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
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|
|
|
For the quarterly period ended September 30,
2009
|
|
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|
or
|
|
|
|
o
|
|
TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
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|
|
|
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
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|
11-3801844
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(State or other jurisdiction of
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(I.R.S. Employer
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incorporation or organization)
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Identification No.)
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555 California Street, 50
th
Floor
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|
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San Francisco, CA
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94104
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(Address of principal executive offices)
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(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 has submitted
electronically and posted on its corporate Web site, if any, every Interactive
Data File required to be submitted and posted pursuant to Rule 405 of
Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or
for such shorter period that the registrant was required to submit and post
such files). Yes
o
No
o
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
o
|
|
Accelerated filer
x
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|
|
|
Non-accelerated filer
o
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Smaller reporting company
o
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(Do not check if a smaller reporting company)
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|
|
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 November 2, 2009 was 158,359,757.
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)
|
|
September 30,
2009
|
|
December 31,
2008
|
|
Assets
|
|
|
|
|
|
Cash and cash equivalents
|
|
$
|
125,862
|
|
$
|
41,430
|
|
Restricted cash and cash equivalents
|
|
188,151
|
|
1,233,585
|
|
Securities available-for-sale, $736,823 and
$553,441 pledged as collateral as of September 30, 2009 and
December 31, 2008, respectively
|
|
736,823
|
|
555,965
|
|
Corporate loans, net of allowance for loan losses
of $470,224 and $480,775 as of September 30, 2009 and December 31,
2008, respectively
|
|
6,221,005
|
|
7,246,797
|
|
Residential mortgage-backed securities, at
estimated fair value, $70,256 and $102,814 pledged as collateral as of
September 30, 2009 and December 31, 2008, respectively
|
|
70,256
|
|
102,814
|
|
Residential mortgage loans, at estimated fair
value
|
|
2,274,585
|
|
2,620,021
|
|
Corporate loans held for sale
|
|
504,093
|
|
324,649
|
|
Private equity investments, at estimated fair
value
|
|
76,310
|
|
5,287
|
|
Derivative assets
|
|
23,163
|
|
73,869
|
|
Interest and principal receivable
|
|
60,811
|
|
116,788
|
|
Reverse repurchase agreements
|
|
80,344
|
|
88,252
|
|
Other assets
|
|
98,062
|
|
105,625
|
|
Total assets
|
|
$
|
10,459,465
|
|
$
|
12,515,082
|
|
Liabilities
|
|
|
|
|
|
Collateralized loan obligation senior secured
notes
|
|
$
|
5,706,882
|
|
$
|
7,487,611
|
|
Collateralized loan obligation junior secured
notes to affiliates
|
|
547,421
|
|
655,313
|
|
Senior secured credit facility
|
|
187,500
|
|
275,633
|
|
Convertible senior notes
|
|
275,800
|
|
291,500
|
|
Junior subordinated notes
|
|
283,671
|
|
288,671
|
|
Residential mortgage-backed securities issued, at
estimated fair value
|
|
2,165,423
|
|
2,462,882
|
|
Accounts payable, accrued expenses and other
liabilities
|
|
7,209
|
|
60,124
|
|
Accrued interest payable
|
|
23,840
|
|
61,119
|
|
Accrued interest payable to affiliates
|
|
2,981
|
|
3,987
|
|
Related party payable
|
|
12,893
|
|
2,876
|
|
Securities sold, not yet purchased
|
|
78,633
|
|
90,809
|
|
Derivative liabilities
|
|
57,091
|
|
171,212
|
|
Total liabilities
|
|
9,349,344
|
|
11,851,737
|
|
Shareholders Equity
|
|
|
|
|
|
Preferred shares, no par value, 50,000,000 shares
authorized and none issued and outstanding at September 30, 2009
and December 31, 2008
|
|
|
|
|
|
Common shares, no par value, 500,000,000 shares
authorized, and 158,359,757 and 150,881,500 shares issued and outstanding at
September 30, 2009 and December 31, 2008, respectively
|
|
|
|
|
|
Paid-in-capital
|
|
2,562,262
|
|
2,550,849
|
|
Accumulated other comprehensive income (loss)
|
|
91,761
|
|
(268,782
|
)
|
Accumulated deficit
|
|
(1,543,902
|
)
|
(1,618,722
|
)
|
Total shareholders equity
|
|
1,110,121
|
|
663,345
|
|
Total liabilities and
shareholders equity
|
|
$
|
10,459,465
|
|
$
|
12,515,082
|
|
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
months ended
September 30,
2009
|
|
For the three
months ended
September 30,
2008
|
|
For the nine
months ended
September 30,
2009
|
|
For the nine
months ended
September 30,
2008
|
|
Net investment income:
|
|
|
|
|
|
|
|
|
|
Securities interest income
|
|
$
|
21,701
|
|
$
|
34,507
|
|
$
|
73,805
|
|
$
|
109,104
|
|
Loan interest income
|
|
113,460
|
|
187,756
|
|
364,583
|
|
588,843
|
|
Dividend income
|
|
26
|
|
358
|
|
313
|
|
2,266
|
|
Other interest income
|
|
49
|
|
4,431
|
|
511
|
|
20,505
|
|
Total investment income
|
|
135,236
|
|
227,052
|
|
439,212
|
|
720,718
|
|
Interest expense
|
|
(57,340
|
)
|
(118,105
|
)
|
(219,625
|
)
|
(400,207
|
)
|
Interest expense to affiliates
|
|
(5,171
|
)
|
(18,794
|
)
|
(16,355
|
)
|
(66,319
|
)
|
Provision for loan losses
|
|
|
|
|
|
(39,795
|
)
|
(10,000
|
)
|
Net investment income
|
|
72,725
|
|
90,153
|
|
163,437
|
|
244,192
|
|
Other income (loss):
|
|
|
|
|
|
|
|
|
|
Net realized and unrealized gain (loss) on
derivatives and foreign exchange
|
|
19,930
|
|
(15,534
|
)
|
58,831
|
|
(68,468
|
)
|
Net realized and unrealized gain (loss) on
investments
|
|
21,181
|
|
(28,278
|
)
|
(85,576
|
)
|
(59,254
|
)
|
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
|
|
(17,681
|
)
|
121
|
|
(44,545
|
)
|
(14,651
|
)
|
Net realized and unrealized (loss) gain on
securities sold, not yet purchased
|
|
(996
|
)
|
14,242
|
|
2,920
|
|
22,892
|
|
Net (loss) gain on restructuring and extinguishment
of debt
|
|
(10,627
|
)
|
3,056
|
|
30,836
|
|
20,281
|
|
Other income
|
|
1,239
|
|
2,470
|
|
4,150
|
|
7,939
|
|
Total other income (loss)
|
|
13,046
|
|
(23,923
|
)
|
(33,384
|
)
|
(91,261
|
)
|
Non-investment expenses:
|
|
|
|
|
|
|
|
|
|
Related party management compensation
|
|
14,616
|
|
9,811
|
|
36,132
|
|
29,357
|
|
General, administrative and directors expenses
|
|
1,539
|
|
3,820
|
|
6,917
|
|
14,094
|
|
Professional services
|
|
441
|
|
1,335
|
|
5,916
|
|
4,263
|
|
Loan servicing
|
|
1,925
|
|
2,274
|
|
6,117
|
|
7,234
|
|
Total non-investment expenses
|
|
18,521
|
|
17,240
|
|
55,082
|
|
54,948
|
|
Income from continuing operations before income tax
expense
|
|
67,250
|
|
48,990
|
|
74,971
|
|
97,983
|
|
Income tax expense
|
|
(63
|
)
|
|
|
(151
|
)
|
(116
|
)
|
Income from continuing operations
|
|
67,187
|
|
48,990
|
|
74,820
|
|
97,867
|
|
Income from discontinued operations
|
|
|
|
|
|
|
|
2,668
|
|
Net income
|
|
$
|
67,187
|
|
$
|
48,990
|
|
$
|
74,820
|
|
$
|
100,535
|
|
|
|
|
|
|
|
|
|
|
|
Net income per common share:
|
|
|
|
|
|
|
|
|
|
Basic
|
|
|
|
|
|
|
|
|
|
Income per share from continuing operations
|
|
$
|
0.42
|
|
$
|
0.32
|
|
$
|
0.49
|
|
$
|
0.71
|
|
Income per share from discontinued operations
|
|
$
|
|
|
$
|
|
|
$
|
|
|
$
|
0.02
|
|
Net income per share
|
|
$
|
0.42
|
|
$
|
0.32
|
|
$
|
0.49
|
|
$
|
0.73
|
|
Diluted
|
|
|
|
|
|
|
|
|
|
Income per share from continuing operations
|
|
$
|
0.42
|
|
$
|
0.32
|
|
$
|
0.49
|
|
$
|
0.71
|
|
Income per share from discontinued operations
|
|
$
|
|
|
$
|
|
|
$
|
|
|
$
|
0.02
|
|
Net income per share
|
|
$
|
0.42
|
|
$
|
0.32
|
|
$
|
0.49
|
|
$
|
0.73
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-average number of common shares
outstanding:
|
|
|
|
|
|
|
|
|
|
Basic
|
|
156,997
|
|
149,612
|
|
152,664
|
|
136,777
|
|
Diluted
|
|
156,997
|
|
149,612
|
|
152,664
|
|
136,777
|
|
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) Income
|
|
Accumulated
Deficit
|
|
Comprehensive
Income
|
|
Total
Shareholders
Equity
|
|
Balance at January 1, 2009
|
|
150,881
|
|
$
|
2,550,849
|
|
$
|
(268,782
|
)
|
$
|
(1,618,722
|
)
|
|
|
$
|
663,345
|
|
Net income
|
|
|
|
|
|
|
|
74,820
|
|
$
|
74,820
|
|
74,820
|
|
Net change in unrealized loss on cash flow hedges
|
|
|
|
|
|
24,569
|
|
|
|
24,569
|
|
24,569
|
|
Net change in unrealized loss on securities
available-for-sale
|
|
|
|
|
|
335,974
|
|
|
|
335,974
|
|
335,974
|
|
Comprehensive income
|
|
|
|
|
|
|
|
|
|
$
|
435,363
|
|
|
|
Issuance of common shares
|
|
7,479
|
|
8,808
|
|
|
|
|
|
|
|
8,808
|
|
Share-based compensation expense related to
restricted common shares
|
|
|
|
2,605
|
|
|
|
|
|
|
|
2,605
|
|
Balance at September 30,
2009
|
|
158,360
|
|
$
|
2,562,262
|
|
$
|
91,761
|
|
$
|
(1,543,902
|
)
|
|
|
$
|
1,110,121
|
|
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, 2009
|
|
For the nine months
ended September 30, 2008
|
|
Cash flows from operating
activities:
|
|
|
|
|
|
Net income
|
|
$
|
74,820
|
|
$
|
100,535
|
|
Adjustments to reconcile net income to net cash
provided by operating activities:
|
|
|
|
|
|
Net realized and unrealized (gain) loss on
derivatives, foreign exchange, and securities sold, not yet purchased
|
|
(61,751
|
)
|
45,576
|
|
Gain on restructuring and extinguishment of debt
|
|
(59,635
|
)
|
(20,281
|
)
|
Write-off of debt issuance costs
|
|
4,611
|
|
1,224
|
|
Lower of cost or estimated fair value adjustment on
corporate loans held for sale
|
|
38,898
|
|
2,353
|
|
Provision for loan losses
|
|
39,795
|
|
10,000
|
|
Impairment on securities available-for-sale
|
|
40,013
|
|
20,254
|
|
Share-based compensation
|
|
2,605
|
|
959
|
|
Net realized and unrealized loss (gain) on
residential mortgage-backed securities, residential mortgage loans, and
liabilities at estimated fair value
|
|
44,545
|
|
(7,568
|
)
|
Net realized and unrealized (gain) loss on
investments
|
|
6,665
|
|
39,735
|
|
Depreciation and net amortization
|
|
(38,731
|
)
|
(26,043
|
)
|
Changes in assets and liabilities:
|
|
|
|
|
|
Interest receivable
|
|
50,057
|
|
32,617
|
|
Other assets
|
|
(11,911
|
)
|
(11,897
|
)
|
Related party payable
|
|
10,017
|
|
(4,623
|
)
|
Accounts payable, accrued expenses and other
liabilities
|
|
(47,847
|
)
|
(27,953
|
)
|
Accrued interest payable
|
|
(37,278
|
)
|
(57,656
|
)
|
Accrued interest payable to affiliates
|
|
18,893
|
|
17,556
|
|
Net cash provided by operating activities
|
|
73,766
|
|
114,788
|
|
Cash flows from investing
activities:
|
|
|
|
|
|
Principal payments from investments
|
|
879,235
|
|
1,307,765
|
|
Proceeds from sale of investments
|
|
1,069,201
|
|
1,415,574
|
|
Purchases of investments
|
|
(685,456
|
)
|
(1,818,037
|
)
|
Net proceeds, purchases, and settlements of
derivatives
|
|
20,530
|
|
(52,811
|
)
|
Net change in reverse repurchase agreements
|
|
7,908
|
|
42,195
|
|
Net reductions to restricted cash and cash
equivalents
|
|
1,045,434
|
|
212,359
|
|
Net cash provided by investing activities
|
|
2,336,852
|
|
1,107,045
|
|
Cash flows from financing
activities:
|
|
|
|
|
|
Net change in repurchase agreements, senior secured
credit facility, and secured demand loan
|
|
(88,133
|
)
|
(2,620,935
|
)
|
Net change in asset-backed secured liquidity notes
|
|
|
|
(136,596
|
)
|
Repayment of residential mortgage-backed securities
issued
|
|
(442,984
|
)
|
(531,601
|
)
|
Repayment of collateralized loan obligation senior
secured notes
|
|
(1,788,694
|
)
|
|
|
Issuance of collateralized loan obligation senior
secured notes
|
|
|
|
1,600,000
|
|
Net change in subordinated notes to affiliates
|
|
|
|
(43,880
|
)
|
Net change in junior subordinated notes
|
|
(1,238
|
)
|
(20,956
|
)
|
Net proceeds from common share offering
|
|
|
|
383,519
|
|
Distributions on common shares
|
|
|
|
(178,310
|
)
|
Other capitalized costs
|
|
(5,137
|
)
|
(628
|
)
|
Net cash used in financing activities
|
|
(2,326,186
|
)
|
(1,549,387
|
)
|
Net increase (decrease) in cash
and cash equivalents
|
|
84,432
|
|
(327,554
|
)
|
Cash and cash equivalents at
beginning of period
|
|
41,430
|
|
524,080
|
|
Cash and cash equivalents at
end of period
|
|
$
|
125,862
|
|
$
|
196,526
|
|
Supplemental cash flow
information:
|
|
|
|
|
|
Cash paid for interest
|
|
$
|
247,029
|
|
$
|
547,266
|
|
Cash paid for income taxes
|
|
$
|
373
|
|
$
|
100
|
|
Non-cash investing and
financing activities:
|
|
|
|
|
|
Conversion from corporate loans to corporate debt
securities
|
|
$
|
|
|
$
|
331,725
|
|
Distributions of securities to the asset-backed
secured liquidity noteholders
|
|
$
|
|
|
$
|
3,623,049
|
|
Conversion of corporate loan to private equity
investment
|
|
$
|
48,467
|
|
$
|
|
|
Exchange of convertible senior notes to equity
|
|
$
|
8,808
|
|
$
|
|
|
Exchange of CLO 2009-1 subordinated notes to
affiliate for 20% interest in CLO 2009-1 assets
|
|
$
|
90,429
|
|
|
|
|
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 below investment grade corporate
debt, including senior secured and unsecured loans, mezzanine loans, high yield
corporate bonds, distressed and stressed debt securities, marketable equity
securities, private equity investments and credit default and total rate of return
swaps. The corporate loans the Company invests in are generally referred to as
syndicated bank loans, or leveraged loans, and are purchased via assignment or
participation in either the primary or secondary market. The majority of the
Companys corporate debt investments are held in collateralized loan obligation
(CLO) transactions that the Company uses as long term financing for these
investments. The Companys CLO transactions are structured as on-balance sheet
securitizations of corporate loans and high yield debt securities. The senior
secured notes issued by the CLO transactions are generally owned by third party
investors who are unaffiliated with the Compa
ny and the Company owns the majority of the
subordinated notes in the CLO transactions.
The Company closely
monitors its liquidity position and believes it has sufficient liquidity and
access to liquidity to meet its financial obligations for at least the next 12
months. The Company believes that it is in compliance with the covenants contained
in its borrowing agreements.
KKR Financial Advisors LLC (the Manager), a
wholly owned subsidiary of Kohlberg Kravis Roberts & Co. (Fixed
Income) LLC, manages the Company pursuant to a management agreement (the Management
Agreement). Kohlberg Kravis Roberts & Co. (Fixed
Income) LLC is 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.
Certain prior period amounts
have been reclassified to conform to the current periods presentation.
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,
2008. 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.
Subsequent Events
The Company
evaluated subsequent events through the date the financial statements were
issued on November 5, 2009.
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 the Financial Accounting Standards Board (FASB)
Accounting Standards Codification (ASC, or collectively the Codification)
810,
Consolidation
(FASB ASC 810). In
general, an enterprise is required 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.
7
Table of Contents
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 KKR Financial CLO 2009-1, Ltd. (CLO
2009-1), 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
FASB ASC 860,
Transfers and Servicing
(FASB
ASC 860)
. 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 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
As defined in FASB ASC 820,
Fair Value Measurements
and Disclosures
(FASB ASC 820), 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 condensed consolidated balance
sheets are categorized based upon the level of judgment associated with the
inputs used to measure their value. Hierarchical levels which are 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, certain corporate loans held
for sale, certain private equity investments, certain securities sold, not yet
purchased and certain financial instruments classified as derivatives where the
fair value is based on observable market inputs.
Level 3: Inputs are unobservable inputs for the asset or
liability, and include situations where there is little, if any, market
activity for the asset or liability. In certain cases, the inputs used to
measure fair value may fall into different levels of the fair value hierarchy.
In such cases, the level in the fair value hierarchy within which the fair
value measurement in its entirety falls has been determined based on the lowest
level input that is significant to the fair value measurement in its entirety.
The Companys assessment of the significance of a particular input to the fair
value measurement in its entirety requires judgment and 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, certain corporate loans
held for sale, certain private equity investments, residential mortgage-backed
securities, residential mortgage loans, real estate owned (REO), residential
mortgage-backed securities issued and certain derivatives.
During
the second quarter of 2009, the Company adopted FASB ASC 820-10-65. This topic
provides additional guidance on determining fair value when the volume and
level of activity for the asset or liability have significantly decreased when
compared with normal market activity for the asset or liability (or similar
assets or liabilities). A significant decrease in the volume and level of
activity for the asset or liability is an indication that transactions or
quoted prices may not be determinative of fair value because in such market
conditions there may be increased instances of transactions that are not
orderly. In those circumstances, further analysis of transactions or quoted
prices is needed, and a significant adjustment to the transactions or quoted
prices may be necessary to estimate fair value. The adoption did not have a material impact on the Companys
condensed consolidated financial statements.
8
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The availability of observable inputs can vary depending on the
financial asset or liability and is affected by a wide variety of factors,
including, for example, the type of product, whether the product is new,
whether the product is traded on an active exchange or in the secondary market,
and the current market condition. To the extent that valuation is based on
models or inputs that are less observable or unobservable in the market, the
determination of fair value requires more judgment. Accordingly, the degree of
judgment exercised by the Company in determining fair value is greatest for
instruments categorized in level 3. In certain cases, the inputs used to
measure fair value may fall into different levels of the fair value hierarchy.
In such cases, for disclosure purposes, the level in the fair value hierarchy
within which the fair value measurement in its entirety falls is determined
based on the lowest level input that is significant to the fair value
measurement in its entirety.
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.
The valuation techniques used for the assets and liabilities that are valued
using level 3 of the fair value hierarchy 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
industry recognized models (including Intex and Bloomberg) and data for similar
instruments (e.g., nationally recognized pricing services or broker
quotes). The most significant inputs to the valuation of these instruments are
default and loss expectations and market 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 valuation models. Valuation
models are based on discounted cash flow techniques, for which the key inputs
are the amount and timing of expected future cash flows, market yields for such
instruments and recovery assumptions. Inputs are generally determined based on
relative value analyses, which incorporate similar instruments from similar
issuers.
Over-the-counter (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.
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand, cash held in banks and
highly liquid investments with original maturities of three months or less.
Interest income earned on cash and cash equivalents is recorded in other
interest income.
Restricted Cash and Cash Equivalents
Restricted cash and cash equivalents represent amounts that are held by
third parties under certain of the Companys financing and derivative
transactions. Interest income earned on restricted cash and cash equivalents is
recorded in other interest income.
On the condensed consolidated statement of cash flows, net additions or
reductions to restricted cash and cash equivalents are classified as an
investing activity as restricted cash and cash equivalents reflect the receipts
from collections or sales of investments, as well as payments made to acquire
investments held by third parties.
Residential Mortgage-Backed Securities
The
Company carries its residential mortgage-backed securities at estimated fair
value with unrealized gains and losses reported in income.
The Company
elected the fair value option for its residential mortgage investments for the
purpose of enhancing the transparency of its financial condition as fair value
is consistent with how the Company manages the risks of its residential
mortgage investments.
9
Table of Contents
Securities Available-for-Sale
The Company classifies its investments in securities as
available-for-sale as the Company may sell them prior to maturity and does not
hold them principally for the purpose of selling them in the near term. These
investments are carried at estimated fair value, with unrealized gains and
losses reported in accumulated other comprehensive income (loss). Estimated
fair values are based on quoted market prices, when available, on estimates
provided by independent pricing sources or dealers who make markets in such
securities, or internal valuation models when external sources of fair value
are not available. 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 and the severity of the decline, the amount of the
unrealized loss, recent events specific to the issuer or industry, external
credit ratings and recent changes in such ratings. In addition, for debt securities,
the Company considers its intent to sell the debt security, the Companys
estimation of whether or not it expects to recover the debt securitys entire
amortized cost if it intends to hold the debt security, and whether it is more
likely than not that the Company will be required to sell the debt security
before its anticipated recovery. For equity securities, the Company also
considers its intent and ability to hold the equity security for a period of
time sufficient for a recovery in value.
The amount of the loss that 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 is dependent on certain factors. If the security is an
equity security or if the security is a debt security that the Company intends
to sell or estimates that it is more likely than not that the Company will be
required to sell before recovery of its amortized cost, then the impairment
amount recognized in earnings is the entire difference between the estimated
fair value of the security and its amortized cost. For debt securities that the
Company does not intend to sell or estimates that it is not more likely than
not to be required to sell before recovery, the impairment is separated into
the estimated amount relating to credit loss and the estimated amount relating
to all other factors. Only the estimated credit loss amount is recognized in
earnings, with the remainder of the loss amount recognized in other
comprehensive income (loss).
During the second quarter of 2009, the Company
adopted FASB ASC 320-10-65 which amends the other-than-temporary impairment
guidance for debt securities to make the guidance more operational and to
improve the presentation and disclosure of other-than-temporary impairments on
debt and equity securities in the financial statements. The adoption of did not
have a material impact on the Companys condensed consolidated financial
statements.
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.
Private Equity Investments
Private equity investments are accounted for under either the cost
method or at fair value if the fair value option of accounting has been
elected. The Company evaluates its investments accounted for under the cost
method on a quarterly basis 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. Private equity investments recorded at
cost are included in other assets on the condensed consolidated balance sheets.
Private equity investments carried at fair value are presented separately on
the condensed consolidated balance sheets, with unrealized gains and losses
reported in net realized and unrealized gains and losses on investments.
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.
10
Table
of Contents
Corporate Loans
The Company purchases participations and assignments in corporate loans
in the primary and secondary market. Loans are held for investment and the
Company initially records loans at their purchase prices. The Company
subsequently accounts for loans based on their outstanding principal plus or
minus unaccreted purchase discounts and unamortized purchase premiums. In
certain instances, where the credit fundamentals underlying a particular loan
have materially changed in such a manner that the Companys expected return may
decrease, the Company may elect to sell a loan held for investment. Interest
income on loans includes interest at stated coupon rates adjusted for accretion
of purchase discounts and the amortization of purchase premiums. Unamortized
premiums and unaccreted discounts are recognized in interest income over the
contractual life, adjusted for actual prepayments, of the loans using the
effective interest method.
A loan is generally 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. As such, loans placed on non-accrual status may or may not
be contractually past due at the time of such determination. 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 using the cost-recovery method, cash-basis method or some
combination of the two methods. An impaired loan may be left on accrual status
during the period the Company is pursuing repayment of the loan. A loan is
placed back on accrual status when the ultimate collectability of the principal
and interest is not in doubt.
Residential Mortgage Loans
The
Company carries its residential mortgage loans at estimated fair value with
unrealized gains and losses reported in income.
The Company elected the
fair value option for its residential mortgage investments for the purpose of
enhancing the transparency of its financial condition as fair value is
consistent with how the Company manages the risks of its residential mortgage
investments.
Corporate Loans Held for Sale
Corporate loans held for sale consist of 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 loan losses represents its estimate of probable credit
losses inherent in its corporate loan portfolio held for investment as of the
balance sheet date. Estimating the Companys allowance for loan losses involves
a high degree of management judgment and is based upon a comprehensive review
of the Companys loan portfolio that is performed on a quarterly basis. The
Companys allowance for loan losses consists of two components, an allocated
component and an unallocated component. The allocated component of the
allowance for loan losses pertains to specific loans that the Company has
determined are impaired. The Company determines a loan is impaired when
management estimates that it is probable that the Company will be unable to
collect all amounts due according to the contractual terms of the loan
agreement. On a quarterly basis, the Company performs a comprehensive review of
its entire loan portfolio and identifies certain loans that it has determined
are impaired. Once a loan is identified as being impaired, the Company places
the loan on non-accrual status, unless the loan is already on non-accrual
status, and records a reserve that reflects managements best estimate of the
loss that the Company expects to recognize from the loan. Generally, the
expected loss is estimated as being the difference between the Companys
current cost basis of the loan, including accrued interest receivable, and the
loans estimated fair value.
The
unallocated component of the Companys allowance for loan losses reflects its
estimate of probable losses in the loan portfolio as of the balance sheet date
where the specific loan that the loan loss relates to is indeterminable. The
Company estimates the unallocated component of the allowance for loan losses
through a comprehensive review of its loan portfolio and identifies certain
loans that demonstrate possible indicators of impairment. This assessment
excludes all loans that are determined to be impaired and as a result, an
allocated reserve has been recorded. Such indicators include, but are not
limited to, the current and/or forecasted financial performance and liquidity
profile of the issuer, specific industry or economic conditions that may impact
the issuer, and the observable trading price of the loan if available. Loans that
demonstrate possible indicators of impairment are aggregated on a watch list
for monitoring and are sub-divided for categorization based on the seniority of
the loan in the issuers capital structure, whether the loan is secured or
unsecured, and the nature of the collateral securing the loan, for purposes of
applying possible default and loss severity ranges based on the nature of the
issuer and the specific loan. The Company applies a range of default and loss
severity estimates in order to estimate a range of loss outcomes upon which to
base its estimate of probable losses that results in the determination of the
unallocated component of the Companys allowance for loan losses.
11
Table of Contents
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 and other secured
and unsecured borrowings. The Company recognizes interest expense on all
borrowings on an accrual basis.
Residential Mortgage-Backed Securities Issued
The
Company carries its residential mortgage-backed securities issued at estimated
fair value with unrealized gains and losses reported in income.
The Company
elected the fair value option for its residential mortgage-backed securities
issued for the purpose of enhancing the transparency of its financial condition
as fair value is consistent with how the Company manages the risks of its
residential mortgage portfolio.
Trust Preferred Securities
Trusts formed by the Company for the sole purpose of issuing trust
preferred securities are not consolidated by the Company as the Company has
determined that it is not the primary beneficiary of such trusts as defined by
FASB ASC 810. 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 on the condensed consolidated
balance sheet 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 non-net
investment 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, 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-United States dollar denominated
securities and loans. As a result, the Company is subject to the risk of
fluctuation in the exchange rate between the United States 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 United States 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 United States 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.
12
Table of Contents
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 16 to these condensed consolidated financial
statements 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 the Manager using a fair value based methodology.
Compensation
cost related to restricted common
shares issued to the Companys
directors is measured at its estimated fair value at
the grant date, and is
amortized and expensed over the
vesting period on a
straight-line basis. Compensation cost related
to restricted common shares
and common
share options issued to the Manager is initially measured at estimated fair
value at the grant date, and is remeasured on subsequent dates to the extent
the
awards are unvested. The Company has elected to use the graded vesting
attribution method to amortize compensation expense for the restricted common
shares and common share options granted to the Manager.
Income Taxes
The Company intends to continue to operate in order to qualify as a
partnership, and not as an association or publicly traded partnership that is
taxable as a corporation, for United States federal income tax purposes.
Therefore, the Company is not subject to United States 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 TRS Holdings, Ltd. (TRS Ltd.), KKR Financial Holdings, Ltd. (KFH
Ltd.), and KFN PEI VII, LLC (PEI VII) are taxable as corporations for United
States federal income tax purposes and thus are not consolidated with the
Company for United States 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 PEI VII, a
domestic taxable corporate subsidiary, because PEI VII is taxed as a regular
corporation under the Internal Revenue Code of 1986, as amended (the Code).
Deferred income tax assets and liabilities are computed based on temporary
differences between the GAAP consolidated financial statements and the United
States 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, CLO 2007-A and CLO 2009-1 are foreign subsidiaries of the Company that
elected to be treated as disregarded entities or partnerships for United States
federal income tax purposes. These subsidiaries were established to facilitate
securitization transactions, structured as secured financing transactions. TRS
Ltd. and KFH Ltd. are foreign corporate subsidiaries that were formed to make
certain foreign 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 United
States federal and state income tax at the corporate entity level because they
restrict their activities in the United States to trading in stock and
securities for their own account. However, the Company will generally be
required to include their current taxable income in the Companys calculation
of its taxable income allocable to shareholders.
Earnings Per Share
Effective January 1, 2009, the Company calculates EPS using the
two-class method which is an earnings allocation formula that determines EPS
for common shares and participating securities. Unvested share-based payment
awards that contain non-forfeitable rights to dividends or dividend equivalents
(whether paid or unpaid) are participating securities and shall be included in
the computation of EPS using the two-class method. Accordingly, all earnings
(distributed and undistributed) are allocated to common shares and
participating securities based on their respective rights to receive dividends.
The Company presents both basic and diluted earnings (loss) per common
share in its condensed consolidated financial statements and footnotes thereto.
Basic earnings (loss) per common share (Basic EPS) excludes dilution and is
computed by dividing net income or loss by the weighted-average number of
common shares, including vested restricted common shares, outstanding for the
period. Diluted earnings (loss) per share (Diluted EPS) reflects the
potential dilution of common share options and unvested restricted common
shares using the treasury method, as well as the potential dilution of
convertible senior notes using the if-converted method, if they are not
anti-dilutive. See Note 3 to these condensed consolidated financial statements
for earnings (loss) per common share computations.
13
Table of Contents
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 January 2009, the FASB issued FASB ASC 325-40-65 which
eliminates the requirement that a holders best estimate of cash flows be based
upon those that a market participant would use. Instead, it requires that an
other-than-temporary impairment be recognized as a realized loss when it is probable
there has been an adverse change in the holders estimated cash flows from the
cash flows previously projected. The topic also reiterates and emphasizes the
related guidance and disclosure requirements in accordance with the FASB ASC
320,
Investments-Debt and Equity Securities
.
The standard is effective for all periods ending after December 15, 2008
and retroactive application is not permitted. The Company has taken this topic
into consideration when evaluating its investments for other-than-temporary
impairment.
On June 12, 2009,
the FASB issued Statement of Financial Accounting Standards (SFAS) No. 166,
Accounting for Transfers of Financial Assets, an
amendment of FASB Statement No. 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities
(SFAS
No. 140) (collectively SFAS No. 166). The most significant
amendments that SFAS No. 166 makes consist of the removal of the concept
of a qualifying special-purpose entity (QSPE) from FASB ASC 860 and the
elimination of the exception for QSPE from the consolidation guidance of FASB
ASC 810. The disclosures required by this standard are to provide greater
transparency about transfers of financial assets and an entitys continuing
involvement in transferred financial assets. SFAS No. 166 will
significantly affect existing securitizations that use QSPEs, as well as future
securitizations. SFAS No. 166 is effective January 1, 2010 for
calendar-year reporting entities and earlier application is prohibited. The
Company
is evaluating the impact of adopting SFAS No. 166.
Also on June 12,
2009, the FASB issued SFAS No. 167,
Amendment to FASB
Interpretation No. 46(R)
(SFAS No. 167) which
addresses the effects of elimination of the QSPE concept from FASB ASC 860 and
responds to concerns about the application of certain key provisions of FASB
ASC 810, including concerns over the transparency of enterprises involvement
with VIEs. SFAS No. 167 requires additional disclosures for various areas
including situations that use significant judgment and assumptions in
determining whether or not to consolidate a VIE as well as the nature of and
changes in the risks associated with a VIE. This standard is effective for
calendar year-end companies beginning on January 1, 2010. The Company is
evaluating the impact of adopting SFAS No. 167.
In September 2009, the FASB issued Accounting
Standards Update (
ASU) 2009-5 which amends FASB ASC 820 to provide
further guidance on how to measure the fair value of a liability. ASU
2009-5 primarily s
ets
forth the types of valuation techniques to be used to value a liability when a
quoted price in an active market for the identical liability is not available.
In these circumstances, ASU 2009-5 states that a company can apply the quoted
price of an identical or similar liability when traded as an asset, or other
valuation techniques that are consistent with principles of FASB ASC 820. ASU
2009-5 is effective beginning the fourth quarter of 2009. The Company does not
believe the adoption of ASU 2009-5 will have a material impact on its financial
statements.
Note 3. Earnings per Share
Effective January 1, 2009, the Company calculates EPS using the
two-class method which is an earnings allocation formula that determines EPS
for common shares and participating securities. Unvested share-based payment
awards that contain non-forfeitable rights to dividends or dividend equivalents
(whether paid or unpaid) are participating securities and shall be included in
the computation of EPS using the two-class method. Accordingly, all earnings
(distributed and undistributed) are allocated to common shares and
participating securities based on their respective rights to receive dividends.
The Company calculates basic net income per common share by dividing
net income for the period by the weighted-average number of shares of its
common shares outstanding for the period. Diluted net income per common share
is calculated by dividing net income by the weighted-average number of common
shares plus potentially dilutive common shares outstanding during the period.
Potentially dilutive common shares include the assumed exercise of outstanding
common share options and assumed vesting of outstanding restricted common
shares using the treasury stock method, as well as the assumed conversion of
convertible senior notes using the if-converted method, if they are not
anti-dilutive.
14
Table of Contents
The following table presents a reconciliation of basic and diluted net
income per common share, as well as the distributions declared per common share
for the three and nine months ended September 30, 2009 and 2008 (amounts
in thousands, except per share information):
|
|
Three months ended September 30,
|
|
Nine months ended September 30,
|
|
|
|
2009 (1)
|
|
2008 (1)
|
|
2009 (1)
|
|
2008 (1)
|
|
Income from continuing operations
|
|
$
|
67,187
|
|
$
|
48,990
|
|
$
|
74,820
|
|
$
|
97,867
|
|
Less: Dividends and undistributed earnings
allocated to participating securities
|
|
574
|
|
378
|
|
657
|
|
856
|
|
Income from continuing operations applicable to
common shareholders
|
|
66,613
|
|
48,612
|
|
74,163
|
|
97,011
|
|
Income from discontinued operations
|
|
|
|
|
|
|
|
2,668
|
|
Net income applicable to common shareholders
|
|
$
|
66,613
|
|
$
|
48,612
|
|
$
|
74,163
|
|
$
|
99,679
|
|
|
|
|
|
|
|
|
|
|
|
Basic:
|
|
|
|
|
|
|
|
|
|
Basic weighted-average shares outstanding
|
|
156,997
|
|
149,612
|
|
152,664
|
|
136,777
|
|
Income per share from continuing operations
|
|
$
|
0.42
|
|
$
|
0.32
|
|
$
|
0.49
|
|
$
|
0.71
|
|
Income per share from discontinued operations
|
|
$
|
|
|
$
|
|
|
$
|
|
|
$
|
0.02
|
|
Net income per share
|
|
$
|
0.42
|
|
$
|
0.32
|
|
$
|
0.49
|
|
$
|
0.73
|
|
|
|
|
|
|
|
|
|
|
|
Diluted:
|
|
|
|
|
|
|
|
|
|
Basic weighted-average shares outstanding
|
|
156,997
|
|
149,612
|
|
152,664
|
|
136,777
|
|
Dilutive effect of restricted common shares
|
|
|
|
|
|
|
|
|
|
Diluted weighted-average shares outstanding (2)
|
|
156,997
|
|
149,612
|
|
152,664
|
|
136,777
|
|
Income per share from continuing operations
|
|
$
|
0.42
|
|
$
|
0.32
|
|
$
|
0.49
|
|
$
|
0.71
|
|
Income per share from discontinued operations
|
|
$
|
|
|
$
|
|
|
$
|
|
|
$
|
0.02
|
|
Net income per share
|
|
$
|
0.42
|
|
$
|
0.32
|
|
$
|
0.49
|
|
$
|
0.73
|
|
Distributions declared per common share
|
|
$
|
|
|
$
|
0.40
|
|
$
|
|
|
$
|
1.30
|
|
(1)
For the three
and nine months ended September 30, 2008, EPS reflects the retrospective
adjustments to include unvested share-based payment awards as participating
securities. No dividend was declared on common shares for the three and nine
months ended September 30, 2009.
(2)
Potential
anti-dilutive common shares excluded from diluted income earnings per share for
both the three and nine months ended September 30, 2009 were 8,896,784
related to convertible debt securities and 1,932,279 related to common share
options. Potential anti-dilutive common
shares excluded from diluted income earnings per share for both the three and
nine months ended September 30, 2008 were 9,667,430 related to convertible
debt securities and 1,932,279 related to common share options.
Note 4. Private Equity Investments
As of September 30, 2009, the Company had private equity
investments carried at cost of $17.5 million and two private equity investments
carried at estimated fair value of $76.3 million. As of December 31, 2008,
the Company had private equity investments at cost of $17.5 million and private
equity investments at estimated fair value of $5.3 million. During the second
quarter of 2009, the Companys term loan investments related to one issuer were
modified and exchanged for equity in a transaction which qualified as a
troubled debt restructuring. This transaction resulted in a charge-off to the
allowance for loan loss of $41.4 million (see Note 6 to these condensed
consolidated financial statements for further discussion). At the time of
restructuring, the Company elected to carry this investment at estimated fair
value, with unrealized gains and losses reported in income.
For the three and nine months ended September 30, 2009, the
Company had net realized and unrealized gains of $22.3 million and $22.6
million, respectively, on private equity investments carried at estimated fair
value. There was no net realized and unrealized gain or loss for the three and
nine months ended September 30, 2008.
Note 10 to these condensed consolidated financial statements describes
the Companys borrowings under which the Company has pledged private equity
investments for borrowings. The following table summarizes the carrying value
of private equity investments pledged as collateral under secured financing
transactions as of September 30, 2009 and December 31, 2008 (amounts
in thousands):
|
|
As of
September 30, 2009
|
|
As of
December 31, 2008
|
|
Pledged as collateral for borrowings under senior
secured credit facility
|
|
$
|
35,898
|
|
$
|
|
|
Pledged as collateral for collateralized loan
obligation senior secured notes and junior secured notes to affiliates
|
|
57,917
|
|
5,287
|
|
Total
|
|
$
|
93,815
|
|
$
|
5,287
|
|
15
Table
of Contents
Note 5. Securities Available-for-Sale
The following table summarizes the Companys securities classified as
available-for-sale as of September 30, 2009, 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
|
|
$
|
592,571
|
|
$
|
168,370
|
|
$
|
(25,312
|
)
|
$
|
735,629
|
|
Common and preferred stock
|
|
713
|
|
481
|
|
|
|
1,194
|
|
Total
|
|
$
|
593,284
|
|
$
|
168,851
|
|
$
|
(25,312
|
)
|
$
|
736,823
|
|
The following table shows the gross
unrealized losses and 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, 2009
(amounts in thousands):
|
|
Less Than 12 months
|
|
12 Months or More
|
|
Total
|
|
Description
|
|
Estimated
Fair Value
|
|
Unrealized
Losses
|
|
Estimated
Fair Value
|
|
Unrealized
Losses
|
|
Estimated
Fair Value
|
|
Unrealized
Losses
|
|
Corporate debt securities
|
|
$
|
|
|
$
|
|
|
$
|
278,399
|
|
$
|
(25,312
|
)
|
$
|
278,399
|
|
$
|
(25,312
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The 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 considers
many factors when evaluating whether an impairment is other-than-temporary. For
corporate debt securities included in the table above, the Company does not
intend to sell them and does not believe that it is more likely than not that
the Company will be required to sell any of its corporate debt securities prior
to recovery. In addition, based on the analyses performed by the Company on
each of its corporate debt securities, it believes that it will be able to
recover the entire amortized cost amount of the corporate debt securities
included in the table above.
During the three and nine months ended
September 30, 2009, the Company recognized a loss totaling nil and $40.0
million, respectively, for corporate debt securities that it determined to be
other-than-temporarily impaired based on the criteria above. The Company
intends to sell these securities and as a result, the entire amount is recorded
through earnings in net realized and unrealized (loss) gain on investments in
the condensed consolidated statements of operations.
As of September 30, 2009 and December 31,
2008, the Company held one corporate debt security that was in default with a
total fair value of $5.9 million and $3.2 million, respectively. This corporate
debt security was determined to be other-than-temporarily impaired as of
September 30, 2009 and December 31, 2008.
The following table summarizes the Companys
securities classified as available-for-sale as of December 31, 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
|
|
$
|
742,474
|
|
$
|
3,676
|
|
$
|
(192,709
|
)
|
$
|
553,441
|
|
Common and preferred stock
|
|
3,126
|
|
|
|
(602
|
)
|
2,524
|
|
Total
|
|
$
|
745,600
|
|
$
|
3,676
|
|
$
|
(193,311
|
)
|
$
|
555,965
|
|
The following table shows the gross
unrealized losses and 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, 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
|
|
$
|
396,279
|
|
$
|
(119,849
|
)
|
$
|
121,080
|
|
$
|
(72,860
|
)
|
$
|
517,359
|
|
$
|
(192,709
|
)
|
Common and preferred stock
|
|
2,499
|
|
(256
|
)
|
25
|
|
(346
|
)
|
2,524
|
|
(602
|
)
|
Total
|
|
$
|
398,778
|
|
$
|
(120,105
|
)
|
$
|
121,105
|
|
$
|
(73,206
|
)
|
$
|
519,883
|
|
$
|
(193,311
|
)
|
16
Table of Contents
The table above excludes $460.4 million of
unrealized losses for securities that it determined to be
other-than-temporarily impaired. These securities were determined to be
other-than-temporarily impaired either due to managements determination that
recovery in value is no longer likely or because the Company has decided to
sell the respective security in response to specific credit concerns regarding
the issuer. 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.
During the three and nine months ended
September 30, 2009, the Company had gross realized gains from the sales of
securities available-for-sale of nil and $10.0 million, respectively, and gross
realized losses from the sales of securities available-for-sale of $2.0 million
and $9.4 million, respectively. During the three and nine months ended
September 30, 2008, the Company had gross realized gains from the sale 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.
Note 10 to these condensed consolidated
financial statements describe the Companys borrowings under which the Company
has pledged securities available-for-sale for borrowings. The following table
summarizes the estimated fair value of securities available-for-sale pledged as
collateral as of September 30, 2009 and December 31, 2008 (amounts in
thousands):
|
|
As of
September 30, 2009
|
|
As of
December 31, 2008
|
|
Pledged as collateral for borrowings under
senior secured credit facility
|
|
$
|
88,768
|
|
$
|
93,764
|
|
Pledged as collateral for collateralized
loan obligation senior secured notes and junior secured notes to affiliates
|
|
648,055
|
|
459,677
|
|
Total
|
|
$
|
736,823
|
|
$
|
533,441
|
|
Note 6. Corporate Loans and Allowance for
Loan Losses
The following table summarizes the Companys
corporate loans as of September 30, 2009 and December 31, 2008 (amounts in
thousands):
|
|
September
30, 2009
|
|
December
31, 2008
|
|
|
|
Principal
|
|
Unamortized
Discount
|
|
Lower of
Cost
or Fair Value
Adjustment
|
|
Net
Carrying
Value
|
|
Principal
|
|
Unamortized
Discount
|
|
Lower of
Cost
or Fair Value
Adjustment
|
|
Net
Carrying
Value
|
|
Corporate
loans(1)
|
|
$
|
7,111,936
|
|
$
|
(420,707
|
)
|
$
|
|
|
$
|
6,691,229
|
|
$
|
7,983,449
|
|
$
|
(255,877
|
)
|
$
|
|
|
$
|
7,727,572
|
|
Corporate
loans held for sale
|
|
547,079
|
|
(13,525
|
)
|
(29,461
|
)
|
504,093
|
|
472,669
|
|
(10,751
|
)
|
(137,269
|
)
|
324,649
|
|
Total
corporate loans
|
|
$
|
7,659,015
|
|
$
|
(434,232
|
)
|
$
|
(29,461
|
)
|
$
|
7,195,322
|
|
$
|
8,456,118
|
|
$
|
(266,628
|
)
|
$
|
(137,269
|
)
|
$
|
8,052,221
|
|
(1)
Gross
of allowance for loan losses of $470.2 million and $480.8 million as of
September 30, 2009 and December 31, 2008, respectively. Principal amount is net
of charge-offs and other adjustments totaling $5.9 million.
17
Table of Contents
The following table summarizes the changes in
the allowance for loan losses for the Companys corporate loan portfolio during
the three and nine months ended September 30, 2009 and 2008 (amounts in
thousands):
|
|
For the three
months ended
September 30,
2009
|
|
For the three
months ended
September 30,
2008
|
|
For the nine
months ended
September 30,
2009
|
|
For the nine
months ended
September 30,
2008
|
|
Balance at beginning of period
|
|
$
|
473,202
|
|
$
|
35,000
|
|
$
|
480,775
|
|
$
|
25,000
|
|
Provision for loan losses
|
|
|
|
|
|
39,795
|
|
10,000
|
|
Charge-offs
|
|
(2,978
|
)
|
|
|
(50,346
|
)
|
|
|
Balance at end of period
|
|
$
|
470,224
|
|
$
|
35,000
|
|
$
|
470,224
|
|
$
|
35,000
|
|
As of September 30, 2009 and December 31,
2008, the Company had an allowance for loan loss of $470.2 million and $480.8
million, respectively. As described in Note 2 to these condensed consolidated
financial statements, the allowance for loan losses represents the Companys
estimate of probable credit losses inherent in its loan portfolio as of the
balance sheet date. The Companys allowance for loan losses consists of two
components, an allocated component and an unallocated component. The allocated
component of the allowance for loan losses consists of individual loans that
are impaired. The unallocated component of the allowance for loan losses
represents the Companys estimate of losses inherent, but not identified, in
its portfolio as of the balance sheet date.
As of September 30, 2009, the allocated component of the allowance for
loan losses totaled $430.8 million and relates to investments in loans issued
by thirteen issuers with an aggregate par amount of $902.0 million and an
aggregate amortized cost amount of $701.6 million. As of December 31, 2008, the
allocated component of the allowance for loan losses totaled $320.6 million and
relates to investments in loans issued by eleven issuers with an aggregate par
amount of $828.2 million and an aggregate amortized cost amount of $715.4
million. The unallocated component of the allowance for loan losses totaled $39.4
million and $160.2 million as of September 30, 2009 and December 31, 2008,
respectively. The Company recorded charge-offs during the three months ended
September 30, 2009 totaling $3.0 million related to loans transferred to loans
held for sale. During the nine months ended September 30, 2009, the Company
recorded charge-offs totaling $50.4 million comprised of the $3.0 million
above, $6.0 million related to a loan sold during the second quarter of 2009,
and $41.4 million related to a loan exchanged for equity and which qualified as
a troubled debt restructuring (see Note 4 to these condensed consolidated
financial statements for further details). There were no charge-offs during the
three and nine months ended September 30, 2008.
As of September 30, 2009 and December 31,
2008, the Company had loans on non-accrual status with total amortized costs of
$730.2 million and $358.0 million, respectively. The average recorded investment in the
impaired loans during the three and nine months ended September 30, 2009 was
$717.3 million and $544.2 million, respectively, and during the three and nine
months ended September 30, 2008 average recorded investment in the impaired
loans was nil. The amount of interest income recognized using the cash-basis
method during the time within the period that the loans were impaired was $8.2
million and $15.0 million for the three and nine months ended September 30,
2009, respectively, and nil for the three and nine months ended September 30,
2008.
As of September 30, 2009, the Company held
loans that were in default with a total amortized cost of $743.6 million from
ten issuers. As of December 31, 2008, the Company held loans that were in
default with a total amortized cost of $312.7 million from three issuers. The
majority of corporate loans in default during 2009 and 2008 were included in
the loans for which the allocated component of the Companys allowance for
losses was related to as of September 30, 2009 and December 31, 2008,
respectively.
Note 10 to these condensed consolidated
financial statements describes the Companys borrowings under which the Company
has pledged loans for borrowings. The following table summarizes the carrying
value of corporate loans pledged as collateral as of September 30, 2009 and
December 31, 2008 (amounts in thousands):
|
|
As of
September 30, 2009
|
|
As of
December 31, 2008
|
|
Pledged as collateral for borrowings under
senior secured credit facility
|
|
$
|
548,519
|
|
$
|
182,899
|
|
Pledged as collateral for collateralized
loan obligation senior secured notes and junior secured notes to affiliates
|
|
6,646,803
|
|
7,816,154
|
|
Total
|
|
$
|
7,195,322
|
|
$
|
7,999,053
|
|
18
Table of Contents
Note 7. Residential Mortgage-Backed
Securities
As of September 30, 2009 and December 31,
2008, residential mortgage-backed securities (RMBS) totaled $70.3 million and
$102.8 million, respectively.
Note 10 to these condensed consolidated
financial statements describes the Companys borrowings under which the Company
has pledged RMBS. The following table summarizes the estimated fair value of
RMBS pledged as collateral as of September 30, 2009 and December 31, 2008
(amounts in thousands):
|
|
As of
September 30, 2009
|
|
As of
December 31, 2008
|
|
Pledged as collateral for borrowings under
senior secured credit facility
|
|
$
|
64,577
|
|
$
|
96,651
|
|
Pledged as collateral for collateralized
loan obligation senior secured notes and junior secured notes to affiliates
|
|
5,679
|
|
6,163
|
|
Total
|
|
$
|
70,256
|
|
$
|
102,814
|
|
Note 8. Residential Mortgage Loans
The following table summarizes the Companys
residential mortgage loans as of September 30, 2009 and December 31, 2008
(amounts in thousands):
|
|
As of
September 30, 2009
|
|
As of
December 31, 2008
|
|
Residential mortgage loans, at estimated
fair value(1)
|
|
$
|
2,274,585
|
|
$
|
2,620,021
|
|
|
|
|
|
|
|
|
|
(1)
|
|
Excludes REO as a result of foreclosure on delinquent loans of $12.8
million and $10.8 million as of September 30, 2009 and December 31, 2008,
respectively. Loans are transferred to REO at the lower of cost or fair
value. REO is recorded within other assets on the Companys condensed
consolidated balance sheets.
|
Note 10 to these condensed consolidated
financial statements describes the Companys borrowings under which the Company
has pledged residential mortgage loans. The following table summarizes the
estimated fair value of residential mortgage loans pledged as collateral as of
September 30, 2009 and December 31, 2008 (amounts in thousands):
|
|
As of
September 30, 2009
|
|
As of
December 31, 2008
|
|
Pledged as collateral for borrowings under
senior secured credit facility
|
|
$
|
121,965
|
|
$
|
167,933
|
|
Pledged as collateral for residential
mortgage-backed securities issued
|
|
2,152,620
|
|
2,452,088
|
|
|
|
$
|
2,274,585
|
|
$
|
2,620,021
|
|
The following is a reconciliation of carrying
amounts of residential mortgage loans for the periods ended September 30, 2009
and December 31, 2008 (amounts in thousands):
|
|
2009
|
|
2008
|
|
Beginning balance
|
|
$
|
2,620,021
|
|
$
|
3,921,323
|
|
Principal payments
|
|
(453,962
|
)
|
(666,900
|
)
|
Transfers out of (in to) REO
|
|
(2,010
|
)
|
(3,594
|
)
|
Net change in unrealized and realized
gain/loss and premium/discount
|
|
110,536
|
|
(630,808
|
)
|
Ending balance
|
|
$
|
2,274,585
|
|
$
|
2,620,021
|
|
As of September 30, 2009, thirty of the
residential mortgage loans owned by the Company with an outstanding balance of
$12.8 million (not included in the table above) were REO as a result of
foreclosure on delinquent loans. As of December 31, 2008, thirty-three of the
residential mortgage loans owned by the Company with an outstanding balance of
$10.8 million (not included in the table above) were REO as a result of
foreclosure on delinquent loans.
19
Table of Contents
The following table summarizes the
delinquency statistics of the residential mortgage loans, excluding REOs, as of
September 30, 2009 and December 31, 2008 (dollar amounts in thousands):
|
|
September 30, 2009
|
|
December 31, 2008
|
|
Delinquency Status
|
|
Number
of Loans
|
|
Principal
Amount
|
|
Number
of Loans
|
|
Principal
Amount
|
|
30 to 59 days
|
|
77
|
|
$
|
29,205
|
|
93
|
|
$
|
37,282
|
|
60 to 89 days
|
|
39
|
|
15,407
|
|
41
|
|
15,654
|
|
90 days or more
|
|
111
|
|
47,034
|
|
76
|
|
29,803
|
|
In foreclosure
|
|
135
|
|
54,776
|
|
67
|
|
22,841
|
|
Total
|
|
362
|
|
$
|
146,422
|
|
277
|
|
$
|
105,580
|
|
As of September 30, 2009 and December 31,
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 $18.2 million and $4.0 million, respectively.
Note 9. Residential Mortgage-Backed
Securities Issued
Residential mortgage-backed securities issued
(RMBS Issued) consists of the senior tranches of six residential mortgage
loan securitization trusts that the Company consolidates under GAAP (see Note 2
to these condensed consolidated financial statements) and for which the Company
reports the debt issued by these trusts that it does not hold on its condensed
consolidated balance sheets. The following table summarizes the Companys RMBS
Issued as of September 30, 2009 and December 31, 2008 (amounts in thousands):
|
|
September 30, 2009
|
|
December 31, 2008
|
|
Description
|
|
Outstanding
|
|
Estimated
Fair
Value
|
|
Outstanding
|
|
Estimated
Fair
Value
|
|
Residential mortgage-backed securities
issued
|
|
$
|
2,711,990
|
|
$
|
2,165,423
|
|
$
|
3,154,974
|
|
$
|
2,462,882
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The Company carries RMBS Issued at estimated
fair value with changes in estimated fair value reflected in net income. As of
September 30, 2009 and December 31, 2008, the weighted average coupon of the
RMBS Issued was 2.7% and 3.4%, respectively, and the weighted average years to
maturity were 26.0 years and 26.8 years as of September 30, 2009 and December
31, 2008, respectively.
Note 10. Borrowings
Certain information with respect to the
Companys borrowings as of September 30, 2009 is summarized in the following
table (dollar amounts in thousands):
|
|
Outstanding
Borrowings
|
|
Weighted
Average
Borrowing
Rate
|
|
Weighted
Average
Remaining
Maturity
(in days)
|
|
Fair Value of
Collateral(1)
|
|
Senior secured credit facility(2)
|
|
$
|
187,500
|
|
4.25
|
%
|
771
|
|
$
|
789,473
|
|
CLO 2005-1 senior secured notes
|
|
832,473
|
|
0.83
|
|
2,765
|
|
869,723
|
|
CLO 2005-2 senior secured notes
|
|
800,300
|
|
0.70
|
|
2,979
|
|
857,820
|
|
CLO 2006-1 senior secured notes
|
|
683,265
|
|
0.76
|
|
3,251
|
|
846,621
|
|
CLO 2007-1 senior secured notes
|
|
2,216,180
|
|
0.98
|
|
4,245
|
|
2,284,074
|
|
CLO 2007-1 junior secured notes to
affiliates(3)
|
|
448,349
|
|
|
|
4,245
|
|
460,404
|
|
CLO 2007-A senior secured notes
|
|
1,174,664
|
|
1.38
|
|
2,937
|
|
1,192,676
|
|
CLO 2007-A junior secured notes to
affiliates(4)
|
|
99,072
|
|
|
|
2,937
|
|
100,592
|
|
Convertible senior notes
|
|
275,800
|
|
7.00
|
|
1,019
|
|
|
|
Junior subordinated notes
|
|
283,671
|
|
5.51
|
|
9,839
|
|
|
|
Total
|
|
$
|
7,001,274
|
|
|
|
|
|
$
|
7,401,383
|
|
(1)
Collateral
for borrowings consists of RMBS, securities available-for-sale, private equity
investments and corporate and residential mortgage loans.
20
Table of Contents
(2)
Calculated
weighted average remaining maturity based on the amended maturity date of
November 10, 2011.
(3)
CLO
2007-1 junior secured notes to affiliates consist of (x) $261.7 million of
mezzanine notes with a weighted average borrowing rate of 5.39% and
(y) $186.6 million of subordinated notes that do not have a
contractual coupon rate, but instead receive a pro rata amount of the net distributions
from CLO 2007-1.
(4)
CLO
2007-A junior secured notes to affiliates consist of
(x) $84.0 million of mezzanine notes with a weighted average
borrowing rate of 6.69% 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.
CLO
2009-1
On
March 31, 2009, the Company completed the restructuring of
Wayzata
Funding LLC (
Wayzata), its
market value CLO transaction. As a result of the restructuring, substantially
all of Wayzatas assets were transferred to CLO 2009-1, a newly formed special
purpose company, which issued $560.8 million aggregate principal amount of
senior notes due April 2017 and $154.3 million aggregate principal amount
of subordinated notes due April 2017 to the existing Wayzata note holders
in exchange for cancellation of the Wayzata notes, due November 2012,
previously held by each of them. CLO 2009-1 was structured as a cash flow
transaction and does not contain the market value provisions contained in
Wayzata. The portfolio manager of the CLO is an affiliate of the Manager. The
notes issued by CLO 2009-1 are secured by the same collateral that secured the
Wayzata facility, consisting primarily of senior secured leveraged loans. As
was the case with Wayzata, the Company and an affiliate of the Manager
currently own all of the subordinated notes issued by the CLO. The subordinated
notes entitle the Company to receive a pro rata
portion of all excess cash flows from the portfolio after all senior
obligations of CLO 2009-1 have been paid in full or otherwise satisfied,
including all outstanding principal of the senior notes and interest thereon
accruing at a rate of 3-month LIBOR plus 4.25%.
The restructuring of Wayzata and the formation of CLO 2009-1 outlined
above qualified as a troubled debt restructuring under FASB ASC 470-60. Prior
to the restructuring on March 31, 2009, an affiliate of the Manager held
an aggregate par amount of $125.0 million of subordinated notes issued by Wayzata
(the Wayzata Subordinated Notes). In connection with the restructuring, the
Wayzata Subordinated Notes were exchanged for $30.9 million par amount of
junior notes issued by CLO 2009-1 (the CLO 2009-1 Junior Notes). The portion
of the CLO 2009-1 Junior Notes held by the affiliate of the Manager was carried
at $90.4 million which represented the total future cash payments that the
affiliate of the Manager could receive from the CLO 2009-1 Junior Notes. The
exchange by the affiliate of the Manager of Wayzata Subordinated Notes for CLO
2009-1 Junior Notes was treated as a modification of terms of the Wayzata
Subordinated Notes. Accordingly, the Company recognized a gain on debt
restructuring totaling $34.6 million, or $0.23 per diluted common share, which
reflected the difference between the Companys carrying amount of interest in
the Wayzata Subordinated Notes held by the affiliate of the Manager, or $125.0
million, and the carrying value of the portion of the CLO 2009-1 Junior Notes
held by the same affiliate of the Manager, or $90.4 million. The Wayzata
Subordinated Notes were included in collateralized loan obligation junior
secured notes to affiliates on the condensed consolidated balance sheets as of
December 31, 2008.
During the second quarter of 2009, the
proceeds from the sale of certain CLO 2009-1 assets were used to pay down
$516.4 million of CLO 2009-1 senior secured notes. On July 24, 2009,
the Company retired the remaining outstanding balance of senior notes issued by
CLO 2009-1 totaling $44.4 million. Prior to the retirement of the senior
notes, an affiliate of the Company held a 20% interest in the subordinated
notes issued by CLO 2009-1 as described above. As part of the deleveraging of
CLO 2009-1, the subordinated notes in CLO 2009-1 held by the Companys
affiliate were retired in exchange for the affiliates proportionate interest
in the assets held by CLO 2009-1.
The retirement of the senior notes issued by CLO 2009-1 included the
payment of a $28.8 million placement fee to the senior note holders that was
paid from the cash held by CLO 2009-1. The placement fee was structured to be
paid by CLO 2009-1 on a quarterly basis over the life of the transaction and
the $28.8 million amount reflects the present value of the future quarterly fee
payments. As the Company consolidates CLO 2009-1, this fee was recognized as an
expense during the third quarter of 2009 and was partially offset by a $14.4
million net gain recognized from the retirement of the subordinated notes
issued by CLO 2009-1 to an affiliate. The net loss from the CLO 2009-1
deleveraging was recorded in (loss) gain on restructuring and extinguishment of
debt on the
condensed consolidated statements of operations.
CLO
Notes
The indentures governing the Companys 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 (OC 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
21
Table of Contents
as interest coverage tests. If a CLO is not in compliance with an OC
Test or an interest coverage 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 OC test is brought back into compliance.
Due to the failure of OC Tests during the third quarter of 2009, CLO 2007-1
senior secured notes were paid down by $27.3 million and CLO 2007-A senior
secured notes were paid down by $16.2 million. During the nine months
ended September 30, 2009, CLO 2005-2 senior secured notes were paid down by
$9.0 million, CLO 2006-1 senior secured notes were paid down by
$32.1 million, CLO 2007-1 senior secured notes were paid down by
$108.6 million and CLO 2007-A senior secured notes were paid down by $38.9
million.
Due to the failure of OC Tests during 2008,
CLO 2006-1 senior secured notes were paid down by $12.1 million and CLO
2007-1 senior secured notes were paid down by $53.6 million.
On July 10, 2009, the Company surrendered for cancellation,
without consideration, approximately $298.4 million in aggregate of mezzanine
notes and junior notes (Surrendered Notes) issued to the Company by CLO
2005-1, CLO 2005-2 and CLO 2006-1. The Surrendered Notes were promptly cancelled
upon receipt by the trustee of each transaction and the related debt was
extinguished by the issuers thereof. The Company consolidates its CLO
subsidiaries and therefore, does not expect this transaction to have an impact
on its consolidated financial statements. Similarly, as CLO 2005-1, CLO 2005-2
and CLO 2006-1 are treated as disregarded entities for tax purposes, this
transaction is not expected to have any tax implications for the Company or its
shareholders.
Senior Secured Credit Facility
On August 5, 2009, the Company entered into
an agreement with its lenders to amend the terms of its senior secured credit
facility. Among other things, the amendment provides that: (i) the size of the
facility be reduced to $200.0 million from $300.0 million, (ii) the lending
commitments of the lenders to this facility be modified to provide for
quarterly amortization of $12.5 million per quarter until the size of the
facility has been reduced to $150 million on June 30, 2010, (iii) the interest
rate applicable to borrowings under the facility be increased from LIBOR plus
300 basis points to LIBOR plus 400 basis points, (iv) the adjusted tangible net
worth covenant be reduced to $700.0 million from $1.0 billion, (v) the maturity
date of the borrowings under the facility be extended to November 10, 2011, and
(vi) certain events of default under the Credit Agreement be added. The
amendment also provides that the Company can (i) pay a yearly distribution to
its shareholders in an amount equal to no greater than 50% of its taxable
income for such year and (ii) use up to $50 million of its unrestricted cash to
repurchase its convertible notes due July 2012 and/or its outstanding trust
preferred securities. In conjunction with this amendment, the Company paid the
lenders of the credit facility fees totaling $4.5 million.
Standby 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 its
Manager and Kohlberg Kravis Roberts & Co. (Fixed Income) LLC, the
parent of its 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. The Company has the right to prepay loans under
the agreement in whole or in part at any time. No borrowings were outstanding
under this facility as of September 30, 2009.
Convertible
Debt
During June 2009, the Company completed two transactions to
exchange a total of $15.7 million par value of convertible notes for 7.2
million of the Companys common shares.
These transactions resulted in the Company recording a gain of $6.9
million, or approximately $0.05 per diluted common share, which was partially
offset by a write-off of $0.1 million of unamortized debt issuance costs and
$0.4 million of other associated costs during the second quarter of 2009.
On May 9, 2008, the FASB issued FASB ASC
470-20-65. The topic clarifies the accounting for convertible debt instruments
which may be settled in cash and in particular, specifies that issuers of such
instruments should separately account for the liability and equity components
in a manner that will reflect the entitys nonconvertible debt borrowing rate
when interest cost is recognized in subsequent periods. The Company has
assessed this topic in relation to its convertible senior notes and determined
that it does not have a material impact on its condensed consolidated financial
statements for the periods presented.
Junior
Subordinated Notes
During the third quarter of 2009, the Company
repurchased $5.0 million of junior subordinated notes, which resulted in a gain
on extinguishment of $3.8 million, partially offset by a $0.1 million write-off
of unamortized debt issuance costs.
22
Table of Contents
Certain information with respect to the
Companys borrowings as of December 31, 2008 is summarized in the
following table (dollar amounts in thousands):
|
|
Outstanding
Borrowings
|
|
Weighted
Average
Borrowing
Rate
|
|
Weighted
Average
Remaining
Maturity
(in days)
|
|
Fair Value of
Collateral(1)
|
|
Senior secured credit facility
|
|
$
|
275,633
|
|
3.44
|
%
|
699
|
|
$
|
441,812
|
|
CLO 2005-1 senior secured notes
|
|
832,025
|
|
3.84
|
|
3,038
|
|
631,937
|
|
CLO 2005-2 senior secured notes
|
|
808,701
|
|
2.48
|
|
3,252
|
|
647,092
|
|
CLO 2006-1 senior secured notes
|
|
715,394
|
|
2.52
|
|
3,524
|
|
623,003
|
|
CLO 2007-1 senior secured notes
|
|
2,318,191
|
|
2.68
|
|
4,518
|
|
1,511,707
|
|
CLO 2007-1 junior secured notes to
affiliates(2)
|
|
436,185
|
|
|
|
4,518
|
|
277,357
|
|
CLO 2007-A senior secured notes
|
|
1,213,300
|
|
5.62
|
|
3,210
|
|
867,666
|
|
CLO 2007-A junior secured notes to
affiliates(3)
|
|
94,128
|
|
|
|
3,210
|
|
67,314
|
|
Wayzata senior secured notes
|
|
1,600,000
|
|
2.95
|
|
1,415
|
|
766,024
|
|
Convertible senior notes
|
|
291,500
|
|
7.00
|
|
1,292
|
|
|
|
Junior subordinated notes
|
|
288,671
|
|
6.84
|
|
10,118
|
|
|
|
Subordinated notes to affiliates(4)
|
|
125,000
|
|
|
|
1,415
|
|
59,846
|
|
Total
|
|
$
|
8,998,728
|
|
|
|
|
|
$
|
5,893,758
|
|
(1)
|
|
Collateral for borrowings consists of RMBS, securities
available-for-sale, and corporate and residential mortgage loans.
|
|
|
|
(2)
|
|
CLO 2007-1 junior secured notes to affiliates consist of
(x) $249.6 million of mezzanine notes with a weighted average
borrowing rate of 7.03% 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.
|
|
|
|
(3)
|
|
CLO 2007-A junior secured notes to affiliates consist of
(x) $79.0 million of mezzanine notes with a weighted average
borrowing rate of 10.90% 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.
|
|
|
|
(4)
|
|
Subordinated notes do not have a contractual coupon rate, but instead
receive a pro rata amount of the net distributions from Wayzata. Note that
the $125.0 million outstanding is included in collateralized loan obligation
junior secured notes to affiliates on the condensed consolidated balance
sheets.
|
Note 11.
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, 2009, the Company had securities sold, not yet purchased
with an amortized cost of $75.3 million and an accumulated net unrealized loss
of $3.3 million. As of December 31, 2008, the Company had securities sold,
not yet purchased with an amortized cost basis of $97.3 million and an
accumulated net unrealized gain of $6.5 million.
For the three and nine months ended
September 30, 2009, the Company had net realized and unrealized (losses)
gains on short security sales of $(1.0) million and $2.9 million, respectively,
compared to net realized and unrealized gains on short security sales of
$14.2 million and $22.9 million, for the three and nine months ended
September 30, 2008, respectively.
Note 12. Derivative Financial
Instruments
The Company enters into derivative
transactions in order to hedge its interest rate risk exposure to the effects
of interest rate changes. Additionally, the Company enters into derivative
transactions in the course of its investing. The counterparties to the
Companys derivative agreements are major financial institutions with which the
Company and its affiliates may also have other financial relationships. In the
event of nonperformance by the counterparties, the Company is potentially
exposed to losses. The counterparties to the Companys derivative agreements
have investment grade ratings and, as a result, the Company does not anticipate
that any of the counterparties will fail to fulfill their obligations.
Cash Flow and Fair Value Hedges
The Company uses interest rate derivatives consisting
of swaps to hedge a portion of the interest rate risk associated with its
borrowings under CLO senior secured notes. The Company designates these
financial instruments as cash flow hedges. The Company also uses interest rate
swaps to hedge all or a portion of the interest rate risk associated with
certain fixed interest rate investments. The Company designates these financial
instruments as fair value hedges.
Free-Standing Derivatives
Free-standing derivatives are derivatives
that the Company has entered into in conjunction with its investment and risk
management activities, but for which the Company has not designated the
derivative contract as a hedging instrument for accounting purposes. Such
derivative contracts may include credit default swaps (CDS), 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.
23
Table of Contents
The table below summarizes the aggregate
notional amount and estimated net fair value of the derivative instruments as
of September 30, 2009 and December 31, 2008 (amounts in thousands):
|
|
As of September 30, 2009
|
|
As of December 31, 2008
|
|
|
|
Notional
|
|
Estimated
Fair Value
|
|
Notional
|
|
Estimated
Fair Value
|
|
Cash
Flow Hedges:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
$
|
383,333
|
|
$
|
(53,869
|
)
|
$
|
383,333
|
|
$
|
(77,668
|
)
|
Fair
Value Hedges:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
|
|
|
|
32,000
|
|
(2,915
|
)
|
Free-Standing
Derivatives:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
97,259
|
|
277
|
|
106,074
|
|
274
|
|
Credit default swapsprotection sold
|
|
51,000
|
|
(773
|
)
|
53,500
|
|
(9,782
|
)
|
Credit default swapsprotection purchased
|
|
|
|
|
|
222,650
|
|
69,972
|
|
Total rate of return swaps
|
|
120,234
|
|
20,437
|
|
207,524
|
|
(77,224
|
)
|
Total
|
|
$
|
651,826
|
|
$
|
(33,928
|
)
|
$
|
1,005,081
|
|
$
|
(97,343
|
)
|
A CDS is a
contract in which the contract buyer pays, in the case of a short position, or
receives, in the case of long position, a periodic
premium until the contract expires or a
credit event occurs. In return for this premium, the contract seller receives a
payment from or makes a payment to the buyer if there is a credit default or
other specified credit event with respect to the issuer (also known as the
referenced entity) of the underlying credit instrument referenced in the CDS.
Typical credit events include bankruptcy,
dissolution or insolvency of the referenced entity, failure to pay and
restructuring of the obligations of the referenced entity.
As of September 30, 2009 and December 31, 2008, the Comp
any had a
notional amount of approximately nil and $222.7 million, respectively, of
credit protection purchased. As of
September 30, 2009 and December 31, 2008, the Company had sold
protection with a notional amount of approximately $51.0 million and $53.5
million, respectively. The Company sells protection to replicate fixed income
securities and to complement the spot market when cash securities of the
referenced entity of a particular maturity are not available or when the
derivative alternative is less expensive compared to other purchasing
alternatives.
For the three and nine
months ended September 30, 2009, the Company recognized realized gains on its
CDS of nil and $59.0 million, respectively. Realized losses of nil and
$1.0 million were recognized for the same periods in 2009, respectively. For
the three and nine months ended September 30, 2008, the Company recognized
realized gains on its CDS of nil and $3.3 million, respectively. Realized
losses of $0.7 million and $1.2 million were recognized for the same periods in
2008, respectively.
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 monthly. During the three and
nine months ended September 30, 2009 and 2008, the Company recognized an
immaterial amount of ineffectiveness in income on the condensed consolidated
statements of operations from its cash flow and fair value hedges.
Note 13. Accumulated Other Comprehensive
Income (Loss)
The components of accumulated other
comprehensive income (loss), were as follows (amounts in thousands):
|
|
As of
September 30, 2009
|
|
As of
December 31, 2008
|
|
Net unrealized gains (losses) on
available-for-sale securities
|
|
$
|
143,539
|
|
$
|
(192,435
|
)
|
Net unrealized losses on cash flow hedges
|
|
(51,778
|
)
|
(76,347
|
)
|
Accumulated other comprehensive income
(loss)
|
|
$
|
91,761
|
|
$
|
(268,782
|
)
|
24
Table of Contents
The components of other comprehensive income (loss) were as follows
(amounts in thousands):
|
|
Three months
ended
September 30, 2009
|
|
Three months
ended
September 30, 2008
|
|
Nine months
ended
September 30, 2009
|
|
Nine months
ended
September 30, 2008
|
|
Unrealized gains (losses) on securities
available-for-sale:
|
|
|
|
|
|
|
|
|
|
Unrealized holding gains (losses) arising
during period
|
|
$
|
146,406
|
|
$
|
(188,065
|
)
|
$
|
312,076
|
|
$
|
(254,042
|
)
|
Reclassification adjustments for losses
realized in net income
|
|
1,972
|
|
17,667
|
|
23,898
|
|
37,464
|
|
Unrealized gains (losses) on securities
available-for-sale
|
|
148,378
|
|
(170,398
|
)
|
335,974
|
|
(216,578
|
)
|
Unrealized (losses) gains on cash flow
hedges
|
|
(7,422
|
)
|
(4,940
|
)
|
24,569
|
|
(4,101
|
)
|
Other comprehensive income (loss)
|
|
$
|
140,956
|
|
$
|
(175,338
|
)
|
$
|
360,543
|
|
$
|
(220,679
|
)
|
Note 14. Commitments and Contingencies
Commitments
As part of its strategy of investing in corporate loans, the Company
commits to purchase interests in primary market loan syndications, which
obligate the Company to acquire a predetermined interest in such loans at a
specified price on a to-be-determined settlement date. Consistent with standard
industry practices, once the Company has been informed of the amount of its
syndication allocation in a particular loan by the syndication agent, the
Company bears the risks and benefits of changes in the fair value of the
syndicated loan from that date forward. As of September 30, 2009, the
Company had committed to purchase corporate loans with aggregate commitments
totaling
$101.2 million.
In addition, the Company participates in certain contingent financing
arrangements, including revolvers and delayed draw facilities, whereby the
Company is committed to provide funding of up to a specific amount at the
discretion of the borrower. As of September 30, 2009, we had
unfunded financing commitments totaling $48.4 million. The Company does
not expect material losses related to those corporate loans for which it
committed to purchase and fund.
Contingencies
On July 10,
2009, the Company surrendered for cancellation, without consideration,
approximately $64.0 million of mezzanine notes issued to the Company by CLO
2005-2, as well as certain other notes issued to the Company by other CLOs as
described in Note 10 to these condensed consolidated financial statements. The
surrendered notes were cancelled by the trustee under the indenture, and the
obligations due under such surrendered notes were deemed extinguished. Holders constituting a majority of the
controlling class of senior notes of CLO 2005-2 (Noteholders) have notified
the related trustee of purported defaults under the indenture related to the
note surrender. The Company does not
believe based on discussions with counsel that an event of default has occurred
and is engaged in discussions with the Noteholders to resolve this matter. Accordingly, the Company does not believe
that this matter will have a material effect on its financial condition.
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 stage 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 Company's condensed consolidated financial statements.
On
August 7, 2008, the members of the Companys board of directors and
certain of its current and former executive officers and the Company
were named in a putative class action 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). On
March 13, 2009, the lead plaintiff filed an Amended Complaint, which
deleted as defendants the members of the Companys board of directors and named
as individual defendants only the Companys former chief executive officer
Saturnino S. Fanlo, the Companys former chief operating officer David A.
Netjes, and the Companys current chief financial officer Jeffrey B. Van Horn
(the Individual Defendants, and, together with the Company,
Defendants). The Amended Complaint alleges that the Companys
April 2, 2007 registration statement and prospectus and the financial
statements incorporated therein contained material omissions in violation
of Section 11 of the Securities Act of 1933, as amended (the 1933 Act),
regarding the risks and potential losses associated with the
Companys real estate-related assets, the Companys ability to finance 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 Amended Complaint further alleges that, pursuant to
Section 15 of the 1933 Act, the Individual Defendants have legal
responsibility for the alleged Section 11 violation. On
April 27, 2009, Defendants filed a motion to dismiss the Amended Complaint
for failure to state a claim under the 1933 Act.
25
Table of
Contents
On August 15, 2008,
the members of the Companys board of directors and its executive officers (the
Kostecka Individual Defendants) were named in a shareholder derivative action
brought by Raymond W. Kostecka, a purported shareholder, in the Superior Court
of California, County of San Francisco (the California Derivative Action).
The Company was named as a nominal defendant. The complaint in the California
Derivative Action asserts claims against the Kostecka Individual 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. By
order dated January 8, 2009, the Court approved the parties stipulation
to stay the proceedings in the California Derivative Action until the Charter
Litigation is dismissed on the pleadings or the Company files an answer to the
Charter Litigation.
On March 23, 2009, the members of the Companys board of directors
and certain of its executive officers (the Haley Individual Defendants) were
named in a shareholder derivative action brought by Paul B. Haley, a purported
shareholder, in the United States District Court for the Southern District of
New York (the New York Derivative Action). The Company was named as a nominal
defendant. The complaint in the New York Derivative Action asserts claims
against the Haley Individual Defendants for breaches of fiduciary duty,
breaches of the duty of full disclosure, and for contribution 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. By order dated June 18, 2009, the Court
approved the parties stipulation to stay the proceedings in the New York
Derivative Action until the Charter Litigation is dismissed on the pleadings or
the Company files an answer to the Charter Litigation.
Note 15. Share Options and Restricted Shares
On May 4, 2007, the Company 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 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, 2009, the 2007 Share Incentive Plan authorizes a total
of 8,464,625 shares that may be used to satisfy awards under the 2007 Share
Incentive Plan. On August 12, 2009, the Compensation Committee of the
Board of Directors granted 220,519 restricted common shares to the Companys
directors pursuant to the 2007 Share Incentive Plan.
The following table summarizes restricted common share transactions:
|
|
Manager
|
|
Directors
|
|
Total
|
|
Unvested shares as of
January 1, 2009
|
|
1,097,000
|
|
66,282
|
|
1,163,282
|
|
Issued
|
|
|
|
220,519
|
|
220,519
|
|
Vested
|
|
|
|
(31,183
|
)
|
(31,183
|
)
|
Cancelled
|
|
|
|
|
|
|
|
Forfeited
|
|
|
|
|
|
|
|
Unvested shares as of
September 30, 2009
|
|
1,097,000
|
|
255,618
|
|
1,352,618
|
|
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 $4.62 and $6.36 per
share at September 30, 2009 and September 30, 2008, respectively.
There were $3.1 million and $6.2 million of total unrecognized
compensation costs related to unvested restricted common shares granted as of September 30,
2009 and 2008, respectively. These costs are expected to be recognized over
three years from the date of grant.
The following table summarizes common share option transactions:
|
|
Number of
Options
|
|
Weighted-Average
Exercise Price
|
|
Outstanding as of
January 1, 2009
|
|
1,932,279
|
|
$
|
20.00
|
|
Granted
|
|
|
|
|
|
Exercised
|
|
|
|
|
|
Forfeited
|
|
|
|
|
|
Outstanding as of
September 30, 2009
|
|
1,932,279
|
|
$
|
20.00
|
|
26
Table of Contents
As of September 30, 2009 and December 31, 2008, 1,932,279
common share options were exercisable. As of September 30, 2009, the
common share options were fully vested and expire in August 2014. For the
three and nine months ended September 30, 2009 and 2008, the components of
share-based compensation expense are as follows (amounts in thousands):
|
|
For the three
months ended
September 30, 2009
|
|
For the three
months ended
September 30, 2008
|
|
For the nine
months ended
September 30, 2009
|
|
For the nine
months ended
September 30, 2008
|
|
Restricted shares granted to Manager
|
|
$
|
2,260
|
|
$
|
(195
|
)
|
$
|
2,225
|
|
$
|
462
|
|
Restricted shares granted to certain directors
|
|
104
|
|
142
|
|
380
|
|
497
|
|
Total share-based compensation expense
|
|
$
|
2,364
|
|
$
|
(53
|
)
|
$
|
2,605
|
|
$
|
959
|
|
Note 16. Management Agreement and Related Party
Transactions
The Manager manages the Companys day-to-day operations, subject to the
direction and oversight of the Companys board of directors. The Management
Agreement expires on December 31 of each year, but is automatically
renewed for a one-year term each December 31 unless terminated upon the
affirmative vote of at least two-thirds of the Companys independent directors,
or by a vote of the holders of a majority of the Companys outstanding common
shares, based upon (1) unsatisfactory performance by the Manager that is
materially detrimental to the Company or (2) a determination that the
management fee payable by the Manager is not fair, subject to the Managers
right to prevent such a termination under this clause (2) by
accepting a mutually acceptable reduction of management fees. The Manager must
be provided 180 days prior notice of any such termination and will be paid
a termination fee equal to four times the sum of the average annual base
management fee and the average annual incentive fee for the two 12-month
periods immediately preceding the date of termination, calculated as of the end
of the most recently completed fiscal quarter prior to the date of termination.
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, 2009, the
Company incurred $3.7 million and $11.0 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 $2.3 million and $2.2 million, respectively,
for the three and nine months ended September 30, 2009 (see Note 15 to
these
condensed consolidated financial statements
). 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 15 to these
condensed consolidated financial statements
). Effective January 1,
2009
, the Manager has agreed to defer 50% of the monthly base management
fee payable by the Company for the period from January 1, 2009 through November 30,
2009. The aggregate amount of fees otherwise payable during the deferral period
will be payable to the Manager upon the earlier of (x) December 15,
2009 and (y) the date of any termination of the Management Agreement
pursuant to either Section 13(a) or Section 15(b) thereof. As of September 30, 2009, the Company
had $6.1 million base management fee payable to the Manager. 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 condensed consolidated statements
of operations. Expenses incurred by the Manager and reimbursed by the Company
are reflected in the respective condensed consolidated statements of
operations, non-investment expense category based on the nature of the expense.
The Manager is waiving base management fees related to the
$230.4 million common share offering and $270.0 million common share
rights offering that occurred during the third quarter of 2007 until such time
as the Companys common share closing price on the NYSE is $20.00 or more for
five consecutive trading days. Accordingly, the Manager permanently waived
approximately $2.2 million of base management fees during each of the three
months ended September 30, 2009 and 2008, and $6.6 million during each of
the nine months ended September 30, 2009 and 2008.
For the three and nine months ended September 30, 2009, $4.5
million of incentive fees were earned and payable to the Manager. The Manager
agreed to defer the $4.5 million incentive fee to December 15, 2009. No
incentive fees were earned or paid to the Manager during the three and nine
months ended September 30, 2008.
27
Table of Contents
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 CLO
2009-1 and is entitled to receive fees for the services performed as collateral
manager. Previously, the collateral
manager had waived the fees it earned for providing management services for the
Companys CLOs. Beginning April 15, 2007, the collateral manager ceased
waiving fees for CLO 2005-1 and beginning January 1, 2009, the
collateral manager ceased waiving fees for CLO 2005-2, CLO 2006-1,
CLO 2007-1, CLO 2007-A and Wayzata (restructured and replaced with
CLO 2009-1 on March 31, 2009). As described above in Note 10 to these
condensed consolidated financial statements, the Company surrendered for
cancellation the Surrendered Notes issued by CLO 2005-1, CLO 2005-2 and CLO
2006-1. As a result, beginning in July 2009, the collateral manager
reinstated waiving the CLO management fees for CLO 2005-2 and CLO 2006-1. For
each of the three and nine months ended September 30, 2009, the collateral
manager waived $2.6 million for CLO 2005-2 and CLO 2006-1. In addition, due to
the deleveraging of CLO 2009-1 completed in July 2009 whereby all the
senior notes were retired, the collateral manager is no longer entitled to
receive management fees from CLO 2009-1.
In addition, beginning January 1, 2009, the Manager permanently
waived reimbursable general and administrative expenses allocable to the
Company in an amount equal to the incremental CLO management fees received by
the Manager. For the three and nine months ended September 30, 2009, the
Manager permanently waived reimbursement of $2.4 million and $7.7 million,
respectively, in allocable general and administrative expenses. For the three
and nine months ended September 30, 2008, the Company reimbursed the
Manager $2.5 million and $7.6 million, respectively, for allocable general,
administrative and other expenses.
The Company has invested in corporate loans, debt securities and other
investments of entities that are affiliates of KKR. As of September 30,
2009, the aggregate par amount of these affiliated investments totaled
$2.9 billion, or approximately 35% of the total investment portfolio, and
consisted of 21 issuers. The total $2.9 billion in affiliated investments
were primarily comprised of $2.3 billion of corporate loans,
$522.6 million of corporate debt securities available-for-sale and
$62.7 million notional amount of total rate of return swaps referenced to
corporate loans issued by affiliates of KKR (included in derivative assets and
liabilities on the condensed consolidated balance sheet). As of December 31,
2008, the aggregate par amount of these affiliated investments totaled
$3.3 billion, or approximately 35% of the total investment portfolio, and
consisted of 23 issuers. The total $3.3 billion in investments were
comprised of $2.6 billion of corporate loans, $587.3 million of
corporate debt securities available for sale, and $92.4 million notional
amount of total rate of return swaps referenced to corporate loans issued by
affiliates of KKR (included in derivative assets and liabilities on the
condensed consolidated balance sheet).
Note 17. Fair Value of Financial Instruments
Fair Value of Financial Instruments
During the second quarter of 2009, the Company adopted FASB ASC 825-10-65 which requires
disclosures about fair value of financial instruments for interim reporting
periods as well as in annual financial statements. The fair value of certain
instruments including securities available-for-sale, loans, derivatives, and
loan commitments is based on quoted market prices or estimates provided by
independent pricing sources. The fair value of cash and cash equivalents,
interest receivable, senior secured credit facility and interest payable,
approximates cost as of September 30, 2009 and December 31, 2008, due
to the short-term nature of these instruments.
The table below discloses the carrying value and the estimated fair
value of the Companys financial instruments as of September 30, 2009
(amounts in thousands):
|
|
Carrying
Amount
|
|
Estimated Fair
Value
|
|
Financial Assets:
|
|
|
|
|
|
Cash, restricted cash, and cash equivalents
|
|
$
|
314,013
|
|
$
|
314,013
|
|
Securities available-for-sale
|
|
736,823
|
|
736,823
|
|
Corporate loans, net of allowance for loan losses
of $470,224
|
|
6,221,005
|
|
5,869,862
|
|
Residential mortgage-backed securities
|
|
70,256
|
|
70,256
|
|
Residential mortgage loans
|
|
2,274,585
|
|
2,274,585
|
|
Corporate loans held for sale
|
|
504,093
|
|
504,093
|
|
Private equity investments, at estimated fair
value
|
|
76,310
|
|
76,310
|
|
Reverse repurchase agreements
|
|
80,344
|
|
80,344
|
|
Interest and principal receivable
|
|
60,811
|
|
60,811
|
|
Derivative assets
|
|
23,163
|
|
23,163
|
|
Private equity investments, at cost
|
|
17,505
|
|
22,074
|
|
|
|
|
|
|
|
Financial Liabilities:
|
|
|
|
|
|
Collateralized loan obligation senior secured
notes
|
|
$
|
5,706,882
|
|
$
|
4,476,213
|
|
Collateralized loan obligation junior secured
notes to affiliates
|
|
547,421
|
|
197,861
|
|
Senior secured credit facility
|
|
187,500
|
|
187,500
|
|
Convertible senior notes
|
|
275,800
|
|
239,946
|
|
Junior subordinated notes
|
|
283,671
|
|
218,427
|
|
Residential mortgage-backed securities issued
|
|
2,165,423
|
|
2,165,423
|
|
Accounts payable, accrued expenses and other
liabilities
|
|
7,209
|
|
7,209
|
|
Accrued interest payable
|
|
23,840
|
|
23,840
|
|
Accrued interest payable to affiliates
|
|
2,981
|
|
2,981
|
|
Related party payable
|
|
12,893
|
|
12,893
|
|
Securities sold, not yet purchased
|
|
78,633
|
|
78,633
|
|
Derivative liabilities
|
|
57,091
|
|
57,091
|
|
28
Table of Contents
The table below discloses the carrying value and the estimated fair
value of the Companys financial instruments as of December 31, 2008
(amounts in thousands):
|
|
Carrying
Amount
|
|
Estimated Fair
Value
|
|
Financial
Assets:
|
|
|
|
|
|
Cash,
restricted cash, and cash equivalents
|
|
$
|
1,275,015
|
|
$
|
1,275,015
|
|
Securities
available-for-sale
|
|
555,965
|
|
555,965
|
|
Corporate
loans, net of allowance for loan losses of $480,775
|
|
7,246,797
|
|
4,772,934
|
|
Residential
mortgage-backed securities
|
|
102,814
|
|
102,814
|
|
Residential
mortgage loans
|
|
2,620,021
|
|
2,620,021
|
|
Corporate
loans held for sale
|
|
324,649
|
|
324,649
|
|
Private
equity investments, at estimated fair value
|
|
5,287
|
|
5,287
|
|
Reverse
repurchase agreements
|
|
88,252
|
|
88,252
|
|
Interest
and principal receivable
|
|
116,788
|
|
116,788
|
|
Derivative
assets
|
|
73,869
|
|
73,869
|
|
Private
equity investments, at cost
|
|
17,505
|
|
17,505
|
|
|
|
|
|
|
|
Financial
Liabilities:
|
|
|
|
|
|
Collateralized
loan obligation senior secured notes
|
|
$
|
7,487,611
|
|
$
|
4,936,286
|
|
Collateralized
loan obligation junior secured notes to affiliates
|
|
655,313
|
|
194,589
|
|
Senior
secured credit facility
|
|
275,633
|
|
275,633
|
|
Convertible
senior notes
|
|
291,500
|
|
84,000
|
|
Junior
subordinated notes
|
|
288,671
|
|
51,300
|
|
Residential
mortgage-backed securities issued
|
|
2,462,882
|
|
2,462,882
|
|
Accounts
payable, accrued expenses and other liabilities
|
|
60,124
|
|
60,124
|
|
Accrued
interest payable
|
|
61,119
|
|
61,119
|
|
Accrued
interest payable to affiliates
|
|
3,987
|
|
3,987
|
|
Related
party payable
|
|
2,876
|
|
2,876
|
|
Securities
sold, not yet purchased
|
|
90,809
|
|
90,809
|
|
Derivative
liabilities
|
|
171,212
|
|
171,212
|
|
Fair Value Measurements
The
following table presents information about the Companys assets and liabilities
(including derivatives that are presented net) measured at fair value on a
recurring basis as of September 30, 2009, 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, 2009
|
|
|
|
|
|
|
|
|
|
|
|
Assets:
|
|
|
|
|
|
|
|
|
|
Securities available-for-sale
|
|
$
|
1,194
|
|
$
|
661,462
|
|
$
|
74,167
|
|
$
|
736,823
|
|
Residential mortgage-backed securities
|
|
|
|
|
|
70,256
|
|
70,256
|
|
Residential mortgage loans
|
|
|
|
|
|
2,274,585
|
|
2,274,585
|
|
Private equity investments, at estimated fair
value
|
|
|
|
72,700
|
|
3,610
|
|
76,310
|
|
Total
|
|
$
|
1,194
|
|
$
|
734,162
|
|
$
|
2,422,618
|
|
$
|
3,157,974
|
|
|
|
|
|
|
|
|
|
|
|
Liabilities:
|
|
|
|
|
|
|
|
|
|
Derivatives, net
|
|
$
|
|
|
$
|
(54,642
|
)
|
$
|
20,714
|
|
$
|
(33,928
|
)
|
Residential mortgage-backed securities issued
|
|
|
|
|
|
(2,165,423
|
)
|
(2,165,423
|
)
|
Securities sold, not yet purchased
|
|
|
|
(78,633
|
)
|
|
|
(78,633
|
)
|
Total
|
|
$
|
|
|
$
|
(133,275
|
)
|
$
|
(2,144,709
|
)
|
$
|
(2,277,984
|
)
|
29
Table of Contents
The following table presents information about the Companys assets
measured at fair value on a non-recurring basis as of September 30, 2009,
and indicates the fair value hierarchy of the valuation techniques utilized by
the Company to determine such fair value (amounts in thousands). There were no
liabilities measured at fair value on a non-recurring basis:
|
|
Quoted Prices in
Active Markets
for Identical Assets
(Level 1)
|
|
Significant Other
Observable Inputs
(Level 2)
|
|
Significant
Unobservable Inputs
(Level 3)
|
|
Balance as of
September 30, 2009
|
|
Loans held for sale
|
|
$
|
|
|
$
|
503,788
|
|
$
|
305
|
|
$
|
504,093
|
|
REO
|
|
|
|
|
|
12,803
|
|
12,803
|
|
Total
|
|
$
|
|
|
$
|
503,788
|
|
$
|
13,108
|
|
$
|
516,896
|
|
The majority of loans held for sale were classified as level 2 given
that the assets were valued using quoted prices and other observable inputs in
an active market. There was a single loan held for sale classified as level 3
given that the valuation required managements judgment.
The
following table presents information about the Companys assets and liabilities
(including derivatives that are presented net) measured at fair value on a
recurring basis as of December 31, 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
December 31, 2008
|
|
|
|
|
|
|
|
|
|
|
|
Assets:
|
|
|
|
|
|
|
|
|
|
Securities available-for-sale
|
|
$
|
2,524
|
|
$
|
464,332
|
|
$
|
89,109
|
|
$
|
555,965
|
|
Residential mortgage-backed securities
|
|
|
|
|
|
102,814
|
|
102,814
|
|
Residential mortgage loans
|
|
|
|
|
|
2,620,021
|
|
2,620,021
|
|
Private equity investments, at estimated fair value
|
|
|
|
|
|
5,287
|
|
5,287
|
|
Total
|
|
$
|
2,524
|
|
$
|
464,332
|
|
$
|
2,817,231
|
|
$
|
3,284,087
|
|
|
|
|
|
|
|
|
|
|
|
Liabilities:
|
|
|
|
|
|
|
|
|
|
Derivatives, net
|
|
$
|
|
|
$
|
(20,393
|
)
|
$
|
(76,950
|
)
|
$
|
(97,343
|
)
|
Residential mortgage-backed securities issued
|
|
|
|
|
|
(2,462,882
|
)
|
(2,462,882
|
)
|
Securities sold, not yet purchased
|
|
(2,220
|
)
|
(88,589
|
)
|
|
|
(90,809
|
)
|
Total
|
|
$
|
(2,220
|
)
|
$
|
(108,982
|
)
|
$
|
(2,539,832
|
)
|
$
|
(2,651,034
|
)
|
During
2008, the Company began valuing its residential mortgage-backed securities,
residential mortgage loans and residential mortgage-backed securities issued
using level 3 inputs. Previously, the Company had valued these financial
instruments based on broker quotes that the Company classified as level 2
inputs; however, due in large part to the widespread dislocation in the
residential mortgage market, the Company was no longer able to obtain level 2
inputs.
The following table presents information about the Companys assets
measured at fair value on a non-recurring basis as of December 31, 2008,
and indicates the fair value hierarchy of the valuation techniques utilized by
the Company to determine such fair value (amounts in thousands). There were no
liabilities measured at fair value on a non-recurring basis:
|
|
Quoted Prices in
Active Markets
for Identical Assets
(Level 1)
|
|
Significant Other
Observable Inputs
(Level 2)
|
|
Significant
Unobservable Inputs
(Level 3)
|
|
Balance as of
December 31, 2008
|
|
Loans held for sale
|
|
$
|
|
|
$
|
219,199
|
|
$
|
105,450
|
|
$
|
324,649
|
|
REO
|
|
|
|
|
|
10,794
|
|
10,794
|
|
Total
|
|
$
|
|
|
$
|
219,199
|
|
$
|
116,244
|
|
$
|
335,443
|
|
Loans held for sale of $105.5 million were transferred into
level 3 as of December 31, 2008 given that they were valued based on
the estimated sale price. REO of $10.8 million were transferred into
level 3 as of December 31, 2008 as there was little market activity
for these assets and the valuation of REOs required managements judgment.
30
Table of Contents
The following table presents additional information about assets,
including derivatives that are measured at fair value on a recurring basis for
which the Company has utilized level 3 inputs to determine fair value, for
the three months ended September 30, 2009 (amounts in thousands):
|
|
Fair Value Measurements Using Significant Unobservable Inputs
(Level 3)
|
|
|
|
Securities
Available-
For-Sale
|
|
Residential
Mortgage-
Backed
Securities
|
|
Residential
Mortgage
Loans
|
|
Private Equity
Investments,
at estimated
fair value
|
|
Derivatives,
net
|
|
Residential
Mortgage-
Backed
Securities
Issued
|
|
Beginning balance as of July 1, 2009
|
|
$
|
89,998
|
|
$
|
76,572
|
|
$
|
2,218,319
|
|
$
|
5,549
|
|
$
|
6,087
|
|
$
|
(2,080,592
|
)
|
Total gains or losses (realized and unrealized):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Included in earnings
|
|
(520
|
)
|
597
|
|
239,114
|
|
(1,939
|
)
|
17,276
|
|
(258,576
|
)
|
Included in other comprehensive income
|
|
12,969
|
|
|
|
|
|
|
|
|
|
|
|
Net transfers in and/or out of level 3
|
|
|
|
|
|
(2,988
|
)
|
|
|
|
|
|
|
Purchases, sales, other settlements and issuances,
net
|
|
(28,280
|
)
|
(6,913
|
)
|
(179,860
|
)
|
|
|
(2,649
|
)
|
173,745
|
|
Ending balance as of September 30, 2009
|
|
$
|
74,167
|
|
$
|
70,256
|
|
$
|
2,274,585
|
|
$
|
3,610
|
|
$
|
20,714
|
|
$
|
(2,165,423
|
)
|
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)
|
|
$
|
|
|
$
|
845
|
|
$
|
241,346
|
|
$
|
(1,939
|
)
|
$
|
11,221
|
|
$
|
(258,130
|
)
|
(1)
Amounts are
included in net realized and unrealized gain (loss) on investments, net
realized and unrealized gain (loss) 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 on a recurring basis for which the
Company has utilized level 3 inputs to determine fair value, for the nine
months ended September 30, 2009 (amounts in thousands):
|
|
Fair Value Measurements Using Significant Unobservable Inputs
(Level 3)
|
|
|
|
Securities
Available-
For-Sale
|
|
Residential
Mortgage-
Backed
Securities
|
|
Residential
Mortgage
Loans
|
|
Private
Equity
Investments,
at estimated
fair value
|
|
Derivatives,
net
|
|
Residential
Mortgage-
Backed
Securities
Issued
|
|
Beginning balance as of January 1, 2009
|
|
$
|
89,109
|
|
$
|
102,814
|
|
$
|
2,620,021
|
|
$
|
5,287
|
|
$
|
(76,950
|
)
|
$
|
(2,462,882
|
)
|
Total gains or losses (realized and unrealized):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Included in earnings
|
|
(6,676
|
)
|
(8,718
|
)
|
110,536
|
|
(1,677
|
)
|
42,556
|
|
(145,525
|
)
|
Included in other comprehensive income
|
|
28,798
|
|
|
|
|
|
|
|
|
|
|
|
Net transfers in and/or out of level 3
|
|
|
|
|
|
(2,010
|
)
|
|
|
|
|
|
|
Purchases, sales, other settlements and issuances,
net
|
|
(37,064
|
)
|
(23,840
|
)
|
(453,962
|
)
|
|
|
55,108
|
|
442,984
|
|
Ending balance as of September 30, 2009
|
|
$
|
74,167
|
|
$
|
70,256
|
|
$
|
2,274,585
|
|
$
|
3,610
|
|
$
|
20,714
|
|
$
|
(2,165,423
|
)
|
The amount of total gains or losses for the
period included in earnings attributable to the change in unrealized
gains or losses relating to assets still held at the reporting date(1)
|
|
$
|
|
|
$
|
(6,713
|
)
|
$
|
119,801
|
|
$
|
(1,677
|
)
|
$
|
55,106
|
|
$
|
(144,215
|
)
|
(1)
Amounts are
included in net realized and unrealized gain (loss) on investments, net
realized and unrealized gain (loss) 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.
31
Table of Contents
The
following table presents additional information about assets, including
derivatives, that are measured at fair value on a recurring basis for which the
Company has utilized level 3 inputs to determine fair value, for the three
months ended September 30, 2008 (amounts in thousands):
|
|
Fair Value Measurements Using Significant Unobservable Inputs
(Level 3)
|
|
|
|
Securities
Available-
For-Sale
|
|
Residential
Mortgage-
Backed
Securities
|
|
Residential
Mortgage
Loans
|
|
Derivatives,
net
|
|
Residential
Mortgage-
Backed
Securities
Issued
|
|
Beginning balance as of July 1, 2008
|
|
$
|
45,343
|
|
$
|
115,652
|
|
$
|
3,394,996
|
|
$
|
3,471
|
|
$
|
(3,204,392
|
)
|
Total gains or losses (realized and unrealized):
|
|
|
|
|
|
|
|
|
|
|
|
Included in earnings
|
|
|
|
1,621
|
|
(168,058
|
)
|
(16,625
|
)
|
168,059
|
|
Included in other comprehensive loss
|
|
(1,532
|
)
|
|
|
|
|
|
|
|
|
Net transfers in and/or out of level 3
|
|
73,959
|
|
|
|
(1,938
|
)
|
(39,067
|
)
|
|
|
Purchases, sales, other settlements and issuances,
net
|
|
(327
|
)
|
(4,293
|
)
|
(170,244
|
)
|
(675
|
)
|
168,101
|
|
Ending balance as of September 30, 2008
|
|
$
|
117,443
|
|
$
|
112,980
|
|
$
|
3,054,756
|
|
$
|
(52,896
|
)
|
$
|
(2,868,232
|
)
|
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
|
|
(1)
|
|
Amounts are included in net realized and unrealized
gain (loss) 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 on a recurring basis for which the
Company has utilized level 3 inputs to determine fair value, for the nine
months ended September 30, 2008 (amounts in thousands):
|
|
Fair Value Measurements Using Significant Unobservable Inputs
(Level 3)
|
|
|
|
Securities
Available-
For-Sale
|
|
Residential
Mortgage-
Backed
Securities
|
|
Residential
Mortgage
Loans
|
|
Derivatives,
net
|
|
Residential
Mortgage-
Backed
Securities
Issued
|
|
Beginning balance as of January 1, 2008
|
|
$
|
99,498
|
|
$
|
|
|
$
|
|
|
$
|
802
|
|
$
|
|
|
Total gains or losses (realized and unrealized):
|
|
|
|
|
|
|
|
|
|
|
|
Included in earnings
|
|
|
|
(5,515
|
)
|
(307,122
|
)
|
(16,158
|
)
|
315,311
|
|
Included in other comprehensive loss
|
|
(5,622
|
)
|
|
|
|
|
|
|
|
|
Net transfers in and/or out of level 3
|
|
41,234
|
|
131,688
|
|
3,917,666
|
|
(36,256
|
)
|
(3,169,353
|
)
|
Purchases, sales, other settlements and issuances,
net
|
|
(17,667
|
)
|
(13,193
|
)
|
(555,788
|
)
|
(1,284
|
)
|
(14,190
|
)
|
Ending balance as of September 30, 2008
|
|
$
|
117,443
|
|
$
|
112,980
|
|
$
|
3,054,756
|
|
$
|
(52,896
|
)
|
$
|
(2,868,232
|
)
|
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
|
|
(1)
|
|
Amounts are included in net realized and unrealized
gain (loss) 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.
|
Note 18. Subsequent Events
On November 5, 2009, the
Companys board of directors agreed to terminate the two year $100.0 million
standby unsecured revolving credit facility, entered into on November 10, 2008
with the Companys Manager and Kohlberg Kravis Roberts & Co. (Fixed Income)
LLC.
32
Table of Contents
Item 2. MANAGEMENTS DISCUSSION
AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Except where otherwise expressly stated or the
context suggests otherwise, the terms we, us and our refer to KKR
Financial Holdings LLC and its subsidiaries.
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
consisting primarily of below investment grade corporate debt, including senior
secured and unsecured loans, mezzanine loans, high yield corporate bonds,
distressed and stressed debt securities, marketable equity securities, private
equity investments and credit default and total rate of return swaps. The
majority of our investments are in senior secured loans of large capitalization
companies. The corporate loans we invest in are generally referred to as
syndicated bank loans, or leveraged loans, and are purchased via assignment or
participation in either the primary or secondary market. The majority of our
corporate debt investments are held in collateralized loan obligation (CLO)
transactions that are structured as on-balance sheet securitizations and are
used as long term financing for these investments. The senior secured notes
issued by the CLO transactions are generally owned by unaffiliated third party
investors and we own the majority of the subordinated notes in the CLO
transactions. Our CLO transactions consist of five cash flow CLO transactions,
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 and, together
with CLO 2005-1, CLO 2005-2, CLO 2006-1, and CLO 2007-1, the Cash Flow CLOs).
In addition to our Cash Flow CLOs, a portion of our assets were
previously held in Wayzata Funding LLC (Wayzata), a market value CLO
transaction.
On March 31,
2009, we completed the restructuring of Wayzata and replaced it with
KKR Financial
CLO 2009-1, Ltd. (CLO 2009-1)
. As a result of the restructuring, substantially all
of Wayzatas assets were transferred to CLO 2009-1, a newly formed special
purpose company, which issued $560.8 million aggregate principal amount of
senior notes due April 2017 and $154.3 million aggregate principal amount
of subordinated notes due April 2017 to the existing Wayzata note holders
in exchange for cancellation of the Wayzata notes, due November 2012,
previously held by each of them. CLO 2009-1 was structured as a cash flow
transaction and does not contain the market value provisions contained in
Wayzata. The portfolio manager of CLO 2009-1 was an affiliate of
KKR Financial
Advisors LLC (our Manager)
. The notes issued by CLO 2009-1 were secured by the
same collateral that secured the Wayzata notes, consisting primarily of senior
secured leveraged loans. As was the case with Wayzata, at the time of the
restructuring, we and an affiliate of our Manager owned all of the subordinated
notes issued by CLO 2009-1.
During the second quarter of 2009, we sold approximately $423.1 million
of investments that were held in CLO 2009-1 in order to generate proceeds to
retire the senior notes outstanding. These sales resulted in us recording a
loss during the second quarter of $27.2 million. During June 2009, we paid
down the senior notes issued by CLO 2009-1 by $516.4 million and on July 24,
2009, we retired the remaining balance of $44.4 million of outstanding senior
notes.
Prior to the
retirement of the senior notes, an affiliate of ours held a 20% interest in the
subordinated notes issued by CLO 2009-1. As part of the deleveraging of CLO
2009-1, the subordinated notes in CLO 2009-1 held by our affiliate were retired
in exchange for our affiliates proportionate interest in the assets held by
CLO 2009-1. As a result of
the deleveraging transaction and the
distribution of assets to our affiliate, we now hold 100% of the residual
assets of CLO 2009-1.
As described above, we own a majority of the subordinated notes issued
by the Cash Flow CLOs and therefore have historically received a majority of
our cash flows from our investments in these entities. The indentures governing
the Cash Flow CLOs include numerous compliance tests, the majority of which
relate to the CLOs portfolio profile. In addition to the portfolio profile
tests, the indentures for the Cash Flow CLOs include over-collateralization
tests (OC 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. If a CLO is not in compliance with an OC Test or an
interest coverage 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 OC Test is brought back into compliance. During
the third quarter of 2009, certain of our Cash Flow CLOs failed certain of
their respective OC Tests. Accordingly, the cash flows we would generally
expect to receive from our investments in the mezzanine and subordinated notes
issued by the Cash Flow CLOs were used to amortize the most senior class of
notes. During the three and nine months ended September 30, 2009, the
senior notes issued by our Cash Flow CLOs were reduced by $43.5 million and
$188.6 million, respectively, due to amortization of the senior note balances
as a result of non-compliance with certain OC Tests in certain of our CLOs.
On
July 10, 2009, we surrendered for cancellation, without consideration,
$298.4 million in aggregate mezzanine and junior notes (Surrendered Notes)
issued to us by CLO 2005-1, CLO 2005-2 and CLO 2006-1. The Surrendered Notes
were promptly cancelled upon receipt by the trustee of each transaction and the
related debt was extinguished by the issuers thereof. As a result of these
transactions, we were in compliance with the OC Tests for these three CLOs,
which enabled the mezzanine and subordinated note holders, including us, to
resume receiving cash flows from these CLOs. These CLO transactions are
consolidated by us under accounting principles generally accepted in the United
States of America (GAAP) and thus, did not have any impact on our condensed
consolidated financial statements. Similarly, as CLO 2005-1, CLO 2005-2 and CLO
2006-1 are treated as disregarded entities for tax purposes, this transaction
did not have any tax implications for us or our shareholders.
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On August 5, 2009, we entered into an agreement with our lenders
to amend the terms of our senior secured credit facility. Among other things,
the amendment provides that: (i) the size of the facility be reduced to
$200.0 million from $300.0 million, (ii) the lending commitments of the
lenders to this facility be modified to provide for quarterly amortization of
$12.5 million per quarter until the size of the facility has been reduced to
$150 million on June 30, 2010, (iii) the interest rate applicable to
borrowings under the facility be increased from LIBOR plus 300 basis points to
LIBOR plus 400 basis points, (iv) the adjusted tangible net worth covenant
be reduced to $700.0 million from $1.0 billion, (v) the maturity date of
the borrowings under the facility be extended to November 10, 2011, and (vi) certain
events of default under the Credit Agreement be added. The amendment also
provides that the we can (i) pay a yearly distribution to our shareholders
in an amount equal to no greater than 50% of our taxable income for such year
and (ii) use up to $50 million of our unrestricted cash to repurchase our
convertible notes due July 2012 and/or our outstanding trust preferred
securities. In conjunction with this amendment, we paid the lenders to our
credit facility fees totaling $4.5 million.
Non-Cash Phantom Taxable Income
We intend to continue to operate so that we qualify, for United States
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 United States 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
corporate subsidiaries, CLO issuers, including those treated as partnerships or
disregarded entities for United States federal income tax purposes, and debt
securities, may produce taxable income without corresponding distributions of
cash to us or may produce taxable income prior to or following the receipt of
cash relating to such income. Consequently, in some taxable years, holders of
our shares may recognize taxable income in excess of our cash distributions.
Furthermore, if we did not pay cash distributions with respect to a taxable
year, holders of our shares may still have a tax liability attributable to
their allocation of taxable income from us during such year.
Investment Portfolio
Overview
As discussed above, the majority of our investments are held through
CLO transactions that are managed by an affiliate of our Manager and for which
we own the majority, and in some cases all, of the economic interests in the
transaction through the subordinated notes in the transaction. On an unconsolidated
basis, our investment portfolio primarily consists of the following as of September 30,
2009: (i) mezzanine and subordinated tranches of CLO transactions with an
aggregate par amount of $1.0 billion; (ii) corporate loans with an
aggregate par amount of $766.8 million and an estimated fair value of
$473.7 million; (iii) corporate debt securities with an aggregate par
amount of $100.8 million and an estimated fair value of $87.6 million; (iv) residential
mortgage-backed securities (RMBS) with a par amount of $284.1 million
and estimated fair value of $186.5 million; (v) private equity
investments with an aggregate cost amount of $29.8 million and an estimated
fair value of $40.5 million; (vi) marketable equity securities with an
aggregate estimated fair value of $1.2 million. In addition, we hold other
investments including loan investments financed under total rate of return
swaps that are accounted for as derivative transactions, credit default swaps,
shorts on equity and debt instruments, and interest rate swaps.
As our condensed consolidated financial statements in this Quarterly
Report on Form 10-Q are presented to reflect the consolidation of the CLOs
we hold investments in, the information contained in this Managements
Discussion and Analysis of Financial Condition and Results of Operations
reflects the CLOs on a consolidated basis consistent with the disclosures in
our condensed consolidated financial statements.
Corporate
Debt Investments
Our investments in corporate debt primarily consist of investments in
below investment grade corporate loans, often referred to as syndicated bank
loans or leveraged loans, and corporate debt securities. As of September 30,
2009, our corporate debt investments, excluding investments held through total
rate of return swaps, had an aggregate par balance of $8.5 billion, an
aggregate net amortized cost of $7.8 billion and an aggregate estimated
fair value of $7.1 billion. Included in these amounts is $7.7 billion par
amount or $6.5 billion estimated fair value of investments held in our Cash
Flow CLOs which have aggregate senior secured notes outstanding totaling $5.7
billion and an aggregate of $547.4 million of mezzanine and subordinated notes
outstanding that are held by an affiliate of our Manager. In addition to the
investments, our Cash Flow CLOs had an aggregate principal cash balance
totaling $66.8 million as of September 30, 2009.
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RMBS
Investments
Our residential mortgage investment portfolio consists of investments
in RMBS with an estimated fair value of $192.2 million as of September 30,
2009. Of the $192.2 million of RMBS investments we hold, $121.9 million
are in six residential mortgage-backed securitization trusts that we
consolidate under GAAP as we hold the majority of the risk of loss on these
transactions. 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 condensed consolidated assets,
liabilities, income and expenses on our condensed consolidated financial
statements. On our condensed consolidated balance sheet as of September 30,
2009, the $192.2 million of RMBS is computed as our investments in RMBS of
$70.3 million, plus $121.9 million, which represents the difference
between residential mortgage loans of $2.3 billion less residential
mortgage-backed securities issued of $2.2 billion plus $12.8 million
of real estate owned (REO) that is 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 our audit committee.
Fair Value of Financial Instruments
As defined in FASB ASC 820,
Fair Value Measurements
and Disclosures
(FASB ASC 820), 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 condensed consolidated
balance sheets are categorized based upon the level of judgment associated with
the inputs used to measure their value. Hierarchical levels which are 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, certain corporate loans held
for sale, certain private equity investments, certain securities sold, not yet
purchased 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, certain corporate loans
held for sale, certain private equity investments, residential mortgage-backed
securities, residential mortgage loans, REO, residential mortgage-backed
securities issued and certain derivatives.
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During
the second quarter of 2009, we adopted FASB ASC 820-10-65. This topic provides
additional guidance on determining fair value when the volume and level of
activity for the asset or liability have significantly decreased when compared
with normal market activity for the asset or liability (or similar assets or
liabilities). A significant decrease in the volume and level of activity for
the asset or liability is an indication that transactions or quoted prices may
not be determinative of fair value because in such market conditions there may
be increased instances of transactions that are not orderly. In those
circumstances, further analysis of transactions or quoted prices is needed, and
a significant adjustment to the transactions or quoted prices may be necessary
to estimate fair value. The adoption
did not have a material impact on our condensed consolidated financial
statements.
The availability of observable inputs can vary depending on the
financial asset or liability and is affected by a wide variety of factors,
including, for example, the type of product, whether the product is new,
whether the product is traded on an active exchange or in the secondary market,
and the current market condition. To the extent that valuation is based on
models or inputs that are less observable or unobservable in the market, the
determination of fair value requires more judgment. Accordingly, the degree of
judgment exercised by us in determining fair value is greatest for instruments
categorized in level 3. In certain cases, the inputs used to measure fair
value may fall into different levels of the fair value hierarchy. In such
cases, for disclosure purposes, the level in the fair value hierarchy within
which the fair value measurement in its entirety falls is determined based on
the lowest level input that is significant to the fair value measurement in its
entirety.
Many financial assets and liabilities have bid and ask prices that can
be observed in the marketplace. Bid prices reflect the highest price that we
and others are willing to pay for an asset. Ask prices represent the lowest
price that we and others are willing to accept for an asset. For financial assets
and liabilities whose inputs are based on bid-ask prices, we do not require
that fair value always be a predetermined point in the bid-ask range. Our
policy is to allow for mid-market pricing and adjusting to the point within the
bid-ask range that meets our best estimate of fair value.
Depending on the relative liquidity in the markets for certain assets,
we may transfer assets to level 3 if we determine that observable quoted
prices, obtained directly or indirectly, are not available. The valuation techniques
used for the assets and liabilities that are valued using level 3 of the
fair value hierarchy 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
industry recognized models (including Intex and Bloomberg) and data for similar
instruments (e.g., nationally recognized pricing services or broker
quotes). The most significant inputs to the valuation of these instruments are
default and loss expectations and market 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 valuation models. Valuation
models are based on discounted cash flow techniques, for which the key inputs
are the amount and timing of expected future cash flows, market yields for such
instruments and recovery assumptions. Inputs are generally determined based on
relative value analyses, which incorporate similar instruments from similar
issuers.
Over-the-counter (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 a fair value based methodology. 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 method.
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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,
2009, share-based compensation was $2.4 million and $2.6 million, respectively.
As of September 30, 2009, substantially all of the non-vested restricted
common shares issued are subject to remeasurement. As of September 30,
2009, 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 and
common share options. As of September 30, 2009, the common share options
were fully exercised and expire in August 2014. As of September 30,
2009, future unamortized share-based compensation totaled $3.1 million, of
which $0.6 million, $2.1 million, and $0.4 million will be recognized
in 2009, 2010, and beyond, respectively.
Accounting for Derivative Instruments and Hedging Activities
We recognize all derivatives on our condensed consolidated balance
sheets at estimated fair value. On the date we enter into a derivative
contract, we designate and document each derivative contract as one of the
following at the time the contract is executed: (i) a hedge of a
recognized asset or liability (fair value hedge); (ii) a hedge of a
forecasted transaction or of the variability of cash flows to be received or
paid related to a recognized asset or liability (cash flow hedge); (iii) a
hedge of a net investment in a foreign operation; or (iv) a derivative
instrument not designated as a hedging instrument (free-standing derivative).
For a fair value hedge, we record changes in the estimated fair value of the
derivative and, to the extent that it is effective, changes in the fair value
of the hedged asset or liability attributable to the hedged risk, in the
current period earnings in the same financial statement category as the hedged
item. For a cash flow hedge, we record changes in the estimated fair value of
the derivative to the extent that it is effective in other comprehensive
income. We subsequently reclassify these changes in estimated fair value to net
income in the same period(s) that the hedged transaction affects earnings in the
same financial statement category as the hedged item. For free-standing
derivatives, we report changes in the fair values in current period
non-interest 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 our hedged transactions. Periodically, we also
formally assess 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,
2009, the estimated fair value of our net derivative liabilities totaled
$33.9 million.
Impairments
We
monitor our 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. We consider 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 and
the severity of the decline, the amount of the unrealized loss, recent events
specific to the issuer or industry, external credit ratings and recent changes
in such ratings. In addition, for debt
securities we consider our intent to sell the debt security, our estimation of
whether or not we expect to recover the debt securitys entire amortized cost
if we intend to hold the debt security, and whether it is more likely than not
that we will be required to sell the debt security before its anticipated
recovery. For equity securities, we also consider our intent and ability to
hold the equity security for a period of time sufficient for a recovery in value.
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The
amount of the loss that 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 is dependent on certain factors. If the security is an equity security or if
the security is a debt security that we intend to sell or estimate that it is
more likely than not that we will be required to sell before recovery of its
amortized cost, then the impairment amount recognized in earnings is the entire
difference between the estimated fair value of the security and its amortized
cost. For debt securities that we do not intend to sell or estimate that we are
not more likely than not to be required to sell before recovery, the impairment
is separated into the estimated amount relating to credit loss and the
estimated amount relating to all other factors. Only the estimated credit loss amount
is recognized in earnings, with the remainder of the loss amount recognized in
other comprehensive income.
This process involves a considerable amount of subjective judgment by
our management. As of September 30, 2009, we had aggregate unrealized losses
on our securities classified as available-for-sale of approximately
$25.3 million, which if not recovered may result in the recognition of
future losses. During the three and nine months ended September 30, 2009,
we recorded charges for impairments of securities that we determined to be
other-than-temporary totaling nil and $40.0 million, respectively.
During the second quarter of 2009, we adopted FASB
ASC 320-10-65, which amends the other-than-temporary impairment guidance for
debt securities. We determined that the adoption did not have a material impact
on our condensed consolidated financial statements.
Allowance for Loan Losses
Our
allowance for loan losses represents our estimate of probable credit losses
inherent in our corporate loan portfolio held for investment as of the balance
sheet date. Estimating our allowance for
loan losses involves a high degree of management judgment and is based upon a
comprehensive review of our loan portfolio that is performed on a quarterly
basis. 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 pertains to specific loans that we have determined
are impaired. We determine a loan is impaired when we estimate that it is
probable that we will be unable to collect all amounts due according to the
contractual terms of the loan agreement. On a quarterly basis we perform a
comprehensive review of our entire loan portfolio and identify certain loans that
we have determined are impaired. Once a loan is identified as being impaired we
place the loan on non-accrual status, unless the loan is already on non-accrual
status, and record a reserve that reflects our best estimate of the loss that
we expect to recognize from the loan. Generally, the expected loss is estimated
as being the difference between our current cost basis of the loan, including
accrued interest receivable, and the loans estimated fair value.
The
unallocated component of our allowance for loan losses reflects our estimate of
probable losses in our loan portfolio as of the balance sheet date where the
specific loan that the loan loss relates to is indeterminable. We estimate the
unallocated component of our allowance for loan losses through a comprehensive
review of our loan portfolio and identify certain loans that demonstrate
possible indicators of impairment. This assessment excludes all loans that are
determined to be impaired and as a result, an allocated reserve has been
recorded as described in the preceding paragraph. Such indicators include, but
are not limited to, the current and/or forecasted financial performance and
liquidity profile of the issuer, specific industry or economic conditions that
may impact the issuer, and the observable trading price of the loan if
available. Loans that demonstrate possible indicators of impairment are
aggregated on a watch list for monitoring and are sub-divided for
categorization based on the seniority of the loan in the issuers capital
structure, whether the loan is secured or unsecured, and the nature of the
collateral securing the loan, for purposes of applying possible default and
loss severity ranges based on the nature of the issuer and the specific loan.
We apply a range of default and loss severity estimates in order to estimate a
range of loss outcomes upon which to base our estimate of probable losses that
results in the determination of the unallocated component of our allowance for
loan losses. As of September 30, 2009, the range of outcomes used to
estimate the probability of default was between 5% and 40% and the range of
loss severity assumptions for loans that may default was between 20% and 75%.
The estimates and assumptions we use to estimate our allowance for loan losses
are based on our estimated range of outcomes that are determined from industry
information providing both historical and forecasted empirical performance of
the type of corporate loans that we invest in, as well as from our own
estimates based on the nature of our corporate loan portfolio. These estimates
and assumptions are susceptible to change due to our corporate loan portfolio
performance as well as industry performance of the corporate loan asset class
and general economic conditions. Changes in the assumptions and estimates used
to estimate our allowance for loan losses could have a material impact on our
financial condition and results of operations.
As of September 30, 2009, our allowance for loan losses totaled
$470.2 million.
Recent Accounting Pronouncements
In January 2009, the FASB issued FASB ASC 325-40-65 which
eliminates the requirement that a holders best estimate of cash flows be based
upon those that a market participant would use. Instead, it requires that an
other-than-temporary impairment be recognized as a realized loss when it is probable
there has been an adverse change in the holders estimated cash flows from the
cash flows previously projected. The topic also reiterates and emphasizes the
related guidance and disclosure requirements in accordance with FASB ASC 320,
Investments-Debt and Equity Securities
. The standard is effective for all
periods ending after December 15, 2008 and retroactive application is not
permitted. We have taken this topic into consideration when evaluating our investments
for other-than-temporary impairment.
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On June 12, 2009,
the FASB issued SFAS No. 166,
Accounting for Transfers
of Financial Assets, an amendment of FASB Statement No. 140, Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities
(SFAS No. 140) (collectively SFAS No. 166).
The most significant amendments that SFAS No. 166 makes consist of the
removal of the concept of a qualifying special-purpose entity (QSPE) from
FASB ASC 860,
Transfers and Servicing
(FASB
ASC 860), and the elimination of the exception for QSPE from FASB ASC 810,
Consolidation
(FASB ASC 810). The disclosures required by
this standard are to provide greater transparency about transfers of financial
assets and an entitys continuing involvement in transferred financial assets.
SFAS No. 166 will significantly affect existing securitizations that use
QSPEs, as well as future securitizations. SFAS No. 166 is effective January 1,
2010 for calendar-year reporting entities and earlier application is
prohibited. We are
evaluating the impact of adopting SFAS No. 166.
Also on June 12,
2009, the FASB issued SFAS No. 167,
Amendment to FASB
Interpretation No. 46(R)
(SFAS No. 167) which
addresses the effects of elimination the QSPE concept from the FASB ASC 860 and
responds to concerns about the application of certain key provisions of FASB
ASC 810, including concerns over the transparency of enterprises involvement
with VIEs. SFAS No. 167 requires additional disclosures for various areas
including situations that use significant judgment and assumptions in
determining whether or not to consolidate a VIE as well as the nature of and
changes in the risks associated with a VIE. This standard is effective for
calendar year-end companies beginning on January 1, 2010. We are
evaluating the impact of adopting SFAS No. 167.
In September 2009, the FASB issued Accounting
Standards Update (
ASU) 2009-5 which amends FASB ASC 820 to provide
further guidance on how to measure the fair value of a liability. ASU
2009-5 primarily s
ets
forth the types of valuation techniques to be used to value a liability when a
quoted price in an active market for the identical liability is
not available. In these circumstances, ASU 2009-5 states that a company
can apply the quoted price of an identical or similar liability when traded as
an asset, or other valuation techniques that are consistent with principles of
FASB ASC 820. ASU 2009-5 is effective beginning the fourth quarter of 2009. We
do not believe the adoption of ASU 2009-5 will have a material impact on our
financial statements.
Results of Operations
Summary
Our net income for the three and nine months ended September 30,
2009 totaled $67.2 million (or $0.42 per diluted common share) and $74.8
million (or $0.49 per diluted common share), respectively, as compared to net
income of $49.0 million (or $0.32 per diluted common share) and $100.5
million (or $0.73 per diluted common share), respectively, for the three and
nine months ended September 30, 2008. Income from continuing operations
for the three and nine months ended September 30, 2009 totaled $67.2
million (or $0.42 per diluted common share) and $74.8 million (or $0.49 per
diluted common share), respectively, as compared to income from continuing
operations of $49.0 million (or $0.32 per diluted common share) and $97.9
million (or $0.71 per diluted common share), respectively, for the three and
nine months ended September 30, 2008. The increase in income from
continuing operations of $18.2 million from the three months ended September 30,
2008 to 2009 was primarily a result of realized and unrealized gains on
derivatives and foreign exchange, and investments, as compared to realized and
unrealized losses in 2008. These gains were partially offset by a decline in
net investment income, loss on restructuring and extinguishment of debt, and
realized and unrealized losses on our residential mortgage portfolio. The
decrease in income from continuing operations of $23.1 million from the nine
months ended September 30, 2008 to 2009 was attributable to significantly
lower net investment income resulting from a smaller investment portfolio and a
lower yield from our investment portfolio due to the continued decline in
interest rates over the past year, most notably LIBOR, partially mitigated by
realized and unrealized gains on derivatives and foreign exchange in 2009.
39
Table
of Contents
Net
Investment Income
The following table presents the components of our net investment
income for the three and nine months ended September 30, 2009 and 2008:
Comparative Net Investment Income Components
(Amounts in
thousands)
|
|
For the three
months ended
September 30, 2009
|
|
For the three
months ended
September 30, 2008
|
|
For the nine
months ended
September 30, 2009
|
|
For the nine
months ended
September 30, 2008
|
|
Investment Income:
|
|
|
|
|
|
|
|
|
|
Corporate loans and securities interest income
|
|
$
|
92,549
|
|
$
|
165,878
|
|
$
|
295,133
|
|
$
|
529,068
|
|
Residential mortgage loans and securities interest
income
|
|
25,369
|
|
41,871
|
|
96,213
|
|
134,718
|
|
Other interest income
|
|
49
|
|
4,431
|
|
511
|
|
20,505
|
|
Dividend income
|
|
26
|
|
358
|
|
313
|
|
2,266
|
|
Net discount accretion
|
|
17,243
|
|
14,514
|
|
47,042
|
|
34,161
|
|
Total investment income
|
|
135,236
|
|
227,052
|
|
439,212
|
|
720,718
|
|
Interest Expense:
|
|
|
|
|
|
|
|
|
|
Repurchase agreements
|
|
|
|
970
|
|
|
|
34,407
|
|
Collateralized loan obligation senior secured
notes
|
|
19,247
|
|
68,246
|
|
98,872
|
|
214,653
|
|
Senior secured credit facility
|
|
5,164
|
|
3,496
|
|
13,022
|
|
9,269
|
|
Secured demand loan
|
|
|
|
|
|
|
|
348
|
|
Convertible senior notes
|
|
4,969
|
|
5,440
|
|
15,474
|
|
16,450
|
|
Junior subordinated notes
|
|
4,092
|
|
4,941
|
|
12,709
|
|
17,045
|
|
Residential mortgage-backed securities issued
|
|
18,940
|
|
31,506
|
|
66,043
|
|
99,938
|
|
Other interest expense
|
|
1,013
|
|
1,665
|
|
3,260
|
|
2,687
|
|
Interest rate swap
|
|
3,915
|
|
1,841
|
|
10,245
|
|
5,410
|
|
Total interest expense
|
|
57,340
|
|
118,105
|
|
219,625
|
|
400,207
|
|
Interest expense to affiliates
|
|
5,171
|
|
18,794
|
|
16,355
|
|
66,319
|
|
Provision for loan losses
|
|
|
|
|
|
39,795
|
|
10,000
|
|
Net investment income
|
|
$
|
72,725
|
|
$
|
90,153
|
|
$
|
163,437
|
|
$
|
244,192
|
|
The decrease in net investment income from the three and nine months
ended September 30, 2008 to 2009 was attributable to a smaller investment
portfolio and a lower yield from our investment portfolio due to the continued
decline in interest rates over the past year, most notably LIBOR, partially
offset by a decline in interest expense related to pay downs of our
collateralized loan obligation senior secured notes during 2009.
40
Table of
Contents
Other Income (Loss)
The following table presents the components of other income (loss) for
the three and nine months ended September 30, 2009 and 2008:
Comparative Other Income (Loss) Components
(Amounts in
thousands)
|
|
For the three
months ended
September 30, 2009
|
|
For the three
months ended
September 30, 2008
|
|
For the nine
months ended
September 30, 2009
|
|
For the nine
months ended
September 30, 2008
|
|
Net realized and unrealized gain (loss) on
derivatives and foreign exchange:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
$
|
(3,347
|
)
|
$
|
(706
|
)
|
$
|
(2,780
|
)
|
$
|
2,820
|
|
Credit default swaps
|
|
3,928
|
|
9,543
|
|
16,836
|
|
19,877
|
|
Total rate of return swaps
|
|
18,061
|
|
(20,019
|
)
|
42,774
|
|
(86,464
|
)
|
Common stock warrants
|
|
|
|
(15
|
)
|
|
|
(722
|
)
|
Foreign exchange(1)
|
|
1,288
|
|
(4,337
|
)
|
2,001
|
|
(3,979
|
)
|
Total net realized and unrealized gain (loss) on
derivatives and foreign exchange
|
|
19,930
|
|
(15,534
|
)
|
58,831
|
|
(68,468
|
)
|
Net realized loss on residential mortgage-backed
securities and residential mortgage loans, carried at estimated fair value
|
|
(1,742
|
)
|
(1,589
|
)
|
(13,418
|
)
|
(3,088
|
)
|
Net unrealized (loss) gain on residential
mortgage-backed securities, residential mortgage loans, and residential
mortgage-backed securities issued, carried at estimated fair value
|
|
(15,939
|
)
|
1,710
|
|
(31,127
|
)
|
(11,563
|
)
|
Net realized and unrealized gain (loss) on
investments(2)
|
|
21,181
|
|
(17,712
|
)
|
(45,563
|
)
|
(39,000
|
)
|
Net realized and unrealized (loss) gain on
securities sold, not yet purchased
|
|
(996
|
)
|
14,242
|
|
2,920
|
|
22,892
|
|
Impairment of securities available for sale
|
|
|
|
(10,566
|
)
|
(40,013
|
)
|
(20,254
|
)
|
Net (loss) gain on restructuring and
extinguishment of debt
|
|
(10,627
|
)
|
3,056
|
|
30,836
|
|
20,281
|
|
Other income
|
|
1,239
|
|
2,470
|
|
4,150
|
|
7,939
|
|
Total other income (loss)
|
|
$
|
13,046
|
|
$
|
(23,923
|
)
|
$
|
(33,384
|
)
|
$
|
(91,261
|
)
|
(1)
|
Includes
foreign exchange contracts and foreign exchange gain or loss.
|
(2)
|
Includes
lower of cost or estimated fair value adjustment to corporate loans held for
sale and unrealized gain (loss) on private equity investments held at
estimated fair value.
|
As presented in the table
above, other income totaled $13.0 million for the three months ended September 30,
2009 and other loss totaled $33.4 million for the nine months ended September 30,
2009, as compared to other loss of $23.9 million and $91.3 million for the
three and nine months ended September 30, 2008, respectively. Total other
income for the three months ended September 30, 2009 primarily consisted
of net realized and unrealized gains on derivatives and foreign exchange
totaling $19.9 million and net realized and unrealized gains on investments
totaling $21.2 million, partially offset by a $10.6 million net loss on
restructuring and extinguishment of debt, and $17.7 million of net realized and
unrealized losses
on
residential mortgage-backed securities, residential mortgage loans and
residential mortgage-backed securities issued. The $10.6 million net loss on
restructuring and extinguishment of debt represents the payment of a $28.8
million placement fee to the senior note holders of CLO 2009-1, partially
offset by a $14.4 million net gain recognized from the retirement of the CLO
2009-1 subordinated notes and a $3.8 million gain on the repurchase of $5.0
million of junior subordinated notes in the third quarter of 2009. See
Liquidity and Capital Resources for further discussion regarding CLO 2009-1.
Total other
loss for the nine months ended September 30, 2009 primarily consisted of
net realized and unrealized losses on investments totaling $45.6 million,
a loss from other-than-temporary
impairments on securities available-for-sale totaling $40.0 million
, and net
realized and unrealized losses on
residential mortgage-backed securities, residential mortgage loans and
residential mortgage-backed securities issued totaling $44.5 million. These
losses were
partially offset by net realized and unrealized
gains on derivatives and foreign exchange totaling $58.8 million and a net
gain on restructuring and extinguishment of debt totaling $30.8 million.
41
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, 2009 and 2008:
Comparative Non-Investment Expense Components
(Amounts in
thousands)
|
|
For the three
months ended
September 30, 2009
|
|
For the three
months ended
September 30, 2008
|
|
For the nine
months ended
September 30, 2009
|
|
For the nine
months ended
September 30, 2008
|
|
Related party management compensation:
|
|
|
|
|
|
|
|
|
|
Base management fees
|
|
$
|
3,720
|
|
$
|
8,729
|
|
$
|
10,998
|
|
$
|
25,089
|
|
Incentive fees
|
|
4,472
|
|
|
|
4,472
|
|
|
|
Share-based compensation
|
|
2,260
|
|
(195
|
)
|
2,225
|
|
462
|
|
CLO management fees
|
|
4,164
|
|
1,277
|
|
18,437
|
|
3,806
|
|
Related party management compensation
|
|
14,616
|
|
9,811
|
|
36,132
|
|
29,357
|
|
Professional services
|
|
441
|
|
1,335
|
|
5,916
|
|
4,263
|
|
Loan servicing
|
|
1,925
|
|
2,274
|
|
6,117
|
|
7,234
|
|
Insurance
|
|
636
|
|
302
|
|
1,242
|
|
621
|
|
Directors expenses
|
|
710
|
|
208
|
|
1,402
|
|
924
|
|
General and administrative
|
|
193
|
|
3,310
|
|
4,273
|
|
12,549
|
|
Total non-investment expenses
|
|
$
|
18,521
|
|
$
|
17,240
|
|
$
|
55,082
|
|
$
|
54,948
|
|
As presented in the table above, our non-investment expenses increased
by approximately $1.3 million from the three months ended September 30,
2008 to 2009 and $0.1 million from the nine months ended September 30,
2008 to 2009. 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. Base management fee decreased by $5.0
million and $14.1 million from the three and nine months ended September 30,
2008 to 2009, respectively, due to the significant decline in equity from the
$1.1 billion loss we reported for the year ended December 31, 2008. E
ffective January 1,
2009
, our Manager agreed to defer 50% of the monthly base management fee
payable by us for the period from January 1, 2009 through November 30,
2009. The aggregate amount of fees otherwise payable during the deferral period
will be payable to our Manager upon the earlier of (x) December 15,
2009 and (y) the date of any termination of the Management Agreement
pursuant to either Section 13(a) or Section 15(b) thereof.
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. Incentive fees of $4.5 million
were earned by our Manager during the three and nine months ended September 30,
2009 and nil during the three and nine months ended September 30, 2008.
Our Manager agreed to defer the $4.5 million incentive fee to December 15, 2009.
An affiliate of our Manager has entered into separate management
agreements with the respective investment vehicles CLO 2005-1, CLO 2005-2, CLO
2006-1, CLO 2007-1, CLO 2007-A and CLO 2009-1 and is entitled to receive fees
for the services performed as collateral manager. Beginning April 15,
2007, the collateral manager ceased waiving fees for CLO 2005-1 and
beginning January 1, 2009, the collateral manager ceased waiving fees for
CLO 2005-2, CLO 2006-1, CLO 2007-1, CLO 2007-A and Wayzata
(restructured and replaced with CLO 2009-1 on March 31, 2009). However, as
a result of the cancellation of Surrendered Notes in July 2009, the
collateral manager reinstated waiving management fees for CLO 2005-2 and CLO
2006-1. For each of the three and nine months ended September 30, 2009,
the collateral manager waived $2.6 million for CLO 2005-2 and CLO 2006-1. In
addition, due to the deleveraging of CLO 2009-1 completed in July 2009
whereby all the senior notes were retired, the collateral manager is no longer
entitled to receive fees for CLO 2009-1. Accordingly, CLO management fees
increased $2.9 million from the three months ended September 30, 2008 to
2009 to account for the fees related to CLO 2007-1 and CLO 2007-A, and $14.6 million
from the nine months ended September 30, 2008 to 2009 to account for the
fees related to all six CLOs for either the full or partial nine month period.
42
Table of
Contents
In addition, beginning January 1, 2009, our Manager permanently
waived reimbursable general and administrative expenses allocable to us in an
amount equal to the incremental CLO management fees received by our Manager.
For the three and nine months ended September 30, 2009, our Manager
permanently waived reimbursement of $2.4 million and $7.7 million,
respectively, in allocable general and administrative expenses. For the three
and nine months ended September 30, 2008, we reimbursed our Manager $2.5
million and $7.6 million, respectively, for expenses.
General and administrative expenses include 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. Professional fees decreased $0.9 million
from the three months ended September 30, 2008 to 2009. In contrast,
professional fees increased $1.7 million from the nine months ended September 30,
2008 to 2009 primarily due to expenses associated with the replacement of
Wayzata with CLO 2009-1 on March 31, 2009. The decrease in general and
administrative expenses of $3.1 million and $8.3 million from the three
and nine months ended September 30, 2008 to 2009, respectively, was
largely attributable to the rebated CLO management fees reducing the general
and administrative expenses otherwise reimbursable to our Manager.
Income Tax Provision
We intend to continue to operate so that we qualify as a partnership,
and not as an association or publicly traded partnership that is taxable as a
corporation, for United States federal income tax purposes. Therefore, we
generally are not subject to United States 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 TRS Holdings, Ltd. (TRS Ltd.), KKR Financial
Holdings, Ltd. (KFH Ltd.), and KFN PEI VII, LLC (PEI VII)
are not consolidated with us for United States federal income tax purposes. For
financial reporting purposes, current and deferred taxes are provided for on
the portion of earnings recognized by us with respect to our interest in PEI
VII, a domestic taxable corporate subsidiary, because PEI VII is taxed as a
regular corporation under the Code. Deferred income tax assets and liabilities
are computed based on temporary differences between the GAAP consolidated
financial statements and the United States 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, CLO 2007-A and CLO 2009-1 are our foreign
subsidiaries that elected to be treated as disregarded entities or partnerships
for United States federal income tax purposes. Those subsidiaries were
established to facilitate securitization transactions, structured as secured
financing transactions. TRS Ltd. and KFH Ltd. are our foreign subsidiaries
and are taxed as corporations for United States federal income tax purposes.
These entities 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 United States federal and state income
tax at the corporate entity level because they restrict their activities in the
United States to trading in stock and securities for their own account. 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
quarter ended September 30, 2009 were recorded; however, we are generally
required to include their current taxable income in our calculation of taxable
income allocable to shareholders.
We own both REIT and domestic taxable corporate subsidiaries, none of
which are expected to incur a 2009 federal or state tax liability.
Investment Portfolio
Corporate Investment Portfolio
Summary
Our corporate investment portfolio primarily consists of investments in
corporate loans and debt securities. Our corporate loans primarily consist of
senior secured, second lien and mezzanine loans. The corporate loans we invest
in are generally below investment grade and are floating rate indexed to either
one-month or three-month LIBOR. Our investments in corporate debt securities
primarily consist of investments in below investment grade corporate bonds that
are senior secured, senior unsecured and subordinated. 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.
Corporate
Loans
Our corporate loan portfolio totaled approximately $7.2 billion as of September 30,
2009 and $8.1 billion as of December 31, 2008. Our corporate loan
portfolio consists of debt obligations of corporations, partnerships and other
entities in the form of senior secured loans, second lien loans and mezzanine
loans.
The following table summarizes our corporate loans portfolio stratified
by type as of September 30, 2009 and December 31, 2008:
43
Table
of Contents
Corporate Loans
(Amounts in
thousands)
|
|
September 30,
2009
|
|
December 31,
2008
|
|
|
|
Carrying
Value (1)
|
|
Amortized
Cost
|
|
Estimated
Fair
Value
|
|
Carrying
Value(1)
|
|
Amortized
Cost
|
|
Estimated
Fair
Value
|
|
Senior secured
|
|
$
|
6,356,334
|
|
$
|
6,356,334
|
|
$
|
5,716,199
|
|
$
|
7,147,665
|
|
$
|
7,147,665
|
|
$
|
4,627,121
|
|
Second lien
|
|
632,288
|
|
632,288
|
|
517,691
|
|
655,371
|
|
655,371
|
|
361,196
|
|
Mezzanine
|
|
206,700
|
|
206,700
|
|
140,065
|
|
249,185
|
|
249,185
|
|
109,266
|
|
Total
|
|
$
|
7,195,322
|
|
$
|
7,195,322
|
|
$
|
6,373,955
|
|
$
|
8,052,221
|
|
$
|
8,052,221
|
|
$
|
5,097,583
|
|
(1)
|
|
Total
carrying value is gross of allowance for loan losses of $470.2 million and
$480.8 million as of September 30, 2009 and December 31, 2008,
respectively, and includes loans held for sale of $504.1 million and
$324.6 million as of September 30, 2009 and December 31, 2008,
respectively.
|
As of September 30, 2009, $7.1 billion, or 98.1%, of our
corporate loan portfolio was floating rate and $0.1 billion, or 1.9%, was
fixed rate. As of December 31, 2008, $7.9 billion, or 98.6%, of our
corporate loan portfolio was floating rate and $0.1 billion, or 1.4%, was
fixed rate. Fixed and floating percentages were calculated based on the
portfolio mix as a percentage of estimated fair value.
All of our floating rate corporate loans have index reset frequencies
of twelve months or less with the majority being quarterly. The
weighted-average coupon on our floating rate corporate loans was 3.7% and 4.6%
as of September 30, 2009 and December 31, 2008, respectively, and the
weighted-average coupon spread to LIBOR of our floating rate corporate loan
portfolio was 3.0% and 2.9% as of September 30, 2009 and December 31,
2008, respectively. The rates above were calculated assuming that non-accrual
loans were accruing interest as of the stated periods. The weighted-average
years to maturity of our floating rate corporate loans was 4.5 years and 5.1
years as of September 30, 2009 and December 31, 2008, respectively.
As of September 30, 2009, our fixed rate corporate loans had a
weighted-average coupon of 13.1% and weighted-average years to maturity of
5.5 years, as compared to 13.7% and weighted-average years to maturity of
6.4 years as of December 31, 2008.
Loans placed on non-accrual status may or may not be contractually past
due at the time of such determination. When placed on non-accrual status,
previously recognized accrued interest is reversed and charged against current
income. While on non-accrual status, interest income is recognized using the
cost-recovery method, cash-basis method or some combination of the two methods.
A loan is placed back on accrual status when the ultimate collectability of the
principal and interest is not in doubt.
As of September 30, 2009 and December 31, 2008, we had $730.2
million and $358.0 million of loans on non-accrual status, respectively.
The average recorded investment in the impaired loans during the three and nine
months ended September 30, 2009 was $717.3 million and $544.2 million,
respectively. As of September 30, 2008, there were no corporate loan
balances placed on non-accrual status. The amount of interest income recognized
using the cash-basis method during the time within the period that the loans
were impaired was $8.2 million and $12.4 million for the three and nine months
ended September 30, 2009, respectively, and nil for the three and nine
months ended September 30, 2008.
As of September 30, 2009, we held loans that were in default with
a total amortized cost of $743.6 million from ten issuers. During the year
ended December 31, 2008, we held investments that were in default with a
total amortized cost of $312.7 million from three issuers. The majority of
corporate loans in default during 2009 and 2008 were included in the
investments for which the allocated component of our allowance for losses was
related to as of September 30, 2009 and December 31, 2008,
respectively.
The following table summarizes the changes in the allowance for loan
losses for our corporate loan portfolio during the three and nine months ended September 30,
2009 and 2008 (amounts in thousands):
|
|
For the three
months ended
September 30, 2009
|
|
For the three
months ended
September 30, 2008
|
|
For the nine
months ended
September 30, 2009
|
|
For the nine
months ended
September 30, 2008
|
|
Balance at beginning of period
|
|
$
|
473,202
|
|
$
|
35,000
|
|
$
|
480,775
|
|
$
|
25,000
|
|
Provision for loan losses
|
|
|
|
|
|
39,795
|
|
10,000
|
|
Charge-offs
|
|
(2,978
|
)
|
|
|
(50,346
|
)
|
|
|
Balance at end of period
|
|
$
|
470,224
|
|
$
|
35,000
|
|
$
|
470,224
|
|
$
|
35,000
|
|
44
Table of
Contents
As
of September 30, 2009 and December 31, 2008, we had an allowance for
loan loss of $470.2 million and $480.8 million, respectively. As described
under Critical Accounting Policies, our allowance for loan losses represents
our estimate of probable credit losses inherent in our corporate loan portfolio
held for investment as of the balance sheet date. Estimating our allowance for
loan losses involves a high degree of management judgment and is based upon a
comprehensive review of our loan portfolio that is performed on a quarterly
basis. 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 pertains to specific loans that we have determined
are impaired. We determine a loan is impaired when we estimate that it is
probable that we will be unable to collect all amounts due according to the
contractual terms of the loan agreement. On a quarterly basis we perform a
comprehensive review of our entire loan portfolio and identify certain loans
that we have determined are impaired. Once a loan is identified as being
impaired we place the loan on non-accrual status, unless the loan is already on
non-accrual status, and record a reserve that reflects our best estimate of the
loss that we expect to recognize from the loan. Generally, the expected loss is
estimated as being the difference between our current cost basis of the loan,
including accrued interest receivable, and the loans estimated fair value.
The
unallocated component of our allowance for loan losses reflects our estimate of
probable losses in our loan portfolio as of the balance sheet date where the
specific loan that the loan loss relates to is indeterminable. We estimate the
unallocated component of our allowance for loan losses through a comprehensive
review of our loan portfolio and identify certain loans that demonstrate
possible indicators of impairment. This assessment excludes all loans that are
determined to be impaired and as a result, an allocated reserve has been
recorded as described in the preceding paragraph. Such indicators include, but
are not limited to, the current and/or forecasted financial performance and
liquidity profile of the issuer, specific industry or economic conditions that
may impact the issuer, and the observable trading price of the loan if
available. Loans that demonstrate possible indicators of impairment are
aggregated on a watch list for monitoring and are sub-divided for
categorization based on the seniority of the loan in the issuers capital
structure, whether the loan is secured or unsecured, and the nature of the
collateral securing the loan, for purposes of applying possible default and
loss severity ranges based on the nature of the issuer and the specific loan.
We apply a range of default and loss severity estimates in order to estimate a
range of loss outcomes upon which to base our estimate of probable losses that
results in the determination of the unallocated component of our allowance for
loan losses.
As of September 30, 2009, the allocated component of the allowance
for loan losses totaled $430.8 million and relates to investments in loans
issued by thirteen issuers with an aggregate par amount of $902.0 million
and an aggregate amortized cost amount of $701.6 million. As of December 31,
2008, the allocated component of the allowance for loan losses totaled $320.6
million and relates to investments in loans issued by eleven issuers with an
aggregate par amount of $828.2 million and an aggregate amortized cost
amount of $715.4 million. The amount recorded to the allocated component of
our allowance for loan losses reflects significant deterioration in the credit
performance of these issuers as demonstrated by default, bankruptcy or a
material deterioration of the issuer such that default or restructuring is
considered likely to occur.
The
unallocated component of the allowance for loan losses totaled $39.4 million
and $160.2 million as of September 30, 2009 and December 31,
2008, respectively. The decline in the unallocated component of our allowance
for loan losses from December 31, 2008 to September 30, 2009 is
attributable to the migration of the unallocated component to the allocated
component of the allowance for loan losses since year end.
As
of September 30, 2009, no additional provision for loan losses was
required based on our review of the allocated and unallocated components of the
allowance for loan losses.
We
recorded charge-offs during the three months ended September 30, 2009
totaling $3.0 million related to loans transferred to loans held for sale.
During the nine months ended September 30, 2009, we recorded charge-offs
totaling $50.4 million comprised of the $3.0 million above, $6.0 million
related to a loan sold during the second quarter of 2009 and $41.4 million
related to a loan exchanged for equity and which qualified as a troubled debt
restructuring. At the time of restructuring, we elected the option to carry
this investment at estimated fair value in accordance with FASB ASC 825,
Financial Instruments
, with unrealized gains and losses
reported in income. There were no charge-offs during the three and nine months
ended September 30, 2008.
We recorded no additional charge to earnings during the quarter ended September 30,
2009 for the lower of cost or estimated fair value adjustment for corporate
loans held for sale which had an estimated fair value of $504.1 million as
of September 30, 2009. 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 loans held for sale which had an estimated
fair value of $28.2 million as of September 30, 2008.
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, 2009 and December 31, 2008:
Corporate Loans
(Amounts in
thousands)
Ratings Category
|
|
As of
September 30, 2009
|
|
As of
December 31, 2008
|
|
Aaa/AAA
|
|
$
|
|
|
$
|
|
|
Aa1/AA+ through Aa3/AA-
|
|
|
|
|
|
A1/A+ through A3/A-
|
|
|
|
|
|
Baa1/BBB+ through Baa3/BBB-
|
|
41,067
|
|
|
|
Ba1/BB+ through Ba3/BB-
|
|
1,498,974
|
|
2,885,285
|
|
B1/B+ through B3/B-
|
|
4,933,381
|
|
4,580,280
|
|
Caa1/CCC+ and lower
|
|
1,095,862
|
|
957,104
|
|
Non-rated
|
|
95,594
|
|
33,449
|
|
Total
|
|
$
|
7,664,878
|
|
$
|
8,456,118
|
|
45
Table
of Contents
Corporate
Debt Securities
Our
corporate debt securities portfolio totaled $735.6 million and
$553.4 million as of September 30, 2009 and December 31, 2008,
respectively. Our corporate debt securities portfolio consists of debt
obligations of corporations, partnerships and other entities in the form of
senior secured, senior unsecured and subordinated bonds.
The
following table summarizes our corporate debt securities portfolio stratified
by type as of September 30, 2009 and December 31, 2008:
Corporate Debt Securities
(Amounts in thousands)
|
|
September 30,
2009
|
|
December 31,
2008
|
|
|
|
Carrying
Value
|
|
Amortized
Cost
|
|
Estimated
Fair
Value
|
|
Carrying
Value
|
|
Amortized
Cost
|
|
Estimated
Fair
Value
|
|
Senior secured
|
|
$
|
87,300
|
|
$
|
44,182
|
|
$
|
87,300
|
|
$
|
57,641
|
|
$
|
75,127
|
|
$
|
57,641
|
|
Senior unsecured
|
|
423,478
|
|
346,701
|
|
423,478
|
|
400,357
|
|
503,897
|
|
400,357
|
|
Subordinated
|
|
224,851
|
|
201,688
|
|
224,851
|
|
95,443
|
|
163,450
|
|
95,443
|
|
Total
|
|
$
|
735,629
|
|
$
|
592,571
|
|
$
|
735,629
|
|
$
|
553,441
|
|
$
|
742,474
|
|
$
|
553,441
|
|
As
of September 30, 2009, $580.3 million, or 78.9%, of our corporate debt
securities portfolio was fixed rate and $155.4 million, or 21.1%, was
floating rate. As of December 31, 2008, $494.6 million, or 89.4%, of our
corporate debt securities portfolio was fixed rate and $58.8 million, or 10.6%,
was floating rate.
As
of September 30, 2009, our fixed rate corporate debt securities had a
weighted-average coupon of 10.1% and weighted-average years to maturity of
6.4 years, as compared to 10.3% and 6.8 years, as of December 31,
2008. 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 3.5% and 7.0% as of September 30,
2009 and December 31, 2008, respectively, and the weighted-average coupon
spread to LIBOR of our floating rate corporate debt securities was 3.1% and
3.6% as of September 30, 2009 and December 31, 2008, respectively.
The weighted-average years to maturity of our floating rate corporate debt
securities was 4.5 years as of both September 30, 2009 and December 31,
2008.
During
the three and nine months ended September 30, 2009, we recorded impairment
losses totaling nil million and $40.0 million, respectively, for corporate
debt and equity securities that we determined to be other-than-temporarily
impaired. These securities were determined to be other-than-temporarily impaired
either due to our determination that recovery in value is no longer likely or
because we decided to sell the respective security in response to specific
credit concerns regarding the issuer. For the three and nine months ended September 30,
2008, we recorded impairment losses totaling $10.6 million and
$20.3 million, respectively, for corporate debt and equity securities that
we determined to be other-than-temporarily impaired.
As of September 30, 2009 and December 31, 2008, we held one
corporate debt security that was in default with a total fair value of
$5.9 million and $3.2 million, respectively. This corporate debt security
was determined to be other-than-temporarily impaired as of September 30,
2009 and December 31, 2008.
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, 2009 and December 31, 2008:
Corporate Debt Securities
(Amounts in
thousands)
Ratings Category
|
|
As of
September 30, 2009
|
|
As of
December 31, 2008
|
|
Aaa/AAA
|
|
$
|
|
|
$
|
|
|
Aa1/AA+ through Aa3/AA-
|
|
|
|
|
|
A1/A+ through A3/A-
|
|
36,000
|
|
37,500
|
|
Baa1/BBB+ through Baa3/BBB-
|
|
|
|
|
|
Ba1/BB+ through Ba3/BB-
|
|
27,381
|
|
32,000
|
|
B1/B+ through B3/B-
|
|
221,935
|
|
408,856
|
|
Caa1/CCC+ and lower
|
|
583,394
|
|
734,303
|
|
Non-Rated
|
|
6,816
|
|
6,816
|
|
Total
|
|
$
|
875,526
|
|
$
|
1,219,475
|
|
Residential Mortgage Investments
Summary
Our residential mortgage investment portfolio consists of investments
in RMBS with an estimated fair value of $192.2 million as of September 30,
2009. The $192.2 million of RMBS is comprised of $95.7 million of
RMBS that are rated investment grade or higher and $96.5 million of RMBS
that are rated below investment grade. Of the $192.2 million of RMBS
investments we hold, $121.9 million are in six residential mortgage-backed
securitization trusts that are not structured as qualifying special-purpose
entities. 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
46
Table of
Contents
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 condensed consolidated assets, liabilities, revenues and
expenses on our condensed consolidated financial statements. On our condensed
consolidated balance sheet as of September 30, 2009, the $192.2 million of
RMBS is computed as our investments in RMBS of $70.3 million, plus
$121.9 million, which represents the difference between residential
mortgage loans of $2.3 billion less residential mortgage-backed securities
issued of $2.2 billion plus $12.8 million of REO that is included in other
assets on our condensed consolidated balance sheet. The $192.2 million of
RMBS as of September 30, 2009 represents a decrease of 29.0% from
$270.7 million as of December 31, 2008.
As our condensed consolidated financial statements included in this
quarterly report 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 table below summarizes the carrying value, amortized cost, and
estimated fair value of our residential mortgage investment portfolio as of September 30,
2009 and December 31, 2008. 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.
Residential Mortgage Investment Portfolio
(Dollar
amounts in thousands)
|
|
September 30, 2009
|
|
December 31, 2008
|
|
|
|
Carrying
Value
|
|
Amortized
Cost
|
|
Estimated
Fair Value
|
|
Carrying
Value
|
|
Amortized
Cost
|
|
Estimated
Fair Value
|
|
Residential Mortgage Loans(1)
|
|
$
|
2,274,585
|
|
$
|
2,905,776
|
|
$
|
2,274,585
|
|
$
|
2,620,021
|
|
$
|
3,371,014
|
|
$
|
2,620,021
|
|
Residential Mortgage-Backed Securities
|
|
70,256
|
|
100,004
|
|
70,256
|
|
102,814
|
|
125,849
|
|
102,814
|
|
Total
|
|
$
|
2,344,841
|
|
$
|
3,005,780
|
|
$
|
2,344,841
|
|
$
|
2,722,835
|
|
$
|
3,496,863
|
|
$
|
2,722,835
|
|
(1)
|
|
Excludes
REO as a result of foreclosure on delinquent loans of $12.8 million and $10.8
million as of September 30, 2009 and December 31, 2008,
respectively.
|
As of September 30, 2009, thirty of our residential mortgage loans
with an outstanding balance of $12.8 million were REO as a result of
foreclosure on delinquent loans. As of December 31, 2008, thirty-three of
our residential mortgage loans owned by us with an outstanding balance of
$10.8 million were REO as a result of foreclosure on delinquent loans.
The following table summarizes the delinquency statistics of our
residential mortgage loans, excluding REOs, as of September 30, 2009 and December 31,
2008 (dollar amounts in thousands):
|
|
September 30, 2009
|
|
December 31, 2008
|
|
Delinquency Status
|
|
Number
of Loans
|
|
Principal
Amount
|
|
Number
of Loans
|
|
Principal
Amount
|
|
30 to 59 days
|
|
77
|
|
$
|
29,205
|
|
93
|
|
$
|
37,282
|
|
60 to 89 days
|
|
39
|
|
15,407
|
|
41
|
|
15,654
|
|
90 days or more
|
|
111
|
|
47,034
|
|
76
|
|
29,803
|
|
In foreclosure
|
|
135
|
|
54,776
|
|
67
|
|
22,841
|
|
Total
|
|
362
|
|
$
|
146,422
|
|
277
|
|
$
|
105,580
|
|
Portfolio Purchases
We purchased $0.3 billion and $0.9 billion par amount of
investments during the three months and nine months ended September 30,
2009, respectively, as compared to $0.5 billion and $1.8 billion for the three
and nine months ended September 30, 2008, respectively.
The table below summarizes our investment portfolio purchases for the
periods indicated and includes the par amount of the securities and loans that
were purchased:
47
Table
of Contents
Investment Portfolio Purchases
(Dollar
amounts in thousands)
|
|
Three months ended
September 30, 2009
|
|
Three months ended
September 30, 2008
|
|
Nine months ended
September 30, 2009
|
|
Nine months ended
September 30, 2008
|
|
|
|
Par Amount
|
|
%
|
|
Par Amount
|
|
%
|
|
Par Amount
|
|
%
|
|
Par Amount
|
|
%
|
|
Securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporate Debt Securities
|
|
$
|
52,052
|
|
20.1
|
%
|
$
|
50,000
|
|
10.5
|
%
|
$
|
94,615
|
|
10.2
|
%
|
$
|
176,747
|
|
9.9
|
%
|
Marketable Equity Securities
|
|
|
|
|
|
|
|
|
|
|
|
|
|
6,496
|
|
0.4
|
|
Total Securities Principal Balance
|
|
52,052
|
|
20.1
|
|
50,000
|
|
10.5
|
|
94,615
|
|
10.2
|
|
183,243
|
|
10.3
|
|
Loans:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporate Loans
|
|
206,873
|
|
79.9
|
|
426,320
|
|
89.5
|
|
831,091
|
|
89.8
|
|
1,597,573
|
|
89.7
|
|
Grand Total Principal Balance
|
|
$
|
258,925
|
|
100.0
|
%
|
$
|
476,320
|
|
100.0
|
%
|
$
|
925,706
|
|
100.0
|
%
|
$
|
1,780,816
|
|
100.0
|
%
|
The schedule above excludes purchases of securities sold, not yet
purchased, with a par amount of nil and $136.4 million as of September 30,
2009 and 2008, respectively.
Shareholders Equity
Our shareholders equity at September 30, 2009 and December 31,
2008 totaled $1.1 billion and $663.3 million, respectively. Included in our
shareholders equity as of September 30, 2009 and December 31, 2008
is accumulated other comprehensive income (loss) totaling $91.8 million and
$(268.8) million, respectively.
Our average shareholders equity and return on average shareholders
equity for the three and nine months ended September 30, 2009 were
$1.0 billion and 26.5% and $841.8 million and 11.9%, respectively. Our average shareholders equity and return
on average shareholders equity and for the three and nine months ended September 30,
2008, were $1.8 billion and 10.7% and $1.8 billion and 7.6%, 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, 2009 and December 31,
2008 was $7.01 and $4.40, respectively, and is computed based on 158,359,757
and 150,881,500 shares issued and outstanding as September 30, 2009 and December 31,
2008, respectively.
Liquidity and Capital Resources
We actively manage our liquidity position with the
objective of preserving our ability to fund our operations and fulfill our
commitments on a timely and cost-effective basis. To achieve this objective, we
completed several initiatives in the past three months as described below. As
of September 30, 2009, we had unrestricted cash and cash equivalents
totaling $125.9 million.
The majority of our investments are held in Cash Flow CLOs (CLO 2005-1,
CLO 2005-2, CLO 2006-1, CLO 2007-1 and CLO 2007-A). Accordingly, the majority
of our cash flows have historically been received from our investments in the
mezzanine and subordinated notes of our Cash Flow CLOs. Current market economic
conditions have had a material adverse impact on our cash flows and liquidity.
During the quarter ended September 30, 2009, certain of our Cash Flow CLOs
were out of compliance with certain compliance tests (specifically, OC Tests)
outlined in their respective indentures and as a result, the cash flows we
would generally expect to receive from our Cash Flow CLO holdings was paid to
the senior note holders of the Cash Flow CLOs that were out of compliance with
their respective OC Tests. Based on current market conditions, most notably the
credit ratings of certain investments held in our Cash Flow CLOs and their
related market values, we expect that certain of our Cash Flow CLOs will be out
of compliance with their respective OC Tests during the remainder of 2009 and
as a result, we expect that the cash flows that we would generally expect to
receive will be used to reduce the principal balances of the senior notes
issued by certain of our Cash Flow CLOs.
On
July 10, 2009, we undertook certain actions with respect to CLO 2005-1,
CLO 2005-2 and CLO 2006-1 that are expected to have a positive cash flow impact
for us. Specifically, we surrendered for cancellation, without consideration,
$298.4 million in aggregate of mezzanine notes and junior notes issued to us by
these three CLO transactions. The Surrendered Notes were promptly cancelled
upon receipt by the trustee of each transaction and the related debt was
extinguished by the issuers thereof. As a result of the transaction, the OC
Tests for these three CLOs were brought into compliance, enabling the mezzanine
and subordinated note holders, including us, to resume receiving cash flows
from these transactions during the period when the OC Tests remain in
compliance.
48
Table of
Contents
In addition to our Cash Flow CLOs, a portion of our assets were
previously held in Wayzata, a market value CLO transaction.
On March 31, 2009, we completed the
restructuring of Wayzata and replaced it with CLO 2009-1. As a result of the
restructuring, substantially all of Wayzatas assets were transferred to CLO
2009-1, a newly formed special purpose company, which issued $560.8 million
aggregate principal amount of senior notes due April 2017 and $154.3
million aggregate principal amount of subordinated notes due April 2017 to
the existing Wayzata note holders in exchange for cancellation of the Wayzata
notes, due November 2012, previously held by each of them. CLO 2009-1 was
structured as a cash flow transaction and does not contain the market value
provisions contained in Wayzata. The portfolio manager of CLO 2009-1 was an
affiliate of
our Manager.
The notes issued by CLO 2009-1 were secured by the
same collateral that secured the Wayzata notes, consisting primarily of senior
secured leveraged loans. As was the case with Wayzata, at the time of the
restructuring, we and an affiliate of our Manager owned all of the subordinated
notes issued by CLO 2009-1.
During June 2009, we paid down the senior notes issued by CLO
2009-1 by $516.4 million and on July 24, 2009, we retired the remaining
balance of $44.4 million of outstanding senior notes.
Prior to the retirement of the senior
notes, an affiliate of ours held a 20% interest in the subordinated notes
issued by CLO 2009-1. As part of the deleveraging of CLO 2009-1, the
subordinated notes in CLO 2009-1 held by our affiliate were retired in exchange
for a 20% interest in each of CLO 2009-1s assets which remained following the
deleveraging.
As a result of the deleveraging transaction and the
distribution of assets to our affiliate, we now hold 100% of the residual
assets of CLO 2009-1.
We closely monitor our
liquidity position and believe we have sufficient liquidity and access to
liquidity to meet our financial obligations for at least the next 12 months.
Sources of Funds
Cash Flow
CLO Transactions
As of September 30, 2009, we had five CLO transactions
outstanding, CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2007-1
and CLO 2007-A. An affiliate of our Manager owns a 37% interest in the junior
notes of both CLO 2007-1 and CLO 2007-A. The aggregate carrying amount of
the junior notes in CLO 2007-1 and CLO 2007-A held by the affiliate of our
Manager is $547.4 million as of September 30, 2009, 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 CLOs to fund our investments
in corporate loans and corporate debt securities. The indentures governing our
Cash Flow CLOs 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 OC 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 Cash Flow CLO
transaction defines the value used to determine the collateral value, which
value is 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 Cash Flow 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 Cash Flow 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 OC Tests at market value and not par.
Defaults of assets in Cash Flow CLOs, ratings downgrade of assets in
Cash Flow 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 OC ratio such that a Cash Flow CLO is not in
compliance. If a Cash Flow CLO is not in compliance with an OC 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 OC Test
is brought back into compliance. Declines in asset prices, particularly in the
corporate loan and high yield securities asset classes during the fourth
quarter of 2008, have been of a historic magnitude and have therefore increased
the risk of failing the OC Tests on all CLO transactions. Accordingly, we
expect that one or more of our CLO transactions will be out of compliance with
the OC Tests for periods of time. While being out of compliance with an OC 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 Quarterly Report on Form 10-Q,
we believe that we are or will be failing one or more of the OC Tests for
certain of our Cash Flow CLO transactions.
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The following table summarizes several of the material tests and
metrics for each of our Cash Flow CLOs. This information is based on the September 2009 monthly
reports which are prepared by the independent third-party trustee for each Cash
Flow CLO transaction:
·
Investments: The par value
of the investments in each CLO plus principal cash in the CLO.
·
Senior interest coverage (IC)
ratio minimum: Minimum required ratio of interest income earned on investments
to interest expense on the senior debt issued by the CLO per the respective CLOs
indenture.
·
Actual senior IC ratio: The
ratio is interest income earned on the investments divided by interest expense
on the senior debt issued by the CLO.
·
CCC amount: The par amount
of assets rated CCC or below (excluding defaults, if any).
·
CCC threshold percentage:
Maximum amount of assets in portfolio that are rated CCC without being subject
to being valued at fair value for purposes of the OC Tests.
·
Senior OC Test minimum:
Minimum senior OC requirement per the respective CLOs indenture.
·
Actual senior OC Test:
Actual senior OC amount as of the report date.
·
Actual cushion / (excess):
Dollar amount that OC test is being passed, cushion, or failed (excess).
·
Subordinated OC Test
minimum: Minimum subordinated OC requirement per the respective CLOs
indenture.
·
Actual subordinated OC Test:
Actual subordinated OC amount as of the report date.
·
Subordinated cushion /
(excess): Dollar amount that the OC Test is being passed, cushion, or failed
(excess).
(dollar amounts in thousands)
|
|
CLO 2005-1
|
|
CLO 2005-2
|
|
CLO 2006-1
|
|
CLO 2007-1
|
|
CLO 2007-A
|
|
Investments
|
|
$
|
1,053,339
|
|
$
|
998,792
|
|
$
|
1,023,013
|
|
$
|
3,485,182
|
|
$
|
1,541,049
|
|
Senior IC ratio minimum
|
|
115.0
|
%
|
125.0
|
%
|
115.0
|
%
|
115.0
|
%
|
120.0
|
%
|
Actual senior IC ratio
|
|
575.9
|
%
|
567.0
|
%
|
392.4
|
%
|
471.1
|
%
|
357.4
|
%
|
CCC amount
|
|
$
|
65,840
|
|
$
|
92,810
|
|
$
|
160,639
|
|
$
|
759,050
|
|
$
|
316,496
|
|
CCC percentage of portfolio
|
|
6.3
|
%
|
9.3
|
%
|
15.7
|
%
|
21.8
|
%
|
20.5
|
%
|
CCC threshold percentage
|
|
5.0
|
%
|
7.5
|
%
|
7.5
|
%
|
7.5
|
%
|
7.5
|
%
|
Senior OC Test minimum
|
|
119.4
|
%
|
123.0
|
%
|
143.1
|
%
|
159.1
|
%
|
119.7
|
%
|
Actual senior OC Test
|
|
127.1
|
%
|
128.8
|
%
|
151.0
|
%
|
153.2
|
%
|
122.2
|
%
|
Cushion / (Excess)
|
|
$
|
59,598
|
|
$
|
43,316
|
|
$
|
48,159
|
|
$
|
(112,511
|
)
|
$
|
28,136
|
|
Subordinated OC Test minimum
|
|
106.2
|
%
|
106.9
|
%
|
114.0
|
%
|
120.1
|
%
|
109.9
|
%
|
Actual OC Test
|
|
108.7
|
%
|
114.4
|
%
|
128.9
|
%
|
107.6
|
%
|
105.4
|
%
|
Cushion / (Excess)
|
|
$
|
22,510
|
|
$
|
62,439
|
|
$
|
106,177
|
|
$
|
(338,482
|
)
|
$
|
(58,077
|
)
|
As reflected in the table above, each of our cash flow CLO transactions
is in compliance with its respective IC ratio tests based on the September 2009 monthly
reports for the respective CLOs. Based on the September 2009 monthly
reports, CLO 2005-1, CLO 2005-2, CLO 2006-1, and CLO 2007-A are in compliance
with their respective senior OC Tests and CLO 2005-1, CLO 2005-2, and CLO
2006-1 are in compliance with their respective subordinated OC Tests.
Senior
Secured Credit Facility
On August 5, 2009, we entered into an agreement with our lenders
to amend the terms of our senior secured credit facility. Among other things,
the amendment provides that: (i) the size of the facility be reduced to
$200.0 million from $300.0 million, (ii) the lending commitments of the
lenders to this facility be modified to provide for quarterly amortization of
$12.5 million per quarter until the size of the facility has been reduced to
$150 million on June 30, 2010, (iii) the interest rate applicable to
borrowings under the
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facility
be increased from LIBOR plus 300 basis points to LIBOR plus 400 basis points, (iv) the
adjusted tangible net worth covenant be reduced to $700.0 million from $1.0
billion, (v) the maturity date of the borrowings under the facility be
extended to November 10, 2011, and (vi) certain events of default
under the Credit Agreement be added. The amendment also provides that the we
can (i) pay a yearly distribution to our shareholders in an amount equal
to no greater than 50% of our taxable income for such year and (ii) use up
to $50 million of our unrestricted cash to repurchase our convertible notes due
July 2012 and/or our outstanding trust preferred securities. In
conjunction with this amendment, we paid the lenders to our credit facility
fees totaling $4.5 million.
As of September 30, 2009, we had borrowings outstanding under the
Facility totaling $187.5 million.
Standby
Revolving Credit Facility
On November 10, 2008, we entered into an agreement for a two-year
$100.0 million standby unsecured revolving credit agreement (the Standby
Agreement) with our Manager and Kohlberg Kravis Roberts & Co.
(Fixed Income) LLC, the parent of our 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. We 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.
No borrowings were outstanding under the Standby Agreement as of September 30,
2009.
On November 5, 2009, our board of directors agreed to terminate
the Standby Agreement.
Convertible
Debt
During
June 2009, we completed two transactions to exchange a total of $15.7
million par value of convertible notes for 7.2 million of our common
shares. As a result of these transactions, we recorded a gain of $6.9 million,
or approximately $0.05 per diluted common share, which was partially offset by
a write-off of $0.1 million of unamortized debt issuance costs and $0.4 million
of other associated costs.
As
of September 30, 2009, we had $275.8 million of convertible debt
outstanding.
Junior
Subordinated Notes
In
August 2009, we repurchased $5.0 million of junior subordinated notes,
which resulted in a gain on extinguishment of debt of $3.8 million, partially
offset by a $0.1 million write-off of unamortized debt issuance costs.
As
of September 30, 2009, we had junior subordinated notes outstanding
totaling $283.7 million.
Off-Balance Sheet Commitments
As of September 30, 2009, we had committed to purchase corporate
loans with aggregate commitments totaling $101.2 million. In addition, 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,
2009, we had unfunded financing commitments totaling $48.4 million. We do
not expect material losses related to the corporate loans for which we commit
to purchase and fund.
Partnership Tax Matters
Non-Cash Phantom Taxable Income
We intend to continue to operate so that we qualify, for United States
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 United States 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
corporate subsidiaries, CLO issuers, including those treated as partnerships or
disregarded entities for United States federal income tax purposes, and debt
securities, may produce taxable income without corresponding distributions of
cash to us or may produce taxable income prior to or following the receipt of
cash relating to such income. Consequently, in some taxable years, holders of
our shares may recognize taxable income in excess of our cash distributions.
Furthermore, if we did not pay cash distributions with respect to a taxable
year, holders of our shares may still have a tax liability attributable to
their allocation of taxable income from us during such year.
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Qualifying Income Exception
We intend to continue to operate so that we qualify as a partnership,
and not as an association or a publicly traded partnership taxable as a
corporation, for United States 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 United States federal income purposes. A publicly traded
partnership will, however, be taxed as a partnership, and not as a corporation,
for United States 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 United States 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.
Our 1940 Act Status
We are organized as a holding company that conducts its operations
primarily through majority-owned subsidiaries and we intend to continue to
conduct our operations so that we are not required to register as an investment
company under the Investment Company Act of 1940, as amended (the 1940 Act). Section 3(a)(1)(C) of
the 1940 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
(within the meaning of the 1940 Act) 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 are, among others, securities issued by majority-owned subsidiaries
unless the subsidiary is an investment company or relies on the exceptions from
the definition of an investment company provided by Section 3(c)(1) or
Section 3(c)(7) of the 1940 Act (a fund). The 1940 Act defines a majority-owned
subsidiary of a person as any company 50% or more of the outstanding voting
securities (
i.e.
, those
securities presently entitling the holder thereof to vote for the election of
directors of the company) of which are owned by that person, or by another
company that is, itself, a majority-owned subsidiary of that person. We are
responsible for determining whether any of our subsidiaries is majority-owned.
We treat subsidiaries in which we own at least 50% of the outstanding voting
securities, including those that issue collateralized loan obligations or CLOs,
as majority-owned for purposes of the 40% test.
We monitor our holdings regularly to confirm our continued compliance
with the 40% test. Some of our subsidiaries may rely solely on Section 3(c)(1) or
Section 3(c)(7) of the 1940 Act. In order for us to satisfy the 40%
test, securities issued to us by those subsidiaries or any of our subsidiaries
that are not majority-owned, together with any other investment securities
that we may own, may not have a combined value in excess of 40% of the value of
our total assets on an unconsolidated basis and exclusive of U.S. government
securities and cash items. However, most of our subsidiaries rely on exceptions
provided by provisions of, and rules and regulations promulgated under,
the 1940 Act (other than Section 3(c)(1) or Section 3(c)(7) of
the 1940 Act) to avoid being defined and regulated as an investment company. In
order to conform to these exceptions, our subsidiaries may be limited with
respect to the assets in which each of them can invest and/or the types of
securities each of them may issue. We must, therefore, monitor each subsidiarys
compliance with its applicable exception and our freedom of action, and that of
our subsidiaries, may be limited as a result. For example, our subsidiaries
that issue CLOs generally rely on Rule 3a-7 under the 1940 Act, while KKR
Financial Holdings II, LLC, or KFH II, our subsidiary that is taxed as a real
estate investment trust or REIT, for United States federal income tax
purposes, generally relies on Section 3(c)(5)(C) of the 1940 Act.
Each of these exceptions requires, among other things that the subsidiary (i) not
issue redeemable securities and (ii) engage in the business of holding
certain types of assets, consistent with the terms of the exception. We do not
treat our interests in majority-owned subsidiaries that rely on Section 3(c)(5)(C) of,
or Rule 3a-7 under, the 1940 Act as investment securities when calculating
our 40% test.
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We sometimes refer to our subsidiaries that rely on Rule 3a-7
under the 1940 Act as CLO subsidiaries. Rule 3a-7 under the 1940 Act is
available to certain structured financing vehicles that are engaged in the
business of holding financial assets that, by their terms, convert into cash
within a finite time period and that issue fixed income securities entitling
holders to receive payments that depend primarily on the cash flows from these
assets, provided that, among other things, the structured finance vehicle does
not engage in certain portfolio management practices resembling those employed
by mutual funds. Accordingly, each of these CLO subsidiaries is subject to an
indenture (or similar transaction documents) that contains specific guidelines
and restrictions limiting the discretion of the CLO subsidiary and its
collateral manager. In particular, these guidelines and restrictions prohibit
the CLO subsidiary from acquiring and disposing of assets primarily for the
purpose of recognizing gains or decreasing losses resulting from market value
changes. Thus, a CLO subsidiary cannot acquire or dispose of assets primarily
to enhance returns to the owner of the equity in the CLO subsidiary; however,
subject to this limitation, sales and purchases of assets may be made so long
as doing so does not violate guidelines contained in the CLO subsidiarys
relevant transaction documents. A CLO subsidiary generally can, for example,
sell an asset if the collateral manager believes that its credit quality has
declined since its acquisition or that the credit profile of the obligor will
deteriorate and the proceeds of permitted dispositions may be reinvested in
additional collateral, subject to fulfilling the requirements set forth in Rule 3a-7
under the 1940 Act and the CLO subsidiarys relevant transaction documents. As
a result of these restrictions, our CLO subsidiaries may suffer losses on their
assets and we may suffer losses on our investments in those CLO subsidiaries.
We sometimes refer to KFH II, our subsidiary that relies on Section 3(c)(5)(C) of
the 1940 Act, as our REIT subsidiary. Section 3(c)(5)(C) of the
1940 Act is available to companies that are primarily engaged in the business
of purchasing or otherwise acquiring mortgages and other liens on and interests
in real estate. While the Securities and Exchange Commission (SEC) has not
promulgated rules to address precisely what is required for a company to
be considered to be primarily engaged in the business of purchasing or
otherwise acquiring mortgages and other liens on and interests in real estate,
the SECs Division of Investment Management, or the Division, has taken the
position, through a series of no-action and interpretive letters, that a
company may rely on Section 3(c)(5)(C) of the 1940 Act if, among
other things, at least 55% of the companys assets consist of mortgage loans
and other assets that are considered the functional equivalent of mortgage
loans (collectively, qualifying real estate assets), and at least 25% of the
companys assets consist of real estate-related assets (reduced by the excess
of the companys qualifying real estate assets over the required 55%), leaving
no more than 20% of the companys assets to be invested in miscellaneous
assets. The Division has also provided guidance as to the types of assets that
can be considered qualifying real estate assets. Because the Divisions
interpretive letters are not binding except as they relate to the companies to
whom they are addressed, if the Division were to change its position as to,
among other things, what assets might constitute qualifying real estate assets
our REIT subsidiary might be required to change its investment strategy to
comply with the changed position. We cannot predict whether such a change would
be adverse.
Based on current guidance, our REIT subsidiary classifies investments
in mortgage loans as qualifying real estate assets, as long as the loans are fully
secured by an interest in real estate on which we retain the right to foreclose.
That is, if the loan-to-value ratio of the loan is equal to or less than 100%,
then the mortgage loan is considered to be a qualifying real estate asset.
Mortgage loans with loan-to-value ratios in excess of 100% are considered to be
only real estate-related assets. Our REIT subsidiary considers agency whole
pool certificates to be qualifying real estate assets. Examples of agencies
that issue whole pool certificates are the Federal National Mortgage
Association, the Federal Home Loan Mortgage Corporation and the Government
National Mortgage Association. An agency whole pool certificate is a
certificate issued or guaranteed as to principal and interest by the U.S.
government or by a federally chartered entity, that represents the entire
beneficial interest in the underlying pool of mortgage loans. By contrast, an
agency certificate that represents less than the entire beneficial interest in
the underlying mortgage loans is not considered to be a qualifying real estate
asset, but is considered to be a real estate-related asset.
Most non-agency mortgage-backed securities do not constitute qualifying
real estate assets, because they represent less than the entire beneficial
interest in the related pool of mortgage loans; however, based on Division guidance
where our REIT subsidiarys investment in non-agency mortgage- backed
securities is the functional equivalent of owning the underlying mortgage
loans, our REIT subsidiary may treat those securities as qualifying real estate
assets. Moreover, investments in mortgage-backed securities that do not
constitute qualifying real estate assets will be classified as real estate-
related assets. Therefore, based upon the specific terms and circumstances
related to each non-agency mortgage-backed security that our REIT subsidiary
owns, our REIT subsidiary will make a determination of whether that security
should be classified as a qualifying real estate asset or as a real estate-
related asset; and there may be instances where a security is recharacterized
from being a qualifying real estate asset to a real estate-related asset, or
conversely, from being a real estate-related asset to being a qualifying real
estate asset based upon the acquisition or disposition or redemption of related
classes of securities from the same securitization trust. If our REIT
subsidiary acquires securities that, collectively, receive all of the principal
and interest paid on the related pool of underlying mortgage loans (less fees,
such as servicing and trustee fees, and expenses of the securitization), and
that subsidiary has foreclosure rights with respect to those mortgage loans,
then our REIT subsidiary will consider those securities, collectively, to be
qualifying real estate assets. If another entity acquires any of the securities
that are expected to receive cash flow from the underlying mortgage loans, then
our REIT subsidiary will consider whether it has appropriate foreclosure rights
with respect to the underlying loans and whether its investment is a first loss
position in deciding whether these securities should be classified as
qualifying real estate assets. If our REIT subsidiary owns more than one
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subordinate
class, then, to determine the classification of subordinate classes other than
the first loss class, our REIT subsidiary will consider whether such classes
are contiguous with the first loss class (with no other classes absorbing
losses after the first loss class and before any other subordinate classes that
our REIT subsidiary owns), whether our REIT subsidiary owns the entire amount
of each such class and whether our REIT subsidiary would continue to have
appropriate foreclosure rights in connection with each such class if the more
subordinate classes were no longer outstanding. If the answers to any of these
questions is no, then our REIT subsidiary would expect not to classify that
particular class, or classes senior to that class, as qualifying real estate
assets.
As noted above, if the combined values of the investment securities
issued by our subsidiaries that must rely on Section 3(c)(1) or Section 3(c)(7) of
the 1940 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 exception, exemption or other
exclusion from the 1940 Act, we could, among other things, be required either (i) to
change substantially the manner in which we conduct our operations to avoid
being subject to the 1940 Act or (ii) to register as an investment
company. Either of these would likely have a material adverse effect on us, 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 1940 Act, we
would become subject to substantial regulation with respect to our capital
structure (including our ability to use leverage), management, operations,
transactions with certain affiliated persons (within the meaning of the 1940
Act), portfolio composition (including restrictions with respect to
diversification and industry concentration) and other matters. Additionally,
our Manager would have the right to terminate our management agreement.
Moreover, if we were required to register as an investment company, we would no
longer be eligible to be treated as a partnership for United States federal
income tax purposes. Instead, we would be classified as a corporation for tax
purposes and would be able to avoid corporate taxation only to the extent that
we were able to elect and qualify as a regulated investment company (RIC)
under applicable tax rules. Because our eligibility for RIC status would depend
on our investments and sources of income at the time that we were required to
register as an investment company, there can be no assurance that we would be
able to qualify as a RIC. If we were to lose partnership status and fail to
qualify as a RIC, we would be taxed as a regular corporation. See Partnership
Tax Matters
Qualifying Income Exception
.
We have not requested approval or guidance from the SEC or its staff
with respect to our 1940 Act determinations, including, in particular: our
treatment of any subsidiary as majority-owned; the compliance of any subsidiary
with Section 3(c)(5)(C) of, or Rule 3a-7 under, the 1940 Act,
including any subsidiarys determinations with respect to the consistency of
its assets or operations with the requirements thereof; or whether our
investments in one or more subsidiaries constitute investment securities for
purposes of the 40% test. If the SEC were to disagree with our treatment of one
or more subsidiaries as being excepted from the 1940 Act pursuant to Rule 3a-7
or Section 3(c)(5)(C), or with our determination that one or more of our
other investments do not constitute investment securities for purposes of the
40% test, we and/or one or more of our subsidiaries would need to adjust our
investment strategies or investments in order for us to continue to pass the
40% test or register as an investment company, which could have a material
adverse effect on us. Moreover, we may be required to adjust our investment
strategy and investments if the SEC or its staff provides more specific or
different guidance regarding the application of relevant provisions of, and rules under,
the 1940 Act. Such guidance could provide additional flexibility, or it could
further inhibit our ability, or the ability of a subsidiary, to pursue a chosen
investment strategy, 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.
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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), securitization transactions structured as secured
financings, and senior or subordinated notes. If we are unable to renew,
replace or expand our sources of financing on acceptable terms, it may have an
adverse effect on our business and results of operations and our ability to
make distributions to shareholders. Upon liquidation, holders of our debt
securities and lenders with respect to other borrowings will receive, and any
holders of preferred shares that we may issue in the future may receive, a
distribution of our available assets prior to holders of our common shares. The
decisions by investors and lenders to enter into equity, and financing
transactions with us will depend upon a number of factors, including our
historical and projected financial performance, compliance with the terms of
our current credit arrangements, industry and market trends, the availability
of capital and our investors and lenders policies and rates applicable
thereto, and the relative attractiveness of alternative investment or lending
opportunities.
We have established a formal liquidity contingency plan which provides
guidelines for liquidity management. We determine our current liquidity
position and forecast liquidity based on anticipated changes in the balance
sheet. We also stress test our liquidity position under several different
stress scenarios. A stress test aims at capturing the impact of extreme (but
rare) market rate changes on the market value of equity and net interest
income. This scenario is applied on a daily basis to our balance sheet and the
resulting loss in cash is evaluated. Besides providing a measure of the
potential loss under the extreme scenario, this technique enables us to
identify the nature of the changes in market risk factors to which it is the
most sensitive, allowing us to take appropriate action to address those risk
factors. A decrease in the fair value of our investments held through total
rate of return swaps would result in us posting additional collateral.
Conversely, an increase in the fair value of these swaps would result in us
receiving a portion of the previously posted collateral.
The table below summarizes the potential impact on our liquidity
position under different stress scenarios as applied to our investments held
through total rate of return swap agreements (amounts in thousands):
|
|
Impact on liquidity due to (decrease) increase in fair value of investments
|
|
|
|
-10.0%
|
|
-7.5%
|
|
-5.0%
|
|
-2.5%
|
|
0.0%
|
|
2.5%
|
|
5.0%
|
|
7.5%
|
|
10.0%
|
|
Total rate of return swaps
|
|
$
|
(7,651
|
)
|
$
|
(5,739
|
)
|
$
|
(3,826
|
)
|
$
|
(1,913
|
)
|
$
|
|
|
$
|
1,913
|
|
$
|
3,826
|
|
$
|
5,739
|
|
$
|
7,651
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As discussed above in Liquidity and Capital Resources, current market
conditions have had a material adverse impact on our cash flows from CLOs as a
result of our CLOs being out of compliance with their OC Tests. However, based
on our current liquidity and access to liquidity, we believe that we are able
to meet our obligations for at least the next 12 months. As of September 30,
2009, we had unencumbered cash and cash equivalents totaling
$125.9 million.
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 for which the value is affected by changes in the market credit spreads
over LIBOR. Our investments in fixed rate loans and securities are valued based
on a market credit spread over the rate payable on fixed rate United States
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.
55
Table of
Contents
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.
Management
Estimates
The preparation of our financial statements requires management to make
estimates and assumptions that affect the amounts reported in our condensed
consolidated financial statements and accompanying notes. Significant
estimates, assumptions and judgments are applied in situations including the
determination of our allowance for loan losses and the valuation of certain
investments. We revise our estimates when appropriate. However, actual results
could materially differ from managements estimates.
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 embedded 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. 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.
The following table summarizes the estimated net fair value of our
derivative instruments held at September 30, 2009 and December 31,
2008 (amounts in thousands):
Derivative Fair Value
|
|
As of
September 30, 2009
|
|
As of
December 31, 2008
|
|
|
|
Notional
|
|
Estimated
Fair Value
|
|
Notional
|
|
Estimated
Fair Value
|
|
Cash Flow Hedges:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
$
|
383,333
|
|
$
|
(53,869
|
)
|
$
|
383,333
|
|
$
|
(77,668
|
)
|
Fair Value Hedges:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
|
|
|
|
32,000
|
|
(2,915
|
)
|
Free-Standing Derivatives:
|
|
|
|
|
|
|
|
|
|
Interest rate swaps
|
|
97,259
|
|
277
|
|
106,074
|
|
274
|
|
Credit default swapsprotection sold
|
|
51,000
|
|
(773
|
)
|
53,500
|
|
(9,782
|
)
|
Credit default swaps protection purchased
|
|
|
|
|
|
222,650
|
|
69,972
|
|
Total rate of return swaps
|
|
120,234
|
|
20,437
|
|
207,524
|
|
(77,224
|
)
|
Total
|
|
$
|
651,826
|
|
$
|
(33,928
|
)
|
$
|
1,005,081
|
|
$
|
(97,343
|
)
|
56
Table of
Contents
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, 2009. Based on their evaluation, the Companys
principal executive and principal financial officer concluded that the Companys
disclosure controls and procedures as of September 30, 2009 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 three and nine months ending September 30,
2009, 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
We have been named as a party in various legal actions which include
the matters described below. We have denied, or believe we have a meritorious
defense and will deny liability in the significant cases pending against us
discussed below. Based on current discussion and consultation with counsel, we
believe that the resolution of these matters will not have a material impact on
our financial condition or cash flow.
On August 7, 2008,
the members of our board of directors and certain of our current and
former executive officers and we were named in a putative class action
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). On March 13, 2009, the lead
plaintiff filed an Amended Complaint, which deleted as defendants the members
of our board of directors and named as individual defendants only our former
chief executive officer Saturnino S. Fanlo, our former chief operating officer
David A. Netjes, and our current chief financial officer Jeffrey B. Van Horn
(the Individual Defendants, and, together with the Company, Defendants). The Amended
Complaint alleges that our April 2, 2007 registration statement and
prospectus and the financial statements incorporated therein contained
material omissions in violation of Section 11 of the Securities Act
of 1933, as amended (the 1933 Act), regarding the risks and
potential losses associated with our real estate-related assets, our
ability to finance our real estate-related assets, and the adequacy of our
loss reserves for our real estate-related assets (the alleged Section 11
violation). The Amended Complaint further alleges that, pursuant to Section 15
of the 1933 Act, the Individual Defendants have legal responsibility
for the alleged Section 11 violation. On April 27, 2009,
Defendants filed a motion to dismiss the Amended Complaint for failure to state
a claim under the 1933 Act.
On August 15, 2008,
the members of our board of directors and our executive officers (the Kostecka
Individual Defendants) were named in a shareholder derivative action brought
by Raymond W. Kostecka, a purported shareholder, in the Superior Court of
California, County of San Francisco (the California Derivative Action). We
are named as a nominal defendant. The complaint in the California Derivative
Action asserts claims against the Kostecka Individual 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. By order dated January 8,
2009, the Court approved the parties stipulation to stay the proceedings in
the California Derivative Action until the Charter Litigation is dismissed on
the pleadings or we file an answer to the Charter Litigation.
On March 23, 2009, the members of our board of directors and
certain of our executive officers (the Haley Individual Defendants) were
named in a shareholder derivative action brought by Paul B. Haley, a purported
shareholder, in the United States District Court for the Southern District of New
York (the New York Derivative Action). We are named as a nominal defendant.
The complaint in the New York Derivative Action asserts claims against the
Haley Individual Defendants for breaches of fiduciary duty, breaches of the
duty of full disclosure, and for contribution 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. By
order dated June 18, 2009, the Court approved the parties stipulation to
stay the proceedings in the New York Derivative Action until the Charter
Litigation is dismissed on the pleadings or we file an answer to the Charter
Litigation.
57
Table
of Contents
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, 2008.
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
Exhibit
Number
|
|
Description
|
|
|
|
31.1
|
|
Chief Executive Officer
Certification
|
31.2
|
|
Chief Financial Officer
Certification
|
32
|
|
Certification Pursuant
to 18 U.S.C. Section 1350
|
58
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/ WILLIAM C.
SONNEBORN
|
|
Chief Executive Officer
(Principal Executive Officer)
|
William
C. Sonneborn
|
|
|
|
|
|
|
|
|
/s/ JEFFREY B. VAN HORN
|
|
Chief Financial Officer
(Principal Financial and Accounting Officer)
|
Jeffrey
B. Van Horn
|
|
|
Date: November 5, 2009
59
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