreements and a
secured revolving credit facility as of September 30, 2008 and
December 31, 2007 (amounts in thousands):
|
|
As of
September 30, 2008
|
|
As of December 31, 2007
|
|
Pledged as collateral for borrowings under
repurchase agreements
|
|
$
|
|
|
$
|
112,465
|
|
Pledged as collateral for borrowings under
secured revolving credit facility
|
|
71,509
|
|
5,368
|
|
Total
|
|
$
|
71,509
|
|
$
|
117,833
|
|
Note 9. Residential Mortgage Loans
The following table summarizes the Companys
residential mortgage loans as of September 30, 2008 and December 31, 2007
(amounts in thousands):
|
|
As of
September 30, 2008
|
|
As of December 31, 2007
|
|
Residential mortgage loans, at estimated
fair value (1)
|
|
$
|
3,054,756
|
|
$
|
3,921,323
|
|
|
|
|
|
|
|
|
|
(1)
Excludes real
estate owned (REO) by the Company as a result of foreclosure on delinquent
loans of $10.9 million and $7.2 million as of September 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 September 30, 2008 and December 31, 2007 (amounts in thousands):
|
|
As of September 30, 2008
|
|
As of December 31, 2007
|
|
Pledged as collateral for borrowings under
repurchase agreements
|
|
$
|
|
|
$
|
163,586
|
|
Pledged as collateral for borrowings under
secured revolving credit facility
|
|
151,454
|
|
25,162
|
|
Total
|
|
$
|
151,454
|
|
$
|
188,748
|
|
19
Table
of Contents
The following table summarizes the
delinquency statistics of the Companys residential mortgage loans as of
September 30, 2008 and December 31, 2007 (dollar amounts in thousands):
|
|
As of September 30, 2008
|
|
As of December 31, 2007
|
|
Delinquency Status
|
|
Number of
Loans
|
|
Principal
Amount
|
|
Number of
Loans
|
|
Principal
Amount
|
|
30 to 59 days
|
|
76
|
|
$
|
28,793
|
|
96
|
|
$
|
30,163
|
|
60 to 89 days
|
|
22
|
|
7,440
|
|
18
|
|
6,151
|
|
90 days or more
|
|
60
|
|
22,361
|
|
43
|
|
14,045
|
|
In foreclosure
|
|
58
|
|
20,665
|
|
38
|
|
11,800
|
|
Total
|
|
216
|
|
$
|
79,259
|
|
195
|
|
$
|
62,159
|
|
As of September 30, 2008,
the loss exposure or uncollected principal amount related to the Companys
delinquent residential mortgage loans in the table above exceeded their fair
value by $3.3 million. As of September 30, 2008, 31 of the residential mortgage
loans owned by the Company with an outstanding balance of $10.9 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
Certain information with respect to the
Companys borrowings as of September 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
|
|
4.92
|
%
|
266
|
|
$
|
487,176
|
|
CLO 2005-1 senior secured notes
|
|
831,876
|
|
3.12
|
|
3,130
|
|
770,546
|
|
CLO 2005-2 senior secured notes
|
|
808,496
|
|
3.12
|
|
3,344
|
|
809,387
|
|
CLO 2006-1 senior secured notes
|
|
727,500
|
|
3.17
|
|
3,616
|
|
811,823
|
|
CLO 2007-1 senior secured notes
|
|
2,368,500
|
|
3.33
|
|
4,610
|
|
2,225,518
|
|
CLO 2007-1 junior secured notes to
affiliates(3)
|
|
431,292
|
|
|
|
4,610
|
|
405,256
|
|
CLO 2007-A senior secured notes
|
|
1,213,300
|
|
3.66
|
|
3,302
|
|
1,161,480
|
|
CLO 2007-A junior secured notes to
affiliates(4)
|
|
94,128
|
|
|
|
3,302
|
|
90,108
|
|
Wayzata senior secured notes
|
|
1,600,000
|
|
3.60
|
|
1,507
|
|
1,495,281
|
|
Convertible senior notes
|
|
300,000
|
|
7.00
|
|
1,384
|
|
|
|
Junior subordinated notes
|
|
288,671
|
|
6.53
|
|
10,210
|
|
|
|
Subordinated notes to affiliates(5)
|
|
84,000
|
|
|
|
|
|
78,502
|
|
Total
|
|
$
|
9,126,069
|
|
|
|
|
|
$
|
8,335,077
|
|
(1)
Collateral
for borrowings consists of RMBS,
securities available-for-sale, and corporate and residential mortgage loans.
(2)
Includes
$100.0 million in borrowings collateralized by retained rated mezzanine
notes and unrated subordinated notes issued by the Companys CLO subsidiaries.
(3)
CLO
2007-1 junior secured notes to affiliates consists of
(x) $244.7 million of mezzanine notes with a weighted-average
borrowing rate of 7.66% 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 consists of
(x) $79.0 million of mezzanine notes with a weighted-average
borrowing rate of 8.94% 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.
20
Table
of Contents
In the third quarter of 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
unamortized debt issuance costs and $0.1 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.
(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 consists 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 consists 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 Companys derivative
transactions are with various counterparties, none of which are concentrated to
the extent of detrimentally affecting the Companys financial condition or
results of operations. 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.
21
Table
of Contents
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 September 30, 2008 and December 31, 2007 (amounts in thousands):
|
|
As of
September 30, 2008
|
|
As of
December 31, 2007
|
|
|
|
Notional
|
|
Estimated
Fair Value
|
|
Notional
|
|
Estimated
Fair Value
|
|
Cash Flow Hedges:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
$
|
383,333
|
|
$
|
(24,168
|
)
|
$
|
383,333
|
|
$
|
(19,018
|
)
|
Fair Value Hedges:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
32,000
|
|
(1,777
|
)
|
32,000
|
|
(1,212
|
)
|
Free-Standing Derivatives:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
181,073
|
|
(13
|
)
|
690,799
|
|
(7,959
|
)
|
Credit default swapslong
|
|
53,500
|
|
(1,063
|
)
|
66,000
|
|
(1,154
|
)
|
Credit default swapsshort
|
|
300,070
|
|
48,168
|
|
268,000
|
|
12,613
|
|
Total rate of return swaps
|
|
416,597
|
|
(51,864
|
)
|
442,204
|
|
(21,998
|
)
|
Foreign exchange contracts
|
|
64,380
|
|
(1,093
|
)
|
9,711
|
|
3
|
|
Common stock warrants
|
|
|
|
77
|
|
|
|
799
|
|
Total
|
|
$
|
1,430,953
|
|
$
|
(31,733
|
)
|
$
|
1,892,047
|
|
$
|
(37,926
|
)
|
For all hedges where hedge accounting 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
nine months ended September 30, 2008 and September 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 September 30, 2008
|
|
As of
December 31, 2007
|
|
Net unrealized losses on available-for-sale
securities
|
|
$
|
(354,805
|
)
|
$
|
(159,802
|
)
|
Net unrealized losses on cash flow hedges
|
|
(23,119
|
)
|
(19,018
|
)
|
Transition adjustment to accumulated
deficit in conjunction with fair value option election for residential mortgage-backed
securities
|
|
|
|
21,575
|
|
Accumulated other comprehensive loss
|
|
$
|
(377,924
|
)
|
$
|
(157,245
|
)
|
22
Table
of Contents
The components of other comprehensive loss
were as follows (amounts in thousands):
|
|
Three months
|
|
Three months
|
|
Nine months
|
|
Nine months
|
|
|
|
ended
|
|
ended
|
|
ended
|
|
ended
|
|
|
|
September 30, 2008
|
|
September 30, 2007
|
|
September 30, 2008
|
|
September 30, 2007
|
|
Unrealized losses on securities
available-for-sale:
|
|
|
|
|
|
|
|
|
|
Unrealized holding losses arising during
period
|
|
$
|
(188,065
|
)
|
$
|
(73,218
|
)
|
$
|
(254,042
|
)
|
$
|
(72,577
|
)
|
Translation adjustment to accumulated
deficit in conjunction with fair value option election for residential
mortgage-backed securities
|
|
|
|
|
|
|
|
21,575
|
|
Reclassification adjustments for losses
(gains) realized in net income (1)
|
|
17,667
|
|
(1,309
|
)
|
37,464
|
|
(30,457
|
)
|
Unrealized losses on available-for-sale
securities from investment in unconsolidated affiliate
|
|
|
|
|
|
|
|
(7,898
|
)
|
Unrealized losses on securities
available-for-sale
|
|
(170,398
|
)
|
(74,527
|
)
|
(216,578
|
)
|
(89,357
|
)
|
Unrealized losses on cash flow hedges:
|
|
|
|
|
|
|
|
|
|
Unrealized holding losses arising during
period
|
|
(4,940
|
)
|
(35,469
|
)
|
(4,101
|
)
|
(25,391
|
)
|
Reclassification adjustments for gains
realized in discontinued operations
|
|
|
|
(28,569
|
)
|
|
|
(28,569
|
)
|
Unrealized losses on cash flow hedges
arising during period
|
|
(4,940
|
)
|
(64,038
|
)
|
(4,101
|
)
|
(53,960
|
)
|
Other comprehensive loss
|
|
$
|
(175,338
|
)
|
$
|
(138,565
|
)
|
$
|
(220,679
|
)
|
$
|
(143,317
|
)
|
(1)
Amounts for the three and nine months ended September 30, 2008 include an
impairment of $20.3 million for investments in common and preferred stock
securities which were 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 September 30, 2008, the 2007 Share
Incentive Plan authorizes a total of 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
|
|
38,349
|
|
1,135,349
|
|
Vested
|
|
(625,000
|
)
|
(41,885
|
)
|
(666,885
|
)
|
Cancelled
|
|
|
|
(2,839
|
)
|
(2,839
|
)
|
Forfeited
|
|
|
|
|
|
|
|
Unvested shares as of September 30, 2008
|
|
1,097,000
|
|
66,282
|
|
1,163,282
|
|
Pursuant to SFAS No. 123(R), the 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 $6.36 and $16.85 per share at September
30, 2008 and September 30, 2007, respectively. There were $6.2 million and
$3.7 million of total unrecognized compensation costs related to unvested
restricted common shares granted as of September 30, 2008 and September 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 September 30, 2008
|
|
1,932,279
|
|
$
|
20.00
|
|
23
Table of Contents
As of September 30, 2008 and
December 31, 2007, 1,932,279 common share options were exercisable. As of
September 30, 2008 and December 31, 2007, the common share options were
fully vested and expire in August 2014. For the three and nine months
ended September 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 nine
|
|
For the nine
|
|
|
|
months ended
|
|
months ended
|
|
months ended
|
|
months ended
|
|
|
|
September 30, 2008
|
|
September 30, 2007
|
|
September 30, 2008
|
|
September 30, 2007
|
|
Options granted to Manager
|
|
$
|
|
|
$
|
(192
|
)
|
$
|
|
|
$
|
246
|
|
Restricted shares granted to Manager
|
|
(195
|
)
|
(4,389
|
)
|
462
|
|
1,651
|
|
Restricted shares granted to certain
directors
|
|
142
|
|
178
|
|
497
|
|
392
|
|
Total share-based compensation expense
|
|
$
|
(53
|
)
|
$
|
(4,403
|
)
|
$
|
959
|
|
$
|
2,289
|
|
Note 14. Management Agreement 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 agreeing to 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.
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 nine months ended September 30, 2008, the
Company incurred $8.7 million and $25.1 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 $0.5 million, respectively, for the
three and nine months ended September 30, 2008 (see Note 13). The
Company also reimbursed the Manager $2.5 million and $7.6 million,
respectively, for expenses for the three and nine months ended
September 30, 2008. For the three and nine months ended
September 30
, 2007, the Company incurred $8.2 million and
$22.5 million, respectively, in base management fees. In addition, the Company
recognized share-based compensation expense related to common share options and
restricted common shares granted to the Manager of $(4.6) million and
$1.9 million, respectively, for the
three and nine months ended September 30, 2007 (see Note 13). The Company also reimbursed the Manager $1.9
million and $5.8 million, respectively, for expenses for the three and nine months ended September 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 the receipt of base
management fees earned 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 the receipt of approximately
$2.2 million and $6.6 million of base management fees earned during the
three and nine months ended September 30, 2008, respectively.
No incentive fees were earned by the Manager
during the three and nine months ended September 30, 2008 and for the
three months ended September 30, 2007, but $12.6 million was earned by the
Manager during the nine months ended September 30, 2007. An affiliate of
the 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 $62.1 million and $18.6 million as of September 30,
2008 and September 30, 2007, respectively. Beginning
24
Table
of Contents
April 15, 2007, an affiliate of the Manager ceased waiving fees
for CLO 2005-1 for the services performed as collateral manager. The Company
recorded an expense of $1.3 million and $3.8 million for collateral
management fees for CLO 2005-1 for the three and nine months ended September
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 September 30, 2008.
The Company has invested in corporate loans and debt securities of entities
that are affiliates of KKR. As of September 30, 2008, t
he aggregate par
amount of these affiliated investments totaled $3.7 billion, or approximately
35% of the total investment portfolio, and consisted of 23 issuers. The total
$3.7 billion in investments were comprised of $2.8 billion of corporate loans,
$720.6 million of corporate debt securities available for sale, and $270.3
million notional amount of corporate 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 as of September 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
September 30, 2008
|
|
Assets:
|
|
|
|
|
|
|
|
|
|
Securities available-for-sale
|
|
$
|
5,577
|
|
$
|
900,256
|
|
$
|
117,443
|
|
$
|
1,023,276
|
|
Residential mortgage-backed securities
|
|
|
|
|
|
112,980
|
|
112,980
|
|
Residential mortgage loans
|
|
|
|
|
|
3,054,756
|
|
3,054,756
|
|
REO
|
|
|
|
|
|
10,857
|
|
10,857
|
|
Corporate loans held for sale
|
|
|
|
28,201
|
|
|
|
28,201
|
|
Total
|
|
$
|
5,577
|
|
$
|
928,457
|
|
$
|
3,296,036
|
|
$
|
4,230,070
|
|
Liabilities:
|
|
|
|
|
|
|
|
|
|
Derivatives, net
|
|
$
|
|
|
$
|
21,163
|
|
$
|
(52,896
|
)
|
$
|
(31,733
|
)
|
Residential mortgage-backed securities
issued
|
|
|
|
|
|
(2,868,232
|
)
|
(2,868,232
|
)
|
Securities sold, not yet purchased
|
|
(58,937
|
)
|
(24,570
|
)
|
|
|
(83,507
|
)
|
Total
|
|
$
|
(58,937
|
)
|
$
|
(3,407
|
)
|
$
|
(2,921,128
|
)
|
$
|
(2,983,472
|
)
|
The following table presents information
about the Companys assets and liabilities (including derivatives that are
presented net) measured at fair value 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
|
)
|
25
Table
of Contents
The following table presents additional
information about assets, including derivatives, that are measured at fair
value for which the Company has utilized level 3 inputs to determine fair
value, for the three months ended September 30, 2008 and 2007 (amounts in
thousands):
|
|
Three months ended September 30, 2008
|
|
Three months ended
September
30, 2007
|
|
|
|
Securities
Available-
For-Sale
|
|
Residential
Mortgage-
Backed
Securities
|
|
Residential
Mortgage
Loans
|
|
REO
|
|
Derivatives,
net
|
|
Residential
Mortgage-
Backed
Securities
Issued
|
|
Securities
Available-
For-Sale
|
|
Derivatives,
net
|
|
Beginning balance as of July 1
|
|
$
|
45,343
|
|
$
|
115,652
|
|
$
|
3,394,996
|
|
$
|
8,919
|
|
$
|
3,471
|
|
$
|
(3,204,392
|
)
|
$
|
57,000
|
|
$
|
1,317
|
|
Total gains or losses (realized and
unrealized):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Included in earnings
|
|
|
|
1,621
|
|
(168,058
|
)
|
|
|
(16,625
|
)
|
168,059
|
|
|
|
145
|
|
Included in other comprehensive loss
|
|
(1,532
|
)
|
|
|
|
|
|
|
|
|
|
|
(538
|
)
|
|
|
Net transfers in and/or out of level 3
|
|
73,959
|
|
|
|
(1,938
|
)
|
1,938
|
|
(39,067
|
)
|
|
|
44,576
|
|
|
|
Purchases, sales, other settlements and
issuances, net
|
|
(327
|
)
|
(4,293
|
)
|
(170,244
|
)
|
|
|
(675
|
)
|
168,101
|
|
|
|
(1,031)
|
|
Ending balance as of September 30
|
|
$
|
117,443
|
|
$
|
112,980
|
|
$
|
3,054,756
|
|
$
|
10,857
|
|
$
|
(52,896
|
)
|
$
|
(2,868,232
|
)
|
$
|
101,038
|
|
$
|
431
|
|
The amount of total gains or losses for the
period included in earnings attributable to the change in unrealized gains or
losses relating to assets still held at the reporting date (1)
|
|
$
|
|
|
$
|
1,055
|
|
$
|
(167,404
|
)
|
$
|
|
|
$
|
(16,625
|
)
|
$
|
168,059
|
|
$
|
|
|
$
|
145
|
|
(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.
The following table presents additional
information about assets, including derivatives that are measured at fair value
for which the Company has utilized level 3 inputs to determine fair value,
for the nine months ended September 30, 2008 and 2007 (amounts in thousands):
|
|
Nine months ended September 30, 2008
|
|
Nine months ended
September 30,
2007
|
|
|
|
Securities
Available-
For-Sale
|
|
Residential
Mortgage-
Backed
Securities
|
|
Residential
Mortgage
Loans
|
|
REO
|
|
Derivatives,
net
|
|
Residential
Mortgage-
Backed
Securities
Issued
|
|
Securities
Available-
For-Sale
|
|
Derivatives,
net
|
|
Beginning balance as of January 1
|
|
$
|
99,498
|
|
$
|
|
|
$
|
|
|
$
|
|
|
$
|
802
|
|
$
|
|
|
$
|
104,498
|
|
$
|
|
|
Total gains or losses (realized and
unrealized):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Included in earnings
|
|
|
|
(5,515
|
)
|
(307,122
|
)
|
|
|
(16,158
|
)
|
315,311
|
|
|
|
431
|
|
Included in other comprehensive loss
|
|
(5,622
|
)
|
|
|
|
|
|
|
|
|
|
|
(36
|
)
|
|
|
Net transfers in and/or out of level 3
|
|
41,234
|
|
131,688
|
|
3,917,666
|
|
10,857
|
|
(36,256
|
)
|
(3,169,353
|
)
|
44,074
|
|
|
|
Purchases, sales, other settlements and
issuances, net
|
|
(17,667
|
)
|
(13,193
|
)
|
(555,788
|
)
|
|
|
(1,284
|
)
|
(14,190
|
)
|
(47,498
|
)
|
|
|
Ending balance as of September 30
|
|
$
|
117,443
|
|
$
|
112,980
|
|
$
|
3,054,756
|
|
$
|
10,857
|
|
$
|
(52,896
|
)
|
$
|
(2,868,232
|
)
|
$
|
101,038
|
|
$
|
431
|
|
The amount of total gains or losses for the
period included in earnings attributable to the change in unrealized gains or
losses relating to assets still held at the reporting date (1)
|
|
$
|
|
|
$
|
(8,195
|
)
|
$
|
(318,679
|
)
|
$
|
|
|
$
|
(16,158
|
)
|
$
|
315,311
|
|
$
|
|
|
$
|
431
|
|
(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.
26
Table
of Contents
Note 16. Contingencies
In
the normal course of business, the Company has been named as a defendant in
legal actions. The Company has denied, or believes it has a meritorious defense
and will deny liability in the significant cases pending against the Company
discussed below. Based on current discussion and consultation with counsel, the
Companys management believes that the resolution of these matters will not
have a material impact on the financial condition or cash flow of the Company.
On
August 7, 2008, the members of the Companys board of directors and certain of
the Companys executive officers (the Individual Defendants) and the Company
(collectively, Defendants) were named in a putative class action complaint
(the Complaint) filed by Charter Township of Clinton Police and Fire
Retirement System in the United States District Court for the Southern District
of New York (the Charter Litigation). The Complaint alleges that the
Companys April 2, 2007 registration statement and prospectus (the April 2,
2007 Registration Statement) contained material misstatements and omissions in
violation of Section 11 of the Securities Act of 1933, as amended (the
"1933 Act"), regarding the
risks associated with the Companys real estate related assets, the state of
the Companys capital in light of its real estate related assets, and the
adequacy of the Companys loss reserves for its real estate related assets (the
alleged Section 11 violation). The Complaint further alleges that pursuant to
Section 15 of the 1933 Act, the Individual Defendants have legal responsibility
for the alleged Section 11 violation.
The
parties have stipulated that Defendants shall not be required to answer or
otherwise respond to the Complaint. Pursuant to section 27(a) of the 1933 Act,
the court is required to appoint a Lead Plaintiff by November 5, 2008. The
parties have stipulated that the Lead Plaintiff shall file and serve a
consolidated amended complaint or designate a previously-filed complaint as the
operative complaint (the Operative Complaint) no later than 45 days after an
order appointing it is entered by the Court.
The parties have further stipulated that Defendants shall file an
answer, motion to dismiss, or other response to the Operative Complaint no
later than 45 days after it is served.
On
August 15, 2008, the members of the Companys board of directors and the
Companys executive officers (the Director and Officer Defendants) were named
in a shareholder derivative action (the Derivative Action) brought by Raymond
W. Kostecka, a purported shareholder of the Company, in the Superior Court of
California, County of San Francisco. The Company is named as a nominal
defendant. The complaint in the
Derivative Action asserts claims against the Director and Officer Defendants
for breaches of fiduciary duty, abuse of control, gross mismanagement, waste of
corporate assets, and unjust enrichment in connection with the conduct at issue
in the Charter Litigation, including the filing of the April 2, 2007
Registration Statement with alleged material misstatements and omissions.
The
parties have submitted a stipulation requesting that the proceedings in the Derivative
Action be stayed until the Charter Litigation is dismissed on the pleadings or
the Company files an answer to the Charter Litigation.
Note
17. Subsequent Events
On November 6,
2008, the Companys board of directors elected to not pay a dividend for the
third quarter of 2008.
On November
10, 2008, the Company entered into an agreement to replace its existing
revolving credit facility with a new $300.0 million senior secured asset-based
revolving credit facility. The new facility matures on November 10, 2010. The
facility bears interest at a rate of 30-day London interbank offered rate
(LIBOR) plus 3.00% per annum and the commitment of the initial lenders in the
facility is reduced to $150.0 million on the one-year anniversary of the facility.
The Company can satisfy the $150.0 million commitment reduction by either
paying down the facility or syndicating the facility to other lenders prior to
November 10, 2009. Under the terms of the credit agreement, the Company will be
restricted from making cash distributions to its shareholders in excess of the
amount estimated by the Company to be necessary for its shareholders to satisfy
their federal and state tax liabilities with respect to their allocable share
of the Company's taxable income. This restriction will terminate as of November
10, 2009 as long as the Company satisfies certain borrowing base conditions
contained in the credit agreement. As of November 7, 2008, the Company had $368.3
million outstanding under its existing revolving credit facility.
On November
10, 2008, the Company entered into an agreement for a two-year $100.0 million
standby unsecured revolving credit agreement with the Companys external
manager, KKR Financial Advisors LLC, and Kohlberg Kravis Roberts & Co.
(Fixed Income) LLC, the parent of the Companys external manager. The borrowing
facility matures in December 2010 and bears interest at a rate equal to LIBOR
for an interest period of 1, 2 or 3 months (at the Companys option) plus
15.00% per annum. Under the terms of the
agreement, the Company can elect to capitalize a portion of accrued interest on
any loan under the agreement by adding up to 80% of the interest due and
payable at a particular time in respect of such loan to the outstanding
principal amount of the loan.
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Table of Contents
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, as amended, and Section 21E of the Securities Exchange Act of 1934,
as amended, 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.
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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.
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.
Impact of Credit Market Events
During the third quarter of 2008, the global
credit markets continued to experience unprecedented challenges and the
landscape of the U.S. financial services industry changed dramatically. During
September 2008, the U.S. federal government assumed a conservatorship role for
both Federal Home Loan Mortgage Corporation and Federal National Mortgage
Association, Lehman Brothers Holdings Inc. filed for bankruptcy, and the U.S.
federal government provided a loan to American International Group Inc. (AIG)
in exchange for an equity interest in AIG. During the same period, events in
the credit markets forced numerous other major U.S. financial institutions to
announce plans to consolidate and/or restructure their existing operations.
During the third quarter of 2008, illiquidity
and wider credit spreads in the credit markets caused a material decline in
asset prices, particularly in equities, corporate loans and high yield
securities. These market conditions have
continued subsequent to quarter end. Current market events may impact our
business in many ways, including the following:
|
·
|
Price declines in the
investments we hold reduce the proceeds we receive for any investments that
we decide to sell and in most cases would result in the realization of losses
on such sales. Realization of losses on such sales, depending on their
magnitude and timing, could cause us to not be in compliance at future
measurement dates with covenants in our secured revolving credit facility and
total rate of return swaps.
|
|
|
|
|
·
|
Declines in market values
have required and may continue to require us to post substantial additional
cash collateral under market value based borrowing transactions and/or
derivative contracts. Specifically, derivative transactions, including total
rate of return swaps, our secured revolving credit facility, and Wayzata
Funding LLC (Wayzata) have certain provisions that require the posting of
additional cash margin due to the decline in the value of assets financed
through those facilities. The posting of additional cash margin adversely
impacts our cash flows available for operations, new investments and dividend
distributions. In addition, Wayzatas market value features result in cash
being effectively trapped in the facility and not being paid to the junior
noteholders, including us, if the net asset value of Wayzata does not meet
certain limits. We believe that based on current asset prices, the net asset
value of Wayzata would result in cash being trapped and that during the
fourth quarter of 2008 Wayzata will cease being cash flow generative to us. We
cannot predict at this time how long the cessation of cash flows will last.
The
posting of additional cash margin and trapping of any cash could also have
adverse consequences regarding our ability to retain assets to which such
margin provisions pertain.
Our
borrowing arrangements are described in further detail under Sources of Funds
in this Managements Discussion and Analysis of Financial Condition and
Results of Operations.
|
|
|
|
|
·
|
Declines in the market
values and downgrades in the ratings of investments financed through our five
cash flow collateralized loan obligation (CLO) transactions may result in
the unrestricted cash flows we receive from the CLOs being used to deleverage
the facilities. While failing over-collateralization tests in these cash flow
CLOs does not affect our investment portfolio or results of operations, it
would adversely impact our cash flows available for operations, new
investments and dividend distributions. We currently believe that during the
fourth quarter of 2008, certain of our CLO facilities will temporarily cease
to be cash flow generative to us
, and we cannot predict at this time
how long the cessation of cash flows will last
. These provisions are described in further detail under Sources of
Funds in this Managements Discussion and Analysis of Financial Condition and
Results of Operations.
|
|
|
|
|
·
|
Current
illiquidity in the financial markets may impact our ability to obtain new
financing facilities or replace existing financing facilities on favorable
terms.
|
In light of the foregoing developments
related to current credit market conditions and their attendant risks, we have
taken or intend to take the following steps:
|
·
|
We have elected
not to pay a dividend for the third
quarter of 2008 in order to retain liquidity and provide maximum flexibility
with respect to uses of liquidity in the current environment.
|
|
|
|
|
·
|
On November 10, 2008, we entered into an agreement to replace our existing
revolving credit facility with a new $300.0 million senior secured
asset-based revolving credit facility. The new facility extends our revolving
credit maturity and provides for less restrictive financial covenants that
will enhance our flexibility to make appropriate portfolio management
decisions on behalf of our shareholders. The new facility matures on November
10, 2010. The facility bears interest at a rate of 30-day London interbank
offered rate (LIBOR) plus 3.00% per annum and the commitment of the initial
lenders in the facility is reduced to $150.0 million on the one-year
anniversary of the facility. We can satisfy the $150.0 million commitment
reduction by either paying down the facility or syndicating the facility to
other lenders prior to November 10, 2009. Under the terms of the credit
agreement, we will be restricted from making cash distributions to our
shareholders in excess of the amount estimated by us to be necessary for our
shareholders to satisfy their federal and state tax liabilities with respect to
their allocable share of our taxable income. This restriction will terminate
as of November 10, 2009 as long as we satisfy certain borrowing base
conditions contained in the credit agreement.
|
|
|
|
|
·
|
On November 10, 2008, we entered into an agreement for a two-year
$100.0 million standby unsecured revolving credit agreement with our Manager,
KKR Financial Advisors LLC, and Kohlberg Kravis Roberts & Co. (Fixed
Income) LLC, the parent of our Manager. We entered into this $100.0 million
standby unsecured revolving credit agreement in order to enhance our
flexibility in bridging the difference in the balance outstanding under our
current credit facility with the borrowing capacity under the new facility. The
borrowing facility matures in December 2010 and bears interest at a rate
equal to LIBOR for an interest period of 1, 2 or 3 months (at our option)
plus 15.00% per annum. Under the terms of the agreement, we can elect to
capitalize a portion of accrued interest on any loan under the agreement by
adding up to 80% of the interest due and payable at a particular time in
respect of such loan to the outstanding principal amount of the loan.
|
|
|
|
|
·
|
We are evaluating whether and how to reduce our exposure and
contracts that require posting of additional collateral when market values
decline. Any such future reduction in exposure may result in losses on
investments, losses on our investments in Wayzata, and reduction or
elimination of borrowings under facilities whose terms would not be
replicable in todays financial environment.
|
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
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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 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 discontinued 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 September 30, 2008 have been reclassified for comparative
presentation.
Extinguishment of
Debt
During the third quarter of 2008, we 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 unamortized debt issuance costs and $0.1 million of other
associated costs. During the nine months ended September 30, 2008, we retired
$40.0 million of junior subordinated notes, which resulted in a gain on
extinguishment of $20.3 million, partially offset by a $1.3 million write-off
of unamortized debt issuance costs and $0.8 million of other associated costs.
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.
Investment Portfolio
As of September 30, 2008, our investments in
corporate loans and debt securities totaled $9.5 billion, which represents a
4.3% decrease from $10.0 billion as of December 31, 2007. Additionally,
our investments in RMBS totaled $310.4 million as of September 30, 2008, which
represents a decrease of 8.1% 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,
$197.4 million of our $310.4 million of RMBS investments are included in the
consolidation of these entities and the $197.4 million represents the net
difference between residential mortgage loans of $3.1 billion and residential
mortgage-backed securities issued of $2.9 billion, plus $10.9 million of real
estate owned (included in other assets on our condensed consolidated balance
sheet).
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 the audit
committee of our board of directors.
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Table of Contents
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,
corporate loans held for sale 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. 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 conditions. 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
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Table of Contents
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 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
September 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 nine months ended
September 30, 2008, share-based compensation totaled
$(0.2) million and $0.5 million, respectively. As of September 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 September 30, 2008, a $1 increase in
the price of our common shares would have increased our future share-based
compensation expense by approximately $1.1 million and this future
share-based compensation expense would be recognized over the remaining vesting
periods of our outstanding restricted common shares. As of September 30, 2008, future unamortized
share-based compensation totaled $6.2 million, of which $0.7 million,
$2.7 million, and $2.8 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
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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
September 30, 2008, the estimated fair value of our net derivative liabilities
totaled $31.7 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, our intent and
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
September 30, 2008, we had aggregate
unrealized losses on our securities classified as available-for-sale of
approximately $356.0 million, which if not recovered may result in the
recognition of future losses. As of
September 30, 2008, there were impairments of $20.3 million which were determined
to be other-than-temporary which were 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 if it is determined that such amounts
are not collectible and interest income is recognized only upon actual receipt.
33
Table of Contents
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
September
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 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.
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.
In October 2008, FASB issued FSP SFAS No.
157-3,
Determining the Fair Value of a Financial Asset
when the Market for that Asset is Not Active
(FSP SFAS No. 157-3).
FSP SFAS No. 157-3 is intended to enhance the comparability and consistency in
fair value measurements of financial assets that trade in inactive markets and
includes illustrative examples addressing how assumptions should be considered
when measuring fair value when relevant observable inputs do not exist, as well
as how market quotes and available observable inputs in an inactive market
should be considered when assessing the measuring fair value. FSP SFAS No.
157-3 is effective upon issuance including prior periods for which financial
statements have not been issued. We have taken FSP SFAS No. 157-3 into
consideration when measuring the fair value of our assets and liabilities.
34
Table of Contents
Results of Operations
Three and nine months ended September 30,
2008 compared to three and nine months ended September 30, 2007
Summary
Our net income for the three and nine months
ended
September 30,
2008 totaled $49.0 million (or $0.33 per diluted common share) and $100.5
million (or $0.73 per diluted common share), respectively, as compared to net
loss of $261.5 million (or $2.98 per diluted common share) and $160.1
million (or $1.93 per diluted common share) for the three and nine months ended
September 30, 2007, respectively.
Income from continuing operations for the three and nine months ended September 30, 2008 totaled
$49.0 million (or $0.33 per diluted common share) and $97.9 million (or
$0.71 per diluted common share), respectively, as compared to
$38.6 million (or $0.44 per diluted common share) and $142.9 million (or
$1.73 per diluted common share) for the three and nine months ended September 30, 2007, respectively.
Net Investment Income
The following table presents the components
of our net investment income for the three and nine months ended
September 30, 2008 and 2007:
Comparative Net Investment Income Components
(Amounts
in thousands)
|
|
For the three
months ended
September 30, 2008
|
|
For the three
months ended
September 30, 2007
|
|
For the nine
months ended
September 30, 2008
|
|
For the nine
months ended
September 30, 2007
|
|
Investment Income:
|
|
|
|
|
|
|
|
|
|
Corporate loans and securities interest income
|
|
$
|
165,878
|
|
$
|
164,287
|
|
$
|
529,068
|
|
$
|
358,178
|
|
Residential mortgage loans and securities
interest income
|
|
41,871
|
|
61,413
|
|
134,718
|
|
194,106
|
|
Other interest income
|
|
4,431
|
|
11,850
|
|
20,505
|
|
20,100
|
|
Dividend income
|
|
358
|
|
782
|
|
2,266
|
|
2,722
|
|
Net discount accretion
|
|
14,514
|
|
2,496
|
|
34,161
|
|
3,660
|
|
Total investment income
|
|
227,052
|
|
240,828
|
|
720,718
|
|
578,766
|
|
Interest Expense:
|
|
|
|
|
|
|
|
|
|
Repurchase agreements
|
|
970
|
|
22,888
|
|
34,407
|
|
63,503
|
|
Collateralized loan obligation senior
secured notes
|
|
68,246
|
|
69,250
|
|
214,653
|
|
149,404
|
|
Secured revolving credit facility
|
|
3,496
|
|
3,190
|
|
9,269
|
|
6,580
|
|
Secured demand loan
|
|
|
|
513
|
|
348
|
|
1,728
|
|
Convertible senior notes
|
|
5,440
|
|
4,183
|
|
16,450
|
|
4,183
|
|
Junior subordinated notes
|
|
4,941
|
|
6,481
|
|
17,045
|
|
16,502
|
|
Residential mortgage-backed securities
issued
|
|
31,506
|
|
38,072
|
|
99,938
|
|
137,650
|
|
Other interest expense
|
|
1,665
|
|
766
|
|
2,687
|
|
2,033
|
|
Interest rate swap
|
|
1,841
|
|
(285
|
)
|
5,410
|
|
(476
|
)
|
Total interest expense
|
|
118,105
|
|
145,058
|
|
400,207
|
|
381,107
|
|
Interest expense to affiliates
|
|
18,794
|
|
21,148
|
|
66,319
|
|
29,404
|
|
Provision for loan losses
|
|
|
|
25,000
|
|
10,000
|
|
25,000
|
|
Net investment income
|
|
$
|
90,153
|
|
$
|
49,622
|
|
$
|
244,192
|
|
$
|
143,255
|
|
As presented in the table above, net
investment income increased $40.5 million, or 81.7%, and $100.9 million,
or 70.5%, from the three and nine months ended September 30, 2007,
respectively, compared to the three and nine months ended September 30, 2008.
For the three months ended September 30, 2008, the increase is primarily attributable
to lower interest expense on residential mortgage-backed securities issued and
no provision for loan loss recorded for the quarter ended September 30, 2008. In
addition, net discount accretion increased by $12.0 million due to our
portfolio of corporate loans and debt securities having a lower
weighted-average purchase price as compared to prior year. For the nine months
ended September 30, 2008, the increase is primarily attributable to the
interest income earned on additional investments in our investment portfolio
during 2008, as well as greater discount accretion on corporate loans and debt
securities. As of September 30, 2008, we held $9.5 billion of investments
in corporate loans and debt securities, excluding the allowance for loan losses
of $35.0 million. In comparison, as of September 30, 2007, investments in
corporate loans and debt securities totaled $8.5 billion, excluding the
allowance for loan losses of $25.0 million.
Net investment income in the table above does
not include equity in income of unconsolidated affiliate of nil for the three
and nine months ended September 30, 2008 and nil and $12.7 million for the
three and nine months ended September 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
CLOs.
35
Table
of Contents
Other (Loss) Income
The following table presents the components
of other (loss) income for the three and nine months ended September 30, 2008
and 2007:
Comparative Other (Loss) Income Components
(Amounts in thousands)
|
|
For the three
months ended
September 30, 2008
|
|
For the three
months ended
September 30, 2007
|
|
For the nine
months ended
September 30, 2008
|
|
For the nine
months ended
September 30, 2007
|
|
Net realized
and unrealized loss on derivatives and foreign exchange:
|
|
|
|
|
|
|
|
|
|
Interest
rate swaptions
|
|
$
|
|
|
$
|
15
|
|
$
|
|
|
$
|
15
|
|
Interest
rate swaps
|
|
(706
|
)
|
(822
|
)
|
2,820
|
|
(822
|
)
|
Credit
default swaps
|
|
9,543
|
|
1,424
|
|
19,877
|
|
2,397
|
|
Total rate
of return swaps
|
|
(20,019
|
)
|
(16,834
|
)
|
(86,464
|
)
|
(4,465
|
)
|
Common stock
warrants
|
|
(15
|
)
|
145
|
|
(722
|
)
|
432
|
|
Foreign
contract
|
|
|
|
|
|
|
|
|
|
Foreign
exchange translation
|
|
(4,337
|
)
|
30
|
|
(3,979
|
)
|
21
|
|
Total
realized and unrealized loss on derivatives and foreign exchange
|
|
(15,534
|
)
|
(16,042
|
)
|
(68,468
|
)
|
(2,422
|
)
|
Net realized
loss on residential loans carried at estimated fair value
|
|
(1,589
|
)
|
(141
|
)
|
(3,088
|
)
|
(342
|
)
|
Net
unrealized gain (loss) on residential mortgage-backed securities, residential
mortgage loans, and residential mortgage-backed securities issued, carried at
estimated fair value
|
|
1,710
|
|
(39,145
|
)
|
(11,563
|
)
|
(40,636
|
)
|
Net realized
(loss) gain on investments
|
|
(17,996
|
)
|
53,400
|
|
(36,647
|
)
|
87,164
|
|
Impairment
of securities available-for-sale
|
|
(10,566
|
)
|
|
|
(20,254
|
)
|
|
|
Lower of
cost or estimated fair value adjustment to loans held for sale
|
|
284
|
|
|
|
(2,353
|
)
|
|
|
Gain on
extinguishment of debt
|
|
3,056
|
|
|
|
20,281
|
|
|
|
Net realized
and unrealized gain on securities sold, not yet purchased
|
|
14,242
|
|
2,220
|
|
22,892
|
|
2,795
|
|
Other income
|
|
2,470
|
|
2,760
|
|
7,939
|
|
7,347
|
|
Total other
(loss) income
|
|
$
|
(23,923
|
)
|
$
|
3,052
|
|
$
|
(91,261
|
)
|
$
|
53,906
|
|
As presented in the table above, total other
loss totaled $23.9 million and $91.3 million for the three and nine months
ended September 30, 2008, respectively, as compared to other income of
$3.1 million and $53.9 million for the three and nine months ended
September 30, 2007, respectively. The change in total other (loss) income for
the three months ended September 30, 2008 is primarily attributable to a
$15.5 million net realized and unrealized loss on derivatives and foreign
exchange of which $20.0 million was related to total rate of return swaps,
an $18.0 million realized loss on sales of investments, and $10.6 million of losses
due to the impairment of securities available-for-sale, all partially offset by
a $3.1 million gain on the extinguishment of junior subordinated notes, a $1.7
million net unrealized gain on the estimated fair value of our residential
mortgage positions, and a $14.2 million net realized and unrealized gain on
securities sold, not yet purchased. The change in total other (loss) income for
the nine months ended September 30, 2008 is primarily attributable to a
$68.5 million net realized and unrealized loss on derivatives and foreign
exchange of which $86.5 million was related to total rate of return swaps,
a $36.6 million realized loss on sales of investments, and $20.3 million of losses
due to the impairment of securities available-for-sale, all partially offset by
a $20.3 million gain on the extinguishment of junior subordinated notes, and a
$22.9 million net realized and unrealized gain on securities sold, not yet
purchased.
36
Table of Contents
Non-Investment Expenses
The following table presents the components
of non-investment expenses for the three and nine months ended September 30,
2008 and 2007:
Comparative Non-Investment Expense Components
(Amounts
in thousands)
|
|
For the three
months ended
September 30, 2008
|
|
For the three
months ended
September 30, 2007
|
|
For the nine
months ended
September 30, 2008
|
|
For the nine
months ended
September 30, 2007
|
|
Related party management compensation:
|
|
|
|
|
|
|
|
|
|
Base management fees
|
|
$
|
8,729
|
|
$
|
8,229
|
|
$
|
25,089
|
|
$
|
22,502
|
|
Incentive fee
|
|
|
|
|
|
|
|
12,620
|
|
Share-based compensation
|
|
(195
|
)
|
(4,581
|
)
|
462
|
|
1,897
|
|
CLO management fees
|
|
1,277
|
|
1,277
|
|
3,806
|
|
2,319
|
|
Related party management compensation
|
|
9,811
|
|
4,925
|
|
29,357
|
|
39,338
|
|
Professional services
|
|
1,335
|
|
2,194
|
|
4,263
|
|
3,495
|
|
Loan servicing expense
|
|
2,274
|
|
2,729
|
|
7,234
|
|
8,751
|
|
Insurance expense
|
|
302
|
|
161
|
|
621
|
|
547
|
|
Directors expenses
|
|
208
|
|
380
|
|
924
|
|
984
|
|
General and administrative expenses
|
|
3,310
|
|
3,301
|
|
12,549
|
|
12,564
|
|
Total non-investment expenses
|
|
$
|
17,240
|
|
$
|
13,690
|
|
$
|
54,948
|
|
$
|
65,679
|
|
As presented in the table above, our
non-investment expenses increased by $3.6 million for the three months ended
September 30, 2008 compared to September 30, 2007, but decreased by
$10.7 million for the nine months ended September 30, 2008 compared to
September 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 or nine months ended September 30, 2008. For the three and
nine months ended September 30, 2007, incentive fees of nil and $12.6 million
were earned by the Manager, respectively.
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), our
wholly-owned subsidiary 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 U.S. federal 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
subsidiaries treated as disregarded entities or partnerships for U.S. federal
income tax purposes that were established to facilitate securitization
transactions, structured as secured financing transactions, and KKR TRS
Holdings, Ltd. (TRS Ltd.) and KKR Financial Holdings, Ltd. (KFH Ltd.)
are foreign taxable corporate subsidiaries that were formed to make certain
foreign and domestic investments from time to time. TRS Ltd. and KFH Ltd. are
organized as exempted companies incorporated with limited liability under the
laws of the Cayman Islands, and are generally not subject to U.S. federal and
state
37
Table
of Contents
income tax at the corporate entity level because they restrict their
activities in the U.S. to trading in stock and securities for their own
account. Therefore, 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 nine months ended September 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 September 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 corporate 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 September 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
|
|
$
|
8,388,705
|
|
$
|
8,388,705
|
|
$
|
7,100,663
|
|
85.9
|
%
|
Corporate Debt Securities
|
|
166,272
|
|
234,400
|
|
166,272
|
|
2.0
|
|
Total Floating Rate
|
|
8,554,977
|
|
8,623,105
|
|
7,266,935
|
|
87.9
|
|
Fixed Rate:
|
|
|
|
|
|
|
|
|
|
Corporate Loans
|
|
133,027
|
|
133,027
|
|
122,572
|
|
1.5
|
|
Corporate Debt Securities
|
|
851,427
|
|
1,125,101
|
|
851,427
|
|
10.3
|
|
Total Fixed Rate
|
|
984,454
|
|
1,258,128
|
|
973,999
|
|
11.8
|
|
Marketable and Non-Marketable Equity
Securities:
|
|
|
|
|
|
|
|
|
|
Marketable Equity Securities
|
|
5,577
|
|
17,322
|
|
5,577
|
|
0.1
|
|
Non-Marketable Equity Securities
|
|
17,505
|
|
17,505
|
|
17,505
|
|
0.2
|
|
Total Marketable and Non-Marketable Equity
Securities
|
|
23,082
|
|
34,827
|
|
23,082
|
|
0.3
|
|
Total(1)
|
|
$
|
9,562,513
|
|
$
|
9,916,060
|
|
$
|
8,264,016
|
|
100.0
|
%
|
(1)
Total carrying value
excludes allowance for loan losses of $35.0 million and includes corporate
loans held for sale.
The schedule above excludes equity securities
sold, not yet purchased, with a cost of $101.3 million and for which we
had accumulated net unrealized gains of $17.8 million as of September 30,
2008.
38
Table
of Contents
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 $8.5
billion as of September 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 September 30, 2008, $8.4
billion, or 98.4%, of our corporate loan portfolio was floating rate and $0.1
billion, or 1.6%, was fixed rate. As of
December 31, 2007, $8.6 billion, or 99.2%, of 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 6.13% and
7.85% as of September 30, 2008 and December 31, 2007, respectively, and
the weighted-average coupon spread to LIBOR of our floating rate corporate loan
portfolio was 2.92% and 2.87% as of September 30, 2008 and December 31,
2007, respectively. The weighted-average years to maturity of our floating rate
corporate loans was 5.2 years and 5.7 years as of September 30, 2008 and
December 31, 2007, respectively.
As of September 30, 2008, our fixed rate
corporate loans had a weighted-average coupon of 14.07% 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 September 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 September 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 September 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 nine months ended September 30, 2008.
We recorded a $2.4 million charge to earnings
during the quarter ended September 30, 2008 for the lower of cost or estimated
fair value adjustment for corporate loans held for sale which had an estimated
fair value of $28.2 million as of September 30, 2008. We had no corporate loans
held for sale as of December 31, 2007.
39
Table of Contents
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 September 30, 2008 and December 31, 2007:
Corporate Loans
(Amounts
in thousands)
Ratings Category
|
|
As of
September 30, 2008
|
|
As of
December 31, 2007
|
|
Aaa/AAA
|
|
$
|
|
|
$
|
|
|
Aa1/AA+ through Aa3/AA
|
|
|
|
|
|
A1/A+ through A3/A
|
|
|
|
|
|
Baa1/BBB+ through Baa3/BBB
|
|
|
|
10,353
|
|
Ba1/BB+ through Ba3/BB
|
|
3,820,459
|
|
4,595,862
|
|
B1/B+ through B3/B
|
|
4,257,648
|
|
3,391,638
|
|
Caa1/CCC+ and lower
|
|
672,966
|
|
405,584
|
|
Non-rated
|
|
32,664
|
|
362,731
|
|
Total
|
|
$
|
8,783,737
|
|
$
|
8,766,168
|
|
Corporate Debt Securities
Our corporate debt securities portfolio
totaled $1.0 billion as of September 30, 2008 and $1.3 billion as of December 31,
2007. Our corporate debt securities portfolio consists of debt obligations of
corporations, partnerships and other entities in the form of senior secured and
subordinated notes. As of September 30, 2008, $0.9 billion, or 83.7%, of our
corporate debt securities portfolio was fixed rate and $0.2 billion, or 16.3%,
was floating rate. As of December 31,
2007, $1.1 billion, or 84.7%, of our corporate debt securities portfolio was
fixed rate and $0.2 billion, or 15.3%, was floating rate.
As of September 30, 2008, our fixed rate
corporate debt securities had a weighted-average coupon of 10.28% and a
weighted-average years to maturity of 7.0 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 6.12% and 8.39% as of September 30, 2008 and
December 31, 2007, respectively, and the weighted-average coupon spread to
LIBOR of our floating rate corporate debt securities was 3.27% and 3.28% as of September
30, 2008 and December 31, 2007, respectively. The weighted-average years
to maturity of our floating rate corporate debt securities was 5.0 years and
5.4 years as of September 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 September 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 September 30, 2008 and December 31, 2007:
Corporate Debt Securities
(Amounts
in thousands)
Ratings Category
|
|
As of
September 30, 2008
|
|
As of
December 31, 2007
|
|
Aaa/AAA
|
|
$
|
|
|
$
|
|
|
Aa1/AA+ through Aa3/AA
|
|
20,000
|
|
|
|
A1/A+ through A3/A
|
|
20,000
|
|
|
|
Baa1/BBB+ through Baa3/BBB
|
|
|
|
|
|
Ba1/BB+ through Ba3/BB
|
|
32,000
|
|
236,553
|
|
B1/B+ through B3/B
|
|
628,006
|
|
431,478
|
|
Caa1/CCC+ and lower
|
|
695,970
|
|
772,315
|
|
Non-Rated
|
|
6,815
|
|
30,000
|
|
Total
|
|
$
|
1,402,791
|
|
$
|
1,470,346
|
|
40
Table
of Contents
Residential Mortgage Investment
Summary
Our residential mortgage investment portfolio
consists of investments in RMBS with an estimated fair value of $310.4 million
as of September 30, 2008. The $310.4 million of RMBS is comprised of $277.2
million of RMBS that are rated investment grade or higher and $33.2 million of
RMBS that are rated below investment grade. Of the $310.4 million of RMBS
investments we hold, $197.4 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 September 30, 2008, the $310.4 million of RMBS
is computed as our investments in RMBS of $113.0 million, plus $197.4 million,
which represents the difference between residential mortgage loans of $3.1
billion less residential mortgage-backed securities issued of $2.9 billion plus
$10.9 million of real estate owned that is included in other assets on our
condensed consolidated balance sheet. The $310.4 million of RMBS as of
September 30, 2008 represents a decrease of 8.1% from $337.6 million as of
December 31, 2007.
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 September 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,
nationally recognized pricing services and/or managements judgment when
relevant observable inputs do not exist.
The table below summarizes our residential
mortgage investment portfolio as of September 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
|
|
$
|
469,576
|
|
$
|
598,838
|
|
$
|
469,576
|
|
14.8
|
%
|
Residential ARM Securities
|
|
38,217
|
|
49,970
|
|
38,217
|
|
1.2
|
|
Total Floating Rate
|
|
507,793
|
|
648,808
|
|
507,793
|
|
16.0
|
|
Hybrid Rate:
|
|
|
|
|
|
|
|
|
|
Residential Hybrid ARM Loans
|
|
2,596,038
|
|
2,893,815
|
|
2,596,038
|
|
81.6
|
|
Residential Hybrid ARM Securities
|
|
74,762
|
|
80,838
|
|
74,762
|
|
2.4
|
|
Total Hybrid Rate
|
|
2,670,800
|
|
2,974,653
|
|
2,670,800
|
|
84.0
|
|
Total
|
|
$
|
3,178,593
|
|
$
|
3,623,461
|
|
$
|
3,178,593
|
|
100.0
|
%
|
The table below summarizes our 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
|
%
|
41
Table
of Contents
Residential
ARM Securities
Our residential ARM securities portfolio
totaled $38.2 million as of September 30, 2008 and $52.0 million as of December 31,
2007. As of September 30, 2008 and December 31,
2007, substantially all of our residential ARM securities were comprised of
one-month LIBOR floating rate securities that reprice monthly and were subject
to a weighted-average maximum net interest rate of 11.33% and 11.76%,
respectively, which was materially above the then current weighted-average net
coupon of 5.83% and 6.52%, respectively.
Residential ARM Securities
(Amounts
in thousands)
Ratings Category
|
|
As of
September 30, 2008
|
|
As of
December 31, 2007
|
|
Aaa/AAA
|
|
$
|
27,937
|
|
$
|
34,960
|
|
Aa1/AA+ through Aa3/AA
|
|
|
|
|
|
A1/A+ through A3/A
|
|
5,341
|
|
7,326
|
|
Baa1/BBB+ through Baa3/BBB
|
|
3,356
|
|
4,466
|
|
Ba1/BB+ through Ba3/BB
|
|
1,191
|
|
2,049
|
|
B1/B+ through B3/B
|
|
275
|
|
1,196
|
|
Caa1/CCC+ and lower
|
|
|
|
|
|
Non-Rated
|
|
117
|
|
1,967
|
|
Total
|
|
$
|
38,217
|
|
$
|
51,964
|
|
Residential
Hybrid ARM Securities
Our residential
hybrid ARM securities portfolio totaled $74.8 million as of September 30, 2008
and $79.7 million as of December 31, 2007. As of September 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 4.35%
and 4.18% as of September 30, 2008 and December 31, 2007, respectively. As
of September 30, 2008 and December 31, 2007, our weighted-average months
until roll date for the mortgage loans underlying our residential hybrid ARM
securities was 7 and 12, respectively.
Residential Hybrid ARM Securities
(Amounts in thousands)
Ratings Category
|
|
As of
September 30, 2008
|
|
As of
December 31, 2007
|
|
Aaa/AAA
|
|
$
|
18,542
|
|
$
|
23,083
|
|
Aa1/AA+ through Aa3/AA
|
|
26,129
|
|
26,756
|
|
A1/A+ through A3/A
|
|
15,434
|
|
14,898
|
|
Baa1/BBB+ through Baa3/BBB
|
|
6,102
|
|
9,002
|
|
Ba1/BB+ through Ba3/BB
|
|
3,021
|
|
2,915
|
|
B1/B+ through B3/B
|
|
1,856
|
|
1,356
|
|
Caa1/CCC+ and lower
|
|
|
|
|
|
Non-Rated
|
|
3,678
|
|
1,714
|
|
Total
|
|
$
|
74,762
|
|
$
|
79,724
|
|
Residential ARM Loans
Our residential ARM loans portfolio totaled $469.6 million as of September
30, 2008 and $628.7 million as of December 31, 2007. As of September
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 3.68% and 6.19%,
respectively.
42
Table of Contents
Residential Hybrid ARM Loans
Our residential hybrid ARM loans portfolio totaled $2.6 billion as of September
30, 2008 and $3.3 billion as of December 31, 2007. As of September 30,
2008 and December 31, 2007, all of our residential hybrid ARM loans 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 4.87% and 4.88% as of September
30, 2008 and December 31, 2007, respectively. As of September 30, 2008 and
December 31, 2007, the weighted-average months until roll date for the
mortgage loans underlying our residential hybrid ARM securities was 15 and 22,
respectively.
Portfolio Purchases
We purchased $0.5 billion and $1.8 billion par amount of
investments during the three and nine months ended September 30, 2008, compared to $2.2 billion and $5.1 billion for
the three and nine months ended September
30, 2007, respectively.
The table below summarizes our investment portfolio purchases for the
periods indicated and includes the par amount of the corporate debt securities
and loans that were purchased:
Investment Portfolio Purchases
(Dollar amounts in thousands)
|
|
Three months ended
September 30, 2008
|
|
Three months ended
September 30, 2007
|
|
Nine months ended
September 30, 2008
|
|
Nine months ended
September 30, 2007
|
|
|
|
Par Amount
|
|
%
|
|
Par Amount
|
|
%
|
|
Par Amount
|
|
%
|
|
Par Amount
|
|
%
|
|
Securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporate Debt Securities
|
|
$
|
50,000
|
|
10.5
|
%
|
$
|
184,500
|
|
8.4
|
%
|
$
|
176,747
|
|
9.9
|
%
|
$
|
942,500
|
|
18.4
|
%
|
Marketable Equity Securities
|
|
|
|
|
|
2,225
|
|
0.1
|
|
6,496
|
|
0.4
|
|
42,859
|
|
0.8
|
|
Non-Marketable Equity Securities
|
|
|
|
|
|
5,690
|
|
0.2
|
|
|
|
|
|
13,190
|
|
0.3
|
|
Total Securities Principal Balance
|
|
50,000
|
|
10.5
|
|
192,415
|
|
8.7
|
|
183,243
|
|
10.3
|
|
998,549
|
|
19.5
|
|
Loans:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporate Loans
|
|
426,320
|
|
89.5
|
|
2,013,571
|
|
91.3
|
|
1,597,573
|
|
89.7
|
|
4,115,402
|
|
80.5
|
|
Grand Total Principal Balance
|
|
$
|
476,320
|
|
100.0
|
%
|
$
|
2,205,986
|
|
100.0
|
%
|
$
|
1,780,816
|
|
100.0
|
%
|
$
|
5,113,951
|
|
100.0
|
%
|
The schedule above excludes equity securities sold, not yet purchased,
with a cost of $101.3 million and $67.2 million as of September 30, 2008 and
2007, respectively.
Discontinued Operations
Summarized financial information for discontinued operations is as
follows (amounts in thousands):
|
|
As of
September 30, 2008
|
|
As of
December 31, 2007
|
|
Assets of discontinued operations
|
|
$
|
|
|
$
|
3,049,758
|
|
Liabilities of discontinued operations
|
|
$
|
|
|
$
|
3,644,083
|
|
(Loss) income from discontinued operations is as follows (amounts in
thousands):
|
|
Three months ended
|
|
Three months ended
|
|
Nine months ended
|
|
Nine months ended
|
|
|
|
September 30, 2008
|
|
September 30, 2007
|
|
September 30, 2008
|
|
September 30, 2007
|
|
(Loss) income from discontinued operations
|
|
$
|
|
|
$
|
(300,105
|
)
|
$
|
2,668
|
|
$
|
(303,055
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Shareholders Equity
Our shareholders equity at September
30, 2008 and December 31, 2007 totaled $1.7 billion and
$1.6 billion, respectively. Included in our shareholders equity as of September 30, 2008 and December 31,
2007, was accumulated other comprehensive loss totaling $377.9 million and
$157.2 million, respectively.
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Our average shareholders equity and return on average shareholders
equity for the three and nine months ended September
30, 2008 was $1.8 billion and 10.7% and $1.8 billion and 7.6%,
respectively. Our average shareholders equity and return on average
shareholders equity for the three and nine months ended September 30, 2007 was
$1.6 billion and (64.7)% and $1.7 billion and (12.8)%, respectively. Return on
average shareholders equity is defined as net income divided by
weighted-average shareholders equity. Our book value per share as of September 30, 2008 and December 31,
2007 was $11.47 and $14.27, respectively, and is computed based on 150,881,500
and 115,248,990 shares issued and outstanding as of September 30, 2008 and December 31, 2007, respectively.
Liquidity and Capital Resources
We manage our liquidity with the intention of maintaining 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 September 30, 2008, we had unrestricted cash and cash equivalents
totaling $196.5 million and as of the date we filed this Form 10-Q, we had
cash and cash equivalents of approximately $120.0 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,
and implementing our long-term business strategy, although there can be no
assurance in this regard.
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), 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.
Additional factors that may impact our liquidity and capital resources
in light of the current economic environment are described under Impact of
Credit Market Events in the Executive Overview section of this Managements
Discussion and Analysis of Financial Condition and Results of Operations.
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.
Cash Flow CLO Transactions
As of September 30, 2008, we had five cash
flow CLO transactions outstanding, consisting of CLO 2005-1, CLO 2005-2,
CLO
2006-1, CLO 2007-1 and CLO 2007-A. In aggregate, these transaction issued an
aggregate of $8.0 billion of secured notes. An affiliate of our Manager owns a
37% interest in CLO 2007-1 and CLO 2007-A. The par amount of the interests in
the cash flow CLOs held by the affiliate of our Manager is $525.4 million,
which is reflected as collateralized loan obligation junior secured notes to
affiliates on our condensed consolidated balance sheet. In accordance with
GAAP, we consolidate each of these CLO transactions. We utilize cash flow CLOs
to fund our investments in corporate loans and corporate debt securities.
The indentures governing our CLO transactions include numerous
compliance tests, the majority of which relate to the CLOs portfolio profile.
In the event that a portfolio profile test is not met, the indenture places
restrictions on the ability of the CLOs manager to reinvest available
principal proceeds generated by the collateral in the CLOs until the specific
test has been cured.
In addition to the portfolio profile tests, the indentures for the CLO
transactions include over-collateralization tests which set the ratio of the
collateral value of the assets in the CLO to the tranches of debt for which the
test is being measured, as well as interest coverage tests. For purposes of the calculation, collateral
value is the par value of the assets unless an asset is in default, is a
discounted obligation, or is a CCC-rated asset in excess of the percentage of
CCC-rated asset limit specified for each CLO transaction. If an asset is in
default, the indenture for each CLO transaction defines the value used to
determine the collateral value, which value is
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generally the
lower of market value of the asset or the recovery value proscribed for the
asset based on its type and rating by Standard & Poors or Moodys.
A discount obligation is an asset with a purchase price of less than a
particular percentage of par. The discount obligation amounts are specified in
each CLO transaction and are generally set at a purchase price of less than 80%
of par for corporate loans and 75% of par for corporate debt securities.
The indenture for each CLO transaction specifies a CCC-threshold for
the percentage of total assets in the CLO that can be rated CCC. All assets in
excess of the CCC threshold specified for the respective CLO are included in
the over-collateralization test at market value and not par.
Defaults of assets in CLOs, ratings downgrade of assets in CLOs to CCC,
price declines of CCC assets in excess of the proscribed CCC threshold amount,
and price declines in assets classified as discount obligations may reduce the
over-collateralization ratio such that a CLO is not in compliance. If a CLO is
not in compliance with an over-collateralization test, cash flows normally
payable to the holders of junior classes of notes will be used by the CLO to
amortize the most senior class of notes until such point as the
over-collateralization test is brought back into compliance. Recent declines in
asset prices, particularly in the corporate loan and high yield securities
asset classes, have been of a historic magnitude and have therefore increased
the risk of failing the over-collateralization tests on all CLO transactions.
Accordingly, we expect that one or more CLO transactions will be out of
compliance with the over-collateralization tests for periods of time. While
being out of compliance with an over-collateralization test would not impact
our investment portfolio or results of operations, it would impact our
unrestricted cash flows available for operations, new investments and dividend
distributions. As of the date we filed this Form 10-Q, we believe that based on
current asset prices that we would be failing one or more of the
over-collateralization tests for CLO 2006-1, CLO 2007-1 and CLO 2007-A.
Wayzata
Wayzata is a $2.0 billion market value CLO transaction. Through the
transaction, $1.6 billion of senior notes were issued to an unaffiliated third
party and $336.0 million and $84.0 million of junior notes are held by us and
an affiliate of our Manager, respectively. As we own the majority of the junior
notes, we consolidate Wayzata on our condensed consolidated financial
statements. Similar to our cash flow CLOs, we utilize Wayzata to fund our
investments in corporate loans and corporate debt securities.
Wayzatas market value structure provides for an approximately 5%
decline in Wayzatas net asset value to occur prior to any requirement to add
additional junior notes to the facility. In the event that the market value of
the assets financed in the facility decline by greater than the aforementioned 5%
trigger amount, the facility will go into default unless junior notes are
issued in an amount equal to or greater than the aggregate amount of the
decline in the net asset value of the assets financed in the facility. If the
facility were to go into default without remedy, then the holders of the senior
notes would foreclose on the collateral of the facility. As of September 30,
2008, Wayzatas net asset value had not declined below the trigger amount;
however, due to the recent market declines in asset prices, there is no
guarantee Wayzatas net asset value may not decline by greater than the
approximately 5% trigger amount. In addition, Wayzatas market value features
result in cash being effectively trapped in the facility and not being paid to
the junior noteholders, including us, if the net asset value of Wayzata does
not meet certain limits. We believe that based on current asset prices, the net
asset value of Wayzata would result in cash being trapped and that during the
fourth quarter of 2008, Wayzata will cease being cash flow generative to us,
and we cannot predict at this time how long the cessation of cash flows will
last. While maintaining a net asset value of Wayzata below the amount required
to receive cash distributions will not impact our investment portfolio or
results of operations, it will impact our unrestricted cash flows available for
operations, new investments and dividend distributions.
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Senior Secured Asset-Based Revolving Credit
Facility
On November 10,
2008, we and certain of our subsidiaries (collectively, the Borrowers)
entered into a Credit Agreement (the Credit Agreement) with Bank of America,
N.A. and Citicorp North America, Inc., as lenders. The Credit Agreement provides for a two-year
$300.0 million senior secured asset-based revolving credit facility (the
Facility). The Facility is subject, among other things, to the terms of a
borrowing base derived from the value of eligible specified financial
assets. The borrowing base is subject to
certain reserves and caps customary for financings of this type. Prior to the one-year anniversary of the
closing of the credit agreement (the Adjustment Date), the Borrowers (i) may
borrow, prepay and reborrow amounts in excess of the borrowing base
availability and (ii) must prepay loans with net cash proceeds from
certain types of asset sales to the extent aggregate amounts outstanding under
the Facility exceed the borrowing base then in effect. On and after the Adjustment Date, if at any
time the aggregate amounts outstanding under the Facility exceed the borrowing
base then in effect, a prepayment of an amount sufficient to eliminate such
excess is required to be made.
The Borrowers
have the right to prepay loans under the Facility in whole or in part at any
time. All amounts borrowed under the Credit Agreement must be repaid on or
before November 10, 2010. Initial
borrowings under the Credit Agreement are subject to, among other things, the
substantially concurrent repayment by the Borrowers of all amounts due and
owing under the existing credit facility and such facilitys effective
termination.
Loans under
the Credit Agreement bear interest, at the Borrowers option, at a rate equal
to LIBOR plus 3.00% per annum or an alternate base rate. Ongoing extensions of credit under the Credit
Agreement are subject to customary conditions, including, after the Adjustment
Date, sufficient availability under the borrowing base. The Credit Agreement also contains covenants
that require the Borrowers to satisfy a net worth financial test and maintain a
certain leverage ratio. In addition, the
Credit Agreement contains customary negative covenants applicable to the
Borrowers and their subsidiaries, including negative covenants that restrict the
ability of such entities to, among other things, (i) incur additional
indebtedness or engage in certain other types of financing transactions, (ii) allow
certain liens to attach to such entities assets, and (iii) pay dividends
or make certain other restricted payments.
The Credit Agreement also includes other covenants, representations,
warranties, indemnities and events of default, that are customary for
facilities of this type, including events of default relating to a change of
control.
Standby
Revolving Credit Facility
On November 10,
2008, the Borrowers entered into an agreement for a two-year $100.0 million
standby unsecured revolving credit agreement (the Standby Agreement) with our
external manager, KKR Financial Advisors LLC, and Kohlberg Kravis Roberts &
Co. (Fixed Income) LLC, the parent of our external manager. The borrowing
facility matures in December 2010 and bears interest at a rate equal to
LIBOR for an interest period of 1, 2 or 3 months (at our option) plus 15.00%
per annum. Under the terms of the agreement, we can elect to capitalize a
portion of accrued interest on any loan under the agreement by adding up to 80%
of the interest due and payable at a particular time in respect of such loan to
the outstanding principal amount of the loan.
The Borrowers have the right to prepay loans under the Standby Agreement
in whole or in part at any time. The Standby Agreement includes covenants,
representations, warranties, indemnities and events of default that are
customary for facilities of this type.
Junior Subordinated
Notes
During the third quarter of 2008, we 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 unamortized debt issuance costs
and $0.1 million of other associated costs.
During the nine months ended September 30,
2008, we retired $40.0 million of junior subordinated notes, which resulted in
a gain on extinguishment of $20.3 million, partially offset by a $1.3 million
write-off of unamortized debt issuance costs and $0.8 million of other
associated costs.
Capital Utilization and Leverage
As of September 30,
2008 and December 31, 2007, we had shareholders equity totaling $1.7
billion and $1.6 billion, respectively and our leverage was 5.3 times and
6.2 times equity, respectively.
Off-Balance Sheet Commitments
As of September 30, 2008,
we had committed to purchase corporate loans with aggregate commitments
totaling $231.1 million. This amount reflects unsettled trades as of
September 30, 2008.
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 September 30, 2008, we had unfunded
financing commitments totaling $170.6 million.
Partnership
Tax
Matters
Qualifying Income Exception
We intend to continue to operate so as to
qualify as a partnership, and not as an association or a 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 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.
If we fail to satisfy the qualifying income
exception described above, items of income, gain, loss, deduction and credit
would not pass through to holders of our shares and such holders would be
treated for U.S. federal (and certain state and local) income tax purposes as
shareholders in a corporation. In such case, we would be required to pay income
tax at regular corporate rates on all of our income. In addition, we would
likely be liable for state and local income and/or franchise taxes on all of
our income. Distributions to holders of our shares would constitute ordinary
dividend income taxable to such holders to the extent of our earnings and
profits, and these distributions would not be deductible by us. If we were taxable
as a corporation, it could result in a material reduction in cash flow and
after-tax return for holders of our shares and thus could result in a
substantial reduction in the value of our shares and any other securities we
may issue.
Non-Cash Phantom Taxable Income
We intend to continue to operate so as to
qualify, for U.S. federal income tax purposes, as a partnership and not as
an association or a publicly traded partnership taxable as a corporation.
Holders of our shares are subject to U.S. federal income taxation and, in
some cases, state, local and foreign income taxation, on their allocable share
of our taxable income, regardless of whether or when they receive cash
distributions. In addition, certain of our investments, including investments in
foreign CLO issuers and debt securities, may produce taxable income without
corresponding distributions of cash to us or produce taxable income prior to or
following the receipt of cash relating to such income. Consequently, in some
taxable years, holders of
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our shares may recognize taxable income in excess of our cash
distributions, and if we did not pay dividends, would not receive cash
distributions, but would have a tax liability attributable to their allocation
of our taxable income.
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 an
investment company as 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 (the 40%
test). 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 exceptions from the definition
of an investment company provided by Section 3(c)(l) or
Section 3(c)(7) of the Investment Company Act.
We are organized as a holding company that conducts its operations
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 (exclusive of U.S. government securities and cash items) on an
unconsolidated basis. This requirement limits the types of businesses in which
we may engage through our subsidiaries.
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 owning 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 our subsidiaries that issue CLOs, in which we own at
least a majority of the outstanding voting securities as majority-owned
subsidiaries for purposes of the 40% test.
Most of our subsidiaries are limited by the provisions of the
Investment Company Act and the rules and regulations promulgated thereunder
with respect to the assets in which each can invest without being regulated as
an investment company. Our subsidiaries that issue CLOs generally will rely on
Rule 3a-7, an exception from the definition of an investment company under
the Investment Company Act available to certain structured financing vehicles.
These structured financings may not engage in portfolio management practices
resembling those employed by mutual funds. Accordingly, each of our CLO
subsidiaries that relies on Rule 3a-7 is subject to specific guidelines
and restrictions limiting the discretion of the CLO issuer and our collateral
manager. In particular, our guidelines, which are included in the CLO
indentures, prohibit the CLO issuer from acquiring and disposing of assets
primarily for the purposes of recognizing gains or decreasing losses resulting
from market value changes. The CLO issuer cannot acquire or dispose of assets
primarily to enhance returns to the owner of the equity in the CLO. Sales and purchases of assets may be made so
long as the CLO issuer does not violate guidelines contained in the indentures.
The proceeds of permitted dispositions may be reinvested by our CLOs in
additional collateral, subject to fulfilling the requirements set forth in the
applicable indentures. As a result of these restrictions, our CLO subsidiaries
may suffer losses on their assets and we may suffer losses on our investments
in our CLO subsidiaries. We do not treat our ownership interests in our
majority-owned CLO subsidiaries that rely on Rule 3a-7 under the Investment
Company Act as investment securities for purposes of the 40% test.
Some of our subsidiaries are currently relying on the exception
provided by Section 3(c)(7) of the Investment Company Act, and therefore, our
ownership interests in these subsidiaries are deemed to be investment
securities for purposes of the 40% test. We must monitor our holdings in these
subsidiaries and any future subsidiaries relying on the exceptions provided by
Section 3(c)(1) or 3(c)(7) to ensure that the value of our investment in such
subsidiaries, together with any other investment securities we may own, does
not exceed 40% of the value of our total assets (exclusive of U.S. government
securities and cash items) on an unconsolidated basis.
If the combined values of the investment securities issued by our
subsidiaries that must rely on Section 3(c)(1) or 3(c)(7) of the Investment
Company Act, together, with any other investment securities we may own, exceeds
40% of the value of our total assets (exclusive of U.S. government securities
and cash items) on an unconsolidated basis, we may be deemed to be an
investment company. If we fail to maintain an exemption, exception or other
exclusion from registration as an investment company, we could, among other
things, be required either (a) to change substantially the manner in which we
conduct our operations to avoid being required to register as an
investment company or (b) to register as
an investment company, either of which could have a material adverse effect on
us and our ability to service our indebtedness and to make distributions on our
shares and on the market price of our shares and any other securities we may
issue. If we were required to register
as an investment company under the Investment Company Act, we would become
subject to substantial regulation with respect to our capital structure
(including our ability to use leverage), management, operations, transactions
with affiliated persons (as defined
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in the
Investment Company Act), portfolio composition, including restrictions with
respect to diversification and industry concentration, and other matters, and
our Manager would have the right to terminate our management agreement.
We have not requested the SEC to approve our treatment of any company
as a majority-owned subsidiary for purposes of the Investment Company Act, our
treatment of any CLO issuer as a subsidiary meeting the requirements of Rule
3a-7 or our determination of whether or not any investment constitutes an
investment security for purposes of the Investment Company Act. If the SEC were
to disagree with our treatment of one or more CLO issuers as subsidiaries able
to rely on Rule 3a-7, or with our determination that one or more of our
investments otherwise do not constitute investment securities for purposes of
the 40% test, we would need to adjust our investment strategy and our
investments in order to continue to pass the 40% test. Any such adjustment in
our investment strategy or investments could have a material adverse effect on
us. Moreover, to the extent that the SEC provides more specific or different
guidance regarding the application of Section 3
(a)(1)(C), Rule 3a-7,
or other provisions of the Investment Company Act to our business or structure,
we may be required to adjust our investment strategy and investments
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 us.
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.
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) 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.
Liquidity
is of critical importance to companies in the financial services sector. Most
failures of financial institutions in recent times have occurred in large part
due to insufficient liquidity resulting from adverse circumstances. As such, 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. In order
to maintain adequate liquidity and funding, 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
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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.
Derivative Risk
Derivative transactions
including engaging in swaps and foreign currency transactions are subject to
certain risks. There is no guarantee that a company can eliminate its exposure
under an outstanding swap agreement by entering into an offsetting swap
agreement with the same or another party. Also, there is a possibility of
default of the other party to the transaction or illiquidity of the derivative
instrument. Furthermore, the ability to successfully use derivative
transactions depends on the ability to predict market movements which cannot be
guaranteed. As such, participation in derivative instruments may result in
greater losses as we would have to sell or purchase an investment at
inopportune times for prices other than current market prices or may force us
to hold an asset we might otherwise have sold. In addition, as certain
derivative instruments are unregulated, they are difficult to value and are
therefore susceptible to liquidity and credit risks.
Collateral posting
requirements are individually negotiated between counterparties and there is no
regulatory requirement concerning the amount of collateral that a counterparty
must post to secure its obligations under certain derivative instruments.
Because they are unregulated, there is no requirement that parties to a
contract be informed in advance when a credit default swap is sold. As a
result, investors may have difficulty identifying the party responsible for
payment of their claims. If a counterpartys credit becomes significantly
impaired, multiple requests for collateral posting in a short period of time
could increase the risk that we may not receive adequate collateral. Amounts
paid by us as premiums and cash or other assets held in margin accounts with
respect to derivative instruments are not available for investment purposes.
Counterparty Risk
We have credit risks that
are generally related to the counterparties with which we do business. If a
counterparty becomes bankrupt, or otherwise fails to perform its obligations
under a derivative contract due to financial difficulties, we may experience
significant delays in obtaining any recovery under the derivative contract in a
bankruptcy or other reorganization proceeding. These risks of non-performance
may differ from risks associated with exchange-traded transactions which are
typically backed by guarantees and have daily marks-to-market and settlement
positions. Transactions entered into directly between parties do not benefit
from such protections and thus, are subject to counterparty default. It may be
the case where any cash or collateral we pledged to the counterparty may be
unrecoverable and we may be forced to unwind our derivative agreements at a
loss. We may obtain only a limited recovery or may obtain no recovery in such
circumstances, thereby reducing liquidity and earnings.
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.
49
Table of Contents
The following table summarizes the estimated net fair value of our
derivative instruments held at September
30, 2008 and December 31, 2007 (amounts in thousands):
Derivative Fair Value
|
|
As of
September 30, 2008
|
|
As of
December 31, 2007
|
|
|
|
Notional
|
|
Estimated
Fair Value
|
|
Notional
|
|
Estimated
Fair Value
|
|
Cash Flow Hedges:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
$
|
383,333
|
|
$
|
(24,168
|
)
|
$
|
383,333
|
|
$
|
(19,018
|
)
|
Fair Value Hedges:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
32,000
|
|
(1,777
|
)
|
32,000
|
|
(1,212
|
)
|
Free-Standing Derivatives:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
181,073
|
|
(13
|
)
|
690,799
|
|
(7,959
|
)
|
Credit default swapslong
|
|
53,500
|
|
(1,063
|
)
|
66,000
|
|
(1,154
|
)
|
Credit default swapsshort
|
|
300,070
|
|
48,168
|
|
268,000
|
|
12,613
|
|
Total rate of return swaps
|
|
416,597
|
|
(51,864
|
)
|
442,204
|
|
(21,998
|
)
|
Foreign exchange contracts
|
|
64,380
|
|
(1,093
|
)
|
9,711
|
|
3
|
|
Common stock warrants
|
|
|
|
77
|
|
|
|
799
|
|
Total
|
|
$
|
1,430,953
|
|
$
|
(31,733
|
)
|
$
|
1,892,047
|
|
$
|
(37,926
|
)
|
Item 3.
Quantitative and Qualitative Disclosures 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 September 30, 2008. Based on their evaluation, the Companys
principal executive and principal financial officer concluded that the
Companys disclosure controls and procedures as of
September 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 nine months ending September 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
The
Company has been named as a party in various legal actions which include the
matters described below. It is inherently difficult to predict the ultimate
outcome, particularly in cases in which claimants seek substantial or
unspecified damages, or where investigations or proceedings are at an early
age, and the Company cannot predict with certainty the loss or range of loss
that may be incurred. The Company has denied, or believes it has a meritorious
defense and will deny liability in the significant cases pending against the
Company discussed below. Based on current discussion and consultation with
counsel, management believes that the resolution of these matters will not have
a material impact on the financial condition or cash flow of the Company.
On
August 7, 2008, the members of the Companys board of directors and certain of
the Companys executive officers (the Individual Defendants) and the Company
(collectively, Defendants) were named in a putative class action complaint (the
Complaint) filed by Charter Township of Clinton Police and Fire Retirement
System in the United States District Court for the Southern District of New
York (the Charter Litigation). The Complaint alleges that the Companys April
2, 2007
50
Table of Contents
registration
statement and prospectus (the April 2, 2007 Registration Statement) contained
material misstatements and omissions in violation of Section 11 of the
Securities Act of 1933, as amended (the "1933 Act"), regarding the risks associated with the
Companys real estate related assets, the state of the Companys capital in
light of its real estate related assets, and the adequacy of the Companys loss
reserves for its real estate related assets (the alleged Section 11
violation). The Complaint further alleges that pursuant to Section 15 of the
1933 Act, the Individual Defendants have legal responsibility for the alleged
Section 11 violation.
The
parties have stipulated that Defendants shall not be required to answer or
otherwise respond to the Complaint. Pursuant to section 27(a) of the 1933 Act,
the court is required to appoint a Lead Plaintiff by November 5, 2008. The
parties have stipulated that the Lead Plaintiff shall file and serve a
consolidated amended complaint or designate a previously-filed complaint as the
operative complaint (the Operative Complaint) no later than 45 days after an
order appointing it is entered by the Court.
The parties have further stipulated that Defendants shall file an
answer, motion to dismiss, or other response to the Operative Complaint no
later than 45 days after it is served.
On
August 15, 2008, the members of the Companys board of directors and the
Companys executive officers (the Director and Officer Defendants) were named
in a shareholder derivative action (the Derivative Action) brought by Raymond
W. Kostecka, a purported shareholder of the Company, in the Superior Court of
California, County of San Francisco. The Company is named as a nominal
defendant. The complaint in the Derivative Action asserts claims against the
Director and Officer Defendants for breaches of fiduciary duty, abuse of
control, gross mismanagement, waste of corporate assets, and unjust enrichment
in connection with the conduct at issue in the Charter Litigation, including
the filing of the April 2, 2007 Registration Statement with alleged material
misstatements and omissions.
The
parties have submitted a stipulation requesting that the proceedings in the
Derivative Action be stayed until the Charter Litigation is dismissed on the
pleadings or the Company files an answer to the Charter Litigation.
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
None.
Item 5.
Other Information
None.
Item 6.
Exhibits
31.1
|
|
Chief Executive Officer Certification
|
31.2
|
|
Chief Financial Officer Certification
|
32
|
|
Certification Pursuant to 18 U.S.C. Section 1350
|
51
Table of Contents
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:
November 10,
2008
|
|
|
52
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