**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

| **x**                                                 | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|-------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
| **For the  fiscal year ended December 31, 2006** |
| **o**                                                 | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

**Forthe transition period from                to**

**Commissionfile number 001-33111**

**ACA Capital Holdings, Inc.**

(Exact name of Registrantas specified in its charter)

| **Delaware**                     |   | **75-3170112**          |
|----------------------------------|--------|-------------------------|
| (State or other  jurisdiction of |   | (I.R.S. Employer        |
| incorporation or  organization)  |   | Identification  Number) |

**140 Broadway**

**New York, New York 10005**

(Address of principal executive officers, includingzip code)

**(212) 375-2000**

(Registrant’s telephonenumber, including area code)

**Securitiesregistered pursuant to Section 12(b) of the Act:**

| **Title of each class**        |   | **Name of  each exchange on which registered** |
|--------------------------------|--------|------------------------------------------------|
| Common Stock,  $0.10 per share |   | New York Stock  Exchange, Inc.            |

Securities registeredpursuant to Section 12(g) of the Act: None

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.   Yes o   Nox

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or15(d) of the Act.            Yes o    Nox

Indicate by check markwhether the Registrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.             Yes x    Noo

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of Registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K  o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o         Acceleratedfiler o         Non-acceleratedfiler x

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Act). Yes o    Nox

The Registrant completedthe initial public offering of its common stock in November 2006.Accordingly, there was no public market for the Registrant’s common stock as ofJune 30, 2006, the last day of the Registrant’s most recently completedsecond fiscal quarter.

As of March 27, 2007,37,038,756 shares of CommonStock, par value $0.10 per share, were outstanding.

**DocumentsIncorporated By Reference**

Part III incorporatescertain information by reference from the Registrant’s definitive proxystatement for the 2007 annual meeting of stockholders, which proxy will befiled no later than 120 days after the close of the Registrant’s fiscal yearended December 31, 2006.

 

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**TABLEOF CONTENTS**
|                                                             | ** ** | ** **                                                                                                                 | ** ** | **Page** |
|-------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------|------------|----------|
| CAUTIONARY STATEMENTS REGARDING FORWARD-LOOKING  STATEMENTS |       |                                                                                                                       |
| PART I                                                 |       |                                                                                                                       |       |     |
| Item 1.                                                     |       | Business.                                                                                                                  |       | 2        |
| Item 1A.                                                    |       | Risk  Factors.                                                                                                             |       | 30       |
| Item 1B.                                                    |       | Unresolved Staff Comments.                                                                                                 |       | 47       |
| Item 2.                                                     |       | Properties.                                                                                                                |       | 47       |
| Item  3.                                                    |       | Legal  Proceedings.                                                                                                        |       | 47       |
| Item 4.                                                     |       | Submission of Matters to a Vote of Security-Holders.                                                                       |       | 47       |
| PART II                                                |       |                                                                                                                       |       |     |
| Item 5.                                                     |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities.        |       | 48       |
| Item 6.                                                     |       | Selected Financial Data.                                                                                                   |       | 50       |
| Item 7.                                                     |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations.      |       | 52       |
| Item 7A.                                                    |       | Quantitative and Qualitative Disclosures About Market  Risk.                                                               |       | 87       |
| Item 8.                                                     |       | Financial Statements and Supplementary Data.                                                                               |       | 91       |
| Item 9.                                                     |       | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure.            |       | 137      |
| Item 9A.                                                    |       | Controls and Procedures.                                                                                                   |       | 137      |
| Item  9B.                                                   |       | Other  Information.                                                                                                        |       | 137      |
| PART III                                               |       |                                                                                                                       |       |     |
| Item 10.                                                    |       | Directors and Executive Officers and Corporate  Governance.                                                                |       | 138      |
| Item 11.                                                    |       | Executive Compensation.                                                                                                    |       | 140      |
| Item 12.                                                    |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters.                           |       | 140      |
| Item 13.                                                    |       | Certain Relationships and Related Transactions.                                                                            |       | 140      |
| Item 14.                                                    |       | Principal Accounting Fees and Services.                                                                                    |       | 140      |
| PART IV                                                |       |                                                                                                                       |       |     |
| Item 15.                                                    |       | Exhibits, Financial Statement Schedules, and Reports  on Form 8-K.                                                    |       | 141      |
| SIGNATURES                                                  |       | 145                                                                                                                        |
| FINANCIAL STATEMENT  SCHEDULES                              |       |                                                                                                                       |

 

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**CAUTIONARYSTATEMENTS REGARDINGFORWARD-LOOKING STATEMENTS**

Some of the statements under “Business,” “RiskFactors,” “Management’s Discussion and Analysis of Financial Condition andResults of Operations” and elsewhere in this Annual Report on Form 10-Kmay include statements that are not historical or current facts and may beconsidered “forward-looking statements” under the Private Securities LitigationReform Act of 1995. The words “believe”, “anticipate”, “project”, “plan”, “expect”,“intend”, “may”, “will likely result”, “looking forward” or “will continue,”and similar expressions identify forward-looking statements. Such statementsreflect management’s current expectations or forecasts of future events basedon its current views and assumptions regarding future events and economicperformance.

Any or all of the forward-looking statements hereinare subject to risks and uncertainties that may cause actual results to differmaterially from those set forth in these statements. Among factors that couldcause actual results to differ materially are: (1) difficulties with the execution of our business strategy; (2) changesin the economic, credit spread or interest rate environment in the UnitedStates and overseas; (3) the level of activity in the national and globaldebt markets; (4) market spreads and pricing on derivative productsinsured or issued by us; (5) significant credit losses in excess ofexpectations and the inability to obtain expected levels of reimbursement orrecoveries; (6) ratings actions with respect to the financial strengthrating assigned by Standard & Poor’s Ratings Services, or S&P, toour insurance subsidiary, ACA Financial Guaranty Corporation, or a change inS&P’s ratings criteria at any time; (7) prepayment speeds on insuredasset-backed securities and other factors that may influence the maturity ofcollateralized debt obligations, or CDOs, and related management fees paid tous; (8) decreased demand for our insurance products or asset managementservices, or increased competition in our markets; (9) changes inaccounting policies or practices that may impact our reported financialresults; (10) the amount of reserves established for losses and lossexpenses and the differences between our reserves and actual losses; (11)changes in regulation or tax laws applicable to us or those with which we dobusiness; (12) governmental action; (13) loss of key personnel; (14)technological developments; (15) the effects of mergers, acquisitions anddivestitures; (16) other risks and uncertainties that have not beenidentified at this time; (17) management’s response to these factors; and (18)other risk factors identified under Part I, Item 1A of this report. Wecaution that forward-looking statements made by us speak only as of the date onwhich they are made, and, except as required by law, we do not undertake anyobligation to update or revise such statements if management’s expectationschange or we become aware that any forward-looking statement is not likely tobe achieved.

If one or more of these orother risks or uncertainties materialize, or if management’s underlyingassumptions prove to be incorrect, actual results may vary materially from whatwe projected. Any forward-looking statements you read in this report reflectmanagement’s current views with respect to future events and are subject tothese and other risks, uncertainties and assumptions relating to ouroperations, results of operations, growth strategy and liquidity. Allsubsequent written and oral forward-looking statements attributable to us or toindividuals acting on our behalf are expressly qualified in their entirety bythis section.

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**PART I**

**Item 1.**                        Business.

**Overview**

ACA Capital Holdings, Inc. (hereafter “ACA”, “we”,“us”, “our” or the “Company”) is a holding company, headquartered in New YorkCity, that provides financial guaranty insurance products to participants inthe global credit derivatives markets, structured finance capital markets andmunicipal finance capital markets. We also provide asset management services tospecific segments of the structured finance capital markets. We participate inour target markets both as a provider of credit protection through the sale offinancial guaranty insurance products, for risk-based revenues, and as an assetmanager, for fee-based revenues. Our business model seeks to combine theoperational leverage of our core credit and asset management capabilities withthe financial leverage provided by our “A” rated financial guaranty insuranceplatform.

Our core competency isselecting, analyzing, structuring and managing credit risk in a variety offixed income financial asset classes, including investment grade andnon-investment grade corporate obligations (including bonds and loans),asset-backed securities, or ABS (including mortgage-backed securities, or MBS,and other asset classes) and municipal and other public finance securities.Throughout our businesses we generally assume credit risk to the scheduledmaturity of the underlying credit, including credit risks that are of low investmentgrade quality or high non-investment grade. We apply a rigorous underwritingand credit process to analyze each transaction and its incremental effect onour existing credit portfolio, and have adopted a risk management approachwhich is designed to ensure that the risk profile of a given credit ortransaction meets our credit, profitability and loss tolerance standards.

**Business Lines**

We operate our businesses through three strategicbusiness lines, which consist of our two financial guaranty insurance lines ofbusiness, Structured Credit and Public Finance, and our CDO Asset Managementbusiness. Each of these businesses relies on our core competencies of creditanalysis, transaction structuring, risk management and surveillance. Applyingthese competencies across our platform allows us to create efficiencies in ouroperations and to deliver a wide range of services and product solutions forour institutional customers.

The following is anoverview of each of our three business lines. For a more detailed discussion ofeach business line, see “—Structured Credit”, “—Public Finance”, and “—CDOAsset Management.”

*Financial GuarantyInsurance Lines of Business*

*StructuredCredit:*   As a part of our financial guarantyinsurance business, we apply our substantial experience in credit analysis to select,structure and sell credit protection, principally on highly rated exposures, throughinsured credit swaps in the institutional fixed income markets. We generaterevenues in our Structured Credit business through the premiums paid to ACAFinancial Guaranty to insure against the risk of default on the assetsunderlying our credit swaps. Although our “A” rating affords our StructuredCredit business significant flexibility to offer credit protection on anyportion of a given capital structure, currently our insured credit swapportfolio is constructed primarily of exposures attaching above the “AAA” ratedlevel of subordination.

Additionally, we recently formed a Credit—focusedAbsolute Return Fixed Income Fund, ACA Capital Partners I, or the CreditFund, as a part of our Structured Credit line of business. As of December 31,2006, our Credit Fund had net assets under management of $25.6 million. TheCredit Fund was created to leverage our expertise in the capital and creditmarkets and as an asset manager. The Credit Fund is managed by ACA Managementand invests primarily in fixed income securities.

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*Public Finance:*   Weprovide financial guaranty insurance on municipal and other public financebonds that guarantee to the investor the timely payment of interest andultimate payment of principal on such obligations. Through ACA FinancialGuaranty, we target low investment grade, high non-investment grade and unratedsectors of the public finance market that, under our analysis, have strong creditprofiles and security, or other enhancements. We also target markets that areunderserved by reason of industry sector, credit characteristics or transactionsize. We generate revenue in our Public Finance business through the receipt ofpremiums for the insurance we provide. ACA Financial Guaranty is licensed toprovide financial guaranty insurance in all 50 states, the District ofColumbia, Guam, Puerto Rico and the U.S. Virgin Islands.

*Other FinancialServices*

*CDOAsset Management:*   We apply our core competenciesof evaluating and managing credit risk for fees in our CDO Asset Managementline of business. Specifically, we serve as an asset manager of collateralizeddebt obligations, or CDOs, for the benefit of the third party investors inthese CDOs. A CDO is a securitization of fixed income assets such as bonds,loans, MBS, ABS and credit swaps. CDO assets are funded by the issuance ofvarious liabilities with credit profiles ranging from “AAA” rated debt tonon-rated equity. Our CDOs have a diverse worldwide institutional investorbase.

Our CDO Asset Management revenues consist of assetmanagement fees and risk-based revenue in the form of return on our equityinvestments in our CDOs. In order to align our interests as a manager withthose of our investors, we typically invest in some portion of the equity ofour managed CDOs, currently targeting 10% of the total equity offered. ACAManagement manages U.S. based assets and ACA Capital Management (U.K.) willmanage European based assets.

Based on our knowledge ofthe market, we believe we are one of the largest global CDO managers as rankedby assets under management. Through our Structured Credit line of business, wehave taken exposure at the most senior level in three of our CDOs. We do notcredit enhance any portion of our CDO liabilities for investors.

**Corporate Structure**

ACA is a Delaware corporation. We began operations in September 1997with a business strategy focused on providing “A” rated financial guarantyinsurance to the municipal finance market. Beginning in 2002, we extended ourfinancial guaranty insurance products to include our Structured Credit businessand expanded our operations generally by establishing our CDO Asset Managementbusiness. In 2006, we opened offices in London and Singapore to further expandour operations into the European and Asian credit markets.

Our principal subsidiarythrough which we currently operate our business is ACA Financial GuarantyCorporation (“ACA Financial Guaranty”), our S&P “A” rated insurancesubsidiary that is organized in the State of Maryland. As of December 31,2006, approximately 85% of our assets on an unconsolidated basis representedour 100% indirect ownership interest in ACA Financial Guaranty. ACA ServiceL.L.C., a wholly-owned direct subsidiary of ACA Financial Guaranty, is aDelaware limited liability company and owns the majority of the special purposeentities through which we execute our insured credit swaps. ACA FinancialGuaranty insures the obligations of the special purpose entities in ourStructured Credit line of business. Our CDO Asset Management services areconducted through our subsidiaries ACA Management, L.L.C. (“ACA Management”),also a wholly-owned indirect subsidiary of ACA Financial Guaranty, and ACA CapitalManagement (U.K.) Pte. Limited, a wholly-owned indirect subsidiary of theCompany. ACA Management, a Delaware limited liability company, is registeredwith the Securities and Exchange Commission (“SEC”) as an investment adviser. ACACapital Management (U.K.), a United 

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Kingdomprivate limited company, became authorized and regulated by the FinancialServices Authority (“FSA”) as an investment manager in January 2007.

**Business Strategy**

Our businessstrategy is to continue to leverage our credit management expertise to generateattractive risk-adjusted returns on our capital in our financial guarantyinsurance lines of business through the insurance of targeted credit exposureand to grow our assets under management. We plan to achieve these objectives throughthe following strategies:

·       Growour insured credit exposure and assets under management, in terms of the numberof transactions, size of transactions and types of asset classes that we insureand manage, both in the United States and internationally.

·       Targetattractive risk-adjusted returns in the credit markets.

·       Expandour existing product lines into broader geographical areas, asset classes andcredit profiles and develop new credit product areas.

·       Expandcounterparty and other key relationships for our insurance lines of business.

·       Maintaina capital base in excess of S&P’s requirements for “A” rated insurers sothat we have excess rating agency capital to absorb unforeseen losses, whilesustaining the operating flexibility of that “A” financial strength rating.

We maintain a website at www.aca.com. We are notincluding or incorporating by reference the information contained on ourwebsite into this report. We make available on our website, free of charge andas soon as reasonably practicable after we file with, or furnish to, the SEC,copies of our most recently filed Annual Report on Form 10-K, allQuarterly Reports on Form 10-Q and all Current Reports on Form 8-K,including all amendments to those reports. In addition, copies of our CorporateGovernance Guidelines, Code of Conduct, Code of Ethics for Chief ExecutiveOfficer and Senior Financial Officers, Policy Regarding Director Independence Determinationsand the governing charters for each Committee of our Board of Directors areavailable free of charge on our website, as well as in print to any stockholderupon request. The public may read and copy materials we file with the SEC inperson at the public reference facility maintained by the SEC at its public referenceroom at 100 F Street, NE, Washington, DC 20549 and copies of all or any partthereof may be obtained from that office upon payment of the prescribed fees.You may call the SEC at 1-800-SEC-0330 for furtherinformation on the operation of the public reference room and you can requestcopies of the documents, upon payment of a duplicating fee, by writing to theSEC. In addition, the SEC maintains a web site at http://www.sec.gov thatcontains reports, proxy and information statements and other informationregarding companies, including us, that file electronically with the SEC.

**Structured Credit**

*General*

We select, structure and sell credit protectionthrough ACA Financial Guaranty, principally on highly rated liabilities ofstructured financings, including layers of risk of single tranche transactionsand fully distributed CDOs, MBS and ABS transactions. Each liability or layerof risk that we insure generally references a diversified portfolio ofcorporate financial obligations such as bonds and loans, or structured financesecurities. In addition, each layer of risk typically benefits fromsubordination, which means that we would not be required to make a paymentuntil a pre-negotiated level of losses resulting from defaults on thereferenced assets or a substitution of referenced assets has been reached. Thepre-negotiated level of losses is referred to as an attachment point.

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Wegenerally assume credit risk in our Structured Credit business by entering intocredit swaps with various counterparties, the required payments under which areinsured by, and payable under, financial guaranty insurance policies. Whilegenerally we receive a fixed payment or premium for the sale of creditprotection on a quarterly basis, in certain circumstances we receive a singlepremium that is paid up front at the time that we enter into such insuredcredit swap. Additionally, our insured credit swaps typically are secured bycontingent collateral arrangements pursuant to which we agree to postcollateral to secure our transactions, primarily in the event we experience acorporate credit event such as a downgrade of ACA Financial Guaranty to belowan “A-“ financial strength rating. Our willingness to provide suchsecurity, combined with our A-rated insurance platform, enhances counterparties’willingness to do business with us and differentiates our business model from “AAA”rated financial guarantors and similar entities that are typically unable orunwilling to provide such collateral arrangements.

Alarge portion of our Structured Credit business consists of the insurance ofsingle tranche transactions referencing a portfolio of corporate credits. Inthese transactions, which we refer to as Collateralized Synthetic Obligations(CSOs), we negotiate with dealers to construct a portfolio of referenceentities, our attachment point and the size of our aggregate exposure that wewill insure, each in accordance with the risk profile that we are willing toassume based on our risk adjusted return requirements.

For CDO, MBS and ABS transactions, we generally sellprotection in the form of insured credit swaps that reference certain tranchesof liabilities issued by those structures. Under our insured credit swaps weare obligated to make payments to a protection buyer in the event that theassets purchased in such structures have insufficient cash available to payprincipal or interest on the referenced liability, or the assets underlying thereferenced liability are written down beyond the enhancement afforded the classof securities insured.

As of December 31,2006, over 99.7% of our insured credit swap portfolio was constructed ofexposures attaching above the “AAA” rated level of subordination. However,beginning in 2005, we have assumed limited amounts of credit risk exposure thatwould be rated lower than “AAA.” We anticipate some growth in insuring creditexposure lower than “AAA” rated credit profiles when we believe such exposureswill meet our risk-adjusted return requirements. We have also grown, and intendto continue to grow our Structured Credit business through the introduction ofnew asset classes and insurance products, including selling credit protectionon single tranches referencing portfolios of MBS with various ratings, sellingprotection on single-name MBS (with various credit ratings), and executingcredit swap transactions that reference the developing ABS indices.

*Structured CreditPortfolio*

The chartbelow shows the notional amounts of our insured Structured Credit portfolio asof the end of each quarter in 2006 and as of the end of each year since weclosed our first Structured Credit transaction in 2002.

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**Historical NotionalAmount of Structured Credit Portfolio(Dollars in billions)**

We executed our first Structured Credit transaction inJuly of 2002. As of December 31, 2006, we had completed 157transactions with 151 of these outstanding as of December 31, 2006 and ourinsured Structured Credit portfolio totaled $39.4 billion (in aggregateinsured credit swap notional amount). One way in which we manage risk in ourinsured credit swap portfolio is by means of diversification based on a varietyof criteria, including reference rating quality, industry type and geographiclocation. As of December 31, 2006, our insured credit swaps written on CSOtranches include well over 1,000 reference entities spread across numerousratings (primarily investment grade) and a wide range of industries andcountries. Reference entities domiciled in the United States and outside of theUnited States comprised 53.7**%** and46.3**%,** respectively, of ouraggregate single tranche corporate credit portfolio as of December 31,2006; of those domiciled outside of the United States, 61.8**%** constituted European reference entitiesand 24.6**%** constituted Asianreference entities. All of our insured credit swaps are denominated in UnitedStates dollars except for seven transactions denominated in Euros.

Thechart below shows our insured Structured Credit portfolio by deal type as of December 31,2006:

| ** **                         | ** ** | **Year Ended December 31,** | ** ** | **As of December 31,** | ** ** |
|------------------------------------|------------|--------------------------------------------|------------|---------------------------------------|------------|
| ** **                         | ** ** | **2006**                                   | ** ** | **2005**                              | ** ** | **2006** | ** ** |
| ** **                         | ** ** | **  Notional  **       | ** ** | **  Notional  **  | ** ** | **Outstanding** | ** ** | **Percentage** | ** ** |
| **Deal Type**                 | ** ** | ** **                                 | ** ** | **Written**                           | ** ** | **Written** | ** ** | **Notional Amount** | ** ** | **of Portfolio** | ** ** |
| CDO/CSO                            |       |                                       |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Corporate                          |       |                                       | $          | 13,537                                |       |   |   | $ | 9,009 |   |   |   | $ | 26,230 |   |   |   | 66.5 | % |   |
| ABS/MBS                            |       |                                       | 11,952     |                                  |       |   | 983 |   |   |   | 12,926 |   |   |   | 32.9 | % |   |
| Multisector                        |       |                                       | —     |                                  |       |   | — |   |   |   | 202 |   |   |   | 0.5 | % |   |
| Other                              |       |                                       | —     |                                  |       |   | 51 |   |   |   | 51 |   |   |   | 0.1 | % |   |
| Total CDO/CSO                      |       |                                       | 25,489     |                                  |       |   | 10,043 |   |   |   | 39,409 |   |   |   | 100.0 | % |   |
| ABS/MBS                            |       |                                       | —     |                                  |       |   | 350 |   |   |   | 8 |   |   |   | 0.0 | % |   |
| Total Structured  Credit Portfolio |       |                                       | $          | 25,489                                |       |   |   | $ | 10,393 |   |   |   | $ | 39,417 |   |   |   | 100.0 | % |   |
|                                    |            |                                            |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Counterparties*

As of December 31,2006, we had 28 institutional counterparties in our Structured Credit business.Strengthening and expanding relationships with our counterparties is animportant element of our business strategy. We enter into master agreements,standardized by the International Swaps and Derivatives Association, Inc.(ISDA) that govern the basic terms of our transactions with each of ourcounterparties, 

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and astandard form financial guaranty insurance policy, which allows us to capitalizeon market fluctuations and execute transactions in a timely and efficientmanner.

*Transaction Pricingand Loss Experience*

The fixed payments that we receive in connection withour transactions are largely determined by the results of our quantitativemodeling and credit swap market conditions, both generally and with respect tothe particular reference entities included in a given portfolio. Our decisionto enter into a particular transaction at a price is framed by our fundamentalanalysis of the underlying credits and by our proprietary model which considersnumerous variables including the asset ratings and credit quality of theportfolio, portfolio industry and geographic concentrations, the explicit orimplicit rating on the tranche, and the transaction terms and structuralfeatures, including the need for and terms of any potential collateral posting.We analyze our model’s output and the market context of the subject transactionin light of our risk and economic return parameters.

Since establishing ourStructured Credit business, we have made no payments in respect of defaultsunder our insured credit swaps.

*Credit Fund*

ACA Capital Partners I Master Fund Ltd. and ACACapital Partners I Ltd. are private investment funds organized under the lawsof the Cayman Islands, and collectively, are referred to as the Credit-focusedAbsolute Return Fixed Income Fund. 100% of ACA Capital Partners I Ltd.’sinvestments are shares in ACA Capital Partners I Master Fund Ltd. The CreditFund was created to leverage our expertise in the capital and credit marketsand as an asset manager. The Credit Fund seeks to create value by investing inthe structured finance, structured credit and corporate credit fixed incomemarkets. As of December 31, 2006, ACA Capital Partners I Master Fund Ltd.had net assets under management of $25.6 million, of which ACA FinancialProducts, Inc., one of our wholly-owned indirect subsidiaries, owned $17.0million. The balance of the $25.6 million was owned by outside investorsthrough investments in ACA Capital Partners I Ltd. As of December 31,2006, the Credit Fund had total assets under management of $264.6 million.The Credit Fund uses repurchase agreements to finance the acquisition of themajority of its assets. The Credit Fund is managed by ACA Management, which ispaid a quarterly asset management fee for that portion of the assets managedfor third parties. ACA Management is not paid a management fee for that portionof the Credit Fund’s assets managed on our subsidiary’s behalf. See “Management’sDiscussion and Analysis of Financial Condition and Results of Operations—StructuredCredit.”

**Public Finance**

*General*

We provide financial guaranty insurance through oursubsidiary ACA Financial Guaranty, focusing on underserved segments of thepublic finance market and specific credits which we believe represent strongrisk-adjusted value to the Company. Our financial guaranty insurance policiesguarantee to investors the payment of the principal and interest on the insuredobligation in accordance with the original payment schedule. ACA FinancialGuaranty is licensed to write financial guaranty insurance in all 50 states,the District of Columbia, Guam, Puerto Rico and the U.S. Virgin Islands. As ofDecember 31, 2006, we had $6.1 billion gross par outstanding.

Consistent with general market practice, we aretypically paid our insurance policy premiums up front. Our premiums arenegotiated to capture a portion of the difference in the borrowing cost, orspread, between our insured obligations and the same obligations if issueduninsured. ACA Financial Guaranty is the sole “A” rated financial guarantor.

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From inception through December 31, 2006, we havepaid **$**5.1 million of net lossesand loss adjustment expenses which represent less than 1.7**%** of premiums written on our total PublicFinance portfolio.

We generally execute our Public Finance transactionsin the form of traditional financial guaranty insurance policies. In each of2005 and 2006, however, we entered into an insured credit default swapreferencing a single Public Finance obligation.

*Target PublicFinance Market*

We target lower investment grade, high non-investmentgrade and non-rated transactions in the public finance market that we believe,by our analysis, have a strong credit profile and sufficient security tosupport our expectation of timely payment. Such additional security typicallyincludes liens on the assets funded by the bond proceeds, mortgages on theunderlying properties and revenue pledges amongst other forms of security asappropriate, all of which would be available to us in order to satisfy theprincipal and interest payments in the case of a default.

Our decision to insure a bond issue is only made followinga detailed underwriting process. During this process, our underwriters performquantitative and qualitative risk assessments that include stress testing thetransaction to a remote-loss standard, a review of the economic rationale andthe motivation of participants, an analysis of relative value and a legalreview of the transaction structure. As part of the risk assessment process,the credit analysts also perform an economic analysis of each transaction,including a review of the proposed pricing relative to credit spreads forsimilar assets available in the market and the return on capital to us based oncapital charges assessed by rating agencies. The ultimate decision to guaranteean issue is based upon such credit factors as the issuer’s ability to repay thebonds, the bond’s security features and the bond’s structure. Further, forissues involving substantial construction, we typically require enhancedsecurity, usually through a combination of third-party guarantees such aspayment and performance bonds and builder’s risk insurance, and liquidityreserve funds to cover completion and certain stabilization risks. As an “A”rated issuer we have greater flexibility from the rating agencies to select thecredits we wish to insure as compared to other participants in the public financemarket.

Prior to June 2004, we also participated in thesecondary market for municipal bonds. In such cases, a holder of outstandingbonds in the secondary market will purchase financial guaranty insurance tofacilitate the future sale of the bonds. Our current business strategy does notinclude any significant secondary market insurance participation; however, wedo employ secondary market executions to supplement existing primary marketexposures or in situations where we know the credit fundamentals of aparticular issue of municipal bonds through primary underwriting. In thesecondary market, the premium is generally payable in full at the time ofpolicy issuance.

*Public FinancePortfolio*

We seek to maintain an insured portfolio that isdesigned to manage risk by means of diversification based on a variety ofcriteria including revenue source, issue size, type of asset, industryconcentrations, type of bond and geographic area. As of December 31, 2006,we had 753 municipal policies outstanding relating to 379 unique obligors. Ourinsured portfolio of bonds is divided into the following major sector types:

*HigherEducation Bonds.**  *Highereducation bonds include bonds that are secured by revenue collected by eitherpublic or private colleges and universities. Such revenue can encompass all ofan institution’s revenue, including tuition and fees, or in other cases, can bespecifically restricted to certain auxiliary sources of revenue. We also insurebonds issued for privatized student housing projects that benefit colleges anduniversities. These bonds are issued by not-for-profit entities that may or maynot be affiliated with the college or university.

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*HealthCare Revenue Bonds.**  *Healthcare revenue bonds include bonds of healthcare facilities including communitybased hospitals and systems. To date, our primary focus in this area has beeninsuring bonds of acute care hospitals that are sole community providers inrural areas or specialty providers of essential services.

*Tax-Backed(Non-General Obligation) Bonds.**  *Tax-backed bonds include a varietyof bonds that are supported, not by a general obligation, but instead by aspecific tax source, and include tax-backed revenue bonds and general fundobligations of the issuer, such as lease revenue bonds. Tax-backed bonds may besecured by a lien on pledged tax revenues, such as revenues from special taxes,including retail sales and gasoline taxes, or from tax increments (or taxallocations) generated by growth in property values within a district.

*Long-TermCare Bonds.**  *Long-termcare bonds that we insure consist primarily of long-term financings for capitalconstruction or improvements of continuing care retirement communities, orCCRCs. CCRCs are organizations that offer a full range of housing, residentialsupportive services and healthcare to residents of retirement age. We typicallyinsure the debt of CCRCs that have been operating with strong demand andstabilized occupancy or are being built to augment established operations.

*GeneralObligation Bonds.**  *Generalobligation or full faith and credit bonds are issued by states, their politicalsubdivisions and other municipal issuers and are supported by the generalobligation of the issuer to pay the bonds from available funds and by a pledgeof the issuer to levy sufficient taxes to provide for the full payment of thebonds.

*TransportationRevenue Bonds.**  *Transportationrevenue bonds include a wide variety of revenue-supported bonds, such as bondsfor airports, ports, tunnels, municipal parking facilities, toll roads and tollbridges.

*HousingRevenue Bonds.**  *Housingrevenue bonds include affordable multi-family housing bonds, with varyingsecurity structures based on the presence of underlying mortgages, reservefunds, and various other features.

*Not-For-ProfitBonds.**  *Not-for-profitbonds include bonds issued by not-for-profit organizations, including museumsand other cultural institutions, the deal structures and security packages forwhich vary among transactions.

*MunicipalUtility Revenue Bonds.**  *Municipalutility revenue bonds include obligations of all forms of municipal utilities,including electric, water and sewer utilities and resource recovery revenuebonds. Insurable utilities may be organized as municipal enterprise systems,authorities or joint-action agencies.

*Investor-OwnedUtilities Bonds.**  *Pollutioncontrol bonds or industrial development bonds are issued to finance projects ofinvestor-owned utilities. The bonds are secured by the senior credit or firstmortgage obligations of an investor-owned utility, typically an electricdistribution utility.

*OtherPublic Bonds.**  *Othertypes of public bonds insured by ACA Financial Guaranty include financings forNative American tribes, stadiums, government office buildings, recreationfacilities, prison facilities and mobile home parks. These bond types aretypically secured by a combination of project-related fee revenue, leasepayments or other support of state or local governmental entities.

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Thefollowing table shows the diversification by bond sector type of our gross parexposure insured for the year ended December 31, 2006 and our gross parexposure outstanding as of December 31, 2006:

**InsuredPublic Finance Portfolio by Bond Type(in millions)**

| ** **            | ** ** | **Year Ended Insured** | ** ** | **Outstanding Gross Par(1)** | ** ** |
|-----------------------|------------|----------------------------------|------------|----------------------------------------|------------|
| ** **            | ** ** | **December 31, 2006**  | ** ** | **December 31, 2006**        | ** ** |
| **Bond Type**    | ** ** | ** **                       | ** ** | **Gross Par**                     | ** ** | **Percentage** | ** ** | **Gross Par** | ** ** | **Percentage** | ** ** |
| Higher Education      |       |                             | $          | 160.5                                  |       |   |   | 25.9 | % |   |   | $ | 1,504.2 |   |   |   | 24.5 | % |   |
| Health Care           |       |                             | —     |                                   |       |   | 0.0 |   |   |   | 843.9 |   |   |   | 13.8 |   |   |
| Tax-Backed            |       |                             | 51.1       |                                   |       |   | 8.3 |   |   |   | 778.0 |   |   |   | 12.7 |   |   |
| Long Term Care        |       |                             | 68.7       |                                   |       |   | 11.1 |   |   |   | 701.3 |   |   |   | 11.4 |   |   |
| General  Obligations  |       |                             | 40.4       |                                   |       |   | 6.5 |   |   |   | 465.2 |   |   |   | 7.6 |   |   |
| Transportation        |       |                             | —     |                                   |       |   | 0.0 |   |   |   | 384.8 |   |   |   | 6.3 |   |   |
| Housing               |       |                             | 42.7       |                                   |       |   | 6.9 |   |   |   | 277.8 |   |   |   | 4.5 |   |   |
| Not For Profit        |       |                             | 117.3      |                                   |       |   | 19.0 |   |   |   | 411.2 |   |   |   | 6.7 |   |   |
| Utility               |       |                             | 12.9       |                                   |       |   | 2.1 |   |   |   | 257.2 |   |   |   | 4.2 |   |   |
| Other                 |       |                             | 125.0      |                                   |       |   | 20.2 |   |   |   | 505.8 |   |   |   | 8.3 |   |   |
| Total Public  Finance |       |                             | $          | 618.6                                  |       |   |   | 100.0 | % |   |   | $ | 6,129.4 |   |   |   | 100.0 | % |   |
|                       |            |                                  |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Debtservice balances for the years ended December 31, 2006 and 2005 are $10.9billion and $11.3 billion, respectively.

The table below sets forththe geographic distribution, by location of the obligor, of our outstandinggross par exposure by the ten largest jurisdictions as of December 31,2006.

**PublicFinance Insured Portfolio by State or Territory(in millions)**

| **Location**                | ** ** | ** ** | ** ** | **Gross Par  Exposure** | ** ** | **Percent of  Public  Portfolio** | ** ** |
|-----------------------------|------------|------------|------------|------------------------------|------------|----------------------------------------|------------|
| California                  |       | $          | 1,020.2    |                         |       | 16.6                                   | %          |   |
| New York                    |       | 642.8      |       |                         | 10.5       |                                   |       |
| Texas                       |       | 374.2      |       |                         | 6.1        |                                   |       |
| Florida                     |       | 333.9      |       |                         | 5.4        |                                   |       |
| Pennsylvania                |       | 279.0      |       |                         | 4.6        |                                   |       |
| Washington                  |       | 278.0      |       |                         | 4.5        |                                   |       |
| Arizona                     |       | 193.8      |       |                         | 3.2        |                                   |       |
| Massachusetts               |       | 190.7      |       |                         | 3.1        |                                   |       |
| Illinois                    |       | 183.5      |       |                         | 3.0        |                                   |       |
| Colorado                    |       | 183.3      |       |                         | 3.0        |                                   |       |
| Top 10 Public Finance       |       | 3,679.4    |       |                         | 60.0       |                                   |       |
| Other States or Territories |       | 2,450.0    |       |                         | 40.0       |                                   |       |
| Total                       |       | $          | 6,129.4    |                         |       | 100.0                                  | %          |   |

 

As of December 31, 2006, the gross par amountoutstanding for our ten largest Public Finance credits, totaling$705.3 million, was 11.5% of our total gross par amount outstanding, withno one credit representing more than 1.7% of our total gross par amountoutstanding.

We underwrite financialguaranty insurance on the assumption that the insurance will remain in forceuntil maturity of the insured obligations.

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**CDO Asset Management**

*General*

As an asset manager ofCDOs we apply our core competencies in analyzing credit risk to construct andmanage CDOs on behalf of third party investors for which we earn managementfees. Increases in fee revenues generally correspond to increases in assetsunder management. To grow our assets under management, we sponsor CDOs thatacquire pools of fixed income assets that we select and manage through ourregistered investment adviser subsidiary, ACA Management and, in the future,through ACA CapitalManagement (U.K.), our FSA regulated investment manager. We completedour first CDO in January 2002 and as of December 31, 2006, we hadclosed 22 CDO transactions and had grown our CDO assets under management from$2.4 billion as of year-end 2002 to $15.7 billion as of December 31,2006. In the first quarter of 2007, ACACapital Management (U.K.) obtained its license to manage CDOs in theUnited Kingdom and most of Europe. At December 31, 2006, our weightedaverage asset management fee was 0.23% on total CDO assets under our management.Based on our knowledge of the market, we believe that we are one of the largestglobal CDO managers as ranked by assets under management.

The chart below reflectsassets under management as of December 31 of each year since we closed ourfirst CDO in 2002.

**CDOAssets Under Management(in billions)**

Wereceive multiple revenue streams in connection with our CDO products. Wereceive fees for structuring the CDOs, fees during the period the CDO assetsare accumulated, which we call the warehouse phase, and fees for providingasset management services during the term of the CDO. In 2006, we invested in theequity of only four of our eight newly originated CDOs, ranging from 5% to 11%of the equity sold, which resulted in total equity investments of$8.6 million with respect to the $5.8 billion in CDO assets undermanagement added. We view our equity investments as an opportunity to increasethe marketability of our CDOs by aligning our interests as manager with thoseof our CDO investors. As an equity investor in our CDOs, we generally receivereturns in respect of our equity investment from proceeds generated by theunderlying collateral in excess of expenses and debt service, includingprincipal payments currently payable on the liabilities issued by the CDO.

Each of our managed CDOsincludes a diversified portfolio of financial obligations such as bonds, loansand/or credit swaps that reference individual bonds or loans. We currentlysponsor and manage CDOs backed by non-investment grade and investment gradecorporate financial obligations, ABS, MBS and other CDO securities, and non-investmentgrade leveraged loans and bonds. CDOs do not always own their underlyingcollateral outright but rather, in certain structures, achieve collateralexposure by entering into credit swaps, in which case we refer to thestructures as synthetic CDOs. Our corporate credit CDOs and certain of our ABSCDOs are synthetic CDOs. In addition, many of our cash flow CDOs allow for someportion of the underlying exposures to be obtained synthetically through creditswaps.

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At December 31, 2006,we managed over 2,500 credit positions across 52 industries in our CDOs, whichare actively monitored by our credit analysts. We have an experienced staff ofprofessionals with backgrounds in insurance, credit analysis, capital marketsand risk assessment that services our CDO Asset Management business as well asa strong infrastructure of legal, accounting, information technology and otherprofessionals.

The following tablesprovide certain information on our CDO assets under management as of December 312006:

**CDOAssets Under Management**
|                                 | ** ** | **Year  Deal  Closed** | ** ** | **Collateral Type(1)** | ** ** | **Current  AUM**       | ** ** | **Original  Investment  in Equity** | ** **                   | **Retained  Equity %** | ** ** | **First  Optional  Call  Date(2)** | ** **   | **Maturity  Date** | ** ** |
|---------------------------------|------------|------------------------|------------|-----------------------------|------------|------------------------|------------|------------------------------------------|------------------------------|-----------------------------|------------|------------------------------------|--------------|--------------------|------------|
| ** **                      | ** ** | ** **             | ** ** | ** **                  | ** ** | **(in millions)** | ** ** | **(in millions)**                   | ** **                   | ** **                  | ** ** | ** **                         | ** **   | ** **         | ** ** |
| **Asset-Backed CDOs:**          |       |                   |       |                        |       |                   |       |                                     |                         |                        |       |                               |         |               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| ACA ABS 2002-1                  |       |                   | 2002       |                        |       | Investment Grade       |       |                                     | $    224 |                        |       |                               | $ 18.0  |               |       |   | 100 |   |   |   | 8/2005 |   |   |   | 8/2037 |   |   |
| ACA ABS 2003-1                  |       |                   | 2003       |                        |       | Investment Grade       |       |                                     | 403                          |                        |       |                               | 18.0         |               |       |   | 100 |   |   |   | 6/2007 |   |   |   | 6/2038 |   |   |
| Grenadier Funding               |       |                   | 2003       |                        |       | High-Grade             |       |                                     | 1,485                        |                        |       |                               | 22.5         |               |       |   | 100 |   |   |   | 8/2008 |   |   |   | 8/2038 |   |   |
| ACA ABS 2003-2                  |       |                   | 2003       |                        |       | Investment Grade       |       |                                     | 725                          |                        |       |                               | 33.5         |               |       |   | 100 |   |   |   | 12/2007 |   |   |   | 12/2038 |   |   |
| ACA ABS 2004-1                  |       |                   | 2004       |                        |       | Investment Grade       |       |                                     | 411                          |                        |       |                               | 10.0         |               |       |   | 61 |   |   |   | 7/2007 |   |   |   | 7/2039 |   |   |
| Zenith Funding                  |       |                   | 2004       |                        |       | High-Grade             |       |                                     | 1,496                        |                        |       |                               | 13.0         |               |       |   | 52 |   |   |   | 12/2009 |   |   |   | 12/2039 |   |   |
| ACA ABS 2005-1                  |       |                   | 2005       |                        |       | Investment Grade       |       |                                     | 433                          |                        |       |                               | 4.4          |               |       |   | 24 |   |   |   | 4/2008 |   |   |   | 4/2040 |   |   |
| ACA ABS 2005-2                  |       |                   | 2005       |                        |       | Investment Grade       |       |                                     | 418                          |                        |       |                               | 2.1          |               |       |   | 10 |   |   |   | 9/2009 |   |   |   | 12/2044 |   |   |
| Khaleej II                      |       |                   | 2005       |                        |       | Investment Grade       |       |                                     | 750                          |                        |       |                               | 4.5          |               |       |   | 14 |   |   |   | 9/2009 |   |   |   | 9/2040 |   |   |
| Lancer Funding                  |       |                   | 2006       |                        |       | High-Grade             |       |                                     | 1,487                        |                        |       |                               | 1.5          |               |       |   | 10 |   |   |   | 7/2010 |   |   |   | 4/2046 |   |   |
| ACA Aquarius 2006-1             |       |                   | 2006       |                        |       | Investment Grade       |       |                                     | 2,000                        |                        |       |                               | —       |               |       |   | — |   |   |   | 9/2010 |   |   |   | 9/2046 |   |   |
| ACA ABS 2006-1                  |       |                   | 2006       |                        |       | Investment Grade       |       |                                     | 748                          |                        |       |                               | 1.4          |               |       |   | 5 |   |   |   | 12/2009 |   |   |   | 6/2041 |   |   |
| ACA ABS 2006-2                  |       |                   | 2006       |                        |       | Investment Grade       |       |                                     | 745                          |                        |       |                               | 3.5          |               |       |   | 11 |   |   |   | 1/2011 |   |   |   | 1/2047 |   |   |
| **Total Asset-Backed CDOs**     | ** ** |                   |       |                        |       |                   |       |                                     | 11,325                       |                        |       |                               | 132.4        |               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Corporate Credit CDOs:**      |       |                   |       |                        |       |                   |       |                                     |                         |                        |       |                               |         |               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| ACA CDS 2001-1                  |       |                   | 2002       |                        |       | Investment Grade       |       |                                     | 975                          |                        |       |                               | 22.5         |               |       |   | 100 |   |   |   | N/A |   |   |   | 4/2007 |   |   |
| ACA CDS 2002-1                  |       |                   | 2002       |                        |       | Investment Grade       |       |                                     | 955                          |                        |       |                               | 22.0         |               |       |   | 100 |   |   |   | N/A |   |   |   | 7/2007 |   |   |
| ACA CDS 2002-2                  |       |                   | 2003       |                        |       | Investment Grade       |       |                                     | 990                          |                        |       |                               | 25.0         |               |       |   | 100 |   |   |   | N/A |   |   |   | 3/2008 |   |   |
| Argon 49                        |       |                   | 2005       |                        |       | Investment Grade       |       |                                     | 66                           | (3)                         |       |                               | —       |               |       |   | — |   |   |   | N/A |   |   |   | 6/2015 |   |   |
| Argon 57                        |       |                   | 2006       |                        |       | Investment Grade       |       |                                     | 66                           | (3)                         |       |                               | —       |               |       |   | — |   |   |   | N/A |   |   |   | 6/2013 |   |   |
| Tribune                         |       |                   | 2006       |                        |       | Investment Grade       |       |                                     | 347                          | (4)                         |       |                               | —       |               |       |   | — |   |   |   | N/A |   |   |   | 9/2016 |   |   |
| **Total Corporate Credit CDOs** | ** ** |                   |       |                        |       |                   |       |                                     | 3,399                        |                        |       |                               | 69.5         |               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Leveraged Loan CDOs:**        | ** ** |                   |       |                        | ** ** | ** **             | ** ** |                                     |                         |                        |       |                               |         |               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| ACA CLO 2005-1                  |       |                   | 2005       |                        |       | Non-Investment Grade   |       |                                     | 300                          |                        |       |                               | 5.0          |               |       |   | 21 |   |   |   | 10/2009 |   |   |   | 10/2017 |   |   |
| ACA CLO 2006-1                  |       |                   | 2006       |                        |       | Non-Investment Grade   |       |                                     | 340                          |                        |       |                               | —       |               |       |   | — |   |   |   | 7/2009 |   |   |   | 7/2018 |   |   |
| ACA CLO 2006-2                  |       |                   | 2006       |                        |       | Non-Investment Grade   |       |                                     | 300                          |                        |       |                               | 2.2          |               |       |   | 10 |   |   |   | 1/2011 |   |   |   | 1/2021 |   |   |
| **Total Leveraged Loan CDOs**   | ** ** |                   |       |                        |       |                   |       |                                     | 940                          |                        |       |                               | 7.2          |               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Total  CDO AUM**              | ** ** |                   |       |                        |       |                   |       |                                     | $ 15,664                |                        |       |                               | $ 209.1 |               |       |   |   |   |   |   |   |   |   |   |   |   |   |

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(1)          Investment gradecollateral is rated “BBB-” or better; however certain of our investment gradeCDOs include the ability to invest a minority portion (20% or less) innon-investment grade assets. High-grade is “A-” or better.

(2)          Cash flow CDOs are generally callable once per quarter by amajority or greater vote of the equity holders beginning on a specific date asnegotiated, which is referred to as the First Optional Call Date.

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(3)          Argon 49 and Argon 57 are denominated in Euros. For purposes of thischart, we have converted the amounts to U.S. dollars at the prevailingcurrency exchange rate on December 31, 2006.

(4)          Tribuneis comprised of 13 distinct trades some of which are denominated in Euros orYen. For purposes of this chart, we have converted the amounts to U.S. dollarsat the prevailing currency exchange rates on December 31, 2006.

*Origination and Structuring of CDOs*

*Structuring and Engagement.**  *We first determine the basicstructure of a CDO, including the types of assets that may be included in thecollateral acquired in the CDO, the minimum average rating of such assets, thefinancing costs to be paid to the investment bank for warehousing such assetsduring the warehousing phase, structuring and management fees to be paid to usand distribution fees for placement of the liabilities to be paid to theinvestment bank. These arrangements are approved by our internal RiskManagement Committee. The Risk Management Committee defines our transactionalunderwriting guidelines and monitors compliance, reviews portfolio riskmanagement policies and procedures, and approves any credit risk we assumeduring the warehousing phase and the appropriateness of all fees paid to us.Once we agree on a structure, we engage an investment bank to warehouse theassets and distribute the liabilities.

*Warehousing and CreditSelection.**  *Weenter into a warehousing agreement with the investment bank to providefinancing for the accumulation of assets to be included in a particular CDO.During the warehousing period, at our direction, the investment bank acquiresthe securities that will constitute the assets of the CDO and continues to “warehouse”those assets until the transaction is closed and the assets are transferred tothe CDO. If the credit quality of any of the selected assets deterioratesduring the warehousing phase, we also advise the investment bank as topotential trading opportunities or strategies. The completion of thewarehousing stage of a CDO typically takes approximately 30 days for asynthetic CDO and six to nine months for a cash flow CDO, though some assetclasses may take a longer period. During this stage, in some transactions wetake credit risk on the accumulating assets and therefore, are accountable topay losses on assets in the portfolio in excess of earnings on the portfolio. Thewarehouse facility has been provided by a third party in all of our CDOtransactions. We have not paid losses on any assets during the warehouse phaseof any of our CDO transactions.

Pursuant to an establishedcredit process that includes extensive analysis of the potential assets to beincluded in a CDO and formalized collateral committee approvals, our creditanalysts identify a suitable group of the relevant fixed income securities tocollateralize the CDO. For example, in evaluating an ABS for potentialinclusion in an ABS CDO, our analysts first perform an extensive review of thecredit and performance of the issuer and/or servicer of the ABS. They thenprepare a comprehensive written analysis of each proposed ABS for the CDO thatfocuses on areas such as the underlying collateral, the structure of the ABS,any legal issues and the relative value of the ABS. Once the credit analysis iscomplete, our analysts make extensive presentations of the results of theanalyses and reviews of the potential assets to the appropriate internalcollateral committee for approval. See “—Underwriting and Risk Management - Underwriting Committee Processfor CDO Asset Management Transactions.”

Obtaining assetallocations on credits approved by us in our targeted credit classes is highlycompetitive. Our ability to source such opportunities is important to oursuccess. We have developed close relationships with numerous financialintermediaries, investment banks, commercial banks and brokerage firms whichprovide a source for many of the assets included in our CDOs. We alsocapitalize on the relationships developed by our senior management andportfolio managers, who have many years of experience in the market, to enhanceour access to such assets.

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*Placement of CDOs.**  *Once the warehousing of assets is completed, we workwith the investment bank to determine the liability structure of the CDO giventhe actual portfolio of assets accumulated. The investment banks distributethese liabilities as well as the preferred shares or equity securities that wedo not purchase to investors worldwide. The investor base for our CDOs iscomprised largely of banks, money managers, hedge funds, non-bank financialinstitutions, pension funds and insurance companies. The liabilities sold tothird party investors have recourse solely to the assets of the CDO; we do notcredit enhance any portion of the CDO liabilities for third party investors.

*Management of CDO Assets*

*Investment Strategy.**  *In structuring and managing our CDOportfolios we seek to diversify among industries, issuers, credit quality,types of instruments and other parameters as required to meet certain testsdeveloped by the rating agencies and necessary to achieve and maintain thedesired ratings on the various classes of CDO liabilities. Depending on thesize of a CDO, it will typically own or reference in excess of 100 individualassets or reference entities.

As an asset manager, we are responsible for monitoringcredits in our CDOs, and, in certain structures, reinvesting principal proceedsreceived by the CDO from the prepayment of underlying collateral. Inconstructing and managing our portfolios we generally follow a buy and holdstrategy. However, we retain the ability to limit losses in our CDOs by tradingdeteriorating credits in a timely manner or hedging potential losses. We haveadopted a defensive trading strategy and therefore trade primarily to offsetdeteriorating credit exposures as opposed to trying to improve yield.

*Typical Asset ManagementAgreement Terms.**  *Underour asset management agreements with each of our CDOs, we are paid managementfees quarterly for managing the selection, acquisition and disposition of theunderlying collateral and for monitoring the underlying collateral. Our feesare typically divided into a senior fee and a subordinated fee and are paid outof cash flow from the underlying assets to the extent available. The senior feeis payable after certain expenses of the CDO but prior to payment on the CDOliabilities, whereas the subordinated fee is payable after payment of debtservice on the CDO liabilities. As of December 31, 2006, we received allcontractually agreed-upon senior and subordinated fees. In certain transactionswe are also paid an incentive fee to the extent returns on the equity of theCDO exceed an agreed-upon annual rate of return. Generally, our services asasset manager may be terminated without cause by a vote of a majority of theholders of each class of debt securities and the equity tranche. We may also beremoved “for cause” upon the occurrence of certain events on the affirmativevote of a majority of the holders of the senior CDO liabilities or a majorityvote of the holders of the equity.

*Equity Investment*

In order to better alignthe interests of the asset manager with those of the CDO investors, CDOinvestors typically require that asset managers purchase a portion of theequity, or first loss position, in their CDOs. We do not view these investmentsas a revenue strategy but rather as an opportunity to increase themarketability of our CDOs and thereby maximize our CDO assets under management.In such circumstances, we purchase a portion of the preferred shares, or, inrespect of our synthetic CDOs, enter into insured credit swaps requiringpayment (pro rata with other equity holders) up to a certain amount on a firstloss basis should defaults occur in the underlying referenced portfolio. Whilecurrently we are purchasing our equity positions with cash, in the past we havefinanced our equity investments, through either the investment bankparticipating with us in the CDO or other corporate borrowings, and may electto finance some or all of our equity positions again in the future. Our equityinvestments, and financing terms, if any, are subject to the approval of ourinternal Investment Committee.

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While in our earlytransactions we invested in 100% of the equity tranches of our CDOs, since2004, our growth in assets under management and historical asset managementperformance have allowed us to reduce the level of equity investments tobetween 5% and 25% of the total equity sold in a CDO. As of December 31,2006, we had completed 22 CDOs, representing $15.7 billion in outstandingCDO assets under management. In 2006, we retained economic exposure through thepurchase of equity in four of our eight newly originated CDOs of$8.6 million relative to $5.8 billion CDO assets under managementadded, which represented 5% to 11% of the equity sold. As of December 31,2006, our total original equity investment in our CDOs was $209.1 million.

*Conflict Resolution*

In addition to providingmanagement services to CDOs we originate and structure, we also providemanagement services to portfolios structured by third parties and provideinvestment advice to the Credit Fund. We may also enter into new lines ofbusiness. We may encounter conflicts of interest in these various roles andinterests and between these roles and interests and our proprietary investmentinterests. We intend to act in a manner which is fair and equitable inallocating business opportunities and have established an allocation andconflict resolution process should conflicts occur; however, because of thesepotential conflicts, we may not be able to participate in certain opportunitieswhich otherwise meet our business objectives.

**Other**

Our fourth line ofbusiness, Other, encompasses insurance products in which we are no longeractive, including industry loss warranty transactions, trade credit reinsuranceand insurance of certain classes of assets in asset-backed securitizations,principally manufactured housing. At December 31, 2006, all of theexposure in this business line had either expired or was in run-off. Run-offindicates that while we will not add new exposure, we have some currentexposure that has not yet expired. See “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Other.”

**Insured Risk Portfolio**

ACA Financial Guarantyassumes credit risk through the issuance of financial guaranty insurancepolicies across all of our business lines. While we are subject to S&Pguidelines and capital adequacy tests which we must meet in order to maintainour “A” rating, as well as internal risk management parameters, our insuredrisk portfolio contains exposures of various credit qualities.

The tables below set forthACA Financial Guaranty’s gross par exposure by business line and, within eachbusiness line, ACA Financial Guaranty’s gross par exposure by credit quality asof December 31, 2006.

**GrossPar Exposure by Business Line**

| **Business Line** | ** ** | ** ** | ** ** | **Amount**             | ** ** | **Percent   of Insured  Portfolio** | ** ** |
|------------------------|------------|------------|------------|------------------------|------------|-----------------------------------------------|------------|
| ** **             | ** ** | ** ** | ** ** | **(in millions)** | ** ** | ** **                                    | ** ** |
| Structured Credit      |       |       | $          | 39,417                 |       |                                          |       | 85.2 | % |   |
| Public Finance         |       |       | 6,129      |                   |       |                                          | 13.3       |   |   |
| CDO Asset  Management  |       |       | 157        |                   |       |                                          | 0.3        |   |   |
| Other                  |       |       | 552        |                   |       |                                          | 1.2        |   |   |
| Total                  |       |       | $          | 46,255                 |       |                                          |       | 100.0 | % |   |

 

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**GrossPar Exposure by Credit Quality**

| **Credit Quality of Portfolio(1)  As of December 31, 2006 (in millions)** | ** ** | ** ** | ** ** | **Public  Finance** | ** ** | **Structured  Credit** | ** ** | **CDO & Other** | ** ** | **Portfolio** | ** ** | **Percent of  Portfolio(2)** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|------------|------------|---------------------|------------|------------------------|------------|-------------------------------|------------|---------------|------------|-----------------------------------|------------|
| AAA                                                                                                          |       | $          | —     |                |       | $                      | 39,326     |                          |       |          | $          | 334                               |       |   | $ | 39,660 |   |   | 85.7 | % |   |
| AA                                                                                                           |       | 45         |       |                | 50         |                   |       |                          | 132        |          |       | 227                               |       |   | .5 |   |   |
| A                                                                                                       |       | 263        |       |                | 8          |                   |       |                          | —     |          |       | 271                               |       |   | .6 |   |   |
| BBB                                                                                                          |       | 3,665      |       |                | —     |                   |       |                          | 12         |          |       | 3,677                             |       |   | 7.9 |   |   |
| Below investment  grade                                                                                      |       | 2,156      |       |                | 33         |                   |       |                          | 231        |          |       | 2,420                             |       |   | 5.3 |   |   |
| Total                                                                                                        |       | $          | 6,129      |                |       | $                      | 39,417     |                          |       |          | $          | 709                               |       |   | $ | 46,255 |   |   | 100.0 | % |   |

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(1)          Ratings assigned areinternal credit ratings.

(2)          Exposurepercentages do not reflect applicable reinsurance or any collateral posted forthe benefit of the insured party.

**Underwriting andRisk Management Processes**

As a part of our credit analysis fundamental to eachof our lines of business, we have adopted formalized underwriting and riskmanagement policies and procedures. These policies and procedures are designedto ensure that the risk profile of a given credit is consistent with our creditstandards and that the related transaction affords us adequate profitabilityand is otherwise appropriate for our portfolio. Our credit assessment,underwriting, risk management and surveillance processes across all of ourbusiness lines are designed to limit loss frequency and severity, though we doanticipate some cyclical and idiosyncratic credit event loss activity acrossour portfolio of credit exposures. Consequently, we place significant emphasison managing loss severity should losses occur. In our Public Finance line ofbusiness, we assume credit risk to the scheduled maturity of the underlyingbonds, which are typically long tenure. Our decision to assume credit risk in aparticular transaction is based on a rigorous quantitative and qualitativeanalysis of such transaction and its incremental effect on our existing riskportfolio.

We have a Senior Credit Committee mandated to createand support a rigorous credit culture throughout our company, establishunderwriting policies and procedures, define underwriting guidelines andmonitor compliance, require appropriate portfolio risk management and approvethe assumption of risk and related pricing, including commitments to insure.The Senior Credit Committee consists of seven members, including, among others,our Chief Executive Officer, Chief Financial Officer, General Counsel andExecutive Vice President-Head of Institutional RiskManagement. An approval by the Senior Credit Committee requires theaffirmative vote of the Chief Executive Officer.

Additionally, we have established an internal RiskManagement Committee that monitors and seeks to limit our exposure to any onecredit on an aggregate basis across our business and our ACA Financial Guarantyinvestment portfolio. We also employ hedging strategies, which are directed byour Risk Management Committee. The Risk Management Committee is overseen by theRisk Oversight Committee of our Board of Directors. We are also subject tocertain regulatory limits and rating agency guidelines on our exposure to asingle risk.

*UnderwritingCommittee Process for Structured Credit Transactions*

The Senior CreditCommittee serves as the principal underwriting committee for Structured Credit.Structured Credit transactions are brought to the Senior Credit Committee bythe applicable internal underwriter and reviewed in context of numerousvariables, including the credit quality of the portfolio, tranche ratings,transaction terms and structural features, such as the need for and terms ofany potential collateral posting. The authority to approve certain transactionswith standard pre-approved transactional and counterparty characteristics hasbeen delegated to the Structured Credit Committee. Any member of 

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theSenior Credit Committee or the Structured Credit Committee may require that aparticular transaction delegated to the Structured Credit Committee be approvedby the Senior Credit Committee.

*UnderwritingCommittee Process for Public Finance Transactions*

Public Finance transactions are subject to theapproval of either the Public Finance Underwriting Committee, which includes,among others, our Chief Executive Officer, our Executive Vice President-Head of Public Finance, ourExecutive Vice President-Head of Institutional RiskManagement and an attorney from the General Counsel’s office, or theSenior Credit Committee. The primary objective of the Public FinanceUnderwriting Committee is to approve routine Public Finance transactions,whereas approval of the Senior Credit Committee is required for largertransactions or those with non-routine collateral packages or transactionterms.

The Public FinanceUnderwriting Committee or the Senior Credit Committee, as the case may be,reviews the transaction terms, security package and credit, as well as proposedpricing relative to market spreads and returns on capital based on S&P’scapital charges.

*UnderwritingCommittee Process for CDO Asset Management Transactions*

In the case of CDO Asset Management transactions, theapplicable portfolio manager seeks approval from our Risk Management Committeefor the asset class being managed on behalf of ACA and other third partyinvestors and for the general terms of such management, including theapplicable management fees. The acquisition of equity in our CDOs must beapproved by the our internal Investment Committee, which is chaired by ourChief Financial Officer, together with the related financing terms, if any. Thedecision to acquire securities for our CDOs is made by the relevant portfoliomanager, however, such acquisitions may only be made from securities that areapproved by the related Collateral Committee.

We have threedifferent Collateral Committees. Each of the Collateral Committees is chairedby either the Managing Director - Head of Corporate Credit or the ManagingDirector—Head of ABS Credit, as applicable.

·       OurABS Collateral Committee approves assets for all cash flow and synthetic ABSCDO transactions.

·       OurCorporate Credit Committee approves exposure to corporate reference entities forour synthetic corporate CDOs.

·       OurLeveraged Loan Committee approves loans which may be included in our leveragedloan CDOs, or CLOs.

The chairpersons of thesecommittees report to our Chief Financial Officer. The relevant CollateralCommittees may elect to approve securities categorically based on specificcredit characteristics. Any such categorical approval will require approval ofthe Risk Management Committee.

**Surveillance**

*Structured Credit and CDO Asset ManagementSurveillance*

We have a dedicated teamof credit analysts with, as of December 31, 2006, an average of over11.5 years of experience in fixed income and corporate credit analysis. Weactively monitor the performance of the underlying assets included in ourStructured Credit and CDO portfolios. As a part of the monitoring process, wereview credit ratings and periodic financial reporting, and track current news,research and monthly asset performance reports, in addition to rating agencyreports and actions, among other available sources of information on individualcredits. The extent to which we monitor a particular credit is generallydetermined by the degree of stress that credit is experiencing, and thepotential impact 

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that aparticular credit may have on a given transaction or across transactions and inour ACA Financial Guaranty investment portfolio. We also continually assess andupdate our systems and the models we employ to analyze the overall impact ofcredit migrations and actual versus expected cash flow on our portfolios, aswell as on our aggregate exposure across our operating business lines and inour investment portfolio.

*Structured Credit.**  *Our proprietary softwareapplications, SARA and ACA Wizard, are the primary applications we use forscreening, surveilling and reporting on our Structured Credit transactions. Theinternal underwriter of a transaction retains primary responsibility formonitoring the performance of that transaction, including availablesubordination to our tranche of exposure, cash flows, conformance withprojections and, in partnership with our credit analysts, the performance ofthe underlying credits. For our ongoing surveillance, we have established afive-point classification system into which all of our Structured Credittransactions are classified, as follows:

·       Category 1—performing;

·       Category 2—underperforming(the credit is deviating from expected performance, but no default isanticipated; more in depth, and potentially more frequent, review is required);

·       Category 3—continueddeterioration (the credit is experiencing recurring and material violations ofsurveillance and/or covenants and a ratings downgrade has occurred or isexpected; these credits are included on our credit monitor list and an actionplan is devised and presented to the internal Risk Management Committee);

·       Category 4—potentialimpairment of principal (the credit is experiencing continued deterioration,operating results and/or enhancement are significantly below projections and apayment default may occur; these credits are presented to the Senior CreditCommittee to formulate and approve an appropriate loss mitigation strategy,which is updated quarterly and more frequently as required to the internal RiskManagement Committee); and

·       Category 5—impairmentof principal (the credit has experienced or is expected to experience a defaultthat will not be cured, resulting in an impairment of principal; a lossmitigation plan is put in place with respect to these credits and reported andupdated quarterly and more frequently as required to the internal RiskManagement Committee).

All Structured Credittransactions which are classified in Categories 3 through 5 are also reportedon a quarterly basis to the Risk Oversight Committee of our Board of Directors.

Our credit analysts andrisk management team also specifically review our credit swap portfolios todetermine the risk of a default or other credit event of any reference entityincluded in our portfolios and the impact on the available subordination to ourtranche of exposure. If we believe this risk exceeds acceptable levels,depending on the likely impact on our subordination and the overall performanceof the relevant portfolio to date, we may seek to reduce or eliminate thiscredit exposure by removing and substituting reference entities within therelevant portfolio, or hedging our exposure outside of the particulartransaction. From time to time, in order to manage our Structured Creditportfolio, we enter into transactions that either unwind prior transactions orassign our position to a third party.

*CDO Asset Management.**  *Our proprietary softwareapplications, SARA and ACA Wizard, are also the primary applications we use forscreening, trading, surveilling and reporting on our CDOs. The CDO AssetManagement group has adopted the same ratings system with respect to theindividual credits in the CDO portfolio as the Structured Credit group appliesto its transactions as a whole. Generally, credits are subject to monthlyreview by the monthly surveillance committee. If certain material events occurconcerning the credit, such as a report of negative performance and financialresults, a decrease in value of credit enhancement, announced litigation oradverse litigation results, or the occurrence of unexpected 

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rating actions, thecommittee will recommend a reclassification of such credit to the appropriatecategory as reflected by its then current state of deterioration. Each of theindividual credits held in our CDOs in Category 3 through 5 are also reviewedand an investment decision, such as to continue to hold, to sell, or to hedgethe exposure, is made. Prior to execution of a trade with respect to any suchcredit, we perform an evaluation of the relevant CDO portfolio. All credits onthe credit monitor list of Category 3 through 5 that are included in CDOsin which we own equity are reported on a quarterly basis to the Risk OversightCommittee of our Board of Directors.

*Public Finance Surveillance*

Our Public Financesurveillance group is responsible for monitoring outstanding issues ofmunicipal bonds that we insure. The group reviews each credit for relevantchanges in the economic or political environment and other criteria that couldinterrupt the timely payment of debt service on an insured issue of municipalbonds. Additionally, our surveillance group and risk management professionalsreview our Public Finance portfolio for concentration of risk by (i) specificbond types; (ii) geographic location; and (iii) size of issue. Oursurveillance group is also responsible for portfolio analysis, which entails abroader examination of trends in specific asset classes and bond types.

Once an obligation isinsured, the surveillance group periodically reviews information relating toeach obligor, including audited and interim financial statements. Potentialproblems uncovered through this review, such as poor financial results, lowfund balances, covenant or other trigger violations, trustee or servicerproblems, or excessive litigation, could result in an immediate in-depthsurveillance review and an evaluation of possible remedial actions. Thesurveillance group also monitors state and municipal finances and budgetdevelopments, and evaluates their impact on issuers of municipal bonds.

Wehave also established a five-point classification system into which all of ourPublic Finance credits are classified, as follows:

·       Category 1—performing;

·       Category 2—underperforming(the credit is deviating from expected performance but no default or claimpayment by us is anticipated; more in depth review and potentially morefrequent review is required);

·       Category 3—declining(the credit is experiencing recurring and material covenant violations andmaterial deviation from operating and cash flow projections, and we may berequired to make a claim payment in the long term; these credits are referredto our director of recovery management and an attorney in our legal departmentfor continued monitoring who, together with surveillance and underwritingpersonnel, develop an action plan that is then reported to the managingdirector of surveillance and periodically updated to the loss mitigationcommittee);

·       Category 4—deteriorating(the credit is experiencing a material decline in creditworthiness and abilityto pay, and draws upon debt service reserve funds indicate that we may berequired to make payment of a claim in the foreseeable future; heightenedinvolvement/review by the director of recovery management is required as aremore frequent updates of loss mitigation strategies to the loss mitigationcommittee); and

·       Category 5—claim(s) paidor imminent (claims have been or will be paid pursuant to a payment default ofthe underlying obligor on the municipal bond; the director of recoverymanagement has continued responsibility for implementing loss mitigationstrategies and frequent reporting, and these credits are subject to write-offsand case basis reserves as determined to be appropriate).

Generally, Category 1credits are reviewed annually and Category 2 credits are reviewedsemi-annually. Category 3 credits are reviewed quarterly, except thatnegatively trending Category 3 credits and 

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allCategory 4 and 5 credits are reviewed monthly or more frequentlyconsistent with any related action plan. All credits classified asCategories 3 through 5 are also reported on a quarterly basis to the RiskOversight Committee of our Board of Directors. In the event a periodic reviewof a given credit reflects that the credit is not performing as expected, or ifan unexpected material event occurs that may adversely affect the relatedobligor’s ability to pay debt service, such as damages pursuant to naturaldisasters, adverse litigation, the loss of tax revenues due to voterinitiatives, or unexpected rating actions, surveillance will recommend areclassification of such credit to the appropriate category as reflected by itsthen-current state of deterioration. Our loss mitigation committee, whichincludes our Chief Executive Officer, Executive Vice President-Head of  Public Finance, Managing Director-Head of Public FinanceSurveillance, Executive Vice President-Head of  Institutional Risk Management and SeniorManaging Director and Chief Accounting Officer, among others, oversees the lossmitigation efforts of the director of recovery management and the PublicFinance surveillance group and periodically reviews and confirms therecommended classifications of our Public Finance credits.

**ACA Financial Guaranty’s Rating**

Our insurance subsidiary’sfinancial strength rating is an important factor in establishing ourcompetitive position in the public finance and structured credit market. Thevalue of ACA Financial Guaranty’s financial guaranty insurance policy is afunction of the “rating” applied to the obligations insured. The rating alsoprovides necessary credit support to our counterparties in our StructuredCredit business who, in entering into the credit swaps, rely on the insuranceprovided in these transactions by ACA Financial Guaranty. From time to time, wealso employ the rating to support our general corporate financing activities,including our outstanding medium-term note obligations and certainoutstanding notes issued in connection with the financing of certain CDO equityinvestments. See “Management’s Discussion and Analysis of FinancialCondition and Results of Operations—Liquidity and Capital Resources—Indebtedness.”ACA Financial Guaranty’s financial strength is rated “A” (“strong,” the sixthhighest of twenty-one rating levels) by S&P.

This rating reflects onlythe views of S&P and is subject to revision or withdrawal at any time. Afinancial strength rating is an opinion regarding the financial securitycharacteristics of an insurance or reinsurance organization with respect to aninsurer’s ability to pay under its insurance policies and contracts inaccordance with their terms. The opinion is not specific to any particularpolicy or contract. Financial strength ratings do not refer to an insurer’sability to meet non-insurance or non-reinsurance obligations and are not arecommendation to purchase or discontinue any policy or contract issued by aninsurer or to buy, hold, or sell any security issued by an insurer or anyparent company of any insurer or reinsurer.

S&P has developed andpublished rating guidelines for rating financial guaranty insurers andreinsurers. The financial strength rating assigned by S&P is based uponfactors relevant to policyholders and is not directed towards the protection ofinvestors in our common stock. The rating criteria used by S&P inestablishing its ratings include consideration of the sufficiency of capitalresources to meet projected growth (as well as access to such additionalcapital as may be necessary to continue to meet applicable capital adequacystandards), a company’s overall financial strength, business plan and strategy,and demonstrated management expertise in financial guaranty and traditionalreinsurance, credit analysis, systems development, marketing, capital marketsand investment operations.

**Reinsurance**

State insurance laws andregulations (as well as the rating agencies) impose minimum capitalrequirements and single risk limits on financial guaranty insurance companies,limiting the aggregate amount of insurance which may be written and the maximumsize of any single risk exposure which may be assumed. Financial guarantyinsurance companies can use reinsurance to diversify risk, increase 

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underwritingcapacity, reduce capital needs and strengthen financial ratios. Although ouruse of reinsurance has been limited, from time to time, ACA Financial Guarantymay employ a variety of reinsurance structures to help manage risk or to complywith single risk or other regulatory requirements. As of December 31,2006, we had ceded an aggregate of $53.7 million of facultativereinsurance in respect of Public Finance bond insurance policies we issued inorder to reduce our single risk exposure to those credits, and additionallyhave obtained catastrophic coverage through an excess of loss reinsurancepolicy.

**Investment Portfolio**

Our investment portfolioprimarily consists of the assets of ACA Financial Guaranty and the assets ofour consolidated transactions, including our CDOs and the Credit Fund. Thefollowing discussion relates to the assets in ACA Financial Guaranty’sinvestment portfolio. Our principal objective in managing such investmentportfolio is to generate an optimal level of after-tax investment income whilepreserving ACA Financial Guaranty’s “A” financial strength rating, to maintainadequate liquidity and to minimize the correlation with insurance risk. Theinvestment policy is set by the Audit and Investment Committee of our Board ofDirectors, and ACA Financial Guaranty’s investment portfolio is managed byoutside professional money managers. To accomplish our objectives, we haveestablished guidelines for building a portfolio of high-quality fixed incomeinvestments, requiring that such investments be rated at least “BBB-” atacquisition and the overall portfolio be rated “A+” on average. The portfoliomay continue to hold fixed income investments falling below the minimum qualitylevel with approval of our internal Investment Committee. Eligible fixed incomeinvestments include, but are not limited to, U.S. Treasury and agencyobligations, corporate bonds, municipal bonds and asset and mortgage backedsecurities. The following tables set forth certain information concerning ourfixed maturity securities investment portfolio.

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The following tablereflects the composition of our non-Variable Interest Entity (“VIE”) investmentportfolio, by security type:

**Non-VIEInvestment Portfolio by Security Type(1)**

| ** **                                        | ** ** | **As of**                  | ** ** | **As of**                  | ** ** |
|---------------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                        | ** ** | **December 31, 2006** | ** ** | **December 31, 2005** | ** ** |
| ** **                                        | ** ** | **Fair  Value**                 | ** ** | **Amortized  Cost**             | ** ** | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** |
| ** **                                        | ** ** | **(in thousands)**              | ** ** |
| **Non-VIE Investments:**                          | ** ** | ** **                      | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| US treasury securities                            |       | $                               | 36,626     |                            | $          | 37,391 |   | $ | 55,576 |   | $ | 56,911 |   |
| Federal-agency securities                         |       | 74,436                          |       | 75,357                          |       | 46,361 |   | 46,952 |   |
| Obligations of  states and political subdivisions |       | 132,852                         |       | 133,027                         |       | 120,878 |   | 121,714 |   |
| Corporate securities                              |       | 99,515                          |       | 101,379                         |       | 106,588 |   | 108,435 |   |
| Asset-backed  securities                          |       | 12,901                          |       | 12,931                          |       | 11,413 |   | 11,496 |   |
| Mortgage-backed  securities                       |       | 133,252                         |       | 136,032                         |       | 146,958 |   | 149,430 |   |
| Cash and cash  equivalents                        |       | 181,030                         |       | 181,030                         |       | 99,300 |   | 99,300 |   |
| Total non-VIE  securities                         |       | $                               | 670,612    |                            | $          | 677,147 |   | $ | 587,074 |   | $ | 594,238 |   |

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(1)          Excludes assets relatedto our consolidated CDOs.

The following tablereflects our non-VIE investment portfolio results for each year in thethree-year period ended December 31, 2006:

**Non-VIE InvestmentResults(1)(2)**

| ** **                   | ** ** | **December 31,**  | ** ** |
|------------------------------|------------|------------------------|------------|
| **Investment Category** | ** ** | ** **             | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                   | ** ** | **(in millions)** | ** ** |
| Average invested  assets     |       | $                      | 616.5      |   | $ | 530.0 |   | $ | 439.2 |   |
| Investment  income(3)        |       | 32.2                   |       | 21.8 |   | 14.5 |   |
| Effective yield(4)           |       | 5.2                    | %          | 4.1 | % | 3.3 | % |
|                              |            |                        |            |  |  |  |  |  |  |  |  |  |

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(1)          Excludes assets andresults related to our consolidated CDOs.

(2)          Includes cash and short-terminvestments.

(3)          Excluding investmentexpenses and realized investment gains (losses).

(4)          Investment income forthe period divided by average invested assets for the same period.

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ACAFinancial Guaranty’s investment portfolio is invested primarily in fixed incomesecurities. The following table shows our non-VIE investment portfolio bycomparable rating as of December 31, 2006:

**Non-VIEInvestment Portfolio by Rating(1)(2)(3)**

| **Rating**                            | ** ** | ** **             | ** ** | **Amount** | ** ** | **Percent of  Investment  Portfolio** | ** ** |
|---------------------------------------|------------|------------------------|------------|------------|------------|--------------------------------------------|------------|
| ** **                            | ** ** | **(in millions)** | ** ** | ** ** | ** ** |
| AAA or equivalent                     |       |                   | $          | 346.3      |       |                                       |       | 70.8 | % |   |
| AA                                    |       |                   | 55.6       |       |       |                                       | 11.4       |   |   |
| A                                |       |                   | 52.1       |       |       |                                       | 10.6       |   |   |
| BBB                                   |       |                   | 24.2       |       |       |                                       | 4.9        |   |   |
| Below investment  grade and non-rated |       |                   | 11.2       |       |       |                                       | 2.3        |   |   |
| Total non-VIE securities              |       |                   | $          | 489.6      |       |                                       |       | 100.0 | % |   |

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(1)          Ratings are representedby the lower of the S&P and Moody’s Investors Service classifications.

(2)          Excludes assets relatedto our consolidated CDOs.

(3)          Includes cash and short-terminvestments.

The following tableindicates the composition of our non-VIE fixed income security portfolio bytime to maturity as of December 31, 2006:

**Distributionof Non-VIE Investments by Maturity(1)(2)(3)**

| **Investment Category**            | ** ** | ** **             | ** ** | **Estimated Fair  Value** | ** ** | **Percent of  Investment  Portfolio** | ** ** |
|-----------------------------------------|------------|------------------------|------------|--------------------------------|------------|--------------------------------------------|------------|
| ** **                              | ** ** | **(in millions)** | ** ** | ** **                     | ** ** |
| Due in one year  or less                |       |                   | $          | 24.2                           |       |                                       |       | 4.9 | % |   |
| Due after one  year through five years  |       |                   | 80.8       |                           |       |                                       | 16.5       |   |   |
| Due after five  years through ten years |       |                   | 148.1      |                           |       |                                       | 30.2       |   |   |
| Due over ten  years                     |       |                   | 236.5      |                           |       |                                       | 48.4       |   |   |
| Total non-VIE securities                |       |                   | $          | 489.6                          |       |                                       |       | 100.0 | % |   |

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(1)          Actual maturities coulddiffer from contractual maturities because borrowers have the right to call orprepay certain obligations which may not include call or prepayment penalties.

(2)          Excludes assets relatedto our consolidated CDOs.

(3)          Includes cash andshort-term investments.

Additionally, we haveproceeds from our initial public offering (the “IPO”) that we currently investin short-term investments.

**Regulation**

The following summary isbased upon current law and is provided for general information only.

*ACA FinancialGuaranty Corporation*

ACA Financial Guaranty is licensed to providefinancial guaranty insurance in the State of Maryland (its state ofincorporation), as well as in each of the other 49 states, the District ofColumbia, Guam, Puerto Rico and the U.S. Virgin Islands. The operations of ACAFinancial Guaranty are subject to 

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regulation by thedepartments of insurance in all of those jurisdictions. The extent of stateinsurance regulation and supervision varies by jurisdiction, but Maryland, NewYork and most other jurisdictions have laws and regulations prescribing minimumstandards of solvency, including minimum capital requirements and businessconduct that must be maintained by licensed insurance companies. These lawsprescribe permitted classes of risks which may be written and limitations onthe size of risks which may be insured. In addition, some state laws andregulations require the approval or filing of policy forms and rates. ACAFinancial Guaranty is required to file detailed annual and quarterly financialstatements with the Maryland Insurance Administration and similar supervisoryagencies in each of the other jurisdictions in which it is licensed. Thesefinancial statements are prepared in accordance with Statutory AccountingPrinciples, or SAP, and procedures prescribed or permitted by the insurancedepartments in the jurisdictions in which ACA Financial Guaranty is licensed todo business. The operations and accounts of ACA Financial Guaranty are subjectto examination by these regulatory agencies at regular intervals. The MarylandInsurance Administration conducts an examination of insurance companiesdomiciled in Maryland every five years. On January 19, 2007, the MarylandInsurance Administration issued its final report in respect of its examinationof ACA Financial Guaranty for the period 1998 through 2003.

*MarylandFinancial Guaranty Insurance Law.**  *Title 31 of the Code of MarylandRegulations establishes, with respect to the transaction of financial guarantyinsurance, single and aggregate risk limits, limits on the types of debtinstruments and monetary obligations which may be insured, and contingencyreserve funding requirements. These limits and reserve requirements are similarto those contained under Article 69 of the New York Insurance Law asdescribed below, which also applies to our financial guaranty insurancepolicies by virtue of our doing business as a foreign insurer in New York. ACAFinancial Guaranty is also subject to the laws and regulations governingfinancial guaranty in the jurisdictions other than Maryland and New York inwhich it transacts the business of financial guaranty insurance. The laws andregulations of these other jurisdictions governing financial guaranty insuranceare generally not more stringent in any material respect than Article 69of the New York Insurance Law.

*NewYork Financial Guaranty Insurance Law.**  *Article 69 of the New YorkInsurance Law, or Article 69, is a comprehensive financial guarantyinsurance statute that governs all financial guaranty insurers licensed to dobusiness in New York, including ACA Financial Guaranty. This statute limits thebusiness of financial guaranty insurers to financial guaranty insurance andrelated lines, such as certain types of surety.

Article 69 requires that financial guarantyinsurers maintain a special statutory accounting reserve called the contingencyreserve to protect policyholders against the impact of excessive lossesoccurring during adverse economic cycles. Article 69 requires ACAFinancial Guaranty to provide a contingency reserve quarterly on a pro ratabasis over a period of 20 years for municipal bonds, special revenue bondsand industrial development bonds, and 15 years for all other obligationsin an amount equal to the greater of 50% of premiums written for the relevantcategory of insurance or a percentage of the principal guaranteed (varying from0.55% to 2.50%, depending upon the type of obligation guaranteed), until thecontingency reserve amount for the category equals the applicable percentage ofnet unpaid principal. Under statutory accounting policies, this reserve must bemaintained for the periods specified above, except that reductions by theinsurer may be permitted under specified circumstances if actual incurredlosses exceed certain thresholds or if the reserve accumulated is deemedexcessive in relation to the insurer’s outstanding insured obligations.Financial guaranty insurers also are required to maintain an unearned premiumreserve as well as reserves for losses and loss adjustment expenses for insuredobligations that have already defaulted.

Article 69 establishes single risk limits forfinancial guaranty insurers applicable to all obligations issued by a singleentity and backed by a single revenue source. For example, under the limitapplicable to each qualifying issue of ABS issued by a single entity and foreach pool of consumer debt obligations, the lesser of (1) the insuredaverage annual debt service for a single risk or (2) the insured unpaidprincipal 

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(reduced by the extent towhich the unpaid principal of the supporting assets and, provided the insuredrisk is investment grade, the excess spread, exceed the insured unpaidprincipal), divided by nine, net of qualifying reinsurance and collateral, maynot exceed 10% of the sum of the insurer’s policyholders’ surplus andcontingency reserve, subject to certain conditions. Under the single risk limitapplicable to municipal obligations, the insured average annual debt servicewith respect to a single issuer, net of qualifying reinsurance and collateral,may not exceed 10% of the sum of the insurer’s policyholders’ surplus and contingencyreserve. In addition, insured principal of municipal obligations attributableto any single issuer, net of qualifying reinsurance and collateral, is limitedto 75% of the insurer’s policyholders’ surplus and contingency reserve. Singlerisk limits also are specified for other categories of insured obligations andgenerally are more restrictive than those listed for asset-backed or municipalobligations.

Article 69 also establishes aggregate risk limitson the basis of aggregate net liability insured as compared to policyholders’surplus and contingency reserves. Aggregate net liability is defined asoutstanding principal and interest of guaranteed obligations insured, net ofqualifying reinsurance and collateral. Under these limits, policyholders’ surplusand contingency reserves must not be less than a percentage of aggregate netliability equal to the sum of various percentages of aggregate net liabilityfor various categories of specified obligations. The percentage varies from0.33% for certain municipal obligations to 4.00% for certain non-investmentgrade obligations.

In addition, Article 69 requires 95% of ACAFinancial Guaranty’s outstanding total liability on municipal bonds, specialrevenue bonds and industrial development bonds, net of reinsurance andcollateral, to be investment grade.

*MarylandInsurance Holding Company Law.**  *ACA Financial Guaranty is subjectto regulation under Maryland’s insurance holding company statute. The holdingcompany statute requires ACA Financial Guaranty to register and file certainreports describing, among other information, our capital structure, ownership,financial condition and transactions with affiliates. The holding companystatute also generally requires prior approval of changes in control, thepayment of certain dividends and other inter-company transfers of assets, andof certain transactions between ACA Financial Guaranty and its affiliates,including us. The holding company statute imposes standards on certaintransactions between ACA Financial Guaranty and related companies that includethat all transactions be fair and reasonable, be appropriately recorded in thebooks of both parties and be appropriately accounted for, and requires priorregulatory approval for transactions not in the ordinary course of businessthat exceed specified limits.

The holding company statute prohibits any person fromacquiring control of us or ACA Financial Guaranty unless that person has fileda notification with specified information with the Maryland InsuranceCommissioner and has obtained the Commissioner’s prior approval. Under theMaryland statute, acquiring ten percent or more of the voting stock of aninsurance company or its parent company is presumptively considered a change ofcontrol, although such presumption may be rebutted. Accordingly, any person whoacquires, directly or indirectly, ten percent or more of our voting securitieswithout either the prior approval of the Maryland Insurance Commissioner or afiled and approved disclaimer of control will be in violation of this law andmay be subject to injunctive action. In addition, many U.S. state insurancelaws require prior notification of state insurance departments of a change incontrol of a non-domiciliary insurance company doing business in that state.While these pre-notification statutes do not authorize the state insurancedepartments to disapprove the change in control, they authorize regulatoryaction in the affected state if particular conditions exist, such as unduemarket concentration. Any future transactions that would constitute a change incontrol of ACA may require prior notification in those states that have adoptedpre-acquisition notification laws.

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These laws maydiscourage potential acquisition proposals and may delay, deter or prevent achange in control of ACA, including through transactions, and in particularunsolicited transactions, that some or all of our stockholders might considerto be desirable.

·       *Dividends*.   ACA Financial Guarantymust give ten days’ prior notice to the Maryland Insurance Commissioner of itsintention to pay any ordinary dividend or make any ordinary distribution.Ordinary dividends and ordinary distributions refer to any dividend or distributionother than an extraordinary dividend or extraordinary distribution (as definedbelow). The Maryland Insurance Commissioner has the right to prevent such anordinary dividend or distribution if he determines, in his discretion, thatafter the payment thereof, ACA Financial Guaranty’s policyholders’ surpluswould be inadequate or could cause ACA Financial Guaranty to be in a hazardousfinancial condition. In the past, the Maryland Insurance Commissioner hasconsented to the payment of dividends by ACA Financial Guaranty sufficient tomake interest payments on the debt service of $40 million of ourindebtedness, the proceeds of which were contributed to ACA Financial Guaranty.

Under Maryland insurance law, ACA Financial Guarantymust provide the Maryland Insurance Commissioner with at least 30 days’ priornotice before paying an “extraordinary dividend” or making an “extraordinarydistribution.” Extraordinary dividends and extraordinary distributions aredividends or distributions that, together with any other dividends anddistributions paid during the immediately preceding 12-month period,would exceed the lesser of:

ten percent of ACA Financial Guaranty’s statutorypolicyholders’ surplus (as determined under SAP as of December 31 of theprior year); and

ACA Financial Guaranty’s net investment incomeexcluding realized capital gains (as determined under SAP) for the 12-monthperiod ending on December 31 of the prior year and pro rata distributionsof any class of ACA Financial Guaranty’s own securities, but including anyamounts of net investment income (excluding realized capital gains) in thethree calendar years prior to the preceding calendar year that have not alreadybeen paid out as dividends.

These statutory limitations are subject to change. ACAFinancial Guaranty may not pay extraordinary dividends or make extraordinarydistributions until either the 30-day notice period has expired (withoutthe Maryland Insurance Commissioner disapproving such payment) or the MarylandInsurance Commissioner has approved the payment within that period.

ACA Financial Guaranty may pay extraordinary dividendsonly out of positive earned surplus. “Earned surplus” is defined as that partof surplus that, after deduction of all losses, represents the net earnings,gains, or profits that have not been distributed to stockholders as dividends,transferred to stated capital or to capital surplus or applied to otherpermissible purposes, but does not include unrealized capital gains orreevaluation of assets. At December 31, 2006, ACA Financial Guaranty had anegative earned surplus of $109.7 million primarily due to theformula-driven calculations which assign surplus to contingency reserves basedon our portfolio of insurance exposures. As a result, ACA Financial Guaranty iscurrently unable to pay extraordinary dividends until it has a positive earnedsurplus calculated on a SAP basis. Further, due to the nature of thecalculation as applied to our business, increases in U.S. GAAP income will notnecessarily result in positive earned surplus.

A surplus note is a subordinated debt instrumentissued by an insurer, with the approval of the Maryland Insurance Commissioner,which, for regulatory purposes, is treated as policyholders’ surplus. Theclaims of the holder of a surplus note are subordinate to the claims ofpolicyholders, insurance claimants and beneficiaries and to all other classesof creditors other than surplus note holders. In the case of a Marylanddomestic insurer, payment of principal and interest on any surplus note issubject to the prior approval of the Maryland Insurance Commissioner. TheMaryland Insurance Commissioner has in 

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the past approved interestpayments on a $10 million surplus note ACA Financial Guaranty issued to usin December 2004.

The foregoing dividendlimitations are determined in accordance with SAP, which generally producestatutory earnings in amounts less than earnings computed in accordance withU.S. GAAP. Similarly, policyholders’ surplus, computed on a SAP basis, willnormally be less than net worth computed on a U.S. GAAP basis.

·       *Guaranty Funds*.   Guaranty fund lawsin most states require insurers transacting business in the state toparticipate in guaranty associations, which pay claims of policyholders andthird-party claimants against impaired or insolvent insurance companies doingbusiness in the state. In most states, insurers licensed to write onlymunicipal bond insurance, financial guaranty insurance and other forms ofsurety insurance, such as ACA Financial Guaranty, are exempt from assessment bythese funds and their policyholders are prohibited from making claims on thesefunds.

·       *Credit Risk Exposure Limits.  *Under Maryland insurancelaw, “A” rated financial guaranty insurance companies total liability, net ofqualifying reinsurance and collateral, for municipal bonds, special revenuebonds and industrial development bonds must be 70% investment grade unless otherwiseapproved by the Maryland Insurance Commissioner. The Maryland InsuranceCommissioner has approved an order permitting ACA Financial Guaranty tomaintain 60% of its total liability of municipal bond, special revenue bond andindustrial development bond exposure, net of qualifying reinsurance andcollateral, in investment grade credits.

*Other ApplicableInsurance Regulatory Laws*

·       *Premium Rates and Policy Forms.  *ACAFinancial Guaranty’s premium rates and policy forms are subject to regulationin every state in which it is licensed to transact business in order to protectpolicyholders against the adverse effects of excessive, inadequate or unfairlydiscriminatory rates and to encourage competition in the insurance marketplace.In most states, premium rates and policy forms must be filed either prior to orshortly after their use. In some states, such rates and forms also must beapproved prior to use. Changes in premium rates are subject to justification,generally on the basis of the insurer’s loss experience, expenses and futuretrend analysis.

·       *Reinsurance.  *Certain restrictionsapply under the laws of several states to any licensed company ceding businessto an unlicensed reinsurer. Under such laws, if a reinsurer is not admitted orapproved in such states, the company ceding business to the reinsurer cannottake credit in its statutory statements for the risk ceded to such reinsurerabsent compliance with certain reinsurance security requirements. Thesesecurity requirements apply to any reinsurance agreements between ACA FinancialGuaranty and an unlicensed reinsurer.

·       *Investment.  *Under Maryland insurance law, ACAFinancial Guaranty may invest in only certain permitted investments and only upto specified amounts. Failure to comply with these investment limitations wouldcause investments exceeding regulatory limitations to be treated asnon-admitted assets for purposes of measuring surplus in accordance with SAP,and in some instances, could require divestiture of such non-qualifying assets.In addition, pursuant to Maryland insurance law, ACA Financial Guaranty maymake an investment only if it is approved (or made pursuant to approvedguidelines) by ACA Financial Guaranty’s board of directors or the committee ofACA Financial Guaranty’s board of directors that is responsible for supervisingor making such investment. Although it is not domiciled in New York, ACAFinancial Guaranty must remain in substantial compliance with New Yorkinsurance law limitations on investments in order to retain its license there.

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*Bermuda InsuranceSubsidiaries*

ACA Assurance Ltd. and ACA Solutions Ltd. arelicensed in Bermuda to write insurance and reinsurance, respectively, and arenot admitted to do business in any jurisdiction other than Bermuda. ACAAssurance’s activities are limited to certain discontinued lines of businessand ACA Solutions has no current activities. The insurance laws of each stateof the United States and of many other jurisdictions regulate the sale ofinsurance within their jurisdictions by alien insurers, such as ACA Assuranceand ACA Solutions. ACA Assurance and ACA Solutions intend to conduct theirbusiness so as not to be subject to the licensing requirements of insuranceregulators in the United States or elsewhere (other than Bermuda).

ACA Assurance and ACASolutions are subject to regulations under the Bermuda Insurance Act of 1978,or Insurance Act, and are registered as insurers by the Bermuda MonetaryAuthority, or the BMA. The Insurance Act imposes on Bermuda insurance companiessolvency and liquidity standards and auditing and reporting requirements as wellas certain restrictions on the payment of dividends. The Insurance Act alsogrants to the BMA powers to supervise, investigate and intervene in the affairsof insurance companies.

*ACA Management,L.L.C.*

Our asset managementsubsidiary, ACA Management, is registered with the SEC as an investment adviserunder the Investment Advisers Act and is subject to the provisions of theInvestment Advisers Act of 1940, or the Investment Advisers Act, and the SEC’sregulations promulgated thereunder. The Investment Advisers Act imposesnumerous obligations on registered investment advisers relating to, among otherthings, fiduciary duties to clients, engaging in transactions with clients,maintaining an effective compliance program with respect to its personnel, performancefees, solicitation arrangements, conflicts of interest, allocations of assets,best execution on pricing, advertising, and recordkeeping, reporting anddisclosure requirements. The SEC is authorized to institute proceedings andimpose sanctions for violations of the Investment Advisers Act, ranging fromfines and censure to termination of an investment adviser’s registration.

*ACA CapitalManagement (U.K.) Pte. Limited*

ACA Capital Management (U.K.) provides investment management servicesin and from the United Kingdom under the regulation of the FSA. In addition tomonitoring and regulating ACA Capital Management (U.K.) to ensure it iscomplying with the regulatory requirements of the Financial Services andMarkets Act 2000 (“FSMA”) and certain other European Union directives, the FSA,among other things, approves the individuals who carry out particular“controlled” functions on behalf of ACA Capital Management (U.K.) and regulatesthe acquisition of “control” of ACA Capital Management (U.K.). Under the FSMA,any person proposing to acquire “control” (i.e., any company or individualdirectly or indirectly acquiring 10% or more of the shares of, or having theright to exercise or control the exercise of 10% or more of the voting power inACA Capital Management (U.K.)) must give prior notification to the FSA of itsintention to do so. The FSA has extensive powers to intervene in the affairs ofan authorized person, culminating in the ultimate sanction of the removal ofauthorization to carry on a regulated activity. The FSMA imposes on the FSAstatutory obligations to monitor compliance with the requirements imposed byFSMA, and to enforce the provisions of FSMA related rules made by the FSA.The FSA also has the power to prosecute criminal offenses arising under FSMA,and to prosecute insider dealing and breaches of money laundering regulations.The FSA’s stated policy is to pursue criminal prosecution in all appropriatecases.

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In addition, ACA CapitalManagement (U.K.) has obtained the right to operate on a passport basisallowing it to conduct its asset management business in European Union statesin addition to the United Kingdom without the necessity of additional licensingor authorization in such other European Union jurisdictions. Although ACACapital Management (U.K.) is principally regulated by the FSA, should it electto conduct business in other European Union jurisdictions pursuant to itspassport, it may have to comply with certain local rules in thosejurisdictions.

**Competition**

All of our business lines are highly competitive,although each line has a different competitive dynamic.

*StructuredCredit Business.**  *Thebusiness of selling credit protection in the form of credit swaps is a quicklyevolving and highly competitive market. Competition is based on many factors,including the general reputation of a counterparty, execution quality andefficiency, perceived financial strength of the protection seller and willingnessto post collateral under certain circumstances, pricing and other terms andconditions of the transaction. We compete with hedge funds, insurance companiesincluding financial guarantors that, like ACA Financial Guaranty, insure theobligations of subsidiaries providing credit protection through swaps, banks,derivative products companies such as Athilon Capital Corp. and non-bankfinancial institutions.

*PublicFinance Business.**  *Asthe sole “A” rated financial guarantor, our target market in our Public Financeline of business is different than that of other financial guarantors. We donot compete directly with “AAA” rated financial guarantors. RadianGroup Inc., as the only “AA” rated financial guarantor, is able toparticipate in our target market, although to a lesser degree than we are. Ourstrongest competition in our target market is from letter of credit banks andhigh-yield municipal mutual funds that purchase uninsured non-investment grademunicipal obligations. We also compete with structural alternatives tothird-party credit enhancement, including senior-subordinated structures. Thesestructural alternatives compete on price, quality of execution, reputation andstructural advantages.

*CDO Asset ManagementBusiness.**  *Thefinancial services industry, and in particular, the market for CDO AssetManagement services, is highly competitive with low barriers to entry. The keycompetitive factors are the historical performance of our portfolios, ourunderwriting processes for the acquisition of credits and the quality of ourportfolio management and credit analyst teams. Our competitors include The TCWGroup, Inc., Vanderbilt Capital Advisors, LLC, Blackrock FinancialManagement, Inc. and GSC Partners, among many financial institutions. Manyof these companies have greater financial resources and are more establishedand well known in the CDO market than us.

**Employees**

As of December 31, 2006, we had 115 full-timeemployees. None of our employees are covered by collective bargainingagreements. We consider our employee relations to be good.

The data included in thisItem 1 and elsewhere in this report regarding markets and product categories,including, but not limited to, the size of certain markets and productcategories, are based on our estimates and definitions, which have been derivedfrom third party sources and management’s knowledge and experience in the areasin which the relevant businesses operate. We have given market data for whichthe most recent information is available, which may be a different time periodfor different markets. We believe that these sources, in each case, providereasonable estimates. However, market data is subject to change and cannot beverified with certainty due to limit, on the availability and reliability ofraw data, the voluntary nature of the data gathering process and otherlimitations and uncertainties inherent in any statistical survey of marketshares. In addition, we may define our markets in a way that may be differentfrom how third parties, including our competitors, define various markets inwhich we participate.

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**Item 1A.**                RiskFactors.

You should carefullyconsider the following information, together with the other informationcontained in this Annual Report on Form 10-K. The risks anduncertainties described below are not the only ones we face. Additional risksthat we currently do not know about or deem to be immaterial may also impairour business or results of operations. Any of the risks described below couldresult in a significant or material adverse effect on our results of operationsor financial condition.

**Risks Related toOur Business**

**Our failure to effectively analyze and monitor creditand other risks could have a material adverse effect on our financialcondition, results of operations and capital adequacy.**

Our ability to analyze, monitor and manage credit riskis at the core of each of our business lines. All of our business lines will bematerially impacted if we fail to do this effectively.

In our Structured Credit business, if we fail toaccurately analyze the credit and other risks associated with selling creditprotection through our financial guaranty insurance products in our StructuredCredit line of business, we may suffer unexpected losses, which couldmaterially and adversely affect our results of operations and financialcondition.

Our Public Finance business also depends significantlyon our ability to effectively analyze and monitor credit risks. We guaranteeobligations over an extended period of time, typically up to 30 years, andin riskier credit rating categories and sectors than the other financialguaranty insurance companies. As of December 31, 2006, based on our riskmanagement internal rating systems, 35.2**%**of our outstanding Public Finance net par exposure was rated non-investmentgrade. We have also targeted certain industry sectors, such as health care andlong-term care, which are higher risk credits than those exposures typicallytaken by other financial guaranty insurers. We have in the past, and expect inthe future to, incur losses in our Public Finance portfolio. If we do notaccurately assess the credit risk and the related security and structuralprotections in these transactions and effectively monitor and manage theserisks on an ongoing basis, we may incur significant losses in excess of ourexpectations.

Our future success instructuring and managing CDOs will depend on our ability to accurately analyzethe financial assets that comprise the CDOs. We manage our CDO portfolio byattempting to sell deteriorating credits in a timely manner in order tomitigate losses as they develop; however, we may not be able to do so or we maynot be able to do so without incurring losses. If we do not effectively manageour CDOs, our reputation as a CDO asset manager could be negatively affected,which could materially and adversely affect our ability to originate futureCDOs. In some cases, we also bear a portion of the risk associated with creditlosses if there are defaults or assets otherwise become ineligible forinclusion in a CDO during the warehousing phase. See “Business—CDO AssetManagement—Origination and Structuring of CDOs.” Furthermore, since we also ownat least some portion, or in our earlier CDOs, all or most, of the first lossor equity tranche in our CDOs, if we experience losses in excess of our modeledexpectations we could experience returns below our expectations or lose aportion or all of our equity interests in those CDOs. Our original aggregatefirst loss, or equity, position in our CDOs was $209.1 million as of December 31,2006.

**We face risks fromthe concentration of our liabilities and investments.**

We face concentration risks in all of our businesses.While we seek diversification across our businesses, in each of our businesslines and in ACA Financial Guaranty’s investment portfolio, we face risks tothe extent that our aggregate exposure to losses is concentrated geographically,by industry, sector, obligor or type of credit or investment.

A large portion of the financial assets included inour CDOs are residential MBS, or RMBS, which present concentration risk to thenational housing market. As of December 31, 2006, there was 

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$10.4 billion of RMBSin our CDO assets under management. Current market trends indicate higherdelinquency and foreclosure rates in the 2006 vintage of sub-prime residentialmortgages. As of December 31, 2006, six of our 22 CDOs in which we owned equityhad material exposure to the 2006 sub-prime vintage. Four of these CDOs assumeexposure to RMBS below the A-/A3 level and ACA has an aggregate exposure tothem of approximately $55.7 million, and two of these CDOs assume exposure toRMBS at or above the A-/A3 level ACA has an aggregate exposure to them ofapproximately $35.5 million. Depending on the severity of actual defaults onthe 2006 vintage subprime mortgages underlying these RMBS, we may experience substantiallyreduced returns on our equity investments in these CDOs. Further, we cannot becertain that actual defaults will not exceed our expectations based on ourmodeled scenarios and that we will not sustain actual losses in respect of someor all of our equity in these six CDOs. In addition, poor performance in ourCDOs relating to this issue could also hurt out reputation as an asset managermaking it difficult for us to continue to originate CDOs in the future. Aswell, to the extent our CDOs continue to acquire RMBS, there is no certainty asto how future vintages of residential mortgages will perform. See “Management’sDiscussion and Analysis of Financial Condition and Results of Operations—Resultsof Operations—CDO Asset Management.”

Additionally, some of the mortgages underlying ourother CDO exposures include interest only payments which are due to reset inthe coming years. The reset of these mortgages to include interest plusprincipal payments may also cause an increase in obligor defaults of thesemortgages. In addition, a significant portion of the assets securing the RMBSthat we buy are secured by mortgages on properties in California and to alesser extent in New York and Florida. Should one of those states specificallyexperience an economic downturn or natural disaster resulting in significantdefaults on mortgages issued in that state, certain RMBS purchased into ourCDOs may also experience defaults or lower market values. The occurrence ofdefaults in RMBS, could materially negatively impact the performance of ourCDOs generally, making it difficult for us to continue to sponsor CDOs, andcause us to experience returns below our expectations on, or lose a portion orall of, our equity investment in our CDOs. A lower rate of appreciation of homevalues, or depreciation of home prices, either nationally or regionally,particularly in areas where we have concentrated exposure, may increase theseverity of the economic impact of this risk. We also have exposure to RMBSunderlying our insured credit swaps in our Structured Credit business. Shouldthere be significant defaults on mortgages underlying RMBS in such insuredcredit swaps, we could also experience an increased number of credit events inour synthetic ABS structured credit transactions.

Our corporate synthetic CDOs, CLOs and StructuredCredit transactions may include concentrations in particular industries or ingeographical regions or in highly correlated industries and geographicalregions. In the event that a particular industry or region experiences aneconomic downturn or natural disaster, the performance of our synthetic CDOs orCLOs may be materially negatively impacted. We may also experience significantnumbers of credit events in relation to the reference entities included in theportfolios against which we sell protection in our Structured Credittransactions. Should such events occur, we could experience returns below ourexpectations on, or lose a portion or all of our equity investments in, ourCDOs. Such an occurrence could harm our ability to continue to originate CDOs.Each of these events could materially and adversely impact our liquidityposition as well as the adequacy of our capital.

In our Public Financebusiness we face default risk from the concentration of our exposure in certainstates and in certain industries. As of December 31, 2006,$1,020.2 million, or 16.6%, of our outstanding gross par exposure wasconcentrated in California, and $2,659.2 million, or 43.4%, of ouroutstanding gross par exposure was concentrated in nine additional states. Thisconcentration increases our vulnerability to economic downturns, naturaldisasters, or terrorist attacks in those states. In addition, as of December 31,2006, $1,504.2 million, or 24.5% of our outstanding gross par exposure,was related to higher education and $1,545.2 million, or 25.2%, of ouroutstanding gross par exposure was in the healthcare and long-term caresectors. Both the health care and long-term care sectors are facing risingcosts and revenue constraints. As a result, health care and long-term care areperceived to be higher risks than other 

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segmentsof the public finance market. These factors could undermine the assumptions wemade in our credit analysis of the issuers in those sectors and cause actuallosses to exceed estimated losses.

**General economic and market factors may materiallyadversely affect our loss experience, the demand for our products and ourfinancial results.**

Our business is impacted by general economic andmarket conditions. We could experience decreased demand for our products orincur losses due to extended economic recessions, business failures, interestrate changes or volatility, credit spread volatility, capital marketsvolatility, or changes in investor perceptions about the value of CDO securitiesor financial guaranty insurance products, or combinations of such factors.Additionally, terrorist attacks of significant scale could cause volatility inthe financial markets, particularly in the credit markets, and uncertainty inthe economies of the areas in which they occur and in the global economy.

The market for the sale of credit protection underinsured credit swaps and, consequently, related premiums are affected by anumber of economic and market factors not within our control. The occurrence ofcredit events with respect to reference entities, for instance, such asbankruptcy or the failure to pay indebtedness, may be caused by cyclicality ofthe economy in general, industry cyclicality or credit events within theindustry and capital market volatility generally, which may impact the supplyand demand conditions in the credit swap market. Our financial results dependto a significant degree upon the premiums that we receive for the sale of ourinsurance products through our credit swaps. These premiums are established atorigination of the transaction and are generally a function of both absolutecredit spreads and the level of correlation among credit portfolios and themovement of related spreads, each of which change over time as a result ofchanges in the overall economy, supply and demand conditions in the credit swapmarket and other factors affecting the corporate credit market in general. If alow credit swap premium environment persists, we may not be able to achieveprofitable growth or profits or growth at all, which may have a materialadverse effect on our financial condition and our results of operations. We cangive no assurance that the credit swap market will continue to grow as it hasin recent periods or at all or that it will not decline. Any such decline couldhave a material adverse effect on our financial condition and results ofoperations.

Prevailing interest rates affect demand for financialguaranty insurance in the public finance market. Higher interest rates may resultin declines in new bond issuances and refunding volumes which may reduce demandfor our financial guaranty products. Lower interest rates generally areaccompanied by narrower interest rate spreads between insured and uninsuredobligations resulting in lower cost savings to issuers from the use offinancial guaranty insurance than is the case during periods of higher interestrates. These lower cost savings could be accompanied by a correspondingdecrease in demand for financial guaranty insurance or lower pricing for ourproducts.

The performance of ourCDOs and our ability to originate future CDOs may be materially adverselyaffected by any of these factors or by a combination of these factors. Changesin the level of credit spreads (*i.e.*,the difference in rates between risky securities and risk remote securities,such as U.S. Treasury securities) can affect our ability to acquire financialassets for our CDOs that create sufficient spread in the transaction to pay theCDO liabilities and the fees and expenses of the CDO, including our assetmanagement fees. If we are unable to acquire assets with sufficient spread, wemay not be able to be paid all or any portion of our asset management fees onour existing CDOs and we may not be able to continue to originate additionalCDOs of the size of our current CDOs or at all. Also, the CDOs may pay returnsbelow our expectations or not pay returns at all which could negatively impactour equity returns and the overall performance of our CDOs. Poor performance inour CDOs could also hurt our reputation as an asset manager.

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**If S&P lowers the financial strength rating thatit has assigned to ACA Financial Guaranty, our ability to generate new businessin our Structured Credit and Public Finance business lines, as well as ourresults of operations and liquidity would be materially adversely affected.**

ACA Financial Guaranty, our insurance subsidiary, hasan “A” financial strength rating from S&P with a “stable” outlook. Thisrating is crucial to our Structured Credit and Public Finance businesses aswell as our ongoing business strategy. This rating is subject to periodicreview by S&P, and S&P may revise or withdraw its rating at any time atits sole discretion. Such an action may be based on factors which are entirelyoutside of our control, such as changes in the views or the policies of therating agencies in relation to the financial guaranty industry, changes to therisk profile of ACA Financial Guaranty’s insurance portfolio or to otherfactors considered by S&P in providing such rating, or adverse developmentsin general economic conditions or the financial condition or results ofoperations of ACA Financial Guaranty.

In addition, the financial strength rating offinancial guaranty companies is based in part on the maintenance of specifiedamounts of resources available to pay claims. As our business grows, we mayneed additional capital and we may not be able to raise such capital. S&P’sstable ratings outlook on ACA Financial Guaranty assumes that our insurancesubsidiaries will continue to satisfy S&P’s current minimum capitalrequirement of $300 million. As of December 31, 2006, ACA FinancialGuaranty met this capital requirement with statutory capital of $387.1 million.Further, S&P may revise its capital requirements for A-rated financialguarantor insurance companies at any time.  A change in applicable capital requirements orthe incurrence of losses in excess of our expectations could diminish ourcapital below required rating agency levels. For instance, in 2004, we had toraise capital in response to an increase in S&P capital requirements. Itmay be difficult or costly for us to raise the additional capital necessary tosatisfy the rating agency levels. Although we currently intend to operate ourbusiness in a manner that maintains our “A” rating, we are under no obligationto do so and we may not be able to do so.

If S&P were to downgrade our financial strengthrating, put us on its CreditWatch negative list or change its outlook for us tonegative, our reputation and financial performance in the structured credit andpublic finance industries could be materially adversely affected, which in turncould materially adversely impact our financial performance. CreditWatchhighlights the potential direction of a rating, focusing on identifiable eventsand short-term trends that cause ratings to be placed under specialsurveillance by S&P. Ratings appear on CreditWatch negative when such anevent or a deviation from an expected trend occurs and S&P needs additionalinformation to evaluate the rating.

Our Structured Credit business would also benegatively affected by a downgrade of ACA Financial Guaranty’s financialstrength rating to below “A” or a withdrawal of our rating. Since ACA FinancialGuaranty insures our credit swaps and our counterparties rely on ACA FinancialGuaranty’s financial strength rating when entering into transaction with us, wemight be unable to enter into any new insured credit swap transactions and wecould be required to provide collateral in the form of cash or securitiessecuring our obligations under most of our existing insured credit swaps andany new credit swaps that we may enter.

In addition, under theterms of our credit agreement, to the extent we had outstanding borrowings underthis facility, these borrowings would become due immediately, and we would beunable to make future borrowings, if our financial strength rating falls below “A-.”  Such collateral posting requirements andacceleration of our existing line of credit could severely disrupt our businessand materially negatively impact our liquidity and reputation. It could alsoseverely strain our capital resources thereby putting us at a competitivedisadvantage.

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**In our Structured Credit business we have contingentcollateral posting requirements that in adverse circumstances may severelystrain our liquidity and capital resources.**

If ACA Financial Guaranty’s financial strength ratingis downgraded below “A-,” we are required to post collateral in excess ofnegotiated threshold amounts with respect to most of our existing insuredcredit swaps in the amount of any negative mark to market fair value of thecredit swap. Additionally, should credit events or, in some circumstances,negative credit migration occur with respect to the reference entities includedin our various Structured Credit transaction portfolios resulting in lossesabove pre-agreed-upon levels or, in some circumstances, a downgrade of ourposition to below a pre-set level, we are generally required to post collateralin an amount that is the lesser of the amount by which actual losses exceedthis pre-agreed point and the amount of any negative mark to market fair valueof the credit swap. Posting collateral could materially and adversely impactour liquidity and our ability to enter into future insured credit swaps. We maynot have sufficient liquidity to meet any posting requirements depending on thesize of the negative mark and/or the level of losses at the time we arerequired to post collateral. See “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Liquidity and Capital Resources.”

**In our Structured Credit business we are dependent oncounterparties’ perception of our creditworthiness.**

Before counterparties in our Structured Creditbusiness enter into insured credit swaps with us, they analyze our financialcondition, particularly the financial condition of ACA Financial Guaranty. Theyestablish credit exposure limits to us based on their assessment of ourfinancial condition, and monitor the appropriateness of these limits on anongoing basis to limit the amount of risk they take should we be financiallyunable to make any payments we owe them. Once a counterparty reaches its creditexposure limit to us, the counterparty generally will not enter into anyadditional transactions with us until such counterparty’s credit limit with usis increased. In the event these counterparty credit limits are not increasedas our insured credit swap portfolio expands, or if limits are reduced due tochanges in our financial position or general economic conditions, prevailinglevels of credit spread or other reasons, our financial performance wouldsuffer. The growth of our Structured Credit business, in particular, will bematerially impacted if we cannot maintain and increase the lines of credit withour existing counterparties and increase the number of counterparties willingto transact with us. We can give no assurance that additional financialinstitutions will become our counterparties or that existing counterpartieswill not reduce their exposure to us.

**We may need to refinance our existing debt andotherwise require additional capital in the future, which may not be availableor may only be available on unfavorable terms.**

Tothe extent that our existing capital or the funds generated from our operationsare insufficient to meet our future requirements, we may need to raiseadditional funds through financings. If additional funds are unavailable, wemay need to curtail our growth, change our business strategy or sell assets. Inaddition, we will have to refinance our medium-term note program, which maturesin 2010 and which date is in advance of the maturity date of many of the assetsacquired with the proceeds of such issuance. See “Management’s Discussion andAnalysis of Financial Condition and Results of Operations—Liquidity and CapitalResources—Indebtedness.”  Any equity ordebt financing, if available at all, may be on terms that are not favorable tous. Equity or debt we may issue in the future may have rights, preferences andprivileges that are senior to those of the current common stock and may containcovenants or restrictions that hamper our ability to operate our business. Inthe case of equity financings, our stockholders could experience materialdilution.

We may also need to obtain reinsurance in order tocomply with state insurance regulatory and rating agency capital requirementsand single risk limits as our business grows. If we need to seek additionalreinsurance, such reinsurance may not be available at acceptable terms or atall. This could have a material adverse impact on our ability to grow ourinsurance business and could materially adversely affect our “A” rating andfuture results of operations. See “Business—Reinsurance” and “Business—Regulation.”

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**We assume construction and completion risk in ourPublic Finance transactions.**

In underwriting PublicFinance transactions, we sometimes assume exposure to the credit duringconstruction or otherwise prior to completion of the related project. In theseprojects, the risk of loss on a Public Finance transaction is typically mostsignificant during the construction and completion phases. Construction costsmay exceed expectations and available funding, and timing delays, which may becaused by construction delays, natural disasters or economic downturns thatdiminish demand for a project, will delay the production of revenue necessaryto pay debt service on the insured bonds. Delays in revenue production may alsobe caused post construction by delays in the commencement of operations. Thesedelays can be caused by a variety of factors including industry-specificconcerns such as obtaining all required regulatory approvals. Such delays inthe production of revenue may result in our payment of claims until the projectis completed and revenue generated. In the event a project is not completed, adefault of the guaranteed bonds may occur resulting in the payment of claims byus. Depending on the status of the construction, our recoveries may bematerially less than our claims paid as we rely on our security interest in theland and project itself for recoveries. Such an occurrence could negativelyimpact our results of operations. Also, should we experience a high level ofdefaults on these credits, the losses incurred could materially adverselyimpact our capital adequacy as well as our financial strength rating.

**Ourfailure to accurately set our loss reserves may result in having to increaseour loss reserves or make payments in excess of our loss reserves, which couldmaterially and adversely impact our financial condition.**

We establish loss reserveson our non-derivative financial guaranty insurance exposures. Setting our lossreserves involves significant reliance upon estimates with regard to theprobability, magnitude and timing of losses. Our reserves may prove to beinaccurate in material amounts, especially during an extended economicdownturn. As of December 31, 2006, we had non-specific loss reserves of$21.9 million and gross case specific loss reserves of $20.2 millionnet of estimated recoveries. If our loss reserves are determined to beinadequate, we will be required to increase our loss reserves which wouldresult in a corresponding reduction in our net income and stockholders’ equityin the period in which the deficiency is recognized. Sizable losses could havea material impact on our capital adequacy and, ultimately, S&P financialstrength rating. In addition, the Financial Accounting Standards Board, orFASB, is considering whether additional accounting guidance is necessaryregarding methods of determining non-specific reserves. We may be required tosignificantly increase our loss reserves or restate our current reserveallocations as a result of FASB’s review. See “Management’s Discussion and Analysisof Financial Condition and Results of Operations—Critical Accounting Policiesand Estimates.”

**We have legacy exposure on manufactured housing bondswe insured.**

In 1999, we insured 12securitized manufactured housing bonds with a collective notional balance of $213.3 million.As of December 31, 2006, four of those bonds, with an aggregate notionalbalance of $63.7 million, are underperforming and have either beenpartially written down or are at risk of being written down. As of December 31,2006, we had a reserve of $23.4 million to cover potential claims on thesefour bonds. We are currently paying claims on one bond and expect to beginpaying claims on the other three in 2007 or 2008. Our reserve represents thepresent value of expected losses, discounted at the applicable treasury rate. Thisreserve may not prove to be adequate because the underlying losses may not be****accurately predicted or our discount maybe lower than the actual discount rate and therefore we may have to paysignificantly more in claims than we have reserved. This could have a materialadverse impact on our results of operations and financial condition.

We are also currentlypaying periodic claims in respect of interest on one of the 12 insured bonds;however, as we expect to receive full recovery of such claims from payments onthe underlying loans, we have not taken loss reserves in connection with thisexposure. As of December 31, 2006, total claims paid, 

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net ofrecoveries, on this bond was $5.5 million. If, however, loss rates on theunderlying portfolio of loans are materially higher than we expect, we may notreceive some portion or any of the recoveries as we currently anticipate.

Based on our analysis, asof December 31, 2006, we believe that a reserve is not currently requiredfor any of the other manufactured housing bonds insured in 1999. Nonetheless,the current ratings on all but one of the 12 manufactured housing bonds havebeen materially downgraded from their initial ratings of “AA” and/or “Aa” byS&P, Moody’s Investor Services or Fitch Ratings Inc. and we cannot becertain that these bonds will not continue to deteriorate. We may be requiredto post additional reserves and we may have to pay claims with respect to suchbonds. We may not be able to recover the amount of such payments.

**Changesin accounting rules relating to the financial guaranty industry could havea material adverse effect on the perception of our results of operations andthat of other industry participants.**

In June 2005, the SECasked the FASB to consider the accounting by financial guaranty insurers forclaims liability recognition, premium recognition and deferred policyacquisition costs in addition to a then-existing request to review lossreserving accounting policies for the financial guaranty industry. The proposedguidance from this review is expected to be issued during 2007. When the FASBreaches a conclusion, it is possible that we and the financial guarantyinsurance industry may be required to change some aspects of our and theindustry’s relevant accounting policies. Changes in our accounting policiesrelating to the timing of premium and expense recognition could have a materialeffect on the perception of our results or operations and that of others in ourindustry. See “Management’s Discussion and Analysis of Financial Condition andResults of Operations—Critical Accounting Policies and Estimates—FASB FinancialGuaranty Insurance Project.”

**Certainof our CDOs must be consolidated in accordance with applicable accounting rules whichintroduces volatility into our balance sheet and statement of operations whichmay result in negative investor perception of us.**

Pursuant to FASB FinancialInterpretation No. 46(R) (“FIN 46(R)”), we are required toconsolidate into our balance sheet, assets and liabilities related to certainof our CDOs when we are deemed to be the primary beneficiary of the CDOvehicle. In general, this occurs when we own more than 35% of the equity of thevehicle. CDO assets are reflected on our balance sheet as fixed-maturitysecurities available for sale, at fair value. Although these CDOs areconsolidated, we do not have the right to use the assets of the CDOs forgeneral operations or in satisfaction of our corporate debt obligations.Similarly, the liabilities issued by the CDO are reflected on our balance sheetas debt. The consolidation of seven of our CDOs makes it more difficult for usto communicate economic trends and factors underlying our business.Additionally, losses in the asset portfolios that are consolidated could exceedour true economic risk. Our true economic risk is the amount of our equityinvestment in these CDOs. To the extent losses in the CDO asset portfoliosexceed our associated equity investment, the financial statement impact isoffset at CDO maturity, when the associated liabilities are written off;however, the potential interim mismatch may be significant and vary from periodto period, which may not be understood by the market. This volatility couldcause a negative investor perception of us and negatively impact our stockprice. Pursuant to FIN 46(R), we are also required to consolidate thetotal assets of our Credit Fund. This consolidation presents the same issues interms of an investor’s ability to understand our financial statements andfinancial condition and their potential perception of us. See “Management’sDiscussion and Analysis of Financial Condition and Results of Operations—CriticalAccounting Policies and Estimates—Consolidation of Variable Interest Entities(VIE) and Other Restricted Investments.”

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**Ournet income may be volatile from reporting period to reporting period because aportion of the credit risk we assume is in the form of insured credit swaps anda number of our consolidated CDOs utilize interest rate swaps, both of whichare derivatives and are accounted for under FAS 133/149, requiring thatthese instruments be marked to market.**

As credit spreads increaseor decrease, the spreads on the underlying assets included in our portfoliosreferenced by our insured credit swaps in our Structured Credit and syntheticCDO transactions will also increase or decrease, which will result in changesto the fair value of the credit swaps. Furthermore, changes in demand for suchproducts, changes in the applicable legal and regulatory environments andoverall growth in this sector can also affect the fair value of our creditswaps. Our insured credit swaps meet the definition of derivatives underStatement of Financial Accounting Standards Nos. 133 and 149 (“FAS 133/149”).Derivatives must be accounted for either as assets or liabilities on thebalance sheet and measured at fair mark to market value. Since market pricesare generally not available on our insured credit swaps we estimate the fairvalue of these swaps by using modeling methodologies which may be less precise thanusing quoted market price. Although there is no cash flow effect from this “markingto market” as we enter into these insured credit swaps with an intent that theyremain outstanding to maturity, changes in the fair value of the derivative arereported in our consolidated statement of operations, together with the fixedpremiums payable to us under the contract, in net insured credit swap revenueand other net credit swap revenue and therefore will affect our reportedearnings. The impact from this marking to market on our reported earnings couldvary significantly from period to period. Volatility in our reported earnings,even if there is no ultimate cash impact, could cause a negative investorperception of us and negatively impact our stock price.

Common events that maycause credit spreads to fluctuate on the underlying assets included in theportfolios referenced by our credit swaps include changes in the state ofnational or regional economic conditions, industry cyclicality, changes in thebusiness or financial assets of a specific issuer of the underlying assets includedin a referenced portfolio, such as the issuer’s competitive position within anindustry, management changes, changes in the ratings of the underlyingsecurity, movements in interest rates, default or failure to pay interest, orany other factor leading investors to revise expectations about such issuer’sability to pay principal and interest on its debt obligations. These events areoutside of our control. Similarly, common events that may cause credit spreadson an underlying structured security referenced by a credit swap to fluctuatemay include the occurrence and severity of collateral defaults, changes indemographic trends impacting the levels of credit enhancement, rating changes,changes in interest rates or prepayment speeds, or any other factor leadinginvestors to revise expectations about the risk of the collateral or theability of the servicer to collect payments on the underlying assets sufficientto pay principal and interest.

In addition, our netincome may be volatile due to the inclusion of interest rate swaps in certainof our CDO transactions, which must be marked to market under FAS 133/149.We use interest rate swaps to hedge the exposure to variable interest rateswithin our CDOs. These interest rate swaps also provide a cost effective formof financing for the placement fees and other initial costs of those CDOs.Interest rate swaps are derivatives under FAS 133/149 and are required tobe marked to market; however, that portion of the mark to market associatedwith the financing of placement fees and other initial costs are required toflow through the consolidated statement of operations, and are recorded in netrealized and unrealized gains (losses) on derivative instruments rather thanbeing recorded directly in stockholders’ equity on our balance sheet wherestandard interest rate hedges would be recorded. This increases the volatilityin our reported earnings which may be confusing to stockholders or, in the caseof negative marks, materially adversely impact investors’ perception of uswhich could negatively impact our stock price.

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**We operate in competitive environments.**

The credit swap market islarge, quickly evolving and highly competitive. Most of our competitors aremore established, have long-term relationships with market participants andhave substantially greater financial resources than we have. Additionally, nosignificant regulatory impediments necessarily exist for new participantsentering the credit swap market under different business models, such asnon-insurance business models. To the extent that new participants enter thecredit swap market, competition may intensify further. We cannot assure youthat increased competition will not materially and adversely affect the volume,pricing and the profitability of this business.

The competitiveenvironment for our Public Finance business principally comes from other formsof credit enhancement and the high yield municipal funds that are purchasing anincreasing amount of high non-investment grade and unrated municipal debt. Continuedgrowth by such competitors may reduce the demand for our financial guarantyinsurance product. Currently no other “A” rated entities provide financialguaranty insurance. That could change, which could negatively impact ourcompetitive standing.

The market for CDO AssetManagement services is highly competitive with low barriers to entry. Wecompete for assets with other managers with greater resources. Competition forassets of the types and classes in which our CDOs invest may lead to increasingasset prices which may further limit our ability to generate our desiredreturns. Also, as spreads tighten, the competition to acquire financial assetswith sufficient spreads to generate the returns required by our CDO investorswill increase, limiting our ability to originate profitable CDOs and toreinvest our current CDOs so as to sustain our historical performance. Inaddition, some of our competitors may have higher risk tolerances or differentrisk assessments, which could allow them to consider a wider variety oftransactions and establish more relationships than we can. If we are unable toacquire enough assets with sufficient spreads, our performance may suffercompared to our competitors. Should this occur, even for a short period, our financialresults may be significantly and quickly negatively impacted.

Further, increasingcompetition in the origination of CDOs generally could negatively impact ourability to attract investors in our CDOs and therefore our ability to continueto generate CDOs and increase our assets under management. In addition, newentrants into the CDO asset management realm may cause a decrease in the rateof fees paid to asset managers and therefore also negatively impact ourprofitability.

Additionally, in ourStructured Credit business, we are seeing the introduction of derivativeproducts companies, or DPCs, which are will be competing with us in this sector.This increased competition could result in spread compression and make it moredifficult for us to price our deals to achieve our minimum risk-adjustedreturns.

See “Business - Competition.”

**Wemay experience fluctuations in quarterly and annual results due to the limitednumber of transactions we enter into in a given period.**

During any given quarteror year we enter into a limited number of transactions in each of our lines ofbusiness and we do not set performance targets based on closing a specifiednumber of transactions or writing or insuring a specific notional or par amountin any particular quarter or year. Our targets are based on other metrics, suchas aggregate fixed premiums, earned or written premiums or assets undermanagement, as appropriate to our different business lines. This permits us toselect only those opportunities, if any, that meet our risk-adjustedexpectations, thereby maximizing our profitability. The transactions in whichwe participate are often highly negotiated and often take significant time toanalyze, underwrite and close. Our Structured Credit and Public Financebusinesses may elect to not transact if attractive opportunities areunavailable. In addition, while we intend to grow our CDO assets undermanagement, we may not be able to sponsor a significantly increasing number ofCDOs from year to year 

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due toinvestor demand, marketing considerations, asset availability and pricingconsiderations. Accordingly, we can provide no assurance that we will enterinto a minimum level of transactions in any given period. As a result, ourfinancial performance and growth will vary significantly depending on marketconditions and the timing and closing of opportunities available to ourbusiness lines. As a result, our financial performance will likely varysignificantly from quarter to quarter and the operating results for any quartershould not be deemed indicative of results for any future period. See “Management’sDiscussion and Analysis of Financial Condition and Results of Operations—Overview.”

**We have a limited operating history.**

We and our subsidiariesare relatively new entities with narrow business focuses and limited operatinghistories. As a result, there is limited historical financial and operatinginformation available to help you evaluate our past performance. We have notoperated our business in a long-term significantly recessionary environment ora long-term inflationary environment. As a result, there is limited historicalinformation available to help you evaluate what our track record may be duringsuch economic cycles.

**Future growth into international markets is subject toadditional risks that are beyond our control.**

Our business strategycontemplates expanding portions of our business into foreign markets. Forexample, we have formed a subsidiary in Singapore through which we have enteredthe Asian structured credit markets, and have also formed another subsidiarythat recently obtained a license as an investment manager in the United Kingdomthrough which we will participate in the European CDO asset management markets.We may not be successful in developing the necessary business relationships togrow our activities in these jurisdictions. If we are able to implement thesestrategies, we will be subject to the significant additional risks associatedwith doing business abroad, including, without limitation: currency exchangefluctuations; the imposition of new laws and regulations; financial reportingaccording to the standards of non-U.S. jurisdictions; restrictions on thetransfer of funds; changes in local economic conditions; and the ability tointegrate our international business and employees separated by large distancesand different time zones effectively and efficiently into our overalloperations and control systems. Our inability to effectively manage these risksand other factors that may be beyond our control could have a material adverseeffect on our business, financial condition and operations.

**Our continued growth into additional product areas andmarkets could strain our resources.**

Since 2001, we havesignificantly increased the scope of our financial guaranty operations,including expanding into insuring credit swaps, and have entered into marketsin which we previously did not conduct business, including the origination,structuring and management of our CDOs. We continue to focus on growing ourbusiness lines and building new products, which could place a strain on ourmanagement, other personnel, resources and financial reporting systems infuture periods. To implement our business strategy, we will need to evaluatecontinually and, where necessary, upgrade our operating and financial systems,procedures and controls, as well as personnel resources. In addition, as partof our business strategy, we plan on entering into new product areas andmarkets and we may not effectively anticipate the required resources, relevantrisks and management challenges to sustaining these operations. We may not beable to effectively manage new operations or successfully integrate them intoour existing operations. If we do not accurately anticipate requiredimprovements in controls or systems and necessarily increases in personnel, ourbusiness and results of operations could be materially and adversely affected.

**Weare a holding company and our cash flow is dependent on payments by oursubsidiaries, which are subject to significant limitations.**

We are a holding companyand, as such, conduct our operations primarily through our subsidiaries. Asignificant portion of our cash flow consists primarily of dividends and otherpermissible payments from 

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oursubsidiaries, plus income on any proceeds of potential financings that weretain at the holding company level. We depend on such payments to meet ourobligations, including the payment of interest and principal on our debt. Themajority of such dividend payments are subject to ACA Financial Guaranty’sability to pay dividends, since we operate most of our lines of businessthrough ACA Financial Guaranty or its subsidiaries. For more informationregarding these restrictions, see “Business—Regulation.”  Our cash flow is further constrained becausefunds available to us from four of our CDOs are pledged as collateral or areused to make required payments in connection with our equity financing on thoseCDOs. See “Management’s Discussion and Analysis of Financial Condition andResults of Operations—Liquidity and Capital Resources.”

While in the past theCommissioner of the Maryland Insurance Administration has consented to thepayment of certain dividends, we cannot be certain that the Maryland InsuranceCommissioner will continue to consent to such payments or other similarpayments in the future. The inability of ACA Financial Guaranty to paysufficient dividends and to make other permitted payments to us could have amaterial adverse effect on our ability to satisfy our ongoing operating expenses,debt service and other cash requirements, as well as our ability to paydividends on our common stock in the future.

**Ourlevel of indebtedness could adversely affect our operations and growth andcould limit our ability to react to changes in the economy or the markets inwhich we compete.**

As of December 31,2006, we had approximately $4,903.7 million of short-term debt, long-term debtand related party debt outstanding, of which approximately $4,732 millionrelated to the liabilities of our consolidated CDOs, $100 million related tothe investment agreement of our special purpose subsidiary ACA ParliamentFunding, L.L.C., $79.9 million related to our obligations under certaintrust preferred securities and $12 million related to other corporate debtoutstanding. In addition, we have entered into a $75 million unfunded lineof credit. We may also incur additional indebtedness in the future to fundacquisitions, working capital and growth in our business or for other generalcorporate purposes. Our level of corporate debt increases our vulnerability tocompetitive pressures and to general adverse economic, market or industryconditions and reduces the availability of cash flow for working capital andother general corporate purposes. This could limit our ability to compete andour flexibility in planning for, or reacting to, changing business, industry oreconomic conditions. See “Financial Statements and Supplementary Data—Note 10.”

**We may incur liabilities because of the unconditionalnature of our financial guaranty insurance policies.**

Issuers whose obligationswe insure may default on those obligations because of fraudulent or otherintentional misconduct. Financial guaranty insurance is unconditional and doesnot provide for any exclusion of liability based on fraud or other misconduct.Despite any risk analysis we conduct, it is impossible to predict fraud orother intentional misconduct, or whether or to what extent we will have anyremedy against any party in connection with such conduct. Payment of any suchclaims could have a material adverse effect on our financial condition andresults of operations.

**If our investments perform poorly, our financialresults and ability to conduct business could be harmed.**

Our operating results areaffected by the performance of our and ACA Financial Guaranty’s investmentportfolios.

Ourand ACA Financial Guaranty’s investment portfolios are subject to:

·       marketvalue risk, which may be due to a change in the yields realized on theinvestment portfolios and prevailing market yields for similar assets, anunfavorable change in the liquidity of the investments or an unfavorable changein the financial prospects or a downgrade in the credit rating of the issuersof the securities in the investment portfolios;

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·       defaultrisk, which is the risk that some of the investments will not pay principal orinterest owed to us when due; and

·       reinvestmentrisk, which is the risk that interest rates and credit spreads will decline andfunds reinvested will earn less than expected.

Interest rates and creditspreads are highly sensitive to many factors, including governmental monetarypolicies, domestic and international economic and political conditions andother factors beyond our control. We may not be able to mitigate these riskseffectively.

**Hedging transactions may limit our income or result inlosses.**

We have and may in thefuture engage in hedging transactions to manage our credit risk exposure acrossour business lines and in our and ACA Financial Guaranty’s investment portfolios.We have and may also in the future engage in certain hedging transactions tolimit our exposure to changes in interest rates, currency exchange rates andother financial market changes. Hedging does not prevent losses or eliminatethe possibility of fluctuations or prevent losses, and could result inadditional losses. Also, certain hedging transactions may limit the opportunityfor income or gain if rates change favorably. Moreover, it may not be possibleto hedge against potential risk of loss or expected rate fluctuations at anacceptable price. Additionally, ACA Financial Guaranty would have to obtainregulatory approval before entering into such transactions in relation to itsinvestment portfolio and we may not be able to obtain such approval.

**Weare highly dependent on information systems and third parties, and systemsfailures could significantly disrupt our business.**

Our businesses are highlydependent on communications and information systems. Any failure orinterruption of our systems could cause delays or other problems in our tradingactivities and our ongoing credit analysis and risk management assessments.This could have a material adverse effect on our operating results.

**We are dependent on key executives.**

Our future success dependsto a significant extent on the efforts of our executive management. We have onekey man insurance policy in effect, which is for our President and ChiefExecutive Officer, Alan S. Roseman. We do not have key man insurance policiesin effect for other members of senior management. We currently have employmentagreements with these individuals, but employment agreements do not assureretention. We believe that there are a limited number of available, qualifiedexecutives with relevant experience in the insurance, capital markets andcredit swap industries, and our inability to hire additional senior executivesor the loss of the services of any of these individuals could adversely affectour business. Failure to retain or attract key personnel could have a materialadverse effect on us.

**Inour Public Finance business we insure low investment grade and highnon-investment grade credit risks which may require significant loss mitigationefforts.**

Given the nature of our Public Finance portfolio,which is predominantly comprised of low investment grade and highnon-investment grade credits, at any given time we are engaged in work-outstrategies with a number of our credits to minimize or eliminate the potentialfor future losses. Such activities may result in increased loss adjustmentexpense, or LAE, reserves which could materially and adversely impact ourresults of operations in the periods such reserves are recorded. In addition,our work-outs may not be successful, which could result in our paying claimswhich could be significant. See “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Critical Accounting Policies andEstimates—Loss and Loss Adjustment Expenses.”

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**In our CDO Asset Management business we are subject totermination under the provisions of our investment advisory agreements.**

Generally, our services asasset manager may be terminated without cause by a vote of a majority of eachclass of debt securities and the equity tranche of a CDO. We may also beremoved “for cause” upon the occurrence of certain events on the affirmativevote of a majority of the senior debt or a majority vote of the equity. Incertain of our investment management agreements, substantial employeedepartures amongst CDO Asset Management and certain other key personnel within,most typically, a 12-month period constitutes a basis for our removal asasset manager. If we are removed as asset manager from one or more of our CDOs,it could have a significant negative impact on our reputation in the market andcould have a material adverse effect on our results of operations, our abilityto do new CDOs and our ability to be retained as an asset manager for our otherCDOs.

**We may be precluded from participating in certainopportunities that we otherwise would participate in due to our role as a CDOasset manager and potential conflicts of interest.**

In addition to providingmanagement services to CDOs originated and structured by us, we also providemanagement services to the Credit Fund, portfolios structured by third partiesand take credit risk directly. Conflicts may exist for us in addressing thesevarious roles and interests. We have developed an allocation policy and intendto act in a manner that is fair and equitable in allocating businessopportunities and to follow our conflict resolution process should conflictsoccur; however, because of these potential conflicts, we may not be able toparticipate in certain opportunities on a proprietary basis which opportunitiesotherwise meet our business objectives. Our inability to pursue certainopportunities due to conflicts of interest could have an adverse impact on ourfuture results of operations.

**Risks Related tothe Regulation of Our Businesses**

**The regulatory systems under which we operate, andpotential changes in regulation, could significantly and adversely affect ourbusiness.**

We operate in a highly regulated industry, and theseregulations can restrict our ability to take actions or conduct our businessfor the ultimate benefit of our stockholders. Our operations may become subjectto increased regulation, and applicable federal and state law or existingregulations may change, which may result in administrative burdens, increasedcosts or other adverse consequences to us. For example, proposals have beenmade in Congress to enact legislation that would increase regulation of thecredit swap market. We cannot predict what restrictions any such legislation,if adopted, would impose and the effect those restrictions would have on ourbusinesses. In addition, we may not accurately predict the effects ofregulation that will be imposed on our business as we continue to enter intoand expand our operations in international markets. Furthermore, regulatorychanges can also impact our counterparties or other persons we do business withand may make our products less attractive to third parties.

We are subject to the insurance holding company law ofthe State of Maryland, where ACA Financial Guaranty is organized and domiciled.This law generally requires each domestic insurance company directly orindirectly owned by a holding company to register with the Maryland InsuranceCommissioner and to furnish financial and other information annually and periodicallyupon the occurrence of material events. Generally, all inter-companytransactions between us or any affiliate and ACA Financial Guaranty in theholding company system must be fair and, if material, require prior notice toand approval by the Maryland Insurance Commissioner.

ACA Financial Guaranty is licensed to write financialguaranty insurance in all 50 states of the United States, the District ofColumbia, Guam, Puerto Rico and the U.S. Virgin Islands. State insurance lawsregulate many aspects of ACA Financial Guaranty’s insurance business and stateinsurance departments supervise its insurance operations. The purpose of thestate insurance regulatory statutes is to protect 

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policyholders, notstockholders. Among other things, Maryland insurance regulation requires ACAFinancial Guaranty to maintain minimum levels of capital, surplus andliquidity, and imposes restrictions on the payment of dividends anddistributions. These statutes and regulations may, in effect, restrict theability of ACA Financial Guaranty to write new business or, as discussed under “Business—Regulation,”distribute funds to us. Also, because ACA Financial Guaranty is authorized toact as a foreign insurer in New York, it is also required to complysubstantially with any requirement or limitation specified in the New YorkInsurance Law that is applicable to similar domestic insurers in New York. Inrecent years, the state insurance regulatory framework has come under increasedfederal scrutiny, and some state legislatures have considered or enacted lawsthat may alter or increase state authority to regulate insurance companies andinsurance holding companies. Although not located or domiciled in the otherjurisdictions in which ACA Financial Guaranty writes business, in order tomaintain its licenses in those jurisdictions it is also subject to regulationin those states and territories as well. If ACA Financial Guaranty fail tocomply with the various state insurance regulations applicable to it, it couldexperience material fines and potentially have its license withdrawn in therelevant jurisdiction, which could materially interfere with its ability towrite insurance policies in the future.

Certain states have financial guaranty insurancestatutes that require an insurer to maintain a ratio of investment grade tonon-investment grade and unrated financial guaranty policies. In New York, forexample, an insurer may insure municipal obligation bonds, special revenuebonds and industrial development bonds that are not investment grade, so longas at least 95% of the insurer’s aggregate net liability on those kinds ofobligations is investment grade. California has a similar statute.Additionally, these statutes include single risk limitations and aggregate risklimitations, which limit the amount of exposure that we may incur to a singleentity from a single revenue source, in the case of single risk, or, in thecase of aggregate risk, the aggregate amount of exposure that we may incur ascompared to our surplus available to policyholders and contingency reserve.While we believe ACA Financial Guaranty is not contravening these statutes, theapplicable state regulators may not agree with our interpretation of theapplication of the statutes. If the regulators of these states do not agreewith our interpretation of these statutes, they may prohibit ACA FinancialGuaranty from writing financial guaranty insurance in that state in the futureor require us to change what insurance it writes which could materially andadversely impact our results of operations.

See “Business—Regulation.”

**If we were required to register as an investmentcompany under the Investment Company Act of 1940, it could limit our growth andincrease our costs; maintaining our exempt status may limit our options in thefuture.**

We believe that we are not required to be registeredas an “investment company” under the Investment Company Act of 1940, orInvestment Company Act, because we do not meet the definition of an “investmentcompany” under the Investment Company Act. Specifically, we believe that we arenot an investment company because, as of December 31, 2006, approximately85% of our total assets on an unconsolidated basis, exclusive of governmentsecurities and cash items, represent our 100% indirect ownership interest inACA Financial Guaranty, a regulated insurance company. We believe that ACAFinancial Guaranty satisfies the requirements to be an “insurance company” asdefined in the Investment Company Act and thus does not fall within the definitionof an investment company. ACA Financial Guaranty is primarily and predominantlyengaged in writing insurance and insurance-related products and is licensed toprovide financial guaranty insurance in all 50 states, the District ofColumbia, Guam, Puerto Rico, and the U.S. Virgin Islands. Our financialguaranty insurance lines of business collectively produce the majority of ACAFinancial Guaranty’s net income on an unconsolidated basis. ACA FinancialGuaranty provides financial guaranty insurance policies for our Public Financebusiness, for the insured 

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credit swaps in ourStructured Credit business and for certain other transactions described in “Management’sDiscussion and Analysis of Financial Condition and Results of Operations—Other.”

If we cannot rely on theexemptions or other exclusions from registration as an investment company orour business or financial condition changes in a way that could make us aninvestment company, we could, among other things, be required either (a) tochange the manner in which we conduct some of our operations (including byforgoing otherwise attractive business opportunities) to avoid being requiredto register as an investment company, (b) to restructure our corporatestructure or (c) to register as an investment company. There may besignificant negative financial implications associated with changing ourcorporate structure or changing the manner in which we conduct our operationsto maintain our exempt status under the Investment Company Act. If we wererequired to register as an investment company, we would have to comply with avariety of restrictions, including limitations on our capital structure,restrictions on our investments, prohibitions on transactions with affiliatesand compliance requirements that could limit our growth and increase our costs.There is no assurance that we could function effectively if we were required toregister as an investment company.

**Our subsidiary, ACA Management, is a registeredinvestment adviser under the Investment Advisers Act of 1940 and if ACAManagement fails to comply with applicable related regulation we may not beable to continue to grow our CDO Asset Management business in accordance withour business plan.**

Our subsidiary, ACAManagement, is a registered investment adviser under the Investment AdvisersAct, and our asset management activities are regulated by the SEC. While webelieve that ACA Management is in material compliance with applicableregulation, it is subject to regular examinations and “theme audits” which maybe conducted by the SEC at any time. ACA Management’s failure to remain instrict compliance with these regulatory requirements could result indisciplinary action which could include material fines or the suspension orrevocation of its investment adviser registration. Any such enforcement actionmay negatively impact the results of our CDO Asset Management business.

**ACA Capital Management (U.K.) is authorized andregulated by the FSA in the United Kingdom and if ACA Capital Management (U.K.)fails to comply with applicable related regulation we may not be able tocontinue to grow our CDO Asset Management business in accordance with ourbusiness plan.**

Our subsidiary, ACA Capital Management (U.K.), isauthorized and regulated by the FSA in the United Kingdom, and its investmentmanagement activities are regulated by the FSA.  While we believe that ACA Capital Management (U.K.) is in material compliance withapplicable regulation, it is subject to regular examinations which may beconducted by the FSA at any time. ACACapital Management (U.K.)’s failure to remain in strict compliance withthese regulatory requirements could result in disciplinary action which couldinclude material fines or the suspension or revocation of its investmentmanagement license. Any such enforcement action may negatively impact theresults of our CDO Asset Management business.

**Our ability to implement, for the fiscal year ended December 31,2007, the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 ina timely and satisfactory manner could materially impact our business and causethe price of our common stock to fall.**

We are presentlyevaluating our existing internal controls with respect to the standards adoptedby the Public Company Accounting Oversight Board. We cannot be certain at thistime that we will be able to successfully and satisfactorily complete theprocedures, certification and attestation requirements of Section 404 ofthe Sarbanes-Oxley Act of 2002 by the time that we are required to file ourAnnual Report on Form 10-K for the year ended December 31,2007, which is the first time that our management and our outside auditors willbe required to deliver reports on our internal controls and procedures inaccordance with the Sarbanes-Oxley Act of 2002. Uncertainty as to our abilityto comply with such requirements or any material weaknesses uncovered as aresult of such procedures could have a material adverse effect on our 

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businessesand the trading price of our common stock. In addition, we may incur increasedcosts associated with such procedures or a diversion of internal resourcesnecessary to prepare for or comply with such requirements.

**Changes in tax lawscould affect the demand for our services and products.**

Any material change in theU.S. or foreign tax treatment of CDOs or investors in CDOs, credit swaps ormunicipal securities could adversely affect the demand for our services andproducts. Future potential changes in U.S. tax laws, such as the imposition ofa “flat tax” or the imposition of a national sales tax in lieu of the currentfederal income tax structure, could adversely affect the market for municipaland other public finance obligations and, consequently, reduce the demand forfinancial guaranty insurance of such obligations.

**Risks Related toOur Common Stock**

**We do not currentlyintend to pay dividends in the foreseeable future.**

It is uncertain when, ifever, we will declare dividends to our stockholders. During the next few yearsof operations, we expect that we will retain all profits. Our ability to paydividends may be constrained by our holding company structure under which weare substantially dependent on payments by our subsidiaries, which are subjectto limitations imposed on them by Maryland law, in the case of ACA FinancialGuaranty, or otherwise with respect to our other subsidiaries. See “Business—Regulation”and Part II, Item 5 of this report. You should not rely on an investmentin us if you require dividend income.

**Insiders have substantial control over us and thiscould limit your ability to influence the outcome of key transactions,including a change in control.**

Our directors, executiveofficers and principal stockholders and entities affiliated with thembeneficially own approximately 61% of our outstanding shares of common stock.As a result, these stockholders, may be able to influence or control mattersrequiring approval by our stockholders including the election of directors andthe approval of mergers or other fundamental transactions. In addition, severalof our largest stockholders have entered into a stockholders agreement and havethe right to nominate directors to our Board of Directors and its committees. Thestockholders agreement in part provides that the parties thereto shall vote forcertain nominees to our board of directors. The level of these rights depend onthe amount of our common stock that such stockholder holds. These stockholdersmay thereby exercise significant control and influence in corporate matters. Suchstockholders may also have interests that differ from yours and may vote in away with which you disagree and which may be adverse to your interests. Theconcentration of ownership may have the effect of delaying, preventing ordeterring a change in control of the Company, could deprive our stockholders ofan opportunity to receive a premium for their shares of common stock as part ofa sale of the Company and might ultimately affect the market price of ourcommon stock.

**Conflicts ofinterest may arise because some of our directors are principals of ourstockholders.**

Our Board of Directorsincludes representatives from BSMB/ACA LLC, SF Holding Corp. (f/k/a StephensGroup, Inc.), Chestnut Hill ACA, LLC and Third Avenue Trust. Thosestockholders and their respective affiliates may invest in entities thatdirectly or indirectly compete with us or companies in which they are currentlyinvested may already compete with us. As a result of these relationships, whenconflicts between the interests of those stockholders or their respectiveaffiliates and the interests of our other stockholders arise, these directorsmay not be disinterested. Under Delaware law, transactions that we enter intoin which a director or officer has a conflict of interest are generallypermissible so long as (1) the material facts relating to the director’sor officer’s relationship or interest as to the transaction are 

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disclosedto our Board of Directors and a majority of our disinterested directorsapproves the transaction, (2) the material facts relating to the director’sor officer’s relationship or interest as to the transaction are disclosed toour stockholders and a majority of our disinterested stockholders approves thetransaction, or (3) the transaction is otherwise fair to us. The BSMB/ACALLC, SF Holding Corp., Chestnut Hill ACA, LLC and Third Avenue Trustrepresentatives on our Board of Directors and the representatives of certain ofour other significant stockholders, should they become members of our Board ofDirectors, by the terms of our Certificate of Incorporation, are not requiredto offer us any transaction opportunity of which they become aware and couldtake any such opportunity for themselves or offer it to other companies inwhich they have an investment, unless such opportunity is expressly offered tothem solely in their capacity as a director of the Company.

**Applicableinsurance laws may make it difficult to effect a change in control of ourcompany.**

The insurance law of Maryland prevents any person fromacquiring control of ACA or of ACA Financial Guaranty unless that person hasfiled a notification with specified information with the Commissioner of theMaryland Insurance Administration and has obtained his or her prior approval.Under Maryland law, acquiring 10% or more of the voting stock of an insurance companyor its parent company is presumptively considered a change in control, althoughsuch presumption may be rebutted. Accordingly, any person who acquires,directly or indirectly, 10% or more of the voting securities of ACA without theprior approval of the Commissioner of the Maryland Insurance Administrationwill be in violation of this law and may be subject to injunctive actionrequiring the disposition or seizure of those securities by the Commissioner ofthe Maryland Insurance Administration or prohibiting the voting of thosesecurities and to other actions determined by the Commissioner of the MarylandInsurance Administration. In addition, many state insurance laws require priornotification to state insurance departments of a change in control of anon-domiciliary insurance company doing business in those states. While thesepre-notification statutes do not authorize the state insurance departments todisapprove the change in control, they authorize regulatory action, includingrevocation of ACA Financial Guaranty’s license, in the affected state ifparticular conditions exist such as undue market concentration. Any futuretransactions that would constitute a change in control of ACA may require priornotification in those states that have adopted pre-acquisition notificationlaws. Given the importance of ACA Financial Guaranty’s “A” rating to ourbusinesses, as a practical matter, a change in control would requireconfirmation in advance from the rating agencies that such transaction wouldnot result in a downgrading of the financial strength rating assigned to ACAFinancial Guaranty. See “Business—Regulation.”

The foregoing legalrestrictions will have the effect of rendering more difficult or discouragingunsolicited takeover bids from third parties or the removal of incumbentmanagement.

**We have anti-takeover defenses that could impede anacquisition or an attempt to replace or remove our directors, which coulddiminish the value of our common stock.**

We have not opted out of Section 203 of the DelawareGeneral Corporation Law, an anti-takeover law. In general, Section 203prohibits a publicly-held Delaware corporation from engaging in a “businesscombination” with an “interested stockholder” for a period of three yearsfollowing the date the person became an interested stockholder, unless (withcertain exceptions) the “business combination” or the transaction in which theperson became an interested stockholder is approved in a prescribed manner. Generally,a “business combination” includes a merger, asset or stock sale, or othertransaction resulting in a financial benefit to the interested stockholder.Generally, an “interested stockholder” is a person who, together withaffiliates and associates, owns (or within three years prior to the determinationof interested stockholder status, did own) 15% or more of a corporation’svoting stock. The existence of this provision would be expected to have ananti-takeover effect with respect to transactions not approved in advance by 

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the Board of Directors, includingdiscouraging attempts that might result in a premium over the market price forthe shares of common stock held by stockholders.

As such, this provision ofDelaware law and certain provisions of our Certificate of Incorporation andBylaws could make it more difficult to acquire us by means of a tender offer, aproxy contest or otherwise, and to remove incumbent officers and directors. Theseprovisions have the effect of discouraging, delaying or preventing hostiletakeovers, including those that might result in a premium being paid over themarket price of our common stock, and discouraging, delaying or preventingchanges in control or our management.

**Item 1B.**               UnresolvedStaff Comments.

None.

**Item 2.**                        Properties.

The principal executiveoffice of the Company is located at 140 Broadway, New York, New York 10005, andconsist of approximately 50,000 square feet of office space. The Company andits subsidiaries also maintain leased space in London (England), Singapore andOrlando (Florida). The Company and its subsidiaries do not own any materialreal property. The Company believes that these facilities are adequate andsuitable for its current needs. The Company’s telephone number at its principalexecutive office is (212) 375-2000.

**Item 3.**                        LegalProceedings.

In the normal course ofbusiness, we may become involved in various claims and legal proceedings,including claims involving employee-related matters. We are not aware of anypending or threatened material litigation which we believe could reasonably belikely to result in a material adverse effect on us or our financial position,results of operations and cash flows.

**Item 4.**                        Submissionof Matters to a Vote of Security-Holders.

On November 9, 2006, our security holders votedthrough written consent to approve a Certificate of Amendment to ourCertificate of Incorporation (the “November Charter Amendment”). The November CharterAmendment revised the definition of “Qualified Public Offering” to include anunderwritten public offering through a nationally recognized underwriter ofcommon stock sold in a registration effected under the Securities Act of 1933,as amended (the “Securities Act”), which results in net proceeds to theCorporation of at least $75 million. On November 13, 2006, the November CharterAmendment was filed with the Secretary of State of the State of Delaware. Thisaction was taken by the affirmative vote of (i) 89.3% of the Company’sseries B senior convertible preferred stock and (ii) 79.6% of all of theCompany’s outstanding stock.

On November 9, 2006,our security holders also voted through written consent to approve Amendment No. 3to the Company’s Stockholders Agreement. This amendment also revised thedefinition of “Qualified Public Offering” to include an underwritten publicoffering through a nationally recognized underwriter of common stock sold in aregistration effected under the Securities Act of 1933, as amended, resultingin net proceeds to the Corporation of at least $75 million. This action wastaken by the affirmative vote of (i) 89.3% of the Company’s series Bsenior convertible preferred stock and (ii) 79.6% of all of the Company’soutstanding stock.

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**PART II**

**Item 5.**                        Marketfor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities.

**Use of Proceeds**

On November 9, 2006, the SEC declared effectiveour Registration Statement in connection with our IPO. The underwriters wereCredit Suisse Securities (USA) LLC, J.P. Morgan Securities Inc., Bear Stearns &Co. Inc., Stephens Inc. and Keefe, Bruyette & Woods, Inc. Ouroffering did not terminate before any securities were sold, but as of the dateof the filing of this report, our offering had terminated and 6,875,000 sharesof our common stock were sold by us.

All 6,875,000 shares of our common stock registered inour offering were sold by us at a price per share of $13.00. The aggregatepurchase price of the offering was $89.4 million and we incurred totalestimated expenses, including the underwriters’ discount and commissions andtransaction expenses paid to unaffiliated third parties in connection with theoffering, of approximately $10.1 million. The net offering proceeds to us afterdeducting these expenses was approximately $79.3 million.

Of the $79.3 millionraised for the account of the Company, as of December 31, 2006, $10.0million and approximately $4.9 million were contributed to ACA FinancialGuaranty and ACA CapitalManagement (U.K.), respectively, to support the continuing growth of ACAFinancial Guaranty and the start-up costs of ACA Capital Management (U.K.), an additional $21.8 million wasinvested in certain Company-managed investment vehicles, including the CreditFund and approximately $5.7 million was used to purchase equity in certain ofthe Company’s recent CDOs. In first quarter 2007, we contributed an additional$10.0 million to one of our subsidiaries to fund an additional investment inthe Credit Fund, purchased $2.5 million in equity of a CDO and refinanced anintercompany note in the amount of $4.3 million. The balance of approximately$20.1 million has been retained at the holding company. We continue to expectthat the remainder of the proceeds from the IPO will be used for investments,as working capital and for general corporate purposes. Pending such uses, thebalance of the approximately $20.1 million is currently invested by us inshort-term investments.

**Market Information**

Our common stock is listed on the New York StockExchange under the symbol “ACA”. The table below sets forth, for thequarter indicated, the high and low sales prices per share of our common stock.No dividends have been declared.

| **2006:**       | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------|------------|----------|------------|---------|------------|
| Fourth Quarter* |       | $        | 15.52      |    | $          | 12.60 |   |
|                 |            |          |            |         |            |  |  |

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*                    Ourcommon stock began trading on November 10, 2006.

**StockholderInformation**

As of March 27, 2007,there were 74 stockholders ofrecord of our common stock.

**Dividend andDistribution Information**

Other than a stockdividend declared on our common stock to effect a six-to-one stock split on August 23,2006, we have not paid, and we do not intend to pay, dividends on our commonstock for the foreseeable future. We plan to retain our earnings for use in theoperation of our business and to fund future growth. Any determination to paycash dividends in the future will be at the discretion of the Board ofDirectors.

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**Equity CompensationPlan**

The information requiredby this part of Item 5 is incorporated by reference to, and will be containedin, our definitive proxy statement, which we anticipate will be filed no laterthan April 30, 2007. Accordingly, we have omitted the information fromthis part of Item 5 pursuant to General Instruction G (3) of Form 10-K.

**Stock Performance**

The following graph sets forth the cumulative return on our common stock sinceNovember 10, 2006, the date on which our stock commenced trading on theNYSE, as compared to cumulative return of the Russell 2000 Index and anindustry peer group, or the Peer Group, consisting of Assured Guaranty Ltd.,Security Capital Assurance Ltd, Radian Group Inc., Primus Guaranty, Ltd., Cohen &Steers, Inc., GAMCO Investors, Inc., and W.P. Stewart & Co.,Ltd. The graph assumes an investment of $100 on November 10, 2006 in ourcommon stock and $100 invested at that time in each of the index and the PeerGroup and the reinvestment of dividends where applicable. The closing marketprice for ACA common stock on December 31, 2006 was $15.46.

In light of the uniqueness of our business model, webelieve that no direct industry or line of business comparables currently existin the market. Accordingly, our Peer Group is constructed of companies thatparticipate in one or more of our three lines of business.

The stock priceperformance shown on the graph is not intended to forecast and does notnecessarily indicate future price performance.

**COMPARISON OF 1MONTH CUMULATIVE TOTAL RETURN***AmongACA Capital Holdings, Inc., The Russell 2000 IndexAnd a Peer Group

* $100 invested on 11/10/06 in stock orindex-including reinvestment of dividends.Fiscal year ending December 31.

Source:   Thomson Financial.

*This performancegraph shall not be deemed “filed” for purposes of Section 18 of theSecurities Exchange Act of 1934 as amended (the “Exchange Act”), or otherwisesubject to the liabilities under that Section, and shall not be deemed to beincorporated by reference into any filing of ACA under the Securities Act orthe Exchange Act.*

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**Item 6.**                        Selected Financial Data.

**SELECTEDCONSOLIDATED FINANCIAL AND OTHER DATA**

Thefollowing table sets forth our selected consolidated financial data for theperiods presented. The consolidated statements of operations for the yearsended December 31, 2006, 2005 and 2004 and the consolidated balance sheetdata as of December 31, 2006 and 2005 are derived from our auditedconsolidated financial statements and related notes included Part II, Item8 of this report. The consolidated statements of operations for the years endedDecember 31, 2003 and 2002 and the consolidated balance sheet data as of December 31,2004, 2003 and 2002 are derived from our historical audited consolidatedfinancial statements not included in this report. The results of operations forprior accounting periods are not necessarily indicative of the results to beexpected for any future accounting periods. You should read this informationtogether with “Management’s Discussion and Analysis of Financial Condition andResults of Operations” in Part II, Item 7 of this report, and ourconsolidated financial statements and the related notes thereto includedelsewhere in this report.
|                                                                       | ** ** | **Year Ended December 31,**                            | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2002**                                                              | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                                            | ** ** | **(in thousands, except per share amounts)** | ** ** |
| **Statement of Operations Data(a):**                                  |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Gross premiums written                                                |       | $                                                                     | 53,350     |   | $ | 60,981 |   | $ | 44,570 |   | $ | 41,280 |   | $ | 31,322 |   |
| Net premiums written                                                  |       | $                                                                     | 45,520     |   | $ | 57,516 |   | $ | 45,481 |   | $ | 41,918 |   | $ | 30,817 |   |
| Premiums earned                                                       |       | $                                                                     | 12,062     |   | $ | 18,796 |   | $ | 29,833 |   | $ | 33,343 |   | $ | 28,699 |   |
| Net insured credit swap  revenue                                      |       | 1,557                                                                 |       | 6,841 |   | 16,018 |   | 21,571 |   | 57,602 |   |
| Net investment income                                                 |       | 20,269                                                                |       | 52,868 |   | 126,170 |   | 254,591 |   | 338,166 |   |
| Net realized gains  (losses) on investments                           |       | 4,138                                                                 |       | 3,188 |   | (6,547 | ) | (2,777 | ) | (4,034 | ) |
| Net realized and  unrealized gains (losses) on derivative instruments |       | (25,092                                                               | )          | 9,124 |   | 6,520 |   | 8,410 |   | 8,559 |   |
| Other net credit swap  revenue                                        |       | 4,975                                                                 |       | 12,121 |   | 10,990 |   | 4,157 |   | 10,106 |   |
| Fee income                                                            |       | 4,236                                                                 |       | 8,898 |   | 6,091 |   | 11,110 |   | 24,495 |   |
| Other income                                                          |       | 676                                                                   |       | 423 |   | 3,937 |   | 189 |   | 522 |   |
| Total revenues                                                        |       | 22,821                                                                |       | 112,259 |   | 193,012 |   | 330,594 |   | 464,115 |   |
| Loss and loss adjustment  expenses                                    |       | 1,801                                                                 |       | 3,168 |   | 46,590 |   | 14,038 |   | 8,800 |   |
| Policy acquisition costs                                              |       | 4,046                                                                 |       | 4,077 |   | 3,835 |   | 8,652 |   | 8,740 |   |
| Other operating expenses                                              |       | 18,683                                                                |       | 29,466 |   | 38,645 |   | 37,443 |   | 49,436 |   |
| Interest expense                                                      |       | 9,869                                                                 |       | 39,260 |   | 101,137 |   | 214,313 |   | 291,757 |   |
| Depreciation and  amortization                                        |       | 1,081                                                                 |       | 4,115 |   | 6,935 |   | 8,583 |   | 9,556 |   |
| Total expenses                                                        |       | 35,480                                                                |       | 80,086 |   | 197,142 |   | 283,029 |   | 368,289 |   |
| (Income) loss of  minority interest                                   |       | —                                                                |       | — |   | 476 |   | (3,708 | ) | (4,038 | ) |
| Income (loss) before  provision (benefit) for income taxes            |       | (12,659                                                               | )          | 32,173 |   | (3,654 | ) | 43,857 |   | 91,788 |   |
| Provision (benefit) for  income taxes                                 |       | (6,318                                                                | )          | 12,206 |   | 135 |   | 15,097 |   | 33,080 |   |
| Net income (loss)                                                     |       | $                                                                     | (6,341     | ) | $ | 19,967 |   | $ | (3,789 | ) | $ | 28,760 |   | $ | 58,708 |   |
| **Share and Per Share Data(b):**                                      |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Earnings (loss) per share                                             |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Basic                                                                 |       | $                                                                     | (1.01      | ) | $ | 3.18 |   | $ | (0.61 | ) | $ | 1.26 |   | $ | 2.38 |   |
| Diluted                                                               |       | $                                                                     | (1.01      | ) | $ | 1.51 |   | $ | (0.61 | ) | $ | 0.96 |   | $ | 1.89 |   |
| Weighted average number of shares of common stock  outstanding        |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Basic                                                                 |       | 6,282                                                                 |       | 6,270 |   | 6,168 |   | 22,794 |   | 24,694 |   |
| Diluted                                                               |       | 6,282                                                                 |       | 13,260 |   | 6,168 |   | 29,886 |   | 31,032 |   |
| Book value per share(c)                                               |       | $                                                                     | 12.42      |   | $ | 15.04 |   | $ | 12.38 |   | $ | 13.04 |   | $ | 13.96 |   |

 

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|                                                            | ** ** | **As of December 31,**                                                                               | ** ** |
|------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                 | ** ** | **2002**                                                                                                            | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                                 | ** ** | **(in thousands, except per share amounts and where otherwise noted)** | ** ** |
| **Summary Balance Sheet Data(a):**                         | ** ** | ** **                                                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents(d)                              |       | $                                                                                                                   | 82,361     |   | $ | 212,511 |   | $ | 259,000 |   | $ | 224,605 |   | $ | 446,966 |   |
| Total  investments(e)                                      |       | 726,184                                                                                                             |       | 3,109,179 |   | 5,275,699 |   | 5,418,079 |   | 5,407,689 |   |
| Derivative assets                                          |       | 6,752                                                                                                               |       | 19,343 |   | 28,460 |   | 15,250 |   | 19,730 |   |
| Total  assets(d)(e)                                        |       | 916,966                                                                                                             |       | 3,463,863 |   | 5,691,961 |   | 5,792,200 |   | 6,038,194 |   |
| Unearned premiums                                          |       | 136,222                                                                                                             |       | 172,278 |   | 180,140 |   | 187,739 |   | 189,537 |   |
| Reserve for  losses and loss adjustment expenses           |       | 6,555                                                                                                               |       | 4,984 |   | 36,006 |   | 34,306 |   | 42,113 |   |
| Total debt(e)                                              |       | 541,470                                                                                                             |       | 2,964,332 |   | 4,903,047 |   | 5,029,348 |   | 4,903,742 |   |
| Derivative  liabilities                                    |       | 40,010                                                                                                              |       | 64,045 |   | 58,755 |   | 46,538 |   | 33,874 |   |
| Total liabilities                                          |       | 757,106                                                                                                             |       | 3,269,557 |   | 5,306,424 |   | 5,385,646 |   | 5,498,190 |   |
| Minority interest                                          |       | —                                                                                                              |       | — |   | 20,923 |   | 22,241 |   | 30,190 |   |
| Accumulated other  comprehensive income or (loss)          |       | (5,583                                                                                                              | )          | 8,896 |   | 21,952 |   | 11,132 |   | (3,308 | ) |
| Total  stockholders’ equity                           |       | $                                                                                                                   | 159,860    |   | $ | 194,306 |   | $ | 364,614 |   | $ | 384,313 |   | $ | 509,814 |   |
| **Other Data(g):**                                         | ** ** | ** **                                                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Credit  exposure(f) (in millions)                     |       | $                                                                                                                   | 6,378      |   | $ | 8,563 |   | $ | 11,296 |   | $ | 21,467 |   | $ | 46,255 |   |
| CDO assets under  management (in millions)                 |       | $                                                                                                                   | 2,403      |   | $ | 5,830 |   | $ | 7,798 |   | $ | 9,907 |   | $ | 15,664 |   |
| **Statutory Financial Data (ACA  Financial Guaranty)(g):** | ** ** | ** **                                                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Contingency  reserve(h)                                    |       | $                                                                                                                   | 21,162     |   | $ | 31,520 |   | $ | 46,129 |   | $ | 74,377 |   | $ | 113,477 |   |
| Policyholders’  surplus                               |       | 123,635                                                                                                             |       | 134,565 |   | 279,985 |   | 266,108 |   | 273,644 |   |
| Qualified statutory  capital(i)                            |       | $                                                                                                                   | 144,797    |   | $ | 166,085 |   | $ | 326,114 |   | $ | 340,485 |   | $ | 387,121 |   |

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(a)           Under U.S. GAAP, we arerequired to consolidate into our financial statements the income, expense,assets and liabilities related to certain of our CDOs when we are deemed to bethe primary beneficiary of the CDO vehicle. Although these CDOs areconsolidated, we do not have the right to use the assets of the CDOs forgeneral operations or in satisfaction of our corporate debt obligations. Ourinvestment exposure to our CDOs is therefore limited to the equity we retain,which is the first loss position of the CDO. For a description of the impact ofconsolidation on our financial statements, see “Management’s Discussion andAnalysis of Financial Condition and Results of Operations—Critical AccountingPolicies and Estimates—Consolidation of Variable Interest Entities (VIEs) andOther Restricted Investments” and “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Results by Business Line—CDOAsset Management—Consolidation of VIEs.”

(b)          Earnings per share andweighted average number of shares of common stock outstanding were restated toreflect the 6-for-1 stock split that was completed on August 23,2006.

(c)           Book value per share isbased on total stockholders’ equity divided by basic common stock outstandingafter giving effect to the August 23, 2006 stock split and reflects theconversion of our convertible preferred stock, senior convertible preferredstock and series B senior convertible preferred stock to common stock.

(d)          Includes cash and cashequivalents related to our consolidated CDOs of $6.1 million,$109.6 million, $141.3 million, $125.2 million and $265.0 millionas of December 31, 2002, 2003, 2004, 2005 and 2006, respectively. Alsoincludes restricted cash balances of $22.0 million, $30.9 million,$30.1 million, $50.2 million and $67.1 million as of December 31,2002, 2003, 2004, 2005 and 2006, respectively. 

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Restricted cash balancesrelate to cash on deposit for the benefit of various counterparties in our CDOAsset Management and Structured Credit businesses.

(e)           Includes investmentsrelated to our consolidated CDOs of $382.7 million, $2,711.4 million,$4,732.2 million, $4,810.9 million and $4,536.7 million and aguaranteed investment contract related to our consolidated CDOs of$122.5 million, $122.5 million, $122.6 million,$119.3 million and $119.3 million both as of December 31, 2002,2003, 2004, 2005 and 2006, respectively. Includes non-recourse debt related toour consolidated CDOs of $494.5 million, $2,804.8 million,$4,728.6 million, $4,833.2 million and $4,711.8 million as of December 31,2002, 2003, 2004, 2005 and 2006, respectively.

(f)             Equal to the amountof notional and net par outstanding guaranteed by ACA Financial Guaranty.

(g)           This information is notderived from our audited consolidated financial statements or unaudited interimconsolidated financial statements.

(h)          Under statutoryaccounting practices, or SAP, prescribed or permitted by the Maryland InsuranceAdministration, we are required to establish contingency reserves based on aspecified percentage of either written premiums or insured exposure by bondtype. A contingency reserve is an additional liability reserve established toprotect the policyholder against the effects of adverse economic developmentsor cycles or other unforeseen circumstances. See “Business—Regulation.”

(i)             Qualifiedstatutory capital, comprised of the sum of policyholders’ surplus andcontingency reserve, is a commonly used measure of statutory based equity inthe financial guaranty industry.

**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

*The following discussion relates to our consolidatedfinancial statements and should be read in conjunction with the financial statementsand notes thereto appearing elsewhere in this report. Statements contained inthis “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations” that are not historical facts may be considered forward-lookingstatements within the meaning of the Private Securities Litigation Reform Actof 1995, and are subject to the safe harbor created by that Act. When used infilings with the SEC, in our press releases, investor presentations, and inoral statements made by or with the approval of one of our executive officers,the words or phrases like “believe”, “anticipate”, “project”, “plan”, “expect”,“intend”, “may”,”will likely result”, “looking forward” or “will continue”, orvariations of such words and similar expressions are intended to identify suchforward-looking statements. These forward-looking statements are not guaranteesof future performance and are subject to risks, uncertainties and assumptions,including, among other things, information set forth in Part I, Item 1A—”RiskFactors.” In making these statements, we are not undertaking to address orupdate these factors in future filings or communications regarding our businessor results except as required by law. In light of these risks, uncertaintiesand assumptions, the forward-looking events discussed in this report might notoccur. There may also be other risks that we are unable to predict at thistime. Any of these risks and uncertainties may cause actual results to differmaterially from the results discussed in the forward-looking statements.*

**Overview**

We are a holding company that provides financialguaranty insurance products to participants in the global credit derivativesmarkets, structured finance capital markets and municipal finance capitalmarkets. We also provide asset management services to specific segments of thestructured finance capital markets. We participate in our target markets bothas a provider of credit protection through the sale of financial guarantyinsurance products, for risk-based revenues, and as an asset manager, forfee-based revenues. We conduct our financial guaranty insurance businessesthrough ACA Financial Guaranty Corporation, our “A” rated, regulated insurancesubsidiary. Approximately 85% of our assets on an unconsolidated basisrepresent our 100% indirect ownership interest in ACA Financial Guaranty. ACAFinancial Guaranty 

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provides financialguaranty insurance policies for our Public Finance business, for the creditswaps in our Structured Credit business and for certain other transactionsdescribed in “Other.”  We conduct ourasset management business through ACA Management, L.L.C., a wholly-ownedindirect subsidiary of ACA Financial Guaranty. Additionally, in January 2007,we obtained a license from the FSA to conduct a European asset management business, which willbe done through our wholly-owned indirect subsidiary ACA Capital Management(U.K.) Pte. Limited. As of December 31, 2006, we had credit exposure of$46.3 billion and our assets under management for third parties were $15.7billion.

Our financial results include three principaloperating lines of business: Structured Credit and Public Finance, which areboth financial guaranty insurance lines of business, and our CDO AssetManagement business. We have a fourth line of business, Other, whichencompasses specified insurance transactions in areas in which we are no longeractive, including industry loss warranty transactions, trade credit reinsuranceand insurance of certain asset-backed securitizations, principally, manufacturedhousing. Our lines of business constitute segments for accounting purposes.

Through our Structured Credit line of business, weselect, structure and sell credit protection, principally in the form ofinsured credit swaps, against a variety of asset classes in the institutionalfixed income markets. At December 31, 2006, Structured Credit alsoincluded the consolidated results of the Credit Fund. The Credit Fund wascreated in 2006 to leverage our expertise in the capital and credit markets andas an asset manager. The fund primarily invests in fixed income securities,particularly in the asset-backed sector.

Within Structured Credit, our principal revenues arenet insured credit swap revenue and net investment income, which includesamounts received from the Credit Fund and its allocated portion of ACAFinancial Guaranty’s investment portfolio income. Generally, we receive insuredcredit swap fees in quarterly installments over the life of the related swapswhich is typically in the range of 5 to 7 years. The principal expenses of thisline of business are its allocated portion of corporate-wide operatingexpenses, interest expense and depreciation and amortization. It also incursdirect interest expense related to the financing of our consolidated CreditFund purchased investments. We enter into our insured credit swaps with anintent that they remain outstanding for the entire term of the contract. Theseinsured credit swaps are accounted for at fair value because they do notqualify for the financial guarantee scope exception under FAS No. 133, “*Accounting for Derivative Instruments and CertainHedging Activities*,” as amended (“FAS 133”). Changes in the fairvalue of these contracts are required to be marked to market under therequirements of FAS 133 and are recorded, together with the related fixedquarterly premium payments payable to us under the insured credit swaps, underthe caption net insured credit swap revenue. Since our insured credit swaptransactions are not actively traded securities and have no observable marketprice, we utilize comprehensive internally developed models to estimate changesin fair value. We expect the fair values of these insured credit swaps tofluctuate primarily based on changes in credit spreads and the credit qualityof the underlying referenced entities. When we hold these insured credit swapsfor the entire term of the contract, the cumulative changes in fair value willnet to zero at the end of the term, provided that we do not incur credit losseson the contract. In certain circumstances, we may agree with a counterparty toterminate an insured credit swap transaction prior to its maturity (such as onrequest of the counterparty or for risk management purposes, such as inconnection with a deterioration of the underlying portfolio) and may experiencerealized gains or losses in connection with the early termination of suchtransactions.

In our Public Finance line of business, we providefinancial guaranty insurance policies guaranteeing the timely payment of interestand the ultimate payment of principal on municipal debt obligations. Ourprincipal revenues in this line of business are premiums earned on ourfinancial guaranty insurance policies and its allocated portion ofcorporate-wide investment income. The principal expenses of this line ofbusiness include its allocated portion of corporate-wide operating expenses,interest expense and depreciation and amortization. We also incur loss and lossadjustment expenses, related to the non-derivative exposure we insure, andpolicy acquisition costs, which are expenses that vary with and are 

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directly attributable tothe generation of insurance premiums and are deferred and recognized over theperiod in which the related premiums are earned. Typically, public financepremiums are received by us on an up front basis. However, they are recognizedinto income over the term of the underlying instrument.

In our CDO Asset Management line of business, we focuson CDO origination, structuring and asset management. Our principal revenues inthis line of business are investment income, management fees, warehouse income,other credit swap revenue and premiums for credit swaps on insured equitytranches of unfunded synthetic CDOs.  Also included is an allocated portion ofcorporate-wide investment income. The principal direct expenses are interestexpense related to the CDO debt issued by us and the amortization of relatedcapitalized debt issuance costs. This line of business also receives anallocated portion of corporate-wide operating expenses, interest expense anddepreciation and amortization. Several of our CDOs are consolidated in ourfinancial statements because we have been determined to be the primarybeneficiary under FIN 46(R), *Consolidationof Variable Interest Entities*—an interpretation of ARB No. 51analyses. See “Results of Operations—CDO Asset Management—SupplementaryInformation” for a discussion on the accounting issues associated withconsolidation.

Our Other line of business includes business in areasand markets in which we are no longer active. Principal direct items arepremiums earned, loss and loss adjustment expenses and policy acquisition costs.This line of business also was allocated a portion of investment income,interest expense and operating expenses in 2006, 2005 and 2004. Beginning in2004, expenses were not allocated to this line of business.

We believe it is more meaningful to analyze ourfinancial performance on an annual, rather than a quarterly, basis in order togive our lines of business flexibility to select only those opportunities thatmeet our risk-adjusted return expectations. We believe this maximizes ourprofitability and allows our lines of business to avoid unfavorable pricing,credit spreads and general market conditions that may occur in any particularquarter. Furthermore, during any given year we enter into a limited number oftransactions in each of our lines of business and do not set corporate goalsbased on closing a specified number of transactions in any particular quarter oryear. The transactions in which we participate are often highly negotiated andoften take a significant period of time from start to finish, up to one year inPublic Finance and up to nine months for a CDO. Accordingly, our financialperformance can vary significantly from quarter to quarter and the operatingresults for any quarter are not indicative of results for any future period.

Additionally, managementreviews our performance using a measure known as net economic income.Management believes that analyzing net economic income enhances theunderstanding of our results of operations by highlighting income attributableto our ongoing operating performance. See “—Net Economic Income.”

**Critical AccountingPolicies and Estimates**

We prepare our financialstatements in accordance with accounting principles generally accepted in theUnited States of America (GAAP). The following accounting policies andestimates are viewed by us to be critical because they require significantjudgment on our part. Financial results could be materially different ifalternate methodologies were used or if we modified our assumptions.

*Financial GuarantyRevenue Recognition*

*PremiumsEarned—*Premiums on financial guaranty insuranceproducts in the form of traditional insurance policies are typically receivedon an up front basis, although certain policies pay premium in periodicinstallments. The vast majority of our Public Finance business is conductedthrough the issuance of traditional policies. Traditional policies are thosethat meet the scope exception of the guidance of FAS 133,paragraph 10d, as amended by FAS 149, “*Amendment of Statement 133 on Derivative Instruments and HedgingActivities*” (“FAS 149”). The scope exception provides that financialguaranty contracts are 

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not subject toFAS 133, if they meet certain specified criteria. Installment premiums areearned over each installment period, which is generally one year or less. Upfront premiums are earned in proportion to the expiration of risk, which ispar. Premium is allocated to each par maturity (*e.g.*, principal payment) included in an insured bond andearned on a straight-line basis for the period the related insured risk isoutstanding. Unearned premiums represent that portion of premiums which isapplicable to coverage of risk to be provided in the future on policiesin-force. When an insured issue is retired or defeased prior to the end of theexpected period of coverage, the remaining unearned premiums, less any amountcredited to the refunding issue insured by us, are recognized as earnedpremium. The amounts earned from refundings were approximately$9.4 million, $6.6 million and $1.8 million, for the years ended December 31,2006, 2005 and 2004, respectively.

In connection with its review ofcertain accounting standards for financial guaranty insurance contracts, theFASB is considering potential changes relating to premium revenue recognition.See “—FASB Financial Guaranty Insurance Project” for further explanationof potential changes.

*NetInsured Credit Swap Revenue*—ACA Financial Guarantyinsures the obligations of ACA’s affiliated special purpose entities underinsured credit swaps, pursuant to which we sell credit protection. The relatedinsured credit swap premiums are included in net insured credit swap revenueand are generally received in quarterly fixed payments over the life of therelated swaps. Obtaining the fair value (as such term is defined inFAS 133) for such instruments requires the use of management judgment.These instruments are valued using pricing models based on the net presentvalue of expected future cash flows and observed prices for other transactionsbearing similar risk characteristics. The fair value of these instruments isincluded in derivative assets or derivative liabilities. We do not believe thatour insured credit swaps meet the scope exception of FAS 133, paragraph10d, as amended by FAS 149, because there is no contractual requirementthat the protection purchaser be exposed to the underlying risk.

Net insured credit swap revenue includes insuredcredit swap premiums received and realized and unrealized gains and losses onsuch credit swaps.

*DerivativeContracts.**  *Allderivative instruments are recognized in our consolidated balance sheet aseither assets or liabilities depending on the fair value to us as a creditprotection seller as of the determination date. All derivative instruments aremeasured at estimated fair value. We value derivative contracts based on quotedmarket prices, when available. However, if quoted prices are not available, thefair value is estimated using valuation models specific to the type of creditprotection. Valuation models include the use of management estimates andcurrent market information. We utilize both proprietary and vendor based models(including rating agency models) and a variety of market data to provide thebest estimate of fair value. Some of the more significant types of market datathat influence our models include, but are not limited to, credit ratings,interest rates, credit spreads, default probabilities and recovery rates. Ifmanagement’s underlying assumptions for evaluating fair value prove to beinaccurate, there could be material changes in our consolidated operatingresults.

*PolicyAcquisition Costs.**  *Policyacquisition costs include those expenses that relate primarily to and vary withpremium production. Such costs are comprised primarily of premium taxes,personnel and personnel related expenses of individuals involved inunderwriting, and certain rating-agency and legal fees for municipal andnon-derivative structured finance business. Anticipated claims and claimadjustment expenses are considered in determining the recoverability ofacquisition costs. Net acquisition costs are deferred and amortized over theperiod in which the related premiums are earned. In connection with its reviewof certain accounting standards for financial guaranty insurance contracts, theFASB is considering potential changes relating to deferred policy acquisitioncosts. See “—FASB Financial Guaranty Insurance Project” for further explanationof potential changes.

*Lossand Loss Adjustment Expenses.*   Financial guarantyloss and loss adjustment expense reserves are established on our non-derivativeexposure in an amount equal to our estimate of identified or case-

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specific reserves andnon-specific reserves, including cost of settlement, on the obligations ACAFinancial Guaranty has incurred. In determining our accounting policy for lossreserves, we rely primarily on FAS 60, “*Accountingand Reporting by Insurance Enterprises*” (“FAS 60”). However, FAS 60was adopted when the financial guaranty industry was just beginning. As aresult, FAS 60 did not contemplate the specific attributes of financialguaranty insurance as distinct from other forms of insurance. In particular,financial guaranty insurance is considered a short-duration insurance product;however, it has features that are more akin to long-duration contracts in thatthe term of some insured obligations can be as long as 30 years or moreand the contracts are generally irrevocable. Under FAS 60, accounting forlosses differs for short-duration and long-duration contracts. Because of thisinconsistency, we also apply FAS 5, “*Accountingfor Contingencies*” (“FAS 5”) in the determination of our lossreserves. Specifically, FAS 5 requires the establishment of reserves when it isprobable that a liability has been incurred at the reporting date, but only tothe extent the loss can be reasonably estimated. We understand that methods ofdetermining non-specific reserves vary within the financial guaranty industry.FASB is considering whether additional accounting guidance is necessary toaddress the calculation of the reserves in the financial guaranty industry. Itis possible that as a result of FASB’s deliberations, the financial guarantyindustry, including us, may have to change aspects of its accounting policiesin this regard. The FASB’s proposed guidance in the form of an exposure draftis expected to be issued in early 2007. See “—FASB Financial Guaranty InsuranceProject” for further explanation of potential changes.

The financial guaranty insurance policies we issueinsure scheduled payments of principal and interest due on various types offinancial obligations against a payment default on such payments by the issuersof the obligations. Active surveillance of our insured portfolio tracks theperformance of insured obligations from period to period. We establish loss andloss adjustment expenses, or LAE, reserves based on surveillance group reports,the latest available industry data, and analysis of historical default andrecovery experience for the relevant sectors of the fixed-income market.Together the case reserves and non-specific reserves represent management’s estimateof incurred losses on our non-derivative insured portfolio exposures.

Case specific reserves are reserves created on thoseobligations identified as currently or likely to be in default, and representthe present value, discounted at the U.S. Treasury Note rate applicable to theterm of the underlying insured obligations, of the expected LAE payments, netof estimated recoveries (under salvage, subrogation or other recovery rights).Gross case-specific reserves, net of estimated recoveries, were $20.2 millionand $17.7 million as of December 31, 2006 and 2005, respectively. Wetake into account a number of variables that depend primarily on the nature ofthe underlying insured obligation when we establish case specific reserves forindividual policies. These variables include the nature and creditworthiness ofthe underlying issuer of the insured obligation, whether the obligation issecured or unsecured and the expected recovery rates on the insured obligation,the projected cash flow or market value of any assets that support the insuredobligation and the historical and projected loss rates on such assets. Thestate of the economy, rates of inflation and the salvage values of specificcollateral, among other factors, may affect the actual ultimate realized lossesfor any policy. Currently, we do not believe that changes to these factorswould materially change the amount of our case specific loss reserves, with theexception of significant changes in salvage values of specific collateral.However, case specific reserves are regularly reviewed in order to incorporaterelevant current facts and circumstances and changes to these factors may inthe future materially change the amount of our case specific loss reserves.

Ournon-specific reserve was derived from the calculation of expected loss, whichwe estimate using a Monte Carlo simulation. A Monte Carlo simulation is atechnique that is commonly used to estimate the probability of certainmathematical outcomes. It randomly selects values to create scenarios ofoutcomes and this random selection process is repeated many times to createmultiple scenarios. Each time a value is randomly selected, it forms onepossible scenario and outcome. Together, these scenarios give a range ofpossible outcomes, some of which are more probable and some less probable. Bydefinition, the average 

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solution will give the most likely potential outcome.Our risk management team typically runs at least 100,000 trials in order todetermine future expected losses. The model uses the current ratings anddefault frequency (net of recovery) applied to each transaction withoutstanding exposure to determine the expected probability distribution ofloss. Default frequency and recovery amounts are published periodically by eachof the major rating agencies. From the model output, we can estimate a range ofexpected loss. The amount of non-specific reserve recorded in the financialstatements is based on the loss ratio resulting from the calculation of totallosses, including past incurred losses and expected future losses divided bypremium. For this purpose, premium is defined as ever-to-date written premiumas of December 31, 2006 plus future installment premium on closedtransactions. This derived loss ratio is applied to total ever-to-date earnedpremiums as of December 31, 2006. Case specific reserves are subtractedfrom this amount to arrive at net non-specific reserves. The table below showsour case and non-specific reserves as of December 31, 2006 and 2005.

| ** **              | ** ** | **2006**                | ** ** | **2005** | ** ** |
|-------------------------|------------|-------------------------|------------|----------|------------|
| ** **              | ** ** | **(in thousands**) | ** ** |
| Case specific  reserves |       | $                       | 20,232     |     | $          | 17,672 |   |
| Non specific  reserves  |       | 21,881                  |       | 16,634   |       |
| Total                   |       | $                       | 42,113     |     | $          | 34,306 |   |

 

*InvestmentPortfolio.*   The primary components of ourinvestment portfolio are the fixed maturity securities of ACA Financial Guaranty,our CDO investments and the investments in the Credit Fund. As perFAS 115, “*Accounting for CertainInvestments in Debt and Equity Securities*” (“FAS 115”) managementdetermines the appropriate classification of these securities at the time ofpurchase. As of December 31, 2006, all investments in fixed maturitysecurities except for those related to the Credit Fund were designated asavailable for sale and were carried at fair value. Unrealized gains and lossesfor available for sales securities are the difference between fair value andamortized cost included in the accumulated other comprehensive income componentof stockholders’ equity, net of applicable deferred income tax. As of December 31,2006, the investments of the Credit Fund were designated as trading securitiesand were also carried at fair value. Unrealized gains and losses for tradingsecurities are included in net income. The fair values of our securities arebased on independent market quotations or, when such quotations are not readilyavailable because the securities are infrequently traded in the public market,from internal valuation models. The valuation results from these models coulddiffer materially from amounts realizable in an open market sale or exchange.

*FASBFinancial Guaranty Insurance Project.*   In January andFebruary 2005, the SEC staff discussed with several financial guarantyindustry participants the difference in loss reserve recognition practices inthe industry. In June 2005, at the request of the SEC, the FASB added aproject to their agenda to review and codify accounting standards for financialguaranty insurance contracts as they relate to loss reserving policies andlater added a review of accounting policies in the financial guaranty insuranceindustry as they relate to premium recognition and deferred policy acquisitioncosts. Proposed guidance is expected to bereleased in the first half of 2007 with the final guidance expected to beissued later in the year. When the FASB issues final guidance, the financialguaranty insurance industry, including us, may have to change certain aspectsof its relevant accounting policies. Until a final standard is released, wecannot predict how the FASB will resolve this issue and the resulting impact onour financial statements. Further, until the issue is resolved, the Companywill continue to apply the accounting policies as disclosed in its auditedfinancials statements as of December 31, 2006 and 2005 and for the yearsended December 31, 2006, 2005 and 2004.

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*Consolidationof Variable Interest Entities (VIEs) and Other Restricted Investments.*   Froman accounting perspective, funded and partially funded CDOs are deemed to beissued out of VIEs. As such, each time a CDO is formed that includes theissuance of debt instruments to third parties and the purchase of investmentassets, we perform an analysis to determine whether we are the primarybeneficiary and thus required to consolidate the CDO under the provisions ofFinancial Interpretation 46R, “*Consolidationof Variable Interest Entities*” (“FIN 46(R)). Prior to 2005, weretained all or most of the equity position in our CDOs, and these CDOs aretherefore consolidated in our financial statements (a total of seven CDOs areconsolidated). Although the VIE is consolidated, we do not have the right touse the assets of the VIE for general operations and the debt liabilities ofthe VIE are without recourse to any assets other than those of the VIE. Ourinvestment exposure to our CDOs is therefore limited to our equity investment,which is a first loss position of the CDO. In the instances that we own lessthan 100% of the CDO VIE’s equity, but are the primary beneficiary and thusconsolidate the CDO VIE, we establish minority interests for the unownedportion. As of December 31, 2006 and 2005, consolidated liabilitiesincluded non-recourse debt from consolidated CDOs of $4,711.8 million and$4,833.2 million, respectively. Also, as of December 31, 2006 and 2005,consolidated assets included investment in fixed maturity securities of$4,536.7 million and $4,810.9 million, respectively, and cash of $265.0 and$125.2 million, respectively, related to CDOs.

Beginning in 2005, we have retained a lesser share ofthe equity position of our newly issued CDOs. Based on analyses under FIN46(R), we are not deemed to be the primary beneficiary of these VIEs. As aresult, these CDOs are not consolidated in our financial statements. Rather,our non-majority investment is recorded as an investment in a single fixedmaturity security under the provisions of FAS 115 and Emerging Issues TaskForce Issue No. 99-20, “*Recognitionof Interest Income and Impairment on Purchased and Retained BeneficialInterests in Securitized Financial Assets*” (“EITT 99-20”).During 2006, we closed eight CDOs and purchased an equity interest in four.During 2005, we closed five CDOs and purchased equity interests in four of thefive CDOs. We were not determined to be the primary beneficiary in any of theseCDOs and therefore do not consolidate them.

In May of 2006, webegan managing our Credit Fund. The Credit Fund was created to leverage ourexpertise in the capital and credit markets and as an asset manager. The CreditFund invests in fixed maturity securities, particularly in the asset-backedsector. The Credit Fund had net assets under management of $25.6 million as of December 31,2006, of which we owned $17.0 million and third party investors owned theremaining $8.6 million. In addition to receiving a return on our investment inthe Credit Fund, we are paid a management fee to select and manage the assetsfor the Credit Fund’s third party investors. Although the Credit Fund isconsolidated pursuant to the requirements of FIN 46(R), we do not have theright to use the assets for general operations. See “—Results of Operations—StructuredCredit.”

**Results ofOperations**

*Summary ofConsolidated Results*

The following describes our consolidated financialresults for the years ended December 31, 2006, 2005 and 2004 and ourfinancial condition as of December 31, 2006 and 2005. In order tounderstand our consolidated financial results, we perform a detailed segment bysegment analysis for our lines of business and therefore, to augment thesegments discussion, the following consolidated discussion has been prepared todescribe (1) revenue and expense items that are allocated to our fourlines of business and (2) the results of our lines of business:  Structured Credit, Public Finance, CDO AssetManagement and Other.

The accounting policies of our lines of business arethe same as those described in the summary of “Critical Accounting Policies andEstimates” above. Our two financialguaranty insurance lines of business, Structured Credit and Public Finance, arepresented as separate lines of business. Items not directly 

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attributableare allocated to each operating line of business. Allocated items consist ofinvestment income from ACA Financial Guaranty’s investment portfolio, realizedgains and losses on that investment portfolio, interest expense on thecorporate debt at the holding company level, all operating expenses, non-CDOrelated depreciation and amortization expenses and income taxes. Income andexpense items that are directly attributable to a business line are recorded assuch.

The Company’s consolidated net income for 2006 was$58.7 million, or $1.89 per diluted share, as compared to $28.8 million, or$0.96 per diluted share, in 2005, an increase of $29.9 million. The Company’sconsolidated net income for 2005 of $28.8 million, or $0.96 per diluted share,was an increase of $32.6 million compared to the Company’s net loss of $(3.8)million, or $(0.61) per diluted share, in 2004.

Thefollowing table summarizes the contribution of each line of business to netconsolidated income for the years 2006, 2005 and 2004:

| ** **                             | ** ** | **Structured  Credit**  | ** ** | **Public   Finance** | ** ** | **CDO Asset  Management** | ** ** | **Other** | ** ** | **Consolidated  Total** | ** ** |
|----------------------------------------|------------|-------------------------|------------|---------------------------|------------|--------------------------------|------------|-----------|------------|-------------------------|------------|
| ** **                             | ** ** | **(in thousands)** | ** ** |
| Net income (loss) by  line of business |       |                    |       |                      |       |                           |       |      |       |                    |       |   |   |   |   |   |   |
| 2006                                   |       |                    | $          | 25,334                    |       |                           | $          | 10,652    |       |                    | $          | 21,412 |   |   | $ | 1,310 |   |   | $ | 58,708 |   |   |
| 2005                                   |       |                    | $          | 10,974                    |       |                           | $          | 8,913     |       |                    | $          | 10,459 |   |   | $ | (1,586 | ) |   | $ | 28,760 |   |   |
| 2004                                   |       |                    | $          | 2,362                     |       |                           | $          | 7,104     |       |                    | $          | 10,556 |   |   | $ | (23,811 | ) |   | $ | (3,789 | ) |   |

* *

*StructuredCredit.**  *Netincome increased to $25.3 million in 2006 compared to $11.0 million in 2005primarily as a result of an increase in the volume of credit swap transactionscompleted in prior periods and impact of premiums received on current yearoriginations and the full-year effect of premiums originated over the course of2005. The increase in revenues was partially offset by increased operatingexpenses attributable to a reallocation of internal resources, effective January 1,2006, to support the growth in this line of business. The increase in 2005 netincome for this line of business compared to 2004 was the result of increasedinsured credit swap premiums earned partially offset by a decrease in premiumsearned on traditional financial guaranty insurance. This decrease in premiumswas the result of our shift in focus from traditional financial guarantyinsurance to the insurance of credit swaps in this line of business.

*PublicFinance.**  *Netincome increased to $10.7 million in 2006 compared to $8.9 million in 2005primarily resulting from a higher level of refunding activity, which**accelerates the earnings of up front premiums paid on therefunded transactions, and slightly lower loss and loss adjustment expenses. Premiumsearned from refundings were $9.4 million in 2006, compared to $6.6 million in2005. This increase was partially offset by increased operating expenses. Theincrease in 2005 net income for this line of business to $8.9 million comparedto $7.1 million in 2004 was the result of lower loss and loss adjustmentexpenses and an increase in premiums earned. The increase in our non-specificreserve was a direct result of the increase in premiums earned and applicationof our non-specific reserve model, and represents management’s estimate oflosses on our insured book of business.

*CDOAsset Management.**  *Netincome increased to $21.4 million in 2006 compared to $10.5 million in 2005primarily as a result of an increase in fee and other income attributable toincreased assets under management. In 2006, we increased assets undermanagement by $5.8 billion for a total of $15.7 billion at year end. We alsoexperienced improved returns on our equity investments in various CDOs. Theseincreases were partially offset by increased operating expenses. Also, in 2005,we had greater losses in our insured credit swap and other credit swap revenueswhen compared to 2006 related to the valuation of these contracts under FAS 133.Unrealized losses in 2006 for these items were $0.5 million in 2006 compared to$4.2 million in 2005. In 2005, we also recognized a realized loss of $3.3million in other credit swap revenues as a result of a credit event on a singlecredit swap. Net income was relatively flat when comparing 2005 to 2004,however, the drivers of each year’s results differed. We recognized increased 

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management fees in 2005,while in 2004, we recognized unrealized gains on the valuation of our insuredcredit swap and other credit swap transaction in the amount of $9.2 million. Assetsunder management increased to $9.9 billion at year end 2005, compared to $7.8billion at year end 2004.

*Other.*   Otherrepresented an immaterial portion of our net income in 2006 and 2005. Werecognized large insured losses in 2004 in connection with certain transactionsin businesses in which we are no longer active. Specifically, we incurred $20.3million in losses on manufactured housing securitizations and $21.0 million onindustry loss warranty contracts.

*Items Allocated toBusiness Lines*

Withinour statement of operations, we have incomeand expense items that are directly attributable to our lines of business anditems that are indirectly attributable. Examples of items that are directlyattributable to lines of business are gross premiums written, premiums earned,insured credit swap revenue, net realized and unrealized gains, losses onderivatives, losses and loss adjustment expenses and amortization anddepreciation related to the consolidation of our CDOs. Certain operatingexpenses, including those related to personnel and other expenses dedicated toa line of business are allocated to that line of business. Remaining expensesare allocated to lines of business based on time and expense studies conductedannually. Due to its run-off status beginning in 2004, other operating expensesare not allocated to our Other line of business. Items allocated to lines ofbusiness include net investment income on the investment portfolio of ACAFinancial Guaranty, net realized gains and losses on that portfolio, operatingexpenses, interest expense related to our corporate debt, depreciation andamortization and income taxes. The net investment income and net realized gainsand losses on investments related to our CDO Asset Management and the CreditFund are considered direct revenues. The following table summarizes theprincipal items in our consolidated statement of operations that are allocatedfor purposes of line of business reporting for the years ended December 31,2006, 2005 and 2004. All other revenue and expense items included in theconsolidated statement of operations are directly attributable to a specificline of business.
|                                                    | ** ** | **Year ended December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                         | ** ** | **(in thousands)**                    | ** ** |
| Net investment income                              |       |                                       |       |   |   |   |   |
| Allocated                                          |       | $                                          | 24,939     |   | $ | 20,689 |   | $ | 13,090 |   |
| Direct to Business Lines                           |       | 313,227                                    |       | 233,902 |   | 113,080 |   |
| Total                                              |       | $                                          | 338,166    |   | $ | 254,591 |   | $ | 126,170 |   |
| Net realized and  unrealized losses on investments |       |                                       |       |   |   |   |   |
| Allocated                                          |       | $                                          | (1,059     | ) | $ | (883 | ) | $ | (244 | ) |
| Direct to Business Lines                           |       | (2,975                                     | )          | (1,894 | ) | (6,303 | ) |
| Total                                              |       | $                                          | (4,034     | ) | $ | (2,777 | ) | $ | (6,547 | ) |
| Other operating  expenses                          |       |                                       |       |   |   |   |   |
| Allocated                                          |       | $                                          | 47,143     |   | $ | 34,691 |   | $ | 36,488 |   |
| Direct to Business Lines                           |       | 2,293                                      |       | 2,752 |   | 2,157 |   |
| Total                                              |       | $                                          | 49,436     |   | $ | 37,443 |   | $ | 38,645 |   |
| Interest expense                                   |       |                                       |       |   |   |   |   |
| Allocated                                          |       | $                                          | 7,218      |   | $ | 5,735 |   | $ | 3,305 |   |
| Direct to Business Lines                           |       | 284,539                                    |       | 208,578 |   | 97,832 |   |
| Total                                              |       | $                                          | 291,757    |   | $ | 214,313 |   | $ | 101,137 |   |

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| Depreciation and  amortization    |   |   |   |   |   |   |   |
|-----------------------------------|--------|--------|--------|--------|--------|--------|--------|
| Allocated                         |   | $      | 1,458  |   | $      | 1,467  |   | $ | 1,764 |   |
| Direct to Business Lines          |   | 8,098  |   | 7,116  |   | 5,171  |   |
| Total                             |   | $      | 9,556  |   | $      | 8,583  |   | $ | 6,935 |   |
| Provision for  income tax expense |   |   |   |   |   |   |   |
| Allocated                         |   | $      | 33,080 |   | $      | 15,097 |   | $ | 135 |   |
| Direct to Business Lines          |   | — |   | — |   | — |   |
| Total                             |   | $      | 33,080 |   | $      | 15,097 |   | $ | 135 |   |

 

*NetInvestment Income.**  *Allocatednet investment income primarily represents the income recognized on theinvestment portfolio of ACA Financial Guaranty. To a much lesser degree,investment income from other companies within the group is included to theextent it is not directly related to any of the lines of business. Investmentincome allocated to each line of business is based upon the estimated capitalutilized by the line of business which is derived from our rating agencycapital adequacy model. For the year ended December 31, 2006, allocatednet investment income increased to $24.9 million from $20.7 million forthe year ended December 31, 2005. This increase was related to growth inthe investment portfolio from $587.1 million at the end of 2005 to $670.6million at the end of 2006. The growth in the investment portfolio wasprimarily related to positive cash flows generated by our businesses and, to alesser extent, from $10 million contributed from the proceeds of our initialpublic offering. From 2004 to 2005, allocated net investment income increasedfrom $13.1 million to $20.7 million. The vast majority of the increasecame from the infusion of equity capital as a result of our recapitalization in2004 whereby we raised $169.7 million in additional capital.

*NetRealized and Unrealized Gains and Losses on Investments.**  *Allocated net unrealized and realized gains andlosses on investments represent those gains and losses incurred on the ACAFinancial Guaranty investment portfolio discussed above and are similarlyallocated to the lines of business. In 2006, the net realized loss of $(1.1)million was the result of a sector reallocation of bonds within the portfolio,while the loss of $0.9 million in 2005 was primarily related to certainimpairments recognized.

*OtherOperating Expenses.**  *Allocatedother operating expenses is comprised of all costs related to personnel, officeleases and expenses, legal, accounting and rating agencies. Allocated otheroperating expenses does not include expenses related to the consolidation ofour CDOs or the Credit Fund. Those expenses are treated as direct expenses ofthe CDO Asset Management line of business and the Credit Fund, respectively,for this purpose. For the year ended December 31, 2006, allocated otheroperating expenses increased to $47.1 million from $34.7 million for the yearended December 31, 2005. The increase in expenses was attributable toadditional personnel hired to support the businesses as well as in connectionwith our new status as a public company. We also incurred greater corporateexpenses such as legal, insurance, and accounting and auditing related to ourpublic status. Incentive compensation also increased in 2006 due to greaterheadcount as well as the achievement of performance targets. Finally, weincurred expenses in connection with the opening of our United Kingdom andSingapore offices in 2006. The decline in allocated other operating expenses in2005 to $34.7 million from $36.5 million in 2004 resulted from a decrease ingeneral corporate overhead, owing to the absence of certain legal, accountingand other costs incurred in 2004 in connection with our recapitalization. Thisdecrease has partially offset by an increase in 2005 of employee compensation,benefits and litigation expenses, on aggregate, of $5.9 million. Employeecompensation and benefits increased in 2005 due to an increase in our workforceto support our growing lines of business and an increase in incentivecompensation due to the achievement of certain performance targets.

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*InterestExpense.**  *Allocatedinterest expense is related to debt issued out of our holding company. It isallocated to our lines of business based on capitalization of the respectivelines of business as described above with respect to net investment income butalso provides for the fact that a certain portion of corporate debt was issuedin connection with the start-up costs related to our CDO Asset Managementbusiness. As a result, this line of business receives an increased allocationfor this fact. The increase in allocated interest expense for the three yearperiod from $3.3 million in 2004 to $5.7 million in 2005 and $7.2 million in2006 was primarily related to the increase in LIBOR since this debt paysinterest on a floating rate basis. No new debt was issued in 2005 or 2006,however, an additional $20 million was issued at the end of 2004. This issuancecontributed to the increase in allocated interest expense for the 2005 yearcompared to 2004.

*Depreciationand Amortization.**  *Allocateddepreciation and amortization expense is related to furniture and computerequipment, leasehold improvements and any costs deferred in connection with theraising of corporate debt. Such expenses are allocated to line of businesssimilarly to other operating expenses.

*Income taxes.**  *Income taxes are generally allocated to line ofbusiness based upon the overall corporate effective tax rate applied to pre-taxincome. The increase in income taxes over the three-year period is a directresult of our increased profitability.

*Structured Credit*

Thefollowing table summarizes the operations of our Structured Credit line ofbusiness for the years ended December 31, 2006, 2005 and 2004:
|                                                        | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                             | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | **(in thousands)**                    | ** ** |
| **REVENUES**                                           |       |                                       |       |   |   |   |   |
| Gross premiums  written                                |       | $                                          | 706        |   | $ | 2,638 |   | $ | 4,670 |   |
| Less premiums  ceded                                   |       | —                                     |       | — |   | — |   |
| Net premiums  written                                  |       | 706                                        |       | 2,638 |   | 4,670 |   |
| (Increase)  decrease in unearned premium reserve - net |       | 89                                         |       | (90 | ) | 1,491 |   |
| Premiums earned                                        |       | 795                                        |       | 2,548 |   | 6,161 |   |
| Net insured credit  swap revenue                       |       | 53,018                                     |       | 20,542 |   | 5,617 |   |
| Net investment  income                                 |       | 8,724                                      |       | 828 |   | 524 |   |
| Net realized and  unrealized losses on investments     |       | (311                                       | )          | (35 | ) | (10 | ) |
| Fee income                                             |       | 825                                        |       | 605 |   | 596 |   |
| Other income                                           |       | 80                                         |       | 27 |   | 48 |   |
| **Total  revenues**                                    | ** ** | **63,131**                                 | ** ** | **24,515** | ** ** | **12,936** | ** ** |
| **EXPENSES**                                           |       |                                       |       |   |   |   |   |
| Other operating  expenses                              |       | 18,393                                     |       | 7,430 |   | 8,870 |   |
| Interest expense                                       |       | 4,060                                      |       | 115 |   | 66 |   |
| Depreciation and  amortization                         |       | 836                                        |       | 235 |   | 190 |   |
| **Total  expenses**                                    | ** ** | **23,289**                                 | ** ** | **7,780** | ** ** | **9,126** | ** ** |
| **Income  of minority interest**                       | ** ** | **(271**                                   | **)**      | **—** | ** ** | **—** | ** ** |
| Income before  income taxes                            |       | 39,571                                     |       | 16,735 |   | 3,810 |   |
| Provision for  income tax expense                      |       | 14,237                                     |       | 5,761 |   | 1,448 |   |
| **Net income**                                         | ** ** | **$**                                      | **25,334** | ** ** | **$** | **10,974** | ** ** | **$** | **2,362** | ** ** |

 

*GrossPremiums Written.*   Gross premiums written withinthis line of business declined to $0.7 million for the year ended 2006 from$2.6 million for the year ended 2005. This decline occurred because 

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transactions with respectto this line of business have been recently conducted in the form of insuredcredit swaps. No new traditional insurance contracts were written in 2006 forthis line of business and the decline relates to the expiration of contractsthat were written in previous years. Our recent trend towards insured creditswap transactions is also evidenced in the 2005 to 2004 comparison of grosspremiums written, whereby gross premiums written declined to $2.6 million in2005 from $4.7 million in 2004.

*PremiumsEarned.*   The change in premiums earned over thethree-year period was directly related to the change in gross premiums writtendescribed above.

*NetInsured Credit Swap Revenue.*   Net insured creditswap revenue grew to $53.0 million in 2006 from $20.5 million in 2005 and $5.6million in 2004. As set forth in the table below, insured credit swap revenueis the sum of premiums earned on our insured credit swap transactions, netrealized gains (losses) which may result from time to time result from anytermination or credit events related to such transactions and unrealized gains(losses) resulting from the changes in fair value of these transactions. Premiumsearned from our insured credit swap transactions increased to $46.2 million in2006 from $23.1 million in 2005 which was a significant increase from $6.4million in 2004. The primary reason for the increases was the higher volume oftransactions completed resulting from increases in available credit fromexisting counterparties and the addition of new counterparties, and the annualrevenues from business written in 2006 compared to 2005 and in 2005 compared to2004. Notional credit exposure increased to $39.4 billion at December 31,2006 from $14.6 billion and $4.7 billion as of December 31, 2005 and 2004,respectively.

As reflected in unrealized gains (losses), a netnarrowing of credit spreads caused valuation gains on insured credit swaps of$4.8 million in 2006 while the net widening of spreads caused net valuationlosses of $(2.5) million in 2005 and $(0.8) million in 2004. Additionally, werealized gains of approximately $2.0 million in 2006 as a result of thetermination of three insured credit swap transactions. No termination gains orlosses were recognized in 2005 or 2004.

Thefollowing table shows the components of net insured credit swap revenue for2006, 2005 and 2004:

| ** **                                         | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                         | ** ** | **(in thousands)**                    | ** ** |
| Insured credit  swap premiums earned               |       | $                                          | 46,163     |   | $ | 23,130 |   | $ | 6,444 |   |
| Unrealized gains  (losses) on insured credit swaps |       | 4,846                                      |       | (2,588 | ) | (827 | ) |
| Realized gains on  insured credit swaps            |       | 2,009                                      |       | — |   | — |   |
| Net insured  credit swap revenue                   |       | $                                          | 53,018     |   | $ | 20,542 |   | $ | 5,617 |   |

 

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*Net Investment Income.*   Netinvestment income was $8.7 million in 2006 compared to $0.8 million in 2005 and$0.5 million in 2004. Of the total net investment income of $8.7 million in2006, $5.7 million related to the Credit Fund and $3.0 million related toallocated investment income. In 2005 and 2004, allocated investment income was$0.8 million and $0.5 million, respectively. Allocated investment incomeincreased in 2006 due to growth within the overall ACA Financial Guarantyinvestment portfolio described in “—Results of Operations—Summary ofConsolidated Results” above and due to an increase in the allocation percentagethat we assigned to this line of business. The allocation increased in 2006given the volume of business transacted. The following table shows the componentsof net investment income for 2006, 2005 and 2004:

| ** **                          | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|
| ** **                          | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                          | ** ** | **(in thousands)**                    | ** ** |
| Investment income  from Credit Fund |       | $                                          | 5,731      |   | $ | — |   | $ | — |   |
| Allocated  investment income        |       | 2,993                                      |       | 828 |   | 524 |   |
| Total investment  income            |       | $                                          | 8,724      |   | $ | 828 |   | $ | 524 |   |

 

The Credit Fund had net assets under management of$25.6 million as of December 31, 2006. ACA Financial Products, Inc.,one of our wholly-owned indirect subsidiaries, owned $17.0 million of theequity of the Credit Fund. The remaining $8.6 million was owned by thirdparty investors. In addition to receiving a return on our investment in theCredit Fund, we are paid a management fee to select and manage the assets ofthe fund for third parties. As of December 31, 2006, the Credit Fund hadtotal assets of $264.6 million, including investments in fixed-maturitysecurities trading of $251.8 million and securities purchased underagreements to resell of $10.2 million, and total liabilities and minorityinterest of $247.7 million, including securities sold under agreements torepurchase of $232.2 million and payable for securities purchased of$5.0 million, all of which are included on our consolidated balance sheet.

*Net Realized andUnrealized Gains (Losses) on Investments.*   Net realizedgains (losses) are derived from our investment in the Credit Fund as well asallocated amounts related to ACA Financial Guaranty’s investment portfolio. Thefollowing table shows the components of net realized (losses) for 2006, 2005and 2004:

| ** **                                           | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                           | ** ** | **(in thousands)**                    | ** ** |
| Net unrealized  and realized losses from Credit Fund |       | $                                          | (127       | ) | $ | — |   | $ | — |   |
| Allocated net  realized losses                       |       | (184                                       | )          | (35 | ) | (10 | ) |
| Net realized and  unrealized losses on investments   |       | $                                          | (311       | ) | $ | (35 | ) | $ | (10 | ) |

 

*OtherOperating Expenses.*   Other operating expensesincreased to $18.4 million in 2006 from $7.4 million in 2005 and $8.9 millionin 2004. The increase in 2006 compared to 2005 was in part related to theallocation of additional personnel related to the credit function in 2006 tothis line of business in connection with its growth in transaction volume.Additionally, higher allocated costs related to our newly acquired status as apublic company in 2006 and increased headcount in support of the insured creditswap portion of this line of business contributed to the growth in expenses. Thedecrease from $8.9 million in 2004 to $7.4 million in 2005 was related to theabsence of expenses resulting from the negative ratings actions experienced byACA Financial Guaranty in 2004 and the resulting reorganization, which did notrecur in 2005.

*InterestExpense.*   Interest expense results from debtcosts at the Credit Fund as well as allocated interest costs associated withcorporate debt at our holding company. The Credit Fund finances its assetpurchases in part through the use of security repurchase agreements. Totalinterest expense related to the 

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Credit Fund in 2006 was$3.7 million. Allocated interest expense totaled $0.4 million in 2006, $0.1million in 2005 and $0.1 million in 2004.

*(Income) Loss of MinorityInterest.*   (Income) loss of minority interest isrelated to our investment in the Credit Fund. While we consolidated the fund in2006, we are not the sole equity investor in the fund. (Income) related to theportion of the Credit Fund not owned by us in 2006 was $(0.3) million.

*Public Finance*

Thefollowing table summarizes the operations of our Public Finance line ofbusiness for the years ended December 31, 2006, 2005 and 2004:
|                                                    | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                         | ** ** | **(in thousands)**                    | ** ** |
| **REVENUES**                                       |       |                                       |       |   |   |   |   |
| Gross premiums  written                            |       | $                                          | 29,711     |   | $ | 34,230 |   | $ | 26,311 |   |
| Less premiums  ceded                               |       | (505                                       | )          | 647 |   | 3,469 |   |
| Net premiums  written                              |       | 29,206                                     |       | 34,877 |   | 29,780 |   |
| Increase in  unearned premium reserve - net        |       | (2,972                                     | )          | (10,988 | ) | (15,850 | ) |
| Premiums earned                                    |       | 26,234                                     |       | 23,889 |   | 13,930 |   |
| Net insured  credit swap revenue                   |       | 477                                        |       | 13 |   | — |   |
| Net investment  income                             |       | 16,210                                     |       | 13,862 |   | 8,770 |   |
| Net realized and  unrealized losses on investments |       | (688                                       | )          | (591 | ) | (163 | ) |
| Fee income                                         |       | 213                                        |       | 225 |   | 272 |   |
| Other income                                       |       | 337                                        |       | 82 |   | 3,785 |   |
| **Total  revenues**                                | ** ** | **42,783**                                 | ** ** | **37,480** | ** ** | **26,594** | ** ** |
| **EXPENSES**                                       |       |                                       |       |   |   |   |   |
| Loss and loss  adjustment expenses                 |       | 6,461                                      |       | 7,459 |   | 4,310 |   |
| Policy  acquisition costs                          |       | 8,236                                      |       | 6,970 |   | 2,238 |   |
| Other operating  expenses                          |       | 8,830                                      |       | 7,201 |   | 7,148 |   |
| Interest expense                                   |       | 1,732                                      |       | 1,663 |   | 958 |   |
| Depreciation and  amortization                     |       | 808                                        |       | 596 |   | 482 |   |
| **Total  expenses**                                | ** ** | **26,067**                                 | ** ** | **23,889** | ** ** | **15,136** | ** ** |
| (Income) loss of  minority interest                |       | —                                     |       | — |   | — |   |
| Income before  income taxes                        |       | 16,716                                     |       | 13,591 |   | 11,458 |   |
| Provision for  income tax expense                  |       | 6,064                                      |       | 4,678 |   | 4,354 |   |
| **Net income**                                     | ** ** | **$**                                      | **10,652** | ** ** | **$** | **8,913** | ** ** | **$** | **7,104** | ** ** |

* *

*GrossPremiums Written.*   Public Finance gross premiumswritten totaled $29.7 million in 2006, $34.2 million in 2005 and $26.3 millionin 2004. The decline in 2006 compared to 2005 was related to the tightening ofcredit spreads in our target market, which is the low investment grade and highnon-investment grade segment of the municipal bond market. These spreads wereat historically tight levels through much of the year, and which, in order tomeet our risk-adjusted return expectations, caused us to be highly selective inour underwriting decisions. Because we are a net retainer of the risks weunderwrite, gross premiums written approximates net premiums written. Thegrowth of $7.9 million of gross premiums written in 2005 compared to 2004 wasdriven by increased market acceptance of our insurance product in our targetmarkets due to the completion of our recapitalization following the negativeratings actions in 2004.

*PremiumsEarned.*   Premiums earned were $26.2 million in2006, $23.9 million in 2005 and $13.9 million in 2004. Premiums earned fromrefundings were $9.4 million in 2006, $6.6 million in 2005 and $1.8 

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million in 2004. Essentially,premiums earned before refundings was flat when comparing 2006 to 2005 atapproximately $17 million. The increase in premiums earned excluding refundingsin 2005 compared to 2004 was due to the increase in recognition of premiumsearned in respect of premiums written in 2004.

*NetInsured Credit Swap Revenue.*   Net insured creditswap revenue was $0.5 million in 2006 and $13 thousand in 2005. We closed twotransactions in the Public Finance line of business that were in the form ofinsured credit swaps, one in 2006 and the other in 2005. Because thesetransactions are in the form of insured credit swaps, they are marked to market.The unrealized gain or loss resulting from the fair valuation of thesetransactions is included in net insured credit swap revenue. An unrealized lossof $0.6 million was included in insured credit swap revenue in 2006. In 2005,the valuation was estimated at $0. We had no credit swaps in 2004.

*NetInvestment Income.*   Net investment income totaled$16.2 million in 2006, $13.9 million in 2005 and $8.8 million in 2004. Theentire amount of net investment income for the Public Finance line of businessis derived from the allocation of investment income from ACA Financial Guaranty’sinvestment portfolio. The increases in investment income are related to thegrowth in the ACA Financial Guaranty investment portfolio.

*NetRealized Gains (Losses) on Investments.*   Netrealized gains (losses) are derived entirely from allocated amounts.

*OtherIncome.*   In 2004, we recognized other income ofapproximately $3.7 million in connection with the one-time termination of oursoft capital facility.

*Provision for Loss andLoss Adjustment Expenses.*   The provision for lossand loss adjustment expenses was $6.5 million in 2006, $7.5 million in 2005 and$4.3 million in 2004. This provision includes amounts for case specific andloss adjustment expenses as well as non-specific reserves. The following tableshows the components of the provision for loss and loss adjustment expenses for2006, 2005 and 2004:

| ** **                                             | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                             | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | **(in thousands)**                    | ** ** |
| Incurred Losses Related To              |       |                                       |       |   |   |   |   |
| Case specific and LAE reserves                         |       | $                                          | 1,214      |   | $ | 1,147 |   | $ | 2,361 |   |
| Non-specific reserves                                  |       | 5,247                                      |       | 6,312 |   | 1,949 |   |
| Total provision  for loss and loss adjustment expenses |       | $                                          | 6,461      |   | $ | 7,459 |   | $ | 4,310 |   |

 

In 2006 and 2005, the case specific reserve amountswere fairly equivalent and vast majority of the case specific activity wasrelated to loss adjustment expense reserves established for certain insuredcredits that were in varying stages of work-out. In 2004, the provision forcase specific reserves included the re-assumption of a previously ceded casereserve on a single municipal credit in the amount of $1.2 million, as well asadditional loss development of $1.2 million on that insured credit.Non-specific reserves are based on the application of our reserving model andtake into account transactional characteristics such as rating, sector andassumed recoveries. The increase in non-specific reserves was a result of theincrease in premiums earned and application of our non-specific reserve model.

*Net Policy Acquisition Costs*.   Netpolicy acquisition costs totaled $8.2 million in 2006, $7.0 million in 2005 and$2.2 million in 2004. Generally, such costs vary in accordance with the changesin premiums earned during each period. The increases from 2004 to 2005 and 2005to 2006 were consistent with the increases in Public Finance premiums earnedand the amortization of deferred expenses.

*Other Operating Expenses*.   Otheroperating expenses were $8.8 million in 2006, $7.2 million in 2005 and $7.1million in 2004. These costs are non-policy acquisition related costs and areallocated. The 

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increase of $1.6 millionin 2006 was primarily related to increased head count to support the businessas well as costs associated with our new status as a public company.

*Interest Expense*.   Interestexpense was $1.7 million in 2006, $1.7 million in 2005 and $1.0 million in2004. Interest expense results from the allocated interest cost associated withcorporate debt at our holding company.

*CDO AssetManagement*

Thefollowing table summarizes the operations of our CDO Asset Management line ofbusiness for the years ended December 31, 2006, 2005 and 2004:
|                                                              | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                   | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                   | ** ** | **(in thousands)**                    | ** ** |
| **REVENUES**                                                 |       |                                       |       |   |   |   |   |
| Net insured  credit swap revenue                             |       | $                                          | 4,107      |   | $ | 1,016 |   | $ | 10,401 |   |
| Net investment  income                                       |       | 309,430                                    |       | 236,591 |   | 114,782 |   |
| Net realized and  unrealized losses on investments           |       | (2,876                                     | )          | (2,010 | ) | (6,335 | ) |
| Net realized and  unrealized gains on derivative instruments |       | 8,559                                      |       | 8,410 |   | 6,520 |   |
| Other net credit  swap revenue                               |       | 10,106                                     |       | 4,157 |   | 10,990 |   |
| Fee income                                                   |       | 23,457                                     |       | 10,280 |   | 5,184 |   |
| Other income                                                 |       | 105                                        |       | 71 |   | — |   |
| **Total  revenues**                                          | ** ** | **352,888**                                | ** ** | **258,515** | ** ** | **141,542** | ** ** |
| **EXPENSES**                                                 |       |                                       |       |   |   |   |   |
| Other operating  expenses                                    |       | 22,178                                     |       | 19,049 |   | 18,910 |   |
| Interest expense                                             |       | 285,604                                    |       | 212,134 |   | 99,882 |   |
| Depreciation and  amortization                               |       | 7,912                                      |       | 7,674 |   | 6,200 |   |
| Total expenses                                               |       | 315,694                                    |       | 238,857 |   | 124,992 |   |
| (Income) loss of  minority interest                          |       | (3,767                                     | )          | (3,708 | ) | 476 |   |
| Income before  income taxes                                  |       | 33,427                                     |       | 15,950 |   | 17,026 |   |
| Provision for  income tax expense (benefit)                  |       | 12,015                                     |       | 5,491 |   | 6,470 |   |
| Net income                                                   |       | $                                          | 21,412     |   | $ | 10,459 |   | $ | 10,556 |   |
| CDO assets under  management (end of year, in millions)      |       | $                                          | 15,664     |   | $ | 9,907 |   | $ | 7,798 |   |

 

*NetInsured Credit Swap Revenue*.   Net insured credit swaprevenue was $4.1 million in 2006, $1.0 million in 2005 and $10.4 million in2004. As set forth in the table below, net insured credit swap revenue is thesum of premiums earned, net realized gains (losses), which may result from timeto time result from any termination or credit events related to suchtransactions and unrealized gains (losses) resulting from the changes in fairvalue of these transactions. We receive insured credit swap premiums from twosynthetic CDOs we closed in 2003 and 2002 in which our insurance subsidiary,ACA Financial Guaranty, insured the equity tranche of each CDO. Because thesewere the only two transactions generating insured credit swap premiums in thethree year period, the year over year variances were relatively minor.   The following table shows the components ofnet insured credit swap revenue for 2006, 2005 and 2004:

| ** **                                         | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                         | ** ** | **(in thousands)**                    | ** ** |
| Insured credit  swap premiums earned               |       | $                                          | 4,392      |   | $ | 4,091 |   | $ | 3,414 |   |
| Unrealized gains  (losses) on insured credit swaps |       | (285                                       | )          | (3,075 | ) | 6,987 |   |
| Realized gains  (losses) on insured credit swaps   |       | —                                     |       | — |   | — |   |
| Net insured  credit swap revenue                   |       | $                                          | 4,107      |   | $ | 1,016 |   | $ | 10,401 |   |

 

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As reflected in unrealized gains (losses), generallywide credit spreads caused valuation losses with respect to the two syntheticCDOs described above in both 2006 and 2005 of $(0.3) million and $(3.1)million, respectively. In 2004, the opposite was true, as tightening creditspreads caused valuation gains of $7.0 million. The valuation or unrealizedlosses in 2006 and 2005 were also related to the fact that these transactionsare in a net valuation gain position and as they approach maturity, those unrealizedgains reverse, resulting in unrealized losses. Both transactions will expire bymid-2008.

*NetInvestment Income*.   Net investment income was $309.4million in 2006, $236.6 million in 2005, and $114.8 million in 2004. Netinvestment income includes income from assets of our consolidated CDOportfolios as well as allocated investment from ACA Financial Guaranty’sinvestment portfolio. No new consolidated CDOs were added in 2006 or 2005,however two were added in 2004. The portion of net investment income related toour consolidated CDO portfolio was $307.4 million in 2006, $233.9 million in2005 and $113.1 million in 2004. The increase in net investment income from2004 to 2005 and 2005 to 2006 was principally related to the increase inshort-term rates, namely one and three month LIBOR. Additionally in 2005, webenefited from the full year effect of interest income related to the twoconsolidated CDOs that were added in 2004. The portion of net investment incomefrom ACA Financial Guaranty’s investment portfolio allocated to the CDO AssetManagement line of business was $2.0 million in 2006, $2.7 million in 2005 and$1.7 million in 2004. The decline from 2005 to 2006 was related to a decreaseof the allocation percentage assigned to this line of business in 2006. Thedecrease was due to the reduced amount of estimated capital utilized by the CDOAsset Management line of business, which resulted principally from the reducedsize of our equity investments in CDOs closed beginning in 2005.

| ** **                                | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                | ** ** | **(in thousands)**                    | ** ** |
| Investment Income from Consolidated  CDOs |       | $                                          | 307,435    |   | $ | 233,901 |   | $ | 113,080 |   |
| Allocated net investment income           |       | 1,995                                      |       | 2,690 |   | 1,702 |   |
| Total  net investment income              |       | $                                          | 309,430    |   | $ | 236,591 |   | $ | 114,782 |   |

 

*NetRealized and Unrealized Gains (Losses) on Investments*.   Netrealized gains (losses) are derived from our consolidated CDOs as well asallocated amounts. There are no unrealized gains or losses on investments forthis line of business. The following table shows the components of net realizedgains (losses) for 2006, 2005 and 2004.

| ** **                                         | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                         | ** ** | **(in thousands)**                    | ** ** |
| Net realized losses from CDOs                      |       | $                                          | (2,792     | ) | $ | (1,894 | ) | $ | (6,393 | ) |
| Allocated net realized gains  (losses)             |       | (84                                        | )          | (116 | ) | 58 |   |
| Net  realized and unrealized losses on investments |       | $                                          | (2,876     | ) | $ | (2,010 | ) | $ | (6,335 | ) |

 

Net realized gains (losses) from CDOs include lossesfrom other than temporary impairments, or OTTI, in the amounts of $3.0 millionin 2006, $1.9 million in 2005 and $6.9 million in 2004. OTTI is recognized whenthe fair value of investments in fixed maturity securities is reported belowamortized cost for stated periods of time. In the case of asset-backedsecurities, of which the vast majority of our CDO portfolio is comprised, themarket value decline is also coupled with a decline in future expected cashflows. OTTI write-downs in the three-year period were associated with certainmortgage-backed securities which experienced declines in value and projectedcash flows.

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*Net Realized andUnrealized Gains (Losses) on Derivative Instruments.*   Thefollowing table illustrates the type of derivative instruments reported in thisline item:

| ** **                                                         | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                         | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                         | ** ** | **(in thousands)**                    | ** ** |
| Interest rate swaps                                                |       | $                                          | 8,770      |   | $ | 8,730 |   | $ | 8,736 |   |
| Interest rate caps                                                 |       | (306                                       | )          | (320 | ) | (975 | ) |
| Trading derivatives                                                |       | 95                                         |       | — |   | — |   |
| Warehouse facilities (realized and  unrealized)                    |       | —                                     |       | — |   | (1,241 | ) |
| Total  net realized and unrealized gains on derivative instruments |       | $                                          | 8,559      |   | $ | 8,410 |   | $ | 6,520 |   |

 

The most significant derivative instruments reportedin this line item are interest rate swaps that are included in our consolidatedCDOs. We have four such swaps and we pay fixed amounts and receive floatingamounts based on three month LIBOR and pre-determined notional schedules. Unrealizedvaluation gains have been recognized on these four swaps as a result of asteady increase in short-term interest rates over the three year period. Interestrate caps are also used within consolidated CDOs to manage interest rate riskand have conversely generated unrealized losses over the three year period. Wealso recognized an unrealized gain in the amount of $95 thousand related to asmall leveraged loan trading program that began in December 2006 that isstructured in the form of a total return swap. Changes in the values of theunderlying leveraged loans represent unrealized gains or losses to us untilsuch time that the loans may be sold. Warehouse facility losses were recognizedin 2004 in connection with two consolidated CDOs. Unrealized and realized gainsassociated with the warehouse or ramp up phase of the two CDOs which areconsolidated in our financial statements were recognized in 2004. Subsequent to2004, we have not been determined to be the primary beneficiary of our CDOs,thus no warehouse unrealized or realized gains (losses) were recognized.

*Other NetCredit Swap Revenue*.   Other net credit swap revenue was$10.1 million in 2006, $4.2 million in 2005 and $11.0 million in 2004. As setforth in the table below, other net credit swap revenue is the sum of creditswap fees earned, net realized gains (losses) which may result from time totime result from any termination of such transactions and any credit events andunrealized gains (losses) resulting from the changes in fair value of thesetransactions. The vast majority of this revenue was credit swap fees from apartially funded consolidated synthetic CDO, in which the underlyinginstruments are credit swaps sold by the CDO to third parties. Also included asrevenue in 2006 is an amount of $3.1 million of distributions to us as equityholder of two synthetic CDOs. In 2005, such distributions amounted to $1.4million. No such distributions were received in 2004. The following table showsthe components of other net credit swap revenue for 2006, 2005 and 2004:

| ** **                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                 | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                 | ** ** | **(in thousands)**                    | ** ** |
| Credit swap fees                           |       | $                                          | 10,286     |   | $ | 8,623 |   | $ | 8,829 |   |
| Realized losses on credit swaps            |       | —                                     |       | (3,295 | ) | — |   |
| Unrealized gains (losses) on credit  swaps |       | (180                                       | )          | (1,171 | ) | 2,161 |   |
| Total  other net credit swap revenue       |       | $                                          | 10,106     |   | $ | 4,157 |   | $ | 10,990 |   |

 

In 2005, we incurred arealized loss in the amount of $3.3 million. This realized loss was inconnection with a single credit swap included in our partially funded CDS CDO.Net unrealized losses related to changes in value were recorded in 2006 and2005, while valuation or unrealized gains were recorded in 2004. These unrealizedgains and losses were related to the then credit spread environment.

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We have exposure to certain classes of residentialmortgaged backed securities, or RMBS, through equity we own in our CDOs. Inparticular, we have equity exposure of $55.7 million to RMBS backed by subprimemortgages originated in 2006 in four of our mezzanine asset-backed CDOs thatinvest in RMBS rated below A-/A3. In December 2006, we made the decisionto purchase credit protection in the form of two credit swaps referencing representativemarket indices to moderate impairments in that 2006 vintage subprimeresidential mortgage exposure. We did this in light of the recent negativedevelopments that we have noted in this asset class. Specifically, the relaxedunderwriting standards of certain sub-prime originators in 2006 have led tosignificantly higher early stage delinquencies. Market participants havespeculated that these RMBS may ultimately represent the worst performingsub-prime bonds on record to date. While we have no current impairments in the2006 vintage sub-prime bonds contained in the CDOs in which we have equityexposure, in light of the uncertainty in the market around this vintage ofRMBS, we determined it prudent to purchase the credit swaps. The aggregatenotional amount of credit protection purchased was $37 million. The annualexpense for the protection will be approximately $0.9 million for future years,recorded in other net credit swap revenue. Additionally, we have equityexposure of $35.5 million to two CDOs which invest in RMBS rated at or aboveA-/A3.

*FeeIncome*.   Fee income is principally related to quarterlymanagement fees, warehouse fees and structuring fees received in connectionwith our unconsolidated CDOs. Total fee income for CDO Asset Management was$23.5 million in 2006, $10.3 million in 2005 and $5.2 million in 2004. Theincrease was the result of increased assets under management which grew to$15.7 billion at December 31, 2006 from $9.9 billion at December 31,2005 and $7.8 billion at December 31, 2004. We also received increasedwarehouse fees in 2006, compared to 2005 and 2004. The increase was principallydue to the larger size of the transactions closed during 2006. In general,structuring fees and to some extent warehousing fees are highly negotiated andvary from transaction to transaction. The change in structuring fees isattributable to these negotiations. The following table shows the components offee income for 2006, 2005 and 2004:

| ** **            | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------|------------|--------------------------------------------|------------|
| ** **            | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **            | ** ** | **(in thousands)**                    | ** ** |
| Asset management fees |       | $                                          | 15,971     |   | $ | 6,051 |   | $ | 3,021 |   |
| Warehousing fees      |       | 5,004                                      |       | 2,408 |   | 1,434 |   |
| Structuring fees      |       | 2,482                                      |       | 1,821 |   | 729 |   |
| Total  fee income     |       | $                                          | 23,457     |   | $ | 10,280 |   | $ | 5,184 |   |

 

*OtherOperating Expenses*.   Other operating expenses totaled$22.2 million in 2006, $19.0 million in 2005 and $18.9 million in 2004. Otheroperating expenses is made up of direct expenses of consolidated CDOs andincludes items such as ongoing rating agency fees, trustee fees, accountingfees and other direct expenses related to the maintenance of the CDO. Alsoincluded in other operating expenses are allocated expenses. The followingtable shows the components of other operating expenses for 2006, 2005 and 2004:

| ** **                   | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------|------------|--------------------------------------------|------------|
| ** **                   | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                   | ** ** | **(in thousands)**                    | ** ** |
| Direct operating expenses    |       | $                                          | 2,117      |   | $ | 2,752 |   | $ | 2,160 |   |
| Allocated operating expenses |       | 20,061                                     |       | 16,297 |   | 16,750 |   |
| Total  operating expenses    |       | $                                          | 22,178     |   | $ | 19,049 |   | $ | 18,910 |   |

 

The 2006 increase compared to 2005 in allocatedexpenses was related to two principal items. First, our new status as apublicly traded company in 2006 caused an increase in certain corporateexpenses.  Additionally, we incurredexpenses for our newly established office in the United Kingdom. This officewas 

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established in connectionwith the expansion of our asset management business in Europe. Other operatingexpenses were relatively flat between 2005 and 2004.

*InterestExpense*.   Interest expense totaled $285.6 million in2006, $212.1 million in 2005 and $99.9 million in 2004. Interest expense ismade up of the allocated portion of interest expense on corporate debt issuedby our holding company, debt issued in connection with the purchase of certainof our CDO equity positions (CDO debt: operating) and debt issued by ourconsolidated CDOs (CDO debt: non-recourse). The following table shows thecomponents of interest expense for 2006, 2005 and 2004:

| ** **              | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------|------------|--------------------------------------------|------------|
| ** **              | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **              | ** ** | **(in thousands)**                    | ** ** |
| Interest expense   |       |                                       |       |   |   |   |   |
| Corporate debt          |       | $                                          | 4,764      |   | $ | 3,556 |   | $ | 2,050 |   |
| CDO debt: operating     |       | 7,513                                      |       | 5,855 |   | 3,802 |   |
| CDO debt: non-recourse  |       | 273,327                                    |       | 202,723 |   | 94,030 |   |
| Total  interest expense |       | $                                          | 285,604    |   | $ | 212,134 |   | $ | 99,882 |   |

 

All outstanding debt paysinterest based on a floating rate above one or three month LIBOR. The increasein interest expense was primarily related to the rise in LIBOR over the threeyear period. No new debt was issued in 2006. Interest expense was $212.1million in 2005 compared with $99.9 million in 2004, an increase of $112.2million. This increase was a result of the full year effect of payments onconsolidated CDO liabilities added in the fourth quarter of 2004 and the impactof rising short-term interest rates over the course of 2005. Interest expensealso included interest expense on debt incurred to finance our CDO equityinvestments. We had $116.2 million of debt related to the financing of CDOequity and the allocation of interest payments in 2005 on debt issued to fourtrust preferred vehicles, and in 2004 on three of these trust preferredvehicles.

*Depreciation and Amortization*.   Depreciationand amortization totaled $7.9 million in 2006, $7.7 million in 2005 and $6.2million in 2004. Depreciation and amortization is comprised of the recognitionof costs deferred in connection with our consolidated CDOs as well as allocatedamounts. Depreciation and amortization related to consolidated CDOs totaled$7.3 million in 2006, $7.0 million in 2005 and $5.1 million in 2004. Theincrease in depreciation and amortization expenses for 2005 compared with 2004was primarily the result of the full year of expense amortization related tothe capitalized debt issuance costs of two consolidated CDOs closed in 2004.

*(Income) Loss from MinorityInterest*.   (Income) from minority interest totaled$(3.8) million in 2006, $(3.7) million in 2005 and $0.5 million in 2004. (Income)loss from minority income results from the fact that we consolidate two CDOs inwhich we own less than 100% of the equity. Minority interest reflected in thestatement of operations represents the share of the (income) or loss of the CDOthat represents the third party equity ownership. In 2006 and 2005, the twoCDOs recognized net income and as a result we recorded minority interest (income)to reduce our net income. Conversely, in 2004, on a net basis, the two CDOsrecorded a loss due to the termination of their associated warehouse facilitiesat a time when the valuation of the assets were less than the acquisition costsof such assets. As a result, we recorded minority interest loss in 2004 whichincreased our net income.

*CDO Asset Management—Supplementary Information*

*Consolidationof VIEs.  *From an accounting perspective, funded andpartially funded CDOs are deemed to be issued out of Variable Interest Entities(VIEs). As such, each time a CDO is formed through the issuance of debtinstruments to third parties and the purchase of investment assets, we performan 

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analysis todetermine whether we are the primary beneficiary and thus required toconsolidate the CDO under the provisions of FIN 46(R). Prior to 2005, weretained all or most of the equity position in our CDOs, and these CDOs aretherefore consolidated in our financial statements (a total of seven CDOs areconsolidated). Although these VIEs are consolidated, we do not have the rightto use the assets of the VIEs for general operations and the debt liabilitiesof the VIEs are without recourse to any assets other than those of the VIEs.Our investment exposure to our CDOs is therefore limited to our retainedequity, which is the first loss position of the CDO. In the transactions inwhich we own less than 100% of the CDO VIE’s equity, but are deemed to be theprimary beneficiary and thus consolidate the CDO VIE, we establish minorityinterests for the portion not owned. Total non-recourse debt of the CDOsincluded on our balance sheet at December 31, 2006 and 2005 were$4.7 billion and $4.8 billion, respectively. Fixed maturitysecurities, a guaranteed investment contract and cash related to consolidatedCDOs included on our balance sheet at December 31, 2006 and 2005 were$5.0 billion and $5.1 billion, respectively.

Beginning in 2005, we have retained a lesser share ofthe equity position of our newly issued CDOs. Based on our analysis of FIN 46(R) weare not deemed to be the primary beneficiary and, as a result, these CDOs arenot consolidated in our financial statements. Rather, our non-majorityinvestment is recorded as an investment in a single fixed maturity securityunder the provisions of FAS 115 and EITF 99-20. During 2005 and2006, we closed thirteen CDOs and purchased equity interests in eight. The fairvalue of our total investment in unconsolidated CDOs at December 31, 2006was $23.8 million, not including synthetic CDOs in which we takederivative exposure but make no investment. We do not anticipate consolidatingnew CDOs in the future given our intention to buy minority portions.

CDOs can be issued in funded, unfunded or partiallyfunded form. Funded CDOs issue debt instruments and purchase investment assets,while unfunded CDOs synthetically acquire assets and issue liabilitiessynthetically (*i.e.*, assets andliabilities are in derivative form). Partially funded CDOs are a combination ofthese two forms. From an accounting perspective, funded and partially fundedCDOs are deemed issued out of VIEs.

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Thefollowing table summarizes our outstanding CDO transactions as of December 31,2006:

| **CDO name**               | ** ** | ** ** | ** ** | **Year  Deal  Closed** | ** ** | **Transaction  Type** | ** ** | **Collateral Type(1)** | ** ** | **Current  AUM** | ** ** | **Consolidated**       | ** ** | **Original  Investment in  Retained Equity** | ** ** | **Retained  Equity %** | ** ** | **First  Optional  Call Date(2)** | ** ** | **Maturity  Date** | ** ** |
|---------------------------------|------------|------------|------------|------------------------|------------|-----------------------|------------|-----------------------------|------------|------------------|------------|------------------------|------------|--------------------------------------------------------|------------|-----------------------------|------------|-----------------------------------|------------|--------------------|------------|
| ** **                      | ** ** | ** ** | ** ** | ** **             | ** ** | ** **            | ** ** | **(in millions)**      | ** ** | ** **       | ** ** | **(in millions)** | ** ** | ** **                                             | ** ** | ** **                  | ** ** | ** **                        | ** ** |
| **Asset-Backed CDOs:**          |       |       |       |                   |       |                  |       |                        |       |             |       |                   |       |                                                   |       |                        |       |                              |       |               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| ACA ABS 2002-1                  |       |       | 2002       |                   |       | Funded                |       | Investment  Grade           |       |             | $          | 224                    |       |                                                   |       | Yes                         |       |                              |       | $                  | 18.0       |   |   |   | 100 |   |   |   | 8/2005 |   |   |   | 8/2037 |   |   |
| ACA ABS 2003-1                  |       |       | 2003       |                   |       | Funded                |       | Investment  Grade           |       |             | 403        |                   |       |                                                   | Yes        |                        |       |                              | 18.0       |               |       |   | 100 |   |   |   | 6/2007 |   |   |   | 6/2038 |   |   |
| Grenadier Funding               |       |       | 2003       |                   |       | Funded                |       | High-Grade                  |       |             | 1,485      |                   |       |                                                   | Yes        |                        |       |                              | 22.5       |               |       |   | 100 |   |   |   | 8/2008 |   |   |   | 8/2038 |   |   |
| ACA ABS 2003-2                  |       |       | 2003       |                   |       | Funded                |       | Investment  Grade           |       |             | 725        |                   |       |                                                   | Yes        |                        |       |                              | 33.5       |               |       |   | 100 |   |   |   | 12/2007 |   |   |   | 12/2038 |   |   |
| ACA ABS 2004-1                  |       |       | 2004       |                   |       | Funded                |       | Investment  Grade           |       |             | 411        |                   |       |                                                   | Yes        |                        |       |                              | 10.0       |               |       |   | 61 |   |   |   | 7/2007 |   |   |   | 7/2039 |   |   |
| Zenith Funding                  |       |       | 2004       |                   |       | Funded                |       | High-Grade                  |       |             | 1,496      |                   |       |                                                   | Yes        |                        |       |                              | 13.0       |               |       |   | 52 |   |   |   | 12/2009 |   |   |   | 12/2039 |   |   |
| ACA ABS 2005-1                  |       |       | 2005       |                   |       | Funded                |       | Investment  Grade           |       |             | 433        |                   |       |                                                   | No         |                        |       |                              | 4.4        |               |       |   | 24 |   |   |   | 4/2008 |   |   |   | 4/2040 |   |   |
| ACA ABS 2005-2                  |       |       | 2005       |                   |       | Funded                |       | Investment  Grade           |       |             | 418        |                   |       |                                                   | No         |                        |       |                              | 2.1        |               |       |   | 10 |   |   |   | 9/2009 |   |   |   | 12/2044 |   |   |
| Khaleej II                      |       |       | 2005       |                   |       | Partially  funded     |       | Investment  Grade           |       |             | 750        |                   |       |                                                   | No         |                        |       |                              | 4.5        |               |       |   | 14 |   |   |   | 9/2009 |   |   |   | 9/2040 |   |   |
| Lancer Funding                  |       |       | 2006       |                   |       | Funded                |       | High-Grade                  |       |             | 1,487      |                   |       |                                                   | No         |                        |       |                              | 1.5        |               |       |   | 10 |   |   |   | 7/2010 |   |   |   | 4/2046 |   |   |
| ACA Aquarius 2006-1             |       |       | 2006       |                   |       | Partially  funded     |       | Investment  Grade           |       |             | 2,000      |                   |       |                                                   | No         |                        |       |                              | —     |               |       |   | — |   |   |   | 9/2010 |   |   |   | 9/2046 |   |   |
| ACA ABS 2006-1                  |       |       | 2006       |                   |       | Funded                |       | Investment  Grade           |       |             | 748        |                   |       |                                                   | No         |                        |       |                              | 1.4        |               |       |   | 5 |   |   |   | 12/2009 |   |   |   | 6/2041 |   |   |
| ACA ABS 2006-2                  |       |       | 2006       |                   |       | Funded                |       | Investment  Grade           |       |             | 745        |                   |       |                                                   | No         |                        |       |                              | 3.5        |               |       |   | 11 |   |   |   | 1/2011 |   |   |   | 1/2047 |   |   |
| **Total Asset-Backed CDOs**     |       |       |       |                   |       |                  |       |                        |       |             | 11,325     |                   |       |                                                   |       |                        |       |                              | 132.4      |               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Corporate  Credit CDOs:**     |       |       |       |                   |       |                  |       |                        |       |             |       |                   |       |                                                   |       |                        |       |                              |       |               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| ACA CDS 2001-1                  |       |       | 2002       |                   |       | Unfunded              |       | Investment  Grade           |       |             | 975        |                   |       |                                                   | No         |                        |       |                              | 22.5       |               |       |   | 100 |   |   |   | N/A |   |   |   | 4/2007 |   |   |
| ACA CDS 2002-1                  |       |       | 2002       |                   |       | Partially  funded     |       | Investment  Grade           |       |             | 955        |                   |       |                                                   | Yes        |                        |       |                              | 22.0       |               |       |   | 100 |   |   |   | N/A |   |   |   | 7/2007 |   |   |
| ACA CDS 2002-2                  |       |       | 2003       |                   |       | Unfunded              |       | Investment  Grade           |       |             | 990        |                   |       |                                                   | No         |                        |       |                              | 25.0       |               |       |   | 100 |   |   |   | N/A |   |   |   | 3/2008 |   |   |
| Argon 49                        |       |       | 2005       |                   |       | Funded                |       | Investment  Grade           |       |             | 66         | (3)                    |       |                                                   | No         |                        |       |                              | —     |               |       |   | — |   |   |   | N/A |   |   |   | 6/2015 |   |   |
| Argon 57                        |       |       | 2006       |                   |       | Funded                |       | Investment  Grade           |       |             | 66         | (3)                    |       |                                                   | No         |                        |       |                              | —     |               |       |   | — |   |   |   | N/A |   |   |   | 6/2013 |   |   |
| Tribune                         |       |       | 2006       |                   |       | Unfunded              |       | Investment  Grade           |       |             | 347        | (4)                    |       |                                                   | No         |                        |       |                              | —     |               |       |   | — |   |   |   | N/A |   |   |   | 9/2016 |   |   |
| **Total Corporate Credit CDOs** |       |       |       |                   |       |                  |       |                        |       |             | 3,399      |                   |       |                                                   |       |                        |       |                              | 69.5       |               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Leveraged  Loan CDOs:**       |       |       |       |                   |       |                  |       |                        |       |             |       |                   |       |                                                   |       |                        |       |                              |       |               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| ACA CLO 2005-1                  |       |       | 2005       |                   |       | Funded                |       | Non-Investment  Grade       |       |             | 300        |                   |       |                                                   | No         |                        |       |                              | 5.0        |               |       |   | 21 |   |   |   | 10/2009 |   |   |   | 10/2017 |   |   |
| ACA CLO 2006-1                  |       |       | 2006       |                   |       | Funded                |       | Non-Investment  Grade       |       |             | 340        |                   |       |                                                   | No         |                        |       |                              | —     |               |       |   | — |   |   |   | 7/2009 |   |   |   | 7/2018 |   |   |
| ACA CLO 2006-2                  |       |       | 2006       |                   |       | Funded                |       | Non-Investment  Grade       |       |             | 300        |                   |       |                                                   | No         |                        |       |                              | 2.2        |               |       |   | 10 |   |   |   | 1/2011 |   |   |   | 1/2021 |   |   |
| **Total Leveraged Loan CDOs**   |       |       |       |                   |       |                  |       |                        |       |             | 940        |                   |       |                                                   |       |                        |       |                              | 7.2        |               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Total**                       |       |       |       |                   |       |                  |       |                        |       |             | **$**      | **15,664**             |       |                                                   |       |                        |       |                              |       | **$**              | **209.1**  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |

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(1)                Investment grade collateral is rated “BBB-” or better;however certain of our investment grade CDOs include the ability to invest aminority portion (20% or less) in non-investment grade assets. High-grade is “A-”or better.

(2)                Cash flow CDOs are generally callable once per quarterby a majority or greater vote of the equity holders on a specific date asnegotiated, which is referred to as the First Optional Call Date.

(3)                Argon 49 and Argon 57 are denominated in Euros. Forpurposes of this chart, we have converted the amounts to U.S. dollars atthe prevailing currency exchange rate on December 31, 2006.

(4)                Tribune is comprised of 13 distinct trades some ofwhich are denominated in Euros or Yen. For purposes of this chart, we haveconverted this amount to U.S. dollars at the prevailing currency exchange rateson December 31, 2006.

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*Accountingfor a Consolidated CDO as Compared to an Unconsolidated CDO.**  *When we consolidate a typicalfunded CDO, for accounting purposes, the CDO issuing vehicle is treatedessentially as our wholly owned operating subsidiary. “Funded” means that atthe CDO’s closing, it issues liabilities in the form of debt and equity and theassets are purchased out of a warehouse facility with the proceeds from theissuance. The following shows the balance sheet impact of consolidating ahypothetical $400 million asset-backed CDO at the closing date, assumingwe purchase the entire equity position of $20 million for cash:

**At Closing**

| ** **                    | ** ** | **CDO VIE**        | ** ** | **ACA Funding   Company(1)** | ** ** | **ACA   Management(2)** | ** ** | **Eliminations** | ** ** | **ACA   Consolidated** | ** ** |
|-------------------------------|------------|-------------------------|------------|----------------------------------------|------------|------------------------------|------------|------------------|------------|-----------------------------|------------|
| ** **                    | ** ** | **(in thousands)** | ** ** |
| *Balance Sheet*               | ** ** | ** **              |       |                                   |       |                         |       |             |       |                        |       |   |   |   |   |   |   |   |   |
| Cash                          |       | $                       | —     |                                   |       | $                            | (20,000    | )                |       |                        | $          | — |   |   |   | $ | — |   |   |   | $ | (20,000 | ) |   |
| Fixed maturity  securities    |       | 400,000                 |       |                                   | 20,000     |                         |       |             | —     |                        |       |   | (20,000 | ) |   |   | 400,000 |   |   |
| Total assets                  |       | $                       | 400,000    |                                   |       | $                            | —     |             |       |                        | $          | — |   |   |   | $ | (20,000 | ) |   |   | $ | 380,000 |   |   |
| Long-term debt                |       | $                       | 380,000    |                                   |       | $                            | —     |             |       |                        | $          | — |   |   |   | $ | — |   |   |   | $ | 380,000 |   |   |
| Total liabilities             |       | 380,000                 |       |                                   | —     |                         |       |             | —     |                        |       |   | — |   |   |   | 380,000 |   |   |
| Equity                        |       | 20,000                  |       |                                   | —     |                         |       |             | —     |                        |       |   | (20,000 | ) |   |   | — |   |   |
| Total liabilities and  equity |       | $                       | 400,000    |                                   |       | $                            | —     |             |       |                        | $          | — |   |   |   | $ | (20,000 | ) |   |   | $ | 380,000 |   |   |

----

(1)          The purchaser of theequity. For illustration purposes we assume the purchase of equity is made withcash, although we sometimes finance our purchases of equity.

(2)          The entity that earnsmanagement fees.

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For purposes of thishypothetical CDO, we assume we do not earn warehouse or structuring fees, whichwe do on a number of our CDOs. This example also excludes the effects of anymark to market adjustments on derivatives contained within the CDO vehicle. Followingthe closing of this hypothetical CDO, we record the activity of the CDO on ourassets and liabilities, as well as ongoing expenses of the CDO as follows,assuming one year has passed and we have realized a 10% return on our$20 million equity position and earned management fees of $1.8 million:

**OneYear Later**

| ** **                    | ** ** | **CDO VIE**        | ** ** | **ACA Funding   Company** | ** ** | **ACA   Management** | ** ** | **Eliminations** | ** ** | **ACA   Consolidated** | ** ** |
|-------------------------------|------------|-------------------------|------------|-------------------------------------|------------|---------------------------|------------|------------------|------------|-----------------------------|------------|
| ** **                    | ** ** | **(in thousands)** | ** ** |
| *Statement of Operations*     | * *   | * *                | * *   |                                | * *   | * *                  |       |             | * *   | * *                    |       |   | * * | * * |   |   | * * | * * |   |
| Investment income             |       | $                       | 27,320     | (1)                                 |       | $                         | —     | * *         |       |                        | $          | — | * * |   |   | $ | — | * * |   |   | $ | 27,320 | * * |   |
| Management fees               |       | (1,800                  | )          |                                | —     | * *                  |       |             | 1,800      | * *                    |       |   | — | * * |   |   | — | * * |   |
| Residual equity  return       |       | —                  |       |                                | 2,000      | * *                  |       |             | —     | * *                    |       |   | (2,000 | *)* |   |   | — | * * |   |
| Total revenues                |       | 25,520                  |       |                                | 2,000      | * *                  |       |             | 1,800      | * *                    |       |   | (2,000 | *)* |   |   | 27,320 | * * |   |
| Interest expense              |       | 22,820                  | (2)        |                                | —     | * *                  |       |             | —     | * *                    |       |   | — | * * |   |   | 22,820 | * * |   |
| Operating  expenses           |       | 700                     |       |                                | —     | * *                  |       |             | —     | * *                    |       |   | — | * * |   |   | 700 | * * |   |
| Total expenses                |       | 23,520                  |       |                                | —     | * *                  |       |             | —     | * *                    |       |   | — | * * |   |   | 23,520 | * * |   |
| Pre-tax income                |       | $                       | 2,000      |                                |       | $                         | 2,000      | * *         |       |                        | $          | 1,800 | * * |   |   | $ | (2,000 | *)* |   |   | $ | 3,800 | * * |   |
| *Balance  Sheet*              | * *   | * *                | * *   |                                | * *   | * *                  |       |             | * *   | * *                    |       |   | * * | * * |   |   | * * | * * |   |
| Cash                          |       | $                       | 2,000      |                                |       | $                         | (20,000    | *)*              |       |                        | $          | 1,800 | * * |   |   | $ | — | * * |   |   | $ | (16,200 | * * |   |
| Fixed maturity  securities    |       | 400,000                 |       |                                | 22,000     | * *                  |       |             | —     | * *                    |       |   | (22,000 | *)* |   |   | 400,000 | * * |   |
| Total assets                  |       | $                       | 402,000    |                                |       | $                         | 2,000      | * *         |       |                        | $          | 1,800 | * * |   |   | $ | (22,000 | *)* |   |   | $ | 383,800 | * * |   |
| Long term debt                |       | $                       | 380,000    |                                |       | $                         | —     | * *         |       |                        | $          | — | * * |   |   | $ | — | * * |   |   | $ | 380,000 | * * |   |
| Total liabilities             |       | 380,000                 |       |                                | —     | * *                  |       |             | —     | * *                    |       |   | — | * * |   |   | 380,000 | * * |   |
| Equity                        |       | 22,000                  |       |                                | 2,000      | * *                  |       |             | 1,800      | * *                    |       |   | (22,000 | *)* |   |   | 3,800 | * * |   |
| Total liabilities and  equity |       | $                       | 402,000    |                                |       | $                         | 2,000      | * *         |       |                        | $          | 1,800 | * * |   |   | $ | (22,000 | *)* |   |   | $ | 383,800 | * * |   |
|                               |            |                         |            |                                     |            |                           |            |                  |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Based on a hypotheticalinvestment rate of 6.83%.

(2)          Based on a hypotheticalliability cost of 5.70%.

Thepresentation above would be proper from a U.S. GAAP reporting perspective. Whenmanagement considers the financial performance of the CDO in relation to theeconomic benefit to the Company, management considers the income that the CDOgenerates in the following two component parts:

| ** **              | ** ** | **After One Year** | ** ** |
|-------------------------|------------|------------------------------|------------|
| ** **              | ** ** | **(in thousands)**      | ** ** |
| Management fees         |       |                         | $          | 1,800 |   |   |
| Residual equity  return |       |                         | 2,000      |   |   |
| Total revenues          |       |                         | 3,800      |   |   |
| Total expenses          |       |                         | —     |   |   |
| Pre-tax Income          |       |                         | $          | 3,800 |   |   |

 

These line items, however, do not appear in ourfinancial statements because of the U.S. GAAP rules of consolidation.

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Conversely,if we were to close the same hypothetical CDO, but only purchase 10% of theequity, we would not be deemed the primary beneficiary and therefore would notconsolidate. Our balance sheet on the date of closing would then include thefollowing:

| ** **                    | ** ** | **At Closing**     | ** ** |
|-------------------------------|------------|-------------------------|------------|
| ** **                    | ** ** | **(in thousands)** | ** ** |
| Cash                          |       |                    | $          | (2,000 | ) |   |
| Fixed maturity  securities    |       |                    | 2,000      |   |   |
| Total assets                  |       |                    | —     |   |   |
| Total liabilities             |       |                    | —     |   |   |
| Equity                        |       |                    | —     |   |   |
| Total liabilities and  equity |       |                    | —     |   |   |   |

 

Afterone year, assuming the same return rates as in the consolidated example abovebut began having only purchased 10% of the equity, our statement of operationswould include the following from this CDO:

| ** **        | ** ** | **After  One Year** | ** ** |
|-------------------|------------|------------------------------------|------------|
| ** **        | ** ** | **(in thousands)**            | ** ** |
| Fee income        |       |                               | $          | 1,800 |   |   |
| Investment income |       |                               | 200        | (1) |   |
| Total revenues    |       |                               | 2,000      |   |   |
| Total expenses    |       |                               | —     |   |   |
| Pre-tax income    |       |                               | $          | 2,000 |   |   |

----

(1)          This represents a 10%return on our equity position.

Wewould view the component parts of this CDO as follows:

| ** **      | ** ** | **After One Year** | ** ** |
|-----------------|------------|------------------------------|------------|
| ** **      | ** ** | **(in thousands)**      | ** ** |
| Management fees |       |                         | $          | 1,800 |   |   |
| Equity return   |       |                         | 200        |   |   |
| Total revenues  |       |                         | 2,000      |   |   |
| Total expenses  |       |                         | —     |   |   |
| Pre-tax income  |       |                         | $          | 2,000 |   |   |

 

Management evaluates the revenue generation of our CDOAsset Management line of business on an unconsolidated basis as an alternativemeasure since management believes it is important to evaluate the revenueassociated with each aspect of the business that relates to our investment orour contractual rights to payment and exclude those revenues that relate toother investors’ economic rights.

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Thetable below sets forth the economic impact of our CDOs assuming all CDOs wereunconsolidated for 2006, 2005 and 2004. Investors should neither place unduereliance on this presentation nor use it as a substitute for our segmentfinancial statements which are prepared in accordance with U.S. GAAP. Thispresentation should be utilized only as a supplemental measure of financialperformance in evaluating our CDO Asset Management line of business.

| ** **                                                                | ** ** | **Year Ended December 31,**                            | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                | ** ** | **2006**                                                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                | ** ** | **(in thousands, except where  otherwise noted)** | ** ** |
| Assets under  management (in millions)                                    |       | $                                                                     | 15,664     |   | $ | 9,907 |   | $ | 7,798 |   |
| Management and other fees(1)                                              |       | 28,850                                                                |       | 19,729 |   | 14,143 |   |
| Warehouse and  structuring fees(2)                                        |       | 6,616                                                                 |       | 3,161 |   | 2,135 |   |
| Equity returns(3)                                                         |       | 21,431                                                                |       | 12,885 |   | 5,487 |   |
| CDO Asset  Management revenue, unconsolidated basis                       |       | $                                                                     | 56,897     |   | $ | 35,775 |   | $ | 21,765 |   |
| Reconciliation to CDO  Asset Management pre-tax income:                   |       |                                                                  |       |   |   |   |   |
| CDO Asset  Management revenue, unconsolidated basis                       |       | $                                                                     | 56,897     |   | $ | 35,775 |   | $ | 21,765 |   |
| Net realized and  unrealized gains (losses) on CDO related derivatives(4) |       | 8,000                                                                 |       | 4,164 |   | 15,668 |   |
| Allocated  investment income(5)                                           |       | 1,995                                                                 |       | 2,690 |   | 1,702 |   |
| Allocated  expenses(5)(5a)                                                |       | (20,061                                                               | )          | (16,297 | ) | (16,750 | ) |
| Allocated  interest expenses(5)(5b)                                       |       | (4,764                                                                | )          | (3,556 | ) | (2,050 | ) |
| Allocated  depreciation(5)(5c)                                            |       | (633                                                                  | )          | (636 | ) | (1,076 | ) |
| Allocated  realized gains (losses)(5)(5d)                                 |       | (85                                                                   | )          | (115 | ) | 58 |   |
| Interest expense—operating(6)                                        |       | (7,513                                                                | )          | (5,855 | ) | (3,802 | ) |
| Minority interest  (mark to market portion)(7)                            |       | (772                                                                  | )          | (468 | ) | 1,200 |   |
| Other                                                                     |       | 363                                                                   |       | 248 |   | 311 |   |
| Total CDO Asset  Management pre-tax income-U.S. GAAP                      |       | $                                                                     | 33,427     |   | $ | 15,950 |   | $ | 17,026 |   |

----

(1)          Represents the sum ofmanagement fees for all CDOs paid by CDO entities to ACA Management, whetherthe CDO is consolidated or unconsolidated. For CDOs that we consolidate,management fees are eliminated from our consolidated financial statements underU.S. GAAP.

(2)          Represents fees receivedduring or at the end of the warehouse, or asset accumulation, phase of the CDO.

(3)          Represents the return onour CDO equity investments. For consolidated CDOs, this is based on theinvestment income of the CDO less direct interest expense, direct realizedlosses, operating expenses, amortization expense and management fees. Forunconsolidated CDOs, equity return is the amount of income recorded on therelated unconsolidated investment.

(4)          Represents the sum ofnet unrealized gains and losses included in net insured credit swap revenue,net realized and unrealized gains (losses) on derivative instruments and othernet credit swap revenue. This adjustment (subtracts) adds back mark to marketgains (losses) on derivatives and realized gains (losses) on warehousefacilities because they represent non-cash adjustments that are expected toreverse themselves over time as the related contracts mature or expire.

(5)          Represents adjustmentsfor the investment income and expenses which are allocated to the CDO AssetManagement line of business but do not relate to the direct economics of ourmanaged CDOs.

(5a)    Direct expenses of ourconsolidated CDOs are included above as a reduction of our equity return andinclude items such as ongoing rating agency CDO expenses, trustee fees,accounting fees, etc. Direct 

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expenses equal totalsegment expense less allocated amounts. Direct CDO expenses were $2.1 millionin 2006, $2.7 million in 2005 and $2.1 million in 2004. When weconsider the results related to our managed CDOs, allocated expenses areexcluded and must be added back in order to reconcile to segment based incomebefore taxes.

(5b)   Represents a portion of ourcorporate debt interest expense allocated to this line of business. Thisallocated interest expense, combined with CDO debt-operating and CDOdebt-non-recourse, equals total segment interest expense.

(5c)    Represents a portion ofcorporate depreciation and amortization expense allocated to this line ofbusiness. Direct amortization of debt issuance costs of consolidated CDOs isincluded above as a reduction of equity returns (see note 3 above) and totaled$7.3 million in 2006, $7.0 million in 2005 and $5.1 million in 2004.

(5d)   Represents a portion of ourcorporate realized (losses) gains allocated to this line of business. Directrealized losses including impairments were $2.8 million in 2006,$1.8 million in 2005 and $6.4 million in 2004. These direct realizedlosses are included above as a reduction of our equity return.

(6)          Represents interestexpense incurred in connection with the financing of our equity purchases. Weview these costs as indirect costs of our CDO Asset Management business andexclude them when we consider direct results of this line of business.Therefore, management subtracts them to arrive at segment income before taxes.

(7)          Representsthe minority interest portion of net unrealized gains (losses) on derivativesfor two consolidated CDOs in which we own less than 100% of the equity. Weexclude this item when we examine the results related to our managed CDOs.

*CDO Structures andRelated Revenue Recognition*

The impact of a CDO on our financial statementsdepends on the structure of the CDO (fully funded, partially funded orunfunded), whether or not the CDO is consolidated and the nature of theunderlying assets and liabilities.

Fully funded CDOs contain investments in interestbearing financial assets such as fixed maturity securities or guaranteedinvestment contracts. We have six fully funded consolidated CDOs and onepartially funded consolidated CDO. The assets and liabilities of these CDOs areincluded on our balance sheets. The income generated by the investments isreflected in net investment income in the consolidated statements ofoperations. The debt liabilities issued in the form of notes pay interest thatis included in interest expense in the consolidated statements of operations. Amanagement fee is paid by the CDO to ACA Management but is eliminated inconsolidation. Our return on our equity investment is the net of the CDO’srevenues (interest income) and expenses, including the management fee paid toACA Management.

Partially funded synthetic, or CDS, CDOs sell creditprotection on referenced assets by entering into credit swaps with variousprotection buyers in the market. The CDO also issues securities, both liabilitiesand equity, in order to use the proceeds from the sale of these securities tocollateralize the CDO’s obligations under its credit swaps, except with respectto the most senior tranche of the CDO’s credit exposure, in connection withwhich a partially funded CDO typically purchases credit protection rather thanissuing funded liability securities. The proceeds of the securities issued bythe partially funded CDO are invested in a guaranteed investment contract, orGIC. We consolidate one partially funded CDS CDO. From this consolidated CDO,we consolidate investment income, relating to the return on the GIC, andinterest expense in connection with the liability securities issued by the CDO.We also consolidate derivative income relating to net revenues from the fixedfees payable to the CDO under the terms of the credit swaps pursuant to whichthe CDS CDO sold credit protection on referenced assets and the fixed 

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fees payable by the CDO onthe credit protection that it purchased. This income is reflected in theconsolidated statements of operations as other net credit swap revenue. Thisincome is used to pay the interest on the liabilities of the CDO and otherexpenses of the CDO, including the management fee. Similar to the fully fundedand consolidated CDOs, all management fees in this partially funded CDS CDO arepaid to ACA Management, but eliminated in consolidation. Our return on ourequity investment is the net of the CDO’s revenues (interest income and othercredit swap income) and the CDO’s expenses, including the management fee paidto ACA Management.

For funded and partially funded unconsolidated CDOs,we reflect management fees and investment income in our consolidated statementsof operations. As of December 31, 2006, we have 12 funded and partiallyfunded CDOs that are not consolidated. In these instances, the investmentincome recorded is only on the equity investment made by us as compared to allof the assets in a consolidated CDO. Partially funded, unconsolidated CDOs inwhich we invest in the funded equity securities are reflected in our financialstatements in the same way as funded unconsolidated CDOs.

We originated a fully synthetic, or unfunded, CDS CDOin each of 2002 and 2003. In these transactions, we act as asset manager, and,through ACA Financial Guaranty, insure the equity or first loss position of theCDO. No variable interest entities, or VIEs, exist in these structures; rather,the sponsoring investment bank acts as the counterparty to the various creditswaps that constitute the assets and liabilities of the synthetic CDO. CDOsthat do not use VIEs are not subject to consolidation under FIN 46(R). For ourvarious roles in the unfunded CDS CDOs, we receive structuring fees, managementfees, premium and residual equity returns. On our consolidated statements ofoperations, these revenues are reflected as fee income, net insured credit swaprevenue and other net credit swap revenue. Net insured credit swap revenue alsoincludes the changes in fair value of the related credit swaps. Our combinedequity position in our two unfunded CDS CDOs, which is the aggregate notionalbalance of our credit swaps insuring the equity tranches of these two CDOs, was$47.5 million at December 31, 2006 and 2005.

In certain funded CDOs, we issued liabilities in theform of notes in order to fund our equity purchases. These borrowings wereaccomplished through the issuance of non-recourse notes by our subsidiaries.These notes are insured as to the repayment of principal and interest by ACAFinancial Guaranty. The premium on the policy insuring the notes payable to ACAFinancial Guaranty is payable by our subsidiary that invested in the preferredshares. These subsidiaries and ACA Financial Guaranty are wholly owned by usand therefore this inter-company premium eliminates in consolidation.

In structuring our CDOs, we collaborate withsponsoring investment banks to develop the type of CDO, either fully funded,partially funded or unfunded, to meet the demand of market participants. At anygiven time, different types of CDOs may be attractive to different potentialinvestors. Whether a CDO is consolidated is a function of the amount of ourequity position in the CDO and the related accounting rules. See “—CDO Asset Management—Supplementary Information-Consolidation of VIEs.”Whether or not a CDO will be consolidated onto our financial statements is nota factor that we consider in determining the types of CDOs that we agree tomanage.

While in early transactions we either invested in orsold credit protection through insured credit swaps on 100% of the equitytranches of our CDOs, and therefore consolidate those CDOs (to the extent theaccounting rules require such consolidation), beginning in 2005 we havebeen able to assume reduced amounts of equity in the CDOs that we manage andtherefore have not been consolidating CDOs originated since that time. We donot anticipate consolidating new CDOs in the future.

We may experienceincreased volatility in our financial statements which is not related to theunderlying economic value of our investment in these CDOs because weconsolidate VIEs where we are the primary beneficiary. This may make theevaluation of our financial statements more difficult. Our investment exposureto our CDOs is limited to our equity interest; however, we record fluctuationsin the fair value of the assets and liabilities of our consolidated CDOs. Thesevaluation fluctuations, in the form 

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ofunrealized mark to market adjustments that are recorded in Accumulated OtherComprehensive Income, have exceeded our economic exposure in the form of ourequity investment in the past and could exceed our economic exposure in thefuture. These valuation adjustments reverse themselves over time, to the extentthe gains or losses are not realized by sales or other than temporaryimpairments. We may have realized losses from the assets (from sales and OTTI)in our consolidated CDOs and those losses could exceed the amount of our equityexposure. These losses are recorded in our consolidated statement of operationsas realized losses. When there are realized losses in the CDO asset portfolios,other CDO investors will bear those losses to the extent the losses exceed ourequity exposure to that CDO. When this occurs, the financial statement impactof the realized losses is offset at CDO maturity, when the associatednon-recourse liabilities are written off. For example, if we had a$400 million CDO in which we owned 100% of the $20 million in equityin the form of preference shares, we would consolidate the CDO, including allof its income, expenses, gains, losses and mark to market valuations. Thirdparty investors would own the $380 million in debt securities issued bythe CDO. The maximum economic loss we could sustain on the CDO is$20 million. However, as we consolidated the CDO in our financialstatements, we could record realized losses, for example, greater than$20 million, should they occur in the $400 million asset portfolio ofthe CDO. The reversal of those losses above our $20 million share would berecorded in our statement of operations at the CDO’s maturity as the CDO writesdown the principal amount of liabilities. The third party investors of the debtsecurities issued by the CDO would as an economic matter sustain those lossesas they would not receive all of their principal investment back in thisscenario.

*Other*

Ourfourth line of business, Other, encompasses insurance products in which we areno longer active, including industry loss warranty transactions, trade creditreinsurance and insurance of certain classes of assets in asset-backedsecuritizations, principally manufactured housing. At December 31, 2006,all of the exposure in this line of business had either expired or was inrun-off. Run-off indicates that while we will not add new exposure, we havesome current exposure that has not yet expired. The following table summarizesthe results of our Other line of business the years ended December 31,2006, 2005 and 2004:

| ** **                                             | ** ** | **Year Ended December 31** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                             | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | **(in thousands)**                   | ** ** |
| **REVENUES**                                           |       |                                      |       |   |   |   |   |
| Gross premiums  written                                |       | $                                         | 905        |   | $ | 4,412 |   | $ | 13,589 |   |
| Less premiums  ceded                                   |       | —                                    |       | (9 | ) | (2,558 | ) |
| Net premiums  written                                  |       | 905                                       |       | 4,403 |   | 11,031 |   |
| (Increase)  decrease in unearned premium reserve - net |       | 765                                       |       | 2,503 |   | (1,289 | ) |
| Premiums earned                                        |       | 1,670                                     |       | 6,906 |   | 9,742 |   |
| Net investment  income                                 |       | 3,802                                     |       | 3,310 |   | 2,094 |   |
| Net realized and  unrealized losses on investments     |       | (159                                      | )          | (141 | ) | (39 | ) |
| Fee income                                             |       | —                                    |       | — |   | 39 |   |
| Other income                                           |       | —                                    |       | 9 |   | 104 |   |
| **Total  revenues**                                    | ** ** | **5,313**                                 | ** ** | **10,084** | ** ** | **11,940** | ** ** |
|                                                        |            |                                           |            |  |  |  |  |  |  |  |

 

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| ** **                                  | ** ** | **Year Ended December 31** | ** ** |
|---------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                  | ** ** | **(in thousands)**                   | ** ** |
| **EXPENSES**                                | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loss and loss  adjustment expenses          |       | 2,339                                     |       | 6,579 |   | 42,280 |   |
| Policy  acquisition costs                   |       | 504                                       |       | 1,682 |   | 1,597 |   |
| Other operating  expenses                   |       | 35                                        |       | 3,763 |   | 3,717 |   |
| Interest expense                            |       | 361                                       |       | 401 |   | 231 |   |
| Depreciation and  amortization              |       | —                                    |       | 78 |   | 63 |   |
| **Total  expenses**                         | ** ** | **3,239**                                 | ** ** | **12,503** | ** ** | **47,888** | ** ** |
| **(Income)  loss of minority interest**     |       | —                                    |       | — |   | — |   |
| Income before  income taxes                 |       | 2,074                                     |       | (2,419 | ) | (35,948 | ) |
| Provision for  income tax expense (benefit) |       | 764                                       |       | (833 | ) | (12,137 | ) |
| **Net income (loss)**                       | ** ** | **$**                                     | **1,310**  | ** ** | **$** | **(1,586** | **)** | **$** | **(23,811** | **)** |
|                                             |            |                                           |            |  |  |  |  |  |  |  |

 

*Total Revenues.**  *Total revenues primarily comprised of net premiumsearned and net investment income, continue to decline for this line of businessdue to the fact that it has been in run-off since 2005. Premiums earneddeclined to $1.7 million in 2006 from $6.9 million in 2005 and $9.7 million in2004. Our exposure in the trade credit business, a component of this line ofbusiness, continues to rapidly decline. Premiums earned for trade credit were$1.1 million in 2006, $4.3 million in 2005 and **$**2.4** **millionin 2004. Premiums earned for the other insurance contracts accounted for inthis line of business also continue to decline. Our exposure to industry losswarranty contracts, a major component of premiums written and earned in 2004,had completely run-off in the first half of 2005. No revenue related to thesecontracts was received in 2006. We still continue to receive a small amount ofinstallment premium for in-force asset-backed securitizations, principallymanufactured housing, that were insured several years ago.

*Net Investment Income.*   Netinvestment income was $3.8 million in 2006, $3.3 million in 2005 and $2.1million in 2004. Net investment income is derived from the allocation of incomefrom ACA Financial Guaranty’s investment portfolio. A portion of our capital isallocated to this line of business because we have outstanding exposure,principally related to our exposure to insured manufactured housingsecuritizations. Notwithstanding the run-off or expiration of our exposureoverall in our Other line of business, allocated investment income increaseddue to the increase in the size of the ACA Financial Guaranty investmentportfolio from 2004 to 2005 and again from 2005 to 2006.

*Losses and Loss AdjustmentExpenses.*   In terms of Losses and Loss AdjustmentExpenses, we continue to record losses for the trade credit business. Likepremium, losses incurred on these contracts continued to decline as theunderlying exposures run off. This loss activity has been within management’sexpectations. Losses incurred for trade credit contracts totaled $0.6 millionin 2006, $2.3 million in 2005 and $1.0 million in 2004.

In 1999, we insured 12securitized manufactured housing bonds with a collective balance of $213.3million. In response to an increase in the rate of delinquencies observed inthe mortgages underlying four of these securitizations, we established a casespecific reserve in 2004 in the amount of $20.3 million. This reserverepresented the present value of expected losses, discounted at the applicabletreasury rate. Due to the very long tenor of these bonds, payments areprojected to continue through 2033. Each year we increase the reserve foraccretion to adjust to the proper present value. Additionally, we regularlyreview the underlying asset performance and assess the need for additionalreserves. As of December 31, 2006, our case specific reserve was $23.4million. While the reserve represents our best estimate at the time ofestablishment of ultimate losses on a present value basis, facts andcircumstances may change such that the estimate is required to be revalued. Threeof the bonds in our securitized manufactured housing portfolio experiencedlosses in 2006, 2005 and 2004. A fourth bond incurred losses in 2006. Lossesincurred for these securitizations totaled $1.7 million in 2006, of whichapproximately $1.0 million was related to normal 

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accretionof the existing reserve which is reported at the discounted value. In 2005,losses incurred were $3.4 million and also included accretion of approximately$1.0 million.

No loss activity has beenrecorded for industry warranty loss contracts since 2004, when losses incurredwere $21.0 million. We no longer have exposure to these contracts.

**Net Economic Income**

In managing our business and assessing growth andprofitability from a strategic and financial planning perspective,  our management and Board of Directorsconsider U.S. GAAP net income results as well as a measurement called neteconomic income. We believe that net economic income enhances the understandingof our results of operations by highlighting income attributable to our ongoingoperating performance. However, net economic income is not a measurement offinancial performance or liquidity under U.S. GAAP. It should not be consideredin isolation or as a substitute for net income, cash flows from operating,investing or financing activities, or any other measure calculated inaccordance with U.S. GAAP.

We define net economic income as net income excludingthe after-tax effects of:

·       unrealizedgains (losses) on derivatives included in:

·        netinsured credit swap revenue;

·        netrealized and unrealized gains (losses) on derivative instruments; and

·        othernet credit swap revenue;

·       realizedgains (losses) on non-CDO investments; and

·       theportion of interest expense related to the principal payments on borrowingsthat were financed with derivatives.

Unrealized gains (losses) on derivatives are excludedbecause (i) they widely vary with changes in the credit market andinterest rate environment and are not necessarily indicative of the performanceof our underlying businesses and (ii) the Company intends to hold thepositions to the derivative contracts’ expiration, at which time the mark tomarket values would revert to zero, to the extent no realized derivative gainsor losses had occurred. Realized gains (losses) on non-CDO investments areexcluded because our investment strategy is focused on the preservation ofcapital and generation of current income as opposed to the generation oftrading gains and losses. We include the unrealized gains (losses) onderivatives and investments generated by trading activity, if any. Alsoexcluded is a portion of interest expense on borrowings that were financed withinterest rate swaps to pay the up front issuance costs of some of ourconsolidated CDOs. FAS 133 requires that all payments made under the interestrate swaps, representing both principal and interest, be recorded as interestexpense. In order to approximate the economic expense on these borrowings, theportion of interest expense that is excluded is related to what would beprincipal payments if these borrowings had been financed with debt obligations.

We had after-taxunrealized gains (losses) of $2.9 million in 2006, $(3.7) million in 2005 and$4.0 million in 2004 on our insured credit swaps included in net insured creditswap revenue. We had after-tax unrealized gains of $5.0 million in 2006, $5.2million in 2005 and $5.3 million in 2004 on our derivatives included in netrealized and unrealized gains (losses) on derivative instruments. We hadunrealized gains (losses) of $(0.1) million in 2006, $(0.8) million in 2005 and$1.4 million in 2004 on our credit swaps included in other net credit swaprevenue. We had realized gains (losses) of $(0.7) million in 2006, $(0.6)million in 2005 and $(0.1) million in 2004 on our non-CDO investments. Lastly,we had after-tax expenses of $3.8 million in 2006, $4.3 million in 2005 and$4.3 million in 2004, which effectively constituted principal payments on ourinterest rate swaps.

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**Liquidity andCapital Resources**

We are a holding company, and as such, have no directoperations of our own. Our liquidity, both on a short-term basis (for the next12 months) and a long-term basis (beyond the next 12 months) is dependentupon how much of our initial public offering proceeds we retain at the holdingcompany level, the ability of our operating subsidiaries, which excludes ourconsolidated CDO entities, to pay dividends or make other payments to us, andour ability to incur indebtedness and otherwise access the capital markets. Asof December 31, 2006, we held at our holding company approximately $36.9million of the approximately $79.3 million in net proceeds from our initialpublic offering of common stock that was completed in November 2006. Forfurther discussion regarding the balance of proceeds after December 31,2006, see Part II, Item 5 of this report. Our principal liquidityrequirement is the payment of interest on our debt and operating expenses. Ouroutstanding indebtedness is described under “—Indebtedness.”  We may also incur additional indebtedness inthe future to fund acquisitions, working capital, growth in our business or forother general corporate purposes. We also may require liquidity to makeperiodic capital investments in our operating subsidiaries. We do not currentlyintend to pay dividends. In the ordinary course of our business, we evaluateour liquidity needs and capital resources in light of holding company expensesand debt-related expenses. Based on the amount of dividends we expect toreceive from our subsidiaries, existing cash, including the remaining proceedsfrom our initial public offering retained at our holding company, andavailability under our revolving credit facility, management believes that wewill have sufficient liquidity to satisfy our needs over the next12 months. Beyond the next 12 months, the ability of our operatingsubsidiaries to declare and pay dividends may be influenced by a variety of factorsincluding market conditions, insurance and rating agencies actions and generaleconomic conditions as well as other items described in our risk factors in Part I,Item 1A of this report. Consequently, although management believes that we willcontinue to have sufficient liquidity to meet our debt service and otherobligations over the long term, we cannot guarantee that we will not berequired to seek external debt or equity financing in order to meet ouroperating expenses and debt service obligations.

As discussed above, one source of our liquidity, forthe next 12 months and for the longer term, will be amounts paid by ouroperating subsidiaries as dividends to us. ACA Financial Guaranty is ourprincipal subsidiary through which we operate all our lines of business. ACAFinancial Guaranty is subject to restrictions under state insurance law on itsability to pay dividends. In May 2005, the Maryland Insurance Commissionerapproved ACA Financial Guaranty’s request to pay a dividend in an amount equalto the interest payments on $40 million of the $80 million of ourtrust preferred issuance outstanding through the year ended December 31,2005. In addition, the Maryland Insurance Commissioner approved ACA FinancialGuaranty’s issuance of a $10 million surplus note to us. Accordingly,during 2005 ACA Financial Guaranty paid dividends of $2.1 million for theultimate benefit of its parent, ACA Capital, and $0.5 million in intereston the surplus note. In December 2005, ACA Financial Guaranty receivedapproval from the Maryland Insurance Commissioner to make dividend payments toACA Capital in an amount equal to the interest due in 2006 on $40 millionof trust preferred debt, the proceeds of which were initially contributed byACA Capital into ACA Financial Guaranty. The Maryland Insurance Commissioneralso approved interest payments by ACA Financial Guaranty on the $10 million surplus note due in the 2006fiscal year. Approval of the Maryland Insurance Commissioner to make dividendand surplus note interest payments due in 2007 on the $40 million of trustpreferred securities and the $10 million surplus note, respectively wasreceived by us in December 2006. We have not received dividends from ouroperating subsidiaries other than ACA Financial Guaranty.

If S&P was to reduce ACA  Financial Guaranty’s financial strengthrating to below the “A” category, we would be severely limited in our abilityto insure additional municipal bonds or insure additional Structured Credittransactions. In addition, if the financial strength rating was reduced below “A-”,we could be required to provide collateral in the form of cash or securities toback certain of our Structured Credit transactions. In the case of certaininsured credit swaps, if the underlying portfolio deteriorates 

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below a pre-agreed point,we are generally required to post collateral in an amount that is the lesser ofthe amount by which actual losses exceed this pre-agreed point and the amountof any negative mark to market value of the insured credit swap. If any ofthese events occurred, it could materially hurt our financial performance andliquidity and severely strain our capital resources. See “Part II, Item 7A—Quantitativeand Qualitative Disclosures About Market Risk.”

Liquidity at our operating subsidiaries is used to payoperating expenses, claim payments and income taxes. Positive cash flow at ACAFinancial Guaranty is only available to pay operating expenses of otheroperating subsidiaries subject to the approval of the Maryland InsuranceCommissioner. In addition, certain of our operating subsidiaries may berequired to post collateral in connection with credit derivatives. We had$60.2 million of collateral posted related to seven synthetic equitytransactions in our CDO Asset Management and Structured Credit businesses as ofDecember 31, 2006. However, in 2007, we expect $40.0 million in collateralheld to be released in connection with the scheduled expiration of the relatedcontracts. On an ongoing basis, our sources of funds at our operating subsidiariesprimarily result from premiums written, asset management fees, investmentincome and proceeds from the sale and redemption of investments. Cash is usedprimarily to pay losses and loss expenses, policy acquisition costs, otheroperating expenses and interest expenses. Our cash flow from operationsgenerally represents the difference between premiums collected along with theinvestment income realized, and investment earnings realized and the losses andloss expenses paid, policy acquisition and other operating expenses andinvestment losses realized. Cash flow from operations may differ substantiallyfrom net income. As of December 31, 2006, we have invested all cash flowthat is not required for operating purposes. Management believes that our subsidiaries’operating needs generally can be met from operating cash flow for at least thenext 12 months.

See “—Indebtedness.”

*Cash Flows for theYear Ended December 31, 2006*

For the year ended December 31,2006, we generated positive net operating cash flow of $46.3 million,primarily related to income from operations and investment income. This amountis net of our $17.0 million investment in our Credit Fund in the secondquarter of 2006. In 2006, we had net proceeds from invested assets of$198.9 million principally from the maturity of fixed maturity securitiesavailable for sale, primarily in our consolidated CDOs. We had net cashoutflows of $39.7 million related to financing activities, which includedthe paydown of $128.7 million of long-term debt, also primarily related to ourconsolidated CDOs, offset against the net proceeds from our initial publicoffering of common stock of $79.3 million. As of December 31, 2006, we hadcontributed $52.4 million of the proceeds from our initial public offering toour subsidiaries. As of December 31, 2006, we had a cash balance of$379.9 million.

*Cash Flows for theYear Ended December 31, 2005*

In the year ended December 31, 2005, we generatedpositive net operating cash flow of $64.4 million, primarily related topremiums written and investment income. During the same period, we invested anet cash amount of $244.1 million. We generated a net cash amount of$125.1 million through financing activities, and as of December 31,2005, had a cash balance of $174.4 million.

In March 2005, one ofour subsidiaries, ACA Parliament Funding, L.L.C., or ACA Parliament, enteredinto an agreement with an investment trust, pursuant to which $99 millionwas deposited in a fund that is maintained and invested by ACA Parliament. ACAParliament is required to make quarterly interest payments at a rate equal tothe three-month LIBOR plus 125 basis points and the maturity date of the noteis 2010.

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*Cash Flows for theYear Ended December 31, 2004*

In the year ended December 31, 2004, we generateda net operating cash inflow of $25.1 million, primarily relating topremiums received and investment income. During the same period, we invested anet cash amount of $2.1 billion. We generated a net cash amount of$2.1 billion through financing activities, and as of December 31,2004 had a cash and cash equivalents balance of $228.9 million.

On December 29, 2004,we privately placed $20.0 million of trust preferred debt which was issuedby a subsidiary trust holding $20.6 million aggregate principal amount ofa 30-year subordinated note of ACA. Net proceeds were $19.4 million.Through a surplus note approved by the Maryland Insurance Commissioner, weprovided a $10 million capital infusion to ACA Financial Guaranty and usedthe remainder of the net proceeds for general corporate purposes.

**CapitalExpenditures**

We did not makesignificant capital expenditures for or during the years ended December 31,2006, 2005 and 2004. We do not anticipate significant capital expenditures in2007.

**Off-Balance SheetArrangements**

We do not have any “off-balancesheet arrangements” (as such term is defined in Item 303 of Regulation S-Kof the General Rules and Regulations under the Securities Act of 1933, asamended) that are reasonably likely to have a current or future effect on ourfinancial condition, changes in financial condition, revenues or expenses,results of operations, liquidity, capital expenditures or capital resources. Wedo, however, have off-balance sheet exposure in the form of our financialguaranty exposure or par in force. Par in force as of December 31, 2006was $46.3 billion and includes exposure to Public Finance, Structured Creditand CDO Asset Management and other transactions in which ACA Financial Guarantyhas issued insurance policies. Par in force as of December 31, 2005, was$21.5 billion.

**ContractualObligations**

Thefollowing table summarized our contractual obligations as of December 31,2006(1):

| ** **                                        | ** ** | **Less Than**      | ** ** | ** **        | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                  | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|-------------------|------------|-------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                        | ** ** | **Total**               | ** ** | **One Year** | ** ** | **1–3 Years** | ** ** | **4–5 Years** | ** ** | **After 5 Years** | ** ** |
| ** **                                        | ** ** | **(in thousands)** | ** ** |
| Debt                                              |       |                    |       |              |       |                    |       |                    |       |                        |       |   |   |
| Corporate debt                                    |       | $                       | 79,899     |              | $          | —                  |       | $                       | —     |                        | $          | — |   |   | $ | 79,899 |   |   |
| CDO debt—operating                           |       | 112,014                 |       | —            |       | —                  |       | 103,413                 |       |                        | 8,601      |   |   |
| CDO debt—non-recourse, net of discounts(2)   |       | 4,711,829               |       | 2,677,828         |       | 102,610                 |       | —                  |       |                        | 1,931,391  |   |   |
| Total debt                                        |       | 4,903,742               |       | 2,677,828         |       | 102,610                 |       | 103,413                 |       |                        | 2,019,891  |   |   |
| Securities sold under agreements to repurchase(3) |       | 232,227                 |       | 232,227           |       | —                  |       | —                  |       |                        | —     |   |   |
| Lease obligations                                 |       | 38,590                  |       | 2,717             |       | 6,810                   |       | 5,596                   |       |                        | 23,467     |   |   |
| Loss reserves(4)                                  |       | 42,113                  |       | 4,910             |       | 4,300                   |       | 3,669                   |       |                        | 29,234     |   |   |
| Total                                             |       | $                       | 5,216,672  |              | $          | 2,917,682               |       | $                       | 113,720    |                        | $          | 112,678 |   |   | $ | 2,072,592 |   |   |

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(1)          Does not include anypotential borrowings under our credit facility, for which there were nooutstanding borrowings as of December 31, 2006, described below under “—Indebtedness.”

(2)          Represents debt incurredby our CDOs that are consolidated under U.S. GAAP and that are withoutrecourse to any assets other than those of the applicable CDO.

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(3)          Represents debt incurredby our Credit Fund that are consolidated under U.S. GAAP and that arewithout recourse to any assets other than those of the Credit Fund.

(4)          Theloss and loss adjustment expenses payments due by period in the table above arebased upon the present value of loss and loss adjustment expenses estimates asof December 31, 2006 and are not contractual liabilities with specifiedtimes of payment. Our contractual liability is to provide benefits under ourpolicies. As a result, our calculation of loss and loss adjustment expensespayments due by period is subject to the same uncertainties associated withdetermining the level of unpaid loss and loss adjustment expenses reservesgenerally and to the additional uncertainties arising from the difficulty ofpredicting when claims (including claims that have not yet been reported to us)will be paid. Actual payments of losses and loss adjustment expenses by periodwill vary, perhaps materially, from the above table to the extent that currentestimates of loss and loss adjustment expenses vary from actual ultimate claimsand amounts and as a result of variations between expected and actual payoutpatterns. Our failure to accurately set our loss reserves may result in havingto increase our loss reserves or make payments in excess of our loss reserves,which could materially and adversely impact our financial condition.

**Restricted Balances**

Our insurance subsidiary,ACA Financial Guaranty, has assets on deposits with various regulatoryauthorities. At December 31, 2006, such assets on deposit were in theamount of $4.9 million. In connection with our CDO Asset Management andStructured Credit businesses, we had on deposit $60.2 million for thebenefit of various counterparties. These funds revert back to us upon theexpiration of the related risk and in certain instances may be used to paylosses should they be incurred. In 2007, we expect $40.0 million incollateral held to be released in connection with the scheduled expiration ofthe related contracts. We also hold $1.5 million in collateral, throughone of our consolidated CDOs, for the benefit of the CDO debt holders.

**Indebtedness**

*Credit Facility*

We entered into a credit agreement as of May 1,2006 with a syndicate of banks. The credit agreement provides for a 364-daysenior unsecured revolving credit facility in an aggregate principal amount ofup to $75 million, which maximum amount may, at our request and subject tothe terms and conditions of the facility, be increased up to $125 million. Asof December 31, 2006, no amounts were outstanding under this facility norhave there been any borrowings under this facility.

We may borrow cash under the credit facility bearinginterest based, at our option, on either (i) a fluctuating rate equal tothe highest of the prime rate and the federal funds rate plus 0.5% or (ii) aEurodollar rate, plus an applicable margin and a utilization fee. We also have theright to solicit fixed or floating rate competitive bids for loans from membersof the syndicate of lenders party to the credit agreement.

The facility’s financialcovenants require us to maintain (i) a minimum net worth, (ii) a maximumleverage ratio, and (iii) a minimum financial strength rating from S&Pof “A-” for ACA Financial Guaranty. The facility also includes customarynegative covenants including: limitations on liens, mergers, consolidations,liquidations and dissolutions, sales of assets, dividends and other payments tothird parties in respect of our capital stock, transactions with affiliates,changes in fiscal year, debt incurred by our subsidiaries (but excludingnon-recourse debt and certain wrapped debt), and changes in line of business.There are no prepayment penalties under the facility. The facility hascustomary events of default including (subject to certain materialitythresholds and grace periods) payment default, material inaccuracy ofrepresentations and warranties, failure to comply with covenants, bankruptcy orinsolvency proceedings, 

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changein control and cross-default to other indebtedness. We were in compliance withthese covenants as of December 31, 2006.

*Trust PreferredSecurities*

We issued floating rate junior subordinated deferrableinterest debentures, structured as trust preferred securities, of $20.6 million,$20.6 million, $20.6 million and $18.0 million on December 29,2004, October 29, 2003, May 15, 2003, and December 4, 2002,respectively. The trust preferred debt securities have an initial stated termof 30 years with a call provision at five years from the date of eachissuance. The current interest rates on the $79.9 million of outstandingtrust preferred debt securities range from 8.71% to 9.47% at December 31,2006. The effective interest rate of these securities is calculated based onthree-month LIBOR plus a margin of 3.35% to 4.1% per annum subject to certaininterest rate caps during the lives of the securities.

The indentures governing the debentures limit ourability to pay dividends and incur other indebtedness. Events of default under theindentures include failure to make timely principal or interest payments,continuation of a breach of the indentures 60 days after proper notice,bankruptcy, liquidation and dissolution.

*Other Financings*

To the extent we purchase equity in our CDOs, we mayissue notes to finance such purchases. These notes are debt obligations securedby our equity interest in the CDO and insured as to the repayment of principaland interest by ACA Financial Guaranty. The notes generally may be redeemedprior to the scheduled maturity date at our option.

In March 2005, one of our subsidiaries, ACAParliament, entered into an agreement with an investment trust, pursuant towhich $99 million was deposited in a fund that is maintained and investedby ACA Parliament in exchange for a medium term note. ACA Parliament isrequired to make quarterly interest payments at a rate equal to the three-monthLIBOR plus 125 basis points and the maturity date of the medium term note is2010. We will have to refinance this medium term note program upon maturity in2010 since the maturity date is in advance of the maturity date of many of theassets acquired with the proceeds of such issuance. Notes outstanding inconnection with the financing of our equity purchases, including the aforementionedterm note, totaled $112.0 million and $116.2 million as ofDecember 31, 2006 and 2005, respectively.

**Item 7A.**                Quantitativeand Qualitative Disclosures About Market Risk.

**Market Risk**

Market risk represents the potential for losses thatmay result from changes in the value of a financial instrument as a result ofchanges in market conditions. The primary market risks that impact ourfinancial instruments are due to interest rates, credit spreads, assetcorrelation, asset-backed security prepayments, CDO reinvestment and CDOcommercial paper refunding. Each of these risks and the specific types offinancial instruments which they impact are described below. Senior managers inour risk management department are responsible for monitoring risk limits andapplying risk measurement methodologies. The estimation of potential lossesarising from adverse changes in market conditions is a key element in managingmarket risk. We use various systems, models and stress test scenarios tomonitor and manage market risk. These models include estimates made bymanagement that use current and historic market information. The valuationresults from these models could differ materially from amounts that actuallyare realized in the market. See “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Critical Accounting Policies andEstimates—Investment Portfolio” and “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Critical Accounting Policies andEstimates—Derivative Contracts.”

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*Interest Rate Risk*

Interest rate risk is the risk that the fair value ofour interest rate sensitive assets or liabilities will change with changes inmarket interest rates. We own both fixed rate and floating rate bonds in ourACA Financial Guaranty investment portfolio and consolidated CDO portfolios.Also, our unconsolidated CDO equity investments have fair values that aresensitive to yield curve movements.

We use interest rate swaps and caps to hedgedifferences in the cash flow of assets and liabilities within many of our CDOs.These hedges also act to reduce the net sensitivity to fair value changes. Wedo not hedge the interest rate risk of our ACA Financial Guaranty investmentportfolio since we prefer the income from this portfolio be predominantly fixedcoupon. As interest rates go up or down, the yield of that investment portfoliowill be fairly stable, however, the fair value will fluctuate and thefluctuation can be material. While this portfolio holds both fixed-andfloating-rate debt obligations, it is predominantly fixed rate. Conversely, ourfunded CDO assets are primarily comprised of floating rate securities. Whilethe values of these securities are generally not sensitive to interest ratemovements, the associated yields are sensitive to changes in interest rates.

Thefollowing table shows the change in fair value for all business activities withsignificant interest rate risk. We employ proprietary cash flow models toderive these values.

| **Business Activity**                   | ** ** | ** **             | ** ** | **Fair Value at  December 31,  2006** | ** ** | **+100 bps   per annum  Shift** | ** ** | **-100 bps  per annum  Shift** | ** ** |
|----------------------------------------------|------------|------------------------|------------|------------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                   | ** ** | **(in millions)** | ** ** |
| ACA Financial  Guaranty investment portfolio |       |                   | $          | 489.6                                                |       |                                           |       | $                                        | (26.2      | ) |   |   | $ | 28.8 |   |   |
| CDOs(1)                                      |       |                   | 4,656.0    |                                                 |       |                                           | (18.5      | )                                        |       |   | 19.1 |   |   |
| Interest rate  swaps                         |       |                   | (14.4      | )                                                    |       |                                           | 13.6       |                                     |       |   | (14.3 | ) |   |
|                                         |       |                   | $          | 5,131.2                                              |       |                                           |       | $                                        | (31.1      | ) |   |   | $ | 33.6 |   |   |

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(1)          Includesguaranteed investment contract balance of $119.3 million.

*Credit Spread Risk*

Credit spread risk is the risk that the fair value ofour credit sensitive assets or other risk exposure will change with changes inthe credit spreads of the referenced entities. Roughly speaking, the “creditspread” is the additional yield above the risk-free benchmark yield that aborrower must pay to its lenders. The credit spread increases as the perceivedrisk of default of the borrower increases. Fluctuations of credit spreadsbehave like movements in the market yield curve (interest rate risk) for simplefixed-income investments and impact fixed- and floating-rate debt equally. Ourcredit swap exposure in our Structured Credit and CDO Asset Managementtransactions is generally more sensitive to movements in credit spreads than tomovements in interest rates since the mathematical models that determine fairvalue use changing spreads as a signal of a changing likelihood of default inthe future.

Thefollowing table shows the change in fair value for all business activities withsignificant credit spread risk. We employ proprietary cash flow and stochasticdefault models to derive these values.

| **Business Activity**                   | ** ** | ** **             | ** ** | **Fair Value at**December 31, 2006 | ** ** | **+25 bps  per annum  Credit Spread Shift** | ** ** | **-25 bps  per annum  Credit Spread Shift** | ** ** |
|----------------------------------------------|------------|------------------------|------------|--------------------------------------------------------|------------|-----------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                   | ** ** | **(in millions)** | ** ** |
| ACA Financial  Guaranty investment portfolio |       |                   | $          | 489.6                                                  |       |                                                            |       | $                                                               | (8.6       | ) |   |   | $ | 8.6 |   |   |
| CDOs(1)                                      |       |                   | 4,656.0    |                                                   |       |                                                            | (37.1      | )                                                               |       |   | 35.8 |   |   |
| Structured Credit                            |       |                   | 3.1        |                                                   |       |                                                            | (3.6       | )                                                               |       |   | 2.7 |   |   |
|                                         |       |                   | $          | 5,148.7                                                |       |                                                            |       | $                                                               | (49.3      | ) |   |   | $ | 47.1 |   |   |

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(1)          Includes guaranteedinvestment contract balance of $119.3 million.

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We chose stresses of plusor minus 25 basis points per annum for the credit spread risk sensitivity, asopposed to a larger value, since many of the underlying spreads are less than100 basis points per annum.

*Asset CorrelationRisk*

For a hypothetical portfolio of debt instruments, thecorrelation among the positions does not affect the fair value of theportfolio. For portfolios of debt instruments that are divided into risk layers(*i.e.* , “AAA” through equity) ortranches, however, the correlation among the risk positions is significantbecause higher correlations could lead to greater or lower risk of defaultbased on the position of the given risk layer. Such risk exists primarily inour CDO Asset Management and Structured Credit businesses. The industrymeasures this correlation as “asset correlation,” which is defined as thecorrelation of the enterprise value of one firm to another. We performproprietary mathematical calculations and assign asset correlation values toall corporate, asset-backed, mortgage-backed, and municipal risk positions inorder to generate fair value and risk-related results.

Thefollowing table shows the change in fair value for these two businessactivities with significant asset correlation risk. We employ proprietary cashflow, asset correlation, and stochastic default models to derive these values.

| **Business Activity** | ** ** | ** **             | ** ** | **Fair Value at**December 31, 2006 | ** ** | **+5% Shift in Asset  Correlation** | ** ** | **-5% Shift in Asset  Correlation** | ** ** |
|----------------------------|------------|------------------------|------------|--------------------------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                 | ** ** | **(in millions)** | ** ** |
| CDOs(1)                    |       |                   | $          | 4,656.0                                                |       |                                               |       | $                                                  | 0.1        |   |   |   | $ | — |   |   |
| Structured Credit          |       |                   | 3.1        |                                                   |       |                                               | (8.5       | )                                                  |       |   | 1.2 |   |   |
|                       |       |                   | $          | 4,659.1                                                |       |                                               |       | $                                                  | (8.4       | ) |   |   | $ | 1.2 |   |   |

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(1)          Includesguaranteed investment contract balance of $119.3 million.

*Other Market Risks*

In addition to the above-mentioned risks, the ultimatereturn we realize on our equity investments in our CDOs is impacted by severalother market risks. These risks are ABS prepayment risk, reinvestment risk andcommercial paper refunding risk. Because our equity exposure behaves like afloating-rate obligation, our equity return depends on the leverage of thetransaction (total portfolio size divided by the equity tranche size). Earlyprepayments on the ABS underlying the CDO would delever the transaction and,thus, diminish the returns to the equity holders. This risk is mitigatedsomewhat by the fact that the majority of the underlying CDO ABS pay interestbased on floating rate, making them less sensitive to prepayments. Our ACAFinancial Guaranty investment portfolio could also be impacted by prepayments.We limit this exposure by imposing limits on the amount of such securities heldin this portfolio.

Nine of our funded CDO transactions are currently inthe “reinvestment period.”  This meansthat as the asset-backed securities (in six CDOs) or the leveraged loans (in threeCDOs) return principal to the CDO portfolios, we re-invest the principalproceeds rather than repay CDO debt. Since the CDO liability cost is frozen atinception (either as a fixed coupon, or, more typically, as a fixed spread toLIBOR), we, as equity investor bear the risk that reinvestment spreads willdecrease. Conversely, increasing reinvestment spreads benefit our equity investment.

In two of our consolidatedCDO transactions, the senior liability (of approximately $1.3 billion ineach as at December 31,2006) is comprised of commercial paper. Hence, our balance sheet carriesapproximately $2.7 billion of short-term debt or commercial paper as at December 31, 2006 that we refund,on average, monthly. The typical yield cost of this commercial paper (includingdealer cost) is LIBOR-flat. Our risk is that future issuances may give thecommercial paper a positive spread to LIBOR. There is no guarantee thatinvestors will continue to buy this CDO commercial paper at LIBOR-flat.Alternatively, this future commercial paper funding could fall below LIBOR. Wemanage this refunding risk by negotiating 

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into theCDO transaction, caps on the spread to LIBOR. As a result, the commercialpaper, or CP, yield cannot exceed LIBOR +40 basis points per annum due to thepresence of put option contracts. An increase in the spread above LIBORdirectly impacts our equity investment. When the CP spread widens (tightens),we receive lesser (greater) cash distributions.

*Credit Fund*

We view the market risks (principally interest rateand credit spread risk) in the Credit Fund as not material to our financialposition as of December 31, 2006. While the Credit Fund is consolidatedfor financial reporting purposes, we owned $17.0 million of equity in the fundat December 31, 2006. Total invested assets of the fund were approximately$264.6 million at December 31, 2006. The fund hedges interest rate risk onits fixed rate assets when necessary to remain close to market neutral withrespect to interest rate risk. At December 31, 2006, the weighted modifiedduration of the portfolio was less than one year. Additionally, at December 31,2006, the vast majority of the bonds held in the fund were floating interestrate payers which have minimal interest rate risk. Finally, over 86**%** of the assets held in the fund as of December 31,2006 had a credit quality of AAA, thereby substantially reducing credit spreadrisk.

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**Item 8.**                        FinancialStatements and Supplementary Data.

**Report ofIndependent Registered Public Accounting Firm**

To the Board of Directors and Stockholders ofACA Capital Holdings, Inc.New York, New York

We have audited the accompanying consolidated balancesheets of ACA Capital Holdings, Inc. and subsidiaries (the “Company”) asof December 31, 2006 and 2005, and the related consolidated statements ofoperations, stockholders’ equity, and cash flows for each of the three years inthe period ended December 31, 2006. Our audits also included the financialstatement schedules listed in the Index at Item 15. These financial statementsand financial statement schedules are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on the financialstatements and financial statement schedules based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. The Company is not required to have, nor were we engaged toperform, an audit of its internal control over financial reporting. Our auditsincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

In our opinion, suchconsolidated financial statements present fairly, in all material respects, thefinancial position of ACA Capital Holdings, Inc.**and subsidiaries at December 31, 2006 and 2005, andthe results of their operations and their cash flows for each of the threeyears in the period ended December 31, 2006, in conformity with accountingprinciples generally accepted in the United States of America. Also, in ouropinion, such financial statement schedules, when considered in relation to thebasic consolidated financial statements taken as a whole, present fairly in allmaterial respects the information set forth therein.

*/s/*DELOITTE &TOUCHE LLP

New York, New YorkMarch 30, 2007

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**ACA CAPITALHOLDINGS, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSAS OF DECEMBER 31, 2006 AND 2005(Dollars in thousands)**
|                                                                                                                                                                                                                                                                     | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **ASSETS**                                                                                                                                                                                                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Investments:                                                                                                                                                                                                                                                        |       |       |       |       |       |
| Fixed-maturity  securities available for sale at fair value, amortized cost of $5,043,239 and  $5,292,081, respectively                                                                                                                                             |       | $          | 5,026,276  |       | $          | 5,298,739 |   |
| Fixed-maturity  securities trading at fair value, amortized cost of $251,884 and $0,  respectively                                                                                                                                                                  |       | 251,825    |       | —     |       |
| Securities  purchased under agreements to resell                                                                                                                                                                                                                    |       | 10,248     |       | —     |       |
| Guaranteed  investment contract                                                                                                                                                                                                                                     |       | 119,340    |       | 119,340    |       |
| Total investments                                                                                                                                                                                                                                                   |       | 5,407,689  |       | 5,418,079  |       |
| Cash:                                                                                                                                                                                                                                                               |       |       |       |       |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                          |       | 379,905    |       | 174,420    |       |
| Restricted cash                                                                                                                                                                                                                                                     |       | 67,061     |       | 50,185     |       |
| Total cash                                                                                                                                                                                                                                                          |       | 446,966    |       | 224,605    |       |
| Accrued investment  income                                                                                                                                                                                                                                          |       | 21,222     |       | 17,258     |       |
| Derivative assets                                                                                                                                                                                                                                                   |       | 19,730     |       | 15,250     |       |
| Deferred policy  acquisition costs, net                                                                                                                                                                                                                             |       | 48,810     |       | 47,414     |       |
| Deferred debt  issuance costs, net                                                                                                                                                                                                                                  |       | 34,104     |       | 40,843     |       |
| Receivable for  securities sold                                                                                                                                                                                                                                     |       | 824        |       | —     |       |
| Prepaid  reinsurance premiums                                                                                                                                                                                                                                       |       | 528        |       | 848        |       |
| Other assets                                                                                                                                                                                                                                                        |       | 58,321     |       | 27,903     |       |
| **Total  assets**                                                                                                                                                                                                                                                   |       | $          | 6,038,194  |       | $          | 5,792,200 |   |
| **LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS’  EQUITY**                                                                                                                                                                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| LIABILITIES                                                                                                                                                                                                                                                         |       |       |       |       |       |
| Unearned premiums                                                                                                                                                                                                                                                   |       | $          | 189,537    |       | $          | 187,739 |   |
| Reserve for losses  and loss adjustment expenses                                                                                                                                                                                                                    |       | 42,113     |       | 34,306     |       |
| Short-term debt                                                                                                                                                                                                                                                     |       | 2,677,828  |       | 2,674,698  |       |
| Long-term debt                                                                                                                                                                                                                                                      |       | 2,125,914  |       | 2,254,650  |       |
| Related party debt                                                                                                                                                                                                                                                  |       | 100,000    |       | 100,000    |       |
| Securities sold  under agreements to repurchase                                                                                                                                                                                                                     |       | 232,227    |       | —     |       |
| Derivative  liabilities                                                                                                                                                                                                                                             |       | 33,874     |       | 46,538     |       |
| Accrued interest  payable                                                                                                                                                                                                                                           |       | 17,900     |       | 15,347     |       |
| Accrued expenses  and other liabilities                                                                                                                                                                                                                             |       | 61,855     |       | 32,277     |       |
| Payable for  securities purchased                                                                                                                                                                                                                                   |       | 9,628      |       | 30,138     |       |
| Current income tax  payable                                                                                                                                                                                                                                         |       | 7,056      |       | 3,044      |       |
| Deferred income  taxes                                                                                                                                                                                                                                              |       | 258        |       | 6,909      |       |
| Total liabilities                                                                                                                                                                                                                                                   |       | 5,498,190  |       | 5,385,646  |       |
| MINORITY INTEREST                                                                                                                                                                                                                                                   |       | 30,190     |       | 22,241     |       |
| COMMITMENTS AND CONTINGENCIES                                                                                                                                                                                                                                       |       |       |       |       |       |
| STOCKHOLDERS’ EQUITY                                                                                                                                                                                                                                           |       |       |       |       |       |
| Senior convertible  preferred stock—0 and 220 shares authorized, 0 shares and 129 shares issued and  outstanding at December 31, 2006 and 2005, respectively                                                                                              |       | —     |       | 7,339      |       |
| Convertible  preferred stock—0 and 1,500 shares authorized, 0 and 959 shares issued and outstanding  at December 31, 2006 and 2005, respectively                                                                            |       | —     |       | 54,858     |       |
| Series B  senior convertible preferred stock—0 and 3,000,000 shares authorized, 0 and  2,785,769 shares issued and outstanding at December 31, 2006 and 2005,  respectively                                                                          |       | —     |       | 164,263    |       |
| Common stock of  100,000,000 shares authorized at December 31, 2006 and 12,000,000 shares  authorized at December 31, 2005; 37,375,123 and 6,442,950 shares issued  and outstanding at December 31, 2006 and 2005, respectively; par value  of $0.10 |       | 3,737      |       | 644        |       |
| Gross paid-in and  contributed capital                                                                                                                                                                                                                              |       | 438,935    |       | 125,184    |       |
| Treasury stock at  cost—851,847 shares and 351,876 shares at December 31, 2006 and 2005,  respectively                                                                                                                                                    |       | (12,088    | )          | (5,500     | )          |
| Notes receivable  from stockholders                                                                                                                                                                                                                                 |       | (3,121     | )          | (1,355     | )          |
| Deferred  compensation                                                                                                                                                                                                                                              |       | (870       | )          | (2,030     | )          |
| Accumulated other  comprehensive (loss) income—net of deferred income tax of $(1,760) and$5,369  at December 31, 2006 and 2005, respectively                                                                                |       | (3,308     | )          | 11,132     |       |
| Retained earnings                                                                                                                                                                                                                                                   |       | 86,529     |       | 29,778     |       |
| Total  stockholders’ equity                                                                                                                                                                                                                                    |       | 509,814    |       | 384,313    |       |
| **Total  liabilities, minority interest and stockholders’ equity**                                                                                                                                                                                             |       | $          | 6,038,194  |       | $          | 5,792,200 |   |

 

See notes to consolidated financial statements.

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**ACA CAPITAL HOLDINGS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSFOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004(Dollars and shares in thousands, except per share amounts)**
|                                                              | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|--------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| REVENUES:                                                    |       |       |       |       |       |       |       |
| Gross premiums written                                       |       | $          | 31,322     |       | $          | 41,280     |       | $ | 44,570 |   |
| Less premiums ceded                                          |       | (505       | )          | 638        |       | 911        |       |
| Net premiums written                                         |       | 30,817     |       | 41,918     |       | 45,481     |       |
| Increase in unearned premium reserve - net                   |       | (2,118     | )          | (8,575     | )          | (15,648    | )          |
| Premiums earned                                              |       | 28,699     |       | 33,343     |       | 29,833     |       |
| Net insured credit swap revenue                              |       | 57,602     |       | 21,571     |       | 16,018     |       |
| Net investment income                                        |       | 338,166    |       | 254,591    |       | 126,170    |       |
| Net realized and unrealized losses on investments            |       | (4,034     | )          | (2,777     | )          | (6,547     | )          |
| Net realized and unrealized gains on derivative  instruments |       | 8,559      |       | 8,410      |       | 6,520      |       |
| Other net credit swap revenue                                |       | 10,106     |       | 4,157      |       | 10,990     |       |
| Fee income                                                   |       | 24,495     |       | 11,110     |       | 6,091      |       |
| Other income                                                 |       | 522        |       | 189        |       | 3,937      |       |
| Total revenues                                               |       | 464,115    |       | 330,594    |       | 193,012    |       |
| EXPENSES:                                                    |       |       |       |       |       |       |       |
| Loss and loss adjustment expenses                            |       | 8,800      |       | 14,038     |       | 46,590     |       |
| Policy acquisition costs                                     |       | 8,740      |       | 8,652      |       | 3,835      |       |
| Other operating expenses                                     |       | 49,436     |       | 37,443     |       | 38,645     |       |
| Interest expense                                             |       | 291,757    |       | 214,313    |       | 101,137    |       |
| Depreciation and amortization                                |       | 9,556      |       | 8,583      |       | 6,935      |       |
| Total expenses                                               |       | 368,289    |       | 283,029    |       | 197,142    |       |
| (Income) loss of minority interest                           |       | (4,038     | )          | (3,708     | )          | 476        |       |
| Income (loss) before income taxes                            |       | 91,788     |       | 43,857     |       | (3,654     | )          |
| Provision for income tax expense                             |       | 33,080     |       | 15,097     |       | 135        |       |
| Net income (loss)                                            |       | $          | 58,708     |       | $          | 28,760     |       | $ | (3,789 | ) |
| **Share  and Per Share Data**                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Earnings (loss) per  share                                   |       |       |       |       |       |       |       |
| Basic                                                        |       | $          | 2.38       |       | $          | 1.26       |       | $ | (0.61 | ) |
| Diluted                                                      |       | $          | 1.89       |       | $          | 0.96       |       | $ | (0.61 | ) |
| Weighted average  shares outstanding                         |       |       |       |       |       |       |       |
| Basic                                                        |       | 24,694     |       | 22,794     |       | 6,168      |       |
| Diluted                                                      |       | 31,032     |       | 29,886     |       | 6,168      |       |

 

See notes to consolidated financial statements.

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**ACA CAPITAL HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004 (Dollars in thousands, except for share amounts)**

| ** **                                                                                   | ** ** | ** **               | ** ** | ** **            | ** ** | **Gross**        | ** ** | ** ** | ** ** | ** **     | ** ** | ** **   | ** ** | **Accumu-l**ated | ** ** | ** **    | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|------------------|------------|------------|------------|----------------|------------|--------------|------------|------------------|------------|---------------|------------|------------|------------|
| ** **                                                                                   | ** ** | ** **               | ** ** | ** **            | ** ** | **Paid in** | ** ** | ** ** | ** ** | ** **     | ** ** | ** **   | ** ** | **Other**        | ** ** | ** **    | ** ** | ** ** | ** ** |
| ** **                                                                                   | ** ** | ** **               | ** ** | ** **            | ** ** | **And**          | ** ** | ** ** | ** ** | **Notes**      | ** ** | ** **   | ** ** | **Compre-**      | ** ** | ** **    | ** ** | **Total**  | ** ** |
| ** **                                                                                   | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Contri-**      | ** ** | ** ** | ** ** | **Receivable** | ** ** | **Deferred** | ** ** | **hensive**      | ** ** | ** **    | ** ** | **Stock-** | ** ** |
| ** **                                                                                   | ** ** | ** **               | ** ** | ** **            | ** ** | ** **       | ** ** | **Par**    | ** ** | **buted**      | ** ** | **Treasury** | ** ** | **from**         | ** ** | **Compensa-** | ** ** | **Income** | ** ** | **Retained** | ** ** | **holders’** | ** ** |
| ** **                                                                                   | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**       | ** ** | **Value**  | ** ** | **Capital**    | ** ** | **Stock**    | ** ** | **Stockholders** | ** ** | **tion**      | ** ** | **(Loss)** | ** ** | **Earnings** | ** ** | **Equity** | ** ** |
| BALANCE—December 31, 2003                                                          |       | 1,088                    |       | $                     | 62,197     |             | 6,442,950  |       | $          | 644            |       | $            | 125,184    |             |       | $             | (3,222     | )          |       |   | $ | (4,200 | ) |   |   | $ | — |   |   | $ | 8,896 |   |   | $ | 4,807 |   |   | $ | 194,306 |   |   |
| Comprehensive income:                                                                        |       |                     |       |                  |       |             |       |       |       |           |       |         |       |             |       |          |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                                                     |       | —                   |       | —                |       | —           |       | —     |       | —         |       |         | —     |             |       |          | —     |       |       |   | — |   |   | — |   |   | (3,789 | ) |   | (3,789 | ) |   |
| Change in unrealized gain on investments, net of  change in deferred income tax of $6,812    |       | —                   |       | —                |       | —           |       | —     |       | —         |       |         | —     |             |       |          | —     |       |       |   | — |   |   | 13,056 |   |   | — |   |   | 13,056 |   |   |
| Total comprehensive income                                                                   |       | —                   |       | —                |       | —           |       | —     |       | —         |       |         | —     |             |       |          | —     |       |       |   | — |   |   | — |   |   | — |   |   | 9,267 |   |   |
| Changes  in Senior convertible preferred stock:                                              |       |                     |       |                  |       |             |       |       |       |           |       |         |       |             |       |          |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Issuance of Series A senior convertible  preferred stock                                |       | 307,131                  |       | 28,600                |       | —           |       | —     |       | —         |       |         | —     |             |       |          | —     |       |       |   | — |   |   | — |   |   | — |   |   | 28,600 |   |   |
| Transfer from Series A senior conv. prf to  Series B                               |       | (307,131                 | )          | (28,600               | )          | —           |       | —     |       | —         |       |         | —     |             |       |          | —     |       |       |   | — |   |   | — |   |   | — |   |   | (28,600 | ) |   |
| Transfer to Series B senior conv. prf from  Series A                               |       | 459,143                  |       | 28,600                |       | —           |       | —     |       | —         |       |         | —     |             |       |          | —     |       |       |   | — |   |   | — |   |   | — |   |   | 28,600 |   |   |
| Issuance of Series B senior convertible  preferred stock                                |       | 2,252,256                |       | 140,293               |       | —           |       | —     |       | —         |       |         | —     |             |       |          | —     |       |       |   | — |   |   | — |   |   | — |   |   | 140,293 |   |   |
| Grant of Series B senior conv. prf stock to CEO                                         |       | 55,869                   |       | 3,480                 |       | —           |       | —     |       | —         |       |         | —     |             |       |          | —     |       |       |   | (3,190 | ) |   | — |   |   | — |   |   | 290 |   |   |
| Less capitalized costs of raising capital                                                    |       | —                   |       | (9,323                | )          | —           |       | —     |       | —         |       |         | —     |             |       |          | —     |       |       |   | — |   |   | — |   |   | — |   |   | (9,323 | ) |   |
| Issuance of Series C senior convertible  preferred stock                                |       | 13,501                   |       | 841                   |       | —           |       | —     |       | —         |       |         | —     |             |       |          | —     |       |       |   | — |   |   | — |   |   | — |   |   | 841 |   |   |
| Employee stock buyback                                                                       |       | —                   |       | —                |       | —           |       | —     |       | —         |       |         | (2,204     | )                |       |          | 2,200      |       |       |   | — |   |   | — |   |   | — |   |   | (4 | ) |   |
| Principal paydowns                                                                           |       | —                   |       | —                |       | —           |       | —     |       | —         |       |         | —     |             |       |          | 344        |       |       |   | — |   |   | — |   |   | — |   |   | 344 |   |   |
| BALANCE—December 31, 2004                                                          |       | 2,781,857                |       | 226,088               |       | 6,442,950        |       | 644        |       | 125,184        |       |         | (5,426     | )                |       |          | (1,656     | )          |       |   | (3,190 | ) |   | 21,952 |   |   | 1,018 |   |   | 364,614 |   |   |
| Comprehensive income:                                                                        |       |                     |       |                  |       |             |       |       |       |           |       |         |       |             |       |          |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                                                                   |       | —                   |       | —                |       | —           |       | —     |       | —         |       |         | —     |             |       |          | —     |       |       |   | — |   |   | — |   |   | 28,760 |   |   | 28,760 |   |   |
| Change in unrealized gain on investments, net of  change in deferred income tax of $(10,343) |       | —                   |       | —                |       | —           |       | —     |       | —         |       |         | —     |             |       |          | —     |       |       |   | — |   |   | (19,212 | ) |   | — |   |   | (19,212 | ) |   |
| Change in derivative hedges, net of change in deferred  income tax of $4,518                 |       | —                   |       | —                |       | —           |       | —     |       | —         |       |         | —     |             |       |          | —     |       |       |   | — |   |   | 8,392 |   |   | — |   |   | 8,392 |   |   |
| Total comprehensive income                                                                   |       | —                   |       | —                |       | —           |       | —     |       | —         |       |         | —     |             |       |          | —     |       |       |   | — |   |   | — |   |   | — |   |   | 17,940 |   |   |
| Changes  in Senior convertible preferred stock:                                              |       |                     |       |                  |       |             |       |       |       |           |       |         |       |             |       |          |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Issuance of Series C senior convertible  preferred stock                                |       | 5,000                    |       | 372                   |       | —           |       | —     |       | —         |       |         | —     |             |       |          | —     |       |       |   | — |   |   | — |   |   | — |   |   | 372 |   |   |
| Vesting of Series B senior conv. prf stock to  CEO                                      |       | —                   |       | —                |       | —           |       | —     |       | —         |       |         | —     |             |       |          | —     |       |       |   | 1,160 |   |   | — |   |   | — |   |   | 1,160 |   |   |
| Transfer from Series C senior conv. prf to  Series B                               |       | (18,501                  | )          | (1,213                | )          | —           |       | —     |       | —         |       |         | —     |             |       |          | —     |       |       |   | — |   |   | — |   |   | — |   |   | (1,213 | ) |   |
| Transfer to Series B senior conv. prf from  Series C                               |       | 18,501                   |       | 1,213                 |       | —           |       | —     |       | —         |       |         | —     |             |       |          | —     |       |       |   | — |   |   | — |   |   | — |   |   | 1,213 |   |   |
| Employee stock buyback                                                                       |       | —                   |       | —                |       | —           |       | —     |       | —         |       |         | (74        | )                |       |          | —     |       |       |   | — |   |   | — |   |   | — |   |   | (74 | ) |   |
| Employee stock principal paydown                                                             |       | —                   |       | —                |       | —           |       | —     |       | —         |       |         | —     |             |       |          | 301        |       |       |   | — |   |   | — |   |   | — |   |   | 301 |   |   |
| BALANCE—December 31,  2005                                                         |       | 2,786,857                |       | 226,460               |       | 6,442,950        |       | 644        |       | 125,184        |       |         | (5,500     | )                |       |          | (1,355     | )          |       |   | (2,030 | ) |   | 11,132 |   |   | 29,778 |   |   | 384,313 |   |   |
|                                                                                              |            |                          |            |                       |            |                  |            |            |            |                |            |              |            |                  |            |               |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

See notes to consolidated financial statements.

94

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**ACA CAPITAL HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued) FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004 (Dollars in thousands, except for share amounts)**

 

| Comprehensive income:                                                                       |   |       |   |     |   |       |   |   |   |    |   |   |   |   |   |   |   |   |   |   |   |   |   |    |   |   |   |   |   |    |   |
|---------------------------------------------------------------------------------------------|--------|------------|--------|----------|--------|------------|--------|--------|--------|---------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|---------|--------|--------|--------|--------|--------|---------|--------|
| Net income                                                                                  |   | —     |   | —   |   | —     |   | — |   | —  |   |   | — |   |   |   | — |   |   |   | — |   |   | —  |   |   | 58,708 |   |   | 58,708  |   |
| Change in unrealized gain on investments, net of  change in deferred income tax of $(6,907) |   | —     |   | —   |   | —     |   | — |   | —  |   |   | — |   |   |   | — |   |   |   | — |   |   | (13,989 | )      |   | — |   |   | (13,989 | )      |
| Change in derivative hedges, net of change in  deferred income tax of $(221)                |   | —     |   | —   |   | —     |   | — |   | —  |   |   | — |   |   |   | — |   |   |   | — |   |   | (411    | )      |   | — |   |   | (411    | )      |
| Foreign exchange unrealized loss                                                            |   | —     |   | —   |   | —     |   | — |   | —  |   |   | — |   |   |   | — |   |   |   | — |   |   | (40     | )      |   | — |   |   | (40     | )      |
| Total comprehensive income                                                                  |   | —     |   | —   |   | —     |   | — |   | —  |   |   | — |   |   |   | — |   |   |   | — |   |   | —  |   |   | — |   |   | 44,268  |   |
| Vesting of Series B senior conv. prf stock to  CEO                                     |   | —     |   | —   |   | —     |   | — |   | —  |   |   | — |   |   |   | — |   |   |   | 1,160  |   |   | —  |   |   | — |   |   | 1,160   |   |
| Exercise of stock options by former officer                                                 |   | —     |   | —   |   | 663,540    |   | 66     |   | 8,024   |   |   | — |   |   |   | — |   |   |   | — |   |   | —  |   |   | — |   |   | 8,090   |   |
| Common stock purchased from former officer                                                  |   | —     |   | —   |   | —     |   | — |   | —  |   |   | (6,588 | )      |   |   | — |   |   |   | — |   |   | —  |   |   | — |   |   | (6,588  | )      |
| Stock based compensation expense                                                            |   | —     |   | —   |   | —     |   | — |   | 895     |   |   | — |   |   |   | — |   |   |   | — |   |   | —  |   |   | — |   |   | 895     |   |
| Issuance of note receivable from stockholder                                                |   | —     |   | —   |   | —     |   | — |   | —  |   |   | — |   |   |   | (2,262 | )      |   |   | — |   |   | —  |   |   | — |   |   | (2,262  | )      |
| Discharge of note receivable from stockholders                                              |   | —     |   | —   |   | —     |   | — |   | —  |   |   | — |   |   |   | 496    |   |   |   | — |   |   | —  |   |   | — |   |   | 496     |   |
| Senior convertible preferred stock dividend                                                 |   | 25         |   | 1,957    |   | —     |   | — |   | —  |   |   | — |   |   |   | — |   |   |   | — |   |   | —  |   |   | (1,957 | )      |   | —  |   |
| Issuance of common stock in initial public offering                                         |   | —     |   | —   |   | 6,875,000  |   | 688    |   | 78,642  |   |   | — |   |   |   | — |   |   |   | — |   |   | —  |   |   | — |   |   | 79,330  |   |
| Grant of restricted stock                                                                   |   | —     |   | —   |   | —     |   | — |   | 112     |   |   | — |   |   |   | — |   |   |   | — |   |   | —  |   |   | — |   |   | 112     |   |
| Conversion of preferred stock to common stock in  conjunction with initial public offering  |   | (2,786,882 | )      | (228,417 | )      | 23,393,633 |   | 2,339  |   | 226,078 |   |   | — |   |   |   | — |   |   |   | — |   |   | —  |   |   | — |   |   | —  |   |

| BALANCE—December 31,  2006 |   | $ | — |   | $ | — |   | 37,375,123 |   | $ | 3,737 |   | $ | 438,935 |   |   | $ | (12,088 | ) |   |   | $ | (3,121 | ) |   |   | $ | (870 | ) |   | $ | (3,308 | ) |   | $ | 86,529 |   |   | $ | 509,814 |   |
|--------------------------------------|--------|---|--------|--------|---|--------|--------|------------|--------|---|-------|--------|---|---------|--------|--------|---|---------|---|--------|--------|---|--------|---|--------|--------|---|------|---|--------|---|--------|---|--------|---|--------|--------|--------|---|---------|--------|

 

See notes to consolidated financial statements.

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**ACA CAPITALHOLDINGS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004(Dollars in thousands)**
|                                                                                           | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |   |
|-------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|--------|
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss)                                                                         |       | $          | 58,708     |       | $          | 28,760     |       | $      | (3,789 | ) |
| Adjustments to reconcile  net income (loss) to net cash provided by operating activities: |       |       |       |       |       |       |       |
| Severance expense related to former executive stock  options exercise                     |       | 1,306      |       | —     |       | —     |       |
| Depreciation and amortization                                                             |       | 9,556      |       | 8,583      |       | 6,935      |       |
| Accrual of discount and amortization of premium on  investment—net                   |       | 517        |       | 503        |       | 312        |       |
| (Income) loss of minority interest                                                        |       | 4,038      |       | 3,708      |       | (476       | )          |
| Net realized losses on fixed-maturity  securities-available-for-sale                      |       | 3,851      |       | 2,777      |       | 6,547      |       |
| Net realized and unrealized losses on fixed-maturity  securities trading                  |       | 183        |       | —     |       | —     |       |
| Proceeds from (payment for) termination of  derivatives                                   |       | —     |       | (3,837     | )          | 916        |       |
| Net realized and unrealized (gains) losses on net  insured credit swap revenue            |       | (6,478     | )          | 5,663      |       | (6,160     | )          |
| Net realized and unrealized gains on derivative  instruments                              |       | (8,559     | )          | (8,410     | )          | (6,520     | )          |
| Net realized and unrealized (gains) losses on other  net credit swap revenue              |       | 180        |       | 4,466      |       | (2,160     | )          |
| Stock based compensation expense                                                          |       | 1,007      |       | —     |       | —     |       |
| Discharge of note receivable from shareholders                                            |       | 496        |       | 264        |       | —     |       |
| Deferred compensation                                                                     |       | 1,160      |       | 1,160      |       | (3,190     | )          |
| Purchase of securities under agreement to resell                                          |       | (10,248    | )          | —     |       | —     |       |
| Purchases of fixed-maturity securities trading                                            |       | (391,731   | )          | —     |       | —     |       |
| Proceeds from sales and maturities of fixed-maturity  securities trading                  |       | 144,466    |       | —     |       | —     |       |
| Securities sold under agreements to repurchase                                            |       | 232,227    |       | —     |       | —     |       |
| Changes in assets and  liabilities:                                                       |       |       |       |       |       |       |       |
| Income taxes payable                                                                      |       | 4,012      |       | 704        |       | 3,783      |       |
| Deferred income tax expense                                                               |       | 1,714      |       | 719        |       | (3,322     | )          |
| Prepaid reinsurance premiums                                                              |       | 320        |       | 976        |       | 7,785      |       |
| Payable and accrued expenses                                                              |       | 1,034      |       | 7,015      |       | 4,881      |       |
| Deferred policy acquisition costs                                                         |       | (1,396     | )          | (858       | )          | (4,833     | )          |
| Unearned premium reserve                                                                  |       | 1,798      |       | 7,599      |       | 7,803      |       |
| Derivative liabilities                                                                    |       | (2,927     | )          | 16,725     |       | 897        |       |
| Loss and loss adjustment expenses                                                         |       | 7,807      |       | (1,700     | )          | 31,022     |       |
| Interest payable                                                                          |       | 2,553      |       | 3,844      |       | 3,849      |       |
| Interest receivable                                                                       |       | (3,964     | )          | (4,904     | )          | (4,894     | )          |
| Other                                                                                     |       | (5,323     | )          | (9,319     | )          | (14,316    | )          |
| Net cash provided by operating activities                                                 |       | 46,307     |       | 64,438     |       | 25,070     |       |   |
| CASH FLOWS FROM INVESTING  ACTIVITIES:                                                    |       |       |       |       |       |       |       |   |
| Net (deposit) release of restricted cash                                                  |       | (16,876    | )          | (20,112    | )          | 660        |       |   |
| Purchases of fixed maturity securities available for  sale                                |       | (1,082,587 | )          | (1,333,288 | )          | (2,918,437 | )          |   |
| Redemptions of guaranteed investment contract                                             |       | —     |       | 3,260      |       | (100       | )          |   |
| Proceeds from sales of fixed maturity securities  available for sale                      |       | 154,015    |       | 187,962    |       | 349,741    |       |   |
| Proceeds from maturities of fixed maturity securities  available for sale                 |       | 1,146,970  |       | 918,716    |       | 479,030    |       |   |
| Net purchase of property and equipment                                                    |       | (2,602     | )          | (597       | )          | (983       | )          |   |
| Net cash provided by (used in) investing activities                                       |       | 198,920    |       | (244,059   | )          | (2,090,089 | )          |   |
| CASH FLOWS FROM FINANCING  ACTIVITIES:                                                    |       |       |       |       |       |       |       |   |
| Proceeds from issuance of debt                                                            |       | —     |       | 106,867    |       | 745,141    |       |   |
| Proceeds from issuance of short term debt—net                                        |       | 3,130      |       | 204,948    |       | 1,207,341  |       |   |
| Paydown on long-term debt                                                                 |       | (128,736   | )          | (185,514   | )          | (13,965    | )          |   |
| Payment of issuance costs for debt                                                        |       | —     |       | (1,461     | )          | (15,993    | )          |   |
| Net proceeds from common stock initial public  offering                                   |       | 79,330     |       | —     |       | —     |       |   |
| Minority interest investment in CDOs                                                      |       | —     |       | —     |       | 18,500     |       |   |
| Minority interest investment in credit fund                                               |       | 8,600      |       | —     |       | —     |       |   |
| Proceeds from issuance of preferred stock net of  issuance costs                          |       | —     |       | 311        |       | 163,891    |       |   |
| Net (payments) proceeds from hedging activities                                           |       | —     |       | —     |       | 8,245      |       |   |
| Purchase of treasury stock                                                                |       | (2,066     | )          | (74        | )          | (4         | )          |   |
| Notes receivable from stockholders                                                        |       | —     |       | 37         |       | 344        |       |   |
| Payment on capital lease obligations                                                      |       | —     |       | —     |       | (1,157     | )          |   |
| Net cash (used in) provided by financing activities                                       |       | (39,742    | )          | 125,114    |       | 2,112,343  |       |   |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                      |       | 205,485    |       | (54,507    | )          | 47,324     |       |   |
| CASH AND CASH EQUIVALENTS—beginning of period                                        |       | 174,420    |       | 228,927    |       | 181,603    |       |   |
| CASH AND CASH EQUIVALENTS—end of period                                              |       | $          | 379,905    |       | $          | 174,420    |       | $      | 228,927 |   |   |
| SUPPLEMENTAL CASH FLOW  DISCLOSURES:                                                      |       |       |       |       |       |       |       |   |
| Federal and local income taxes paid                                                       |       | $          | 27,635     |       | $          | 14,070     |       | $      | 420 |   |   |
| Interest paid                                                                             |       | $          | 289,204    |       | $          | 210,469    |       | $      | 97,288 |   |   |
| SUPPLEMENTAL DISCLOSURE  OF NON-CASH FINANCING ACTIVITIES—                           |       |       |       |       |       |       |       |   |
| Common stock acquired in exchange for note receivable                                     |       | $          | 2,262      |       | $          | —     |       | $      | 2,200 |   |   |
| Share redemptions related  to exercised options by former employee                        |       | $          | 4,522      |       | $          | —     |       | $      | — |   |   |
|                                                                                           |            |            |            |            |            |            |            |        |  |  |  |  |  |  |  |

 

See notes to consolidated financial statements.

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**ACA CAPITALHOLDINGS, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004**

**1.**   BUSINESS,ORGANIZATION AND OPERATIONS

ACA Capital Holdings, Inc. (“ACA” or the “Company”),is a Delaware domiciled holding company that provides financial guarantyinsurance products to participants in the global credit derivatives markets,structured finance capital markets and municipal finance capital markets, aswell as providing asset management services. The Company’s principal activitiesinclude financial guaranty insurance of public finance obligations, structuredcredit risk assumption through insured credit derivatives and collateralizeddebt obligation asset management. ACA conducts its business through threeprincipal wholly-owned indirect subsidiaries. Its financial guaranty insurancebusiness is conducted through ACA Financial Guaranty Corporation (“ACAFinancial Guaranty”), a Maryland domiciled insurance company. ACA FinancialGuaranty is licensed to conduct financial guaranty insurance business, whichprovides credit enhancement on municipal and other public finance obligations,in all 50 states, the District of Columbia, Guam, the U.S. Virgin Islands andPuerto Rico. Standard & Poor’s Rating Services (“S&P”) hasassigned a financial strength rating of “A” to ACA Financial Guaranty. ACAFinancial Guaranty also provides the credit support for the Company’sStructured Credit business activities. Through ACA Service L.L.C. and ACAManagement, L.L.C., the Company conducts its CDO Asset Management business.This business encompasses the origination (in collaboration with investmentbanks), structuring and management of collateralized debt obligations(including collateralized loan obligations and other similarly securitizedasset classes, collectively “CDOs”). In January 2007, the Company’swholly-owned indirect subsidiary, ACA Capital Management (U.K.) Pte. Limited,became authorized and regulated by the Financial Services Authority as aninvestment manager to manage CDOs in the United Kingdom and most of Europe.

The Company defines its business as being composed ofthree distinct continuing lines of business or segments. They are PublicFinance, Structured Credit and CDO Asset Management. A fourth line of business,Other, includes business in areas and markets in which the Company is no longeractive. Although the Public Finance and Structured Credit businesses arereported in separate segments, together they form the Company’s financialguaranty insurance business. Public Finance provides financial guarantyinsurance policies guaranteeing the timely payment of scheduled principal andinterest on municipal debt obligations. Structured Credit structures and sellscredit protection, principally in the form of insured credit swaps (“CDS”),against a variety of asset classes in the institutional fixed income markets.CDO Asset Management focuses on CDO origination, structuring and management.The Company will at times assume risk in the CDOs it manages through investmentin some portion of the capital structure.

ACA was originally incorporated in Delaware on January 3,1997. On November 22, 2002, ACA changed its jurisdiction of incorporationfrom Delaware to Bermuda. During 2004, the Board of Directors determined that re-domesticatingto Delaware would eliminate certain adverse consequences of remaining inBermuda, facilitate ACA’s access to U.S. capital markets, simplify its taxfilings, accounting and operations, and reduce the costs of compliance with twosets of filing obligations and laws (as ACA stockholders are U.S. entities andindividuals). On September 15, 2004, therefore, ACA re-domesticated fromBermuda to Delaware through a process called a “discontinuation” under Bermudalaw and “domestication” under Delaware law. As a result, it became a Delawaredomiciled holding company and changed its name from American Capital AccessHoldings, Ltd. to its current name.

On November 9, 2006,the Company priced its initial public offering of 6,875,000 shares of newlyissued common stock and 23,541 shares of existing common stock. The Companyrealized gross proceeds 

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of $13per share on the newly issued common stock, or $89.4 million. Net proceeds tothe Company were $79.3 million, after issuance costs. On November 10,2006, the Company’s common stock commenced trading on the New York StockExchange under the symbol “ACA.”  In conjunction with the initial publicoffering, the Company’s senior convertible preferred stock, convertiblepreferred stock and series B senior convertible preferred stock all convertedto common stock concurrently with the closing of our offering on November 15,2006 at their conversion ratios of 6,000:1 shares, 6,000:1 shares and 6:1shares, respectively.

**2.**   SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES

***Basis ofPresentation******—***Theseconsolidated financial statements have been prepared in accordance withaccounting principles generally accepted in the United States of America, orU.S. GAAP. The preparation of financial statements in conformity with U.S. GAAPrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting periods. Actual results could differfrom those estimates.

Certain prior year items have been reclassified toconform to the current year presentation. These adjustments had no impact onnet income, earnings per share, cash flows or total stockholders’ equity.

***Principles ofConsolidation******—***Theconsolidated financial statements include the accounts of the Company and itssubsidiaries, which includes variable interest entities (“VIEs”) that are underthe Company’s control or where the Company is the primary beneficiary (seeNote 4). All intercompany accounts and transactions have been eliminatedin consolidation.

***Investments******—***The majorcomponents of the Company’s investment portfolio are the fixed maturitysecurities of ACA Financial Guaranty, the Company’s consolidated CDOs and itsCredit-focused Absolute Return Fixed Income Fund (the “Credit Fund”) (see Notes6 and 12). The Company accounts for its investments in fixed maturitysecurities in accordance with the Financial Accounting Standards Board’s (“FASB”)Statement of Financial Accounting Standards (“FAS”) 115, “*Accounting for Certain Investments in Debt and EquitySecurities*” (“FAS 115”) and Emerging Issues Task Force (“EITF”)Issue No. 99-20, “*Recognition ofInterest Income and Impairment on Purchased and Retained Beneficial Interestsin Securitized Financial Assets*” (“EITF 99-20”)  Managementdetermines the appropriate classification of securities at the time ofpurchase. As of December 31, 2006 and 2005, all investments in fixedmaturity securities, with the exception of the Company’s investments in theCredit Fund, were designated as available-for-sale and were carried at fairvalue. Fixed maturity securities in the Credit Fund are designated as tradingand are also carried at fair value. The difference between fair value andamortized cost of available for sale securities is included in the accumulatedother comprehensive income component of stockholders’ equity, net of applicabledeferred income tax. The Company recognized investment gains (losses) in itsStatement of Operation related to amounts included in other comprehensiveincome in prior years of $(4.1) million, $0.4 million and $(0.6) million forthe years ended December 31, 2006, 2005 and 2004, respectively. Theseamounts net of tax were $(2.7) million, $0.3 million and$(0.4) million for the years ended December 31, 2006, 2005 and 2004,respectively. Changes in fair value of trading securities are included in netincome. The fair values of these securities are based on independent marketquotations, broker quotes or, when such quotations are not readily availablebecause the securities are infrequently traded in the public market, frominternal valuation models. These models include estimates, made by management,which utilize current market information. The valuation results from thesemodels could differ materially from amounts realizable in an open market saleor exchange.

The Company consolidates a VIE whose primaryinvestment is a guaranteed investment contract (“GIC”). In the absence ofreadily ascertainable market value, GIC contracts are stated at fair value asdetermined by management. Management considers the GIC’s fair value toapproximate contract value, as the interest rate is variable at LIBOR less0.02% and resets on an annual basis. If, in the opinion of management, therewere an impairment of value based on their credit risk assessment, suchimpairment 

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would be recorded as anadjustment to the investment. As of December 31, 2006 and 2005, fair valueapproximates contract value.

Bond discounts and premiums are amortized over theremaining terms of the securities using the effective-yield method. Investmentincome is recorded as earned. For mortgaged-backed securities and any otherholdings for which there is prepayment risk, prepayment assumptions areevaluated at least annually and revised as necessary. Any adjustments requireddue to the resulting change in effective yields and maturities are recognizedcurrently in the Company’s consolidated statements of operations.

Realized gains and losses on the sale of investmentsare determined on the basis of specific identification and are included in netincome.

***Other thanTemporary Declines in Investments***—The Company’sprocess for identifying declines in the fair value of investments that areother than temporary involves consideration of several factors. These factorsinclude (i) the duration of a significant decline in value, (ii) theliquidity, business prospects and overall financial condition of the issuer, (iii) themagnitude of the decline, (iv) the collateral structure and other creditsupport, as applicable, (v) the Company’s intent and ability to hold theinvestment until the values recover, and (vi) for asset backed securities,the estimated cash flows. When the analysis of the above factors results in aconclusion that a decline in fair values is other than temporary, the cost ofthe security is written down to fair value as of the reporting date and anypreviously unrealized loss is realized in the period such a determination ismade (see Note 6).

***Cash and CashEquivalents***—Cash and cash equivalents include cashon hand, money market accounts and time deposits with banks with originalmaturities of three months or less. Included in cash and cash equivalents is$213.5 million and $106.3 million in cash of consolidated VIEs at December 31,2006 and 2005, respectively.

***Restricted Cash***—TheCompany, principally as collateral for certain credit default swap (“CDS”)exposures, has restricted cash on deposit not available for general operatingpurposes (see Note 22).

***DerivativeContracts***—All derivative instruments arerecognized in the consolidated balance sheets as either assets or liabilitiesdepending on the rights or obligations under the contracts. All derivativeinstruments are measured at estimated fair value. The fair values of derivativeinstruments are determined by broker quotes or valuation models when brokerquotes are not available. Valuation models include estimates made by managementutilizing current market information. The valuation results from these modelscould differ materially from amounts that would actually be realized in theopen market.

The Company has three main types of derivativeinstruments, each reported in different captions of the consolidated statementsof operations. The three types are insured credit swaps, principally recordedin the Structured Credit line of business, credit swaps in consolidated CDOsthat are not insured and interest swaps and caps included in consolidated CDOs.

Within the consolidated statements of operations,derivative contracts comprising insured credit swaps are reported as netinsured credit swap revenue. Credit swaps issued out of consolidated CDOs orthat are not insured by ACA Financial Guaranty are reported as other net creditswap revenue. Interest rate swaps and caps, entirely related to the CDO AssetManagement segment, are reported as net realized and unrealized gains (losses)on derivative instruments.

The Company uses interest rate swaps to hedge theexposure to variable interest rates within the CDOs it structures and manages.To the extent cash flow hedges are properly designated and are highlyeffective, gains and losses on interest rate swaps are reported in accumulatedother comprehensive income in stockholders’ equity, until earnings are affectedby the variability in cash flows of the designated hedged item. Hedgeeffectiveness is assessed quarterly using the Volatility Reduction Measure, anaccepted methodology for such analyses. Effective July 1, 2005, theCompany met the documentation standards of FAS 133 to qualify these swapsas cash flow hedges for accounting purposes on a prospective basis. Based 

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on the Company’seffectiveness assessment methodology, the hedges have been deemed highlyeffective since designation. Prior to July 1, 2005, the Company had notmet the documentation standards to achieve cash flow hedge accounting asrequired by FAS 133. As a result, these derivative contracts were notdesignated as cash flow hedges and the associated mark to market adjustmentswere included in the Company’s consolidated statements of operations.

***Furniture andEquipment***—Furniture and equipment are recorded atcost less accumulated depreciation and amortization. Depreciation is computedusing the straight-line method over the estimated useful lives of the assets,which range from three to five years. Furniture and equipment held undercapital leases and leasehold improvements are amortized over the shorter of theestimated lives of the assets or the related lease term. These items arereported in Other assets on the Company’s consolidated balance sheets.

***Capitalization ofSoftware***—The Company accounts for thecapitalization of certain internally developed software costs in accordancewith Statement of Position 98-1, “*Accountingfor the Costs of Computer Software Developed or Obtained for Internal Use*”(“SOP 98-1”). These costs are amortized over their estimated useful life,which is five years, commencing upon the determination of the software beingready for its intended use.

***Premiums Earned***—Premiumson financial guaranty insurance products in the form of traditional insurancepolicies are typically received on an up front basis, although certain policiespay premium in periodic installments. The vast majority of the Company’s PublicFinance business is conducted by the issuance of traditional policies.Traditional policies are those that meet the scope exception of the guidance ofFAS 133, “*Accounting for Derivative Instrumentsand Certain Hedging Activities*,” paragraph 10d, as amended byFAS 149, “*Amendment ofStatement 133 on Derivative Instruments and Hedging Activities*”(“FAS 149”). The scope exception provides that financial guaranty contracts arenot subject to FAS 133, if they meet certain specified criteria. Ingeneral, premiums from insured municipal obligations are received on an upfront basis. Installment premiums are earned over each installment period,which is generally one year or less. Up front premiums are earned in proportionto the expiration of risk, which is par. Premium is allocated to each parmaturity (*e.g.*, principalpayment) included in an insured bond and earned on a straight-line basis forthe period the related par is outstanding. Unearned premiums represent thatportion of premiums which is applicable to coverage of risk to be provided inthe future on policies in-force. When an insured issue is retired or defeasedprior to the end of the expected period of coverage, the remaining unearned premiums,less any amount credited to a refunding issue insured by the Company, arerecognized as earned premium. The amounts earned from refundings wereapproximately $9.4 million, $6.6 million and $1.8 million, in2006, 2005 and 2004, respectively.

***Net Insured CreditSwap Revenue***—The Company’s net insured credit swaprevenue is comprised of credit swap transactions in which the Company providescredit protection through the use of credit swaps that are insured by ACAFinancial Guaranty. Net insured credit swap revenue includes insured creditswap premiums earned and realized and unrealized gains and losses on thosecredit swaps. Insured credit swap premiums are earned over the life of thetransaction. Realized gains and losses occur due to the occurrence oftermination events or credit events requiring payment to or by the Companyunder the credit swap. Unrealized gains and losses represent the changes infair value of the instruments that are required to be recorded under FAS 133.Obtaining the fair value (as such term is defined in FAS 133) for suchinstruments requires the use of management judgment. These instruments arevalued using pricing models based on the net present value of expected futurecash flows and observed prices for other transactions bearing similar riskcharacteristics. The fair value of these instruments is included in derivativeassets or derivative liabilities. The Company does not believe that its insuredcredit swaps meet the scope exception of FAS 133 paragraph 10d, as amendedby FAS 149, because there is no contractual requirement that theprotection purchaser be exposed to the underlying risk.

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***Other Net CreditSwap Revenue***—Revenues from credit swap fees fromCDS of a consolidated CDS CDO and other credit derivative fees are earned overthe life of the underlying transactions and recognized in other net credit swaprevenue. Other net credit swap revenue also includes related net realized gainsand losses as well as net unrealized gains and losses resulting from thechanges in fair value associated with these CDS (see Note 4).

***Fee Income***—TheCompany receives fees in connection with each of its businesses, although thevast majority comes from its CDO Asset Management business. As part of the CDOAsset Management business, the Company is paid management and structuring feesas well as warehouse income. Management fees represent remuneration for theCompany’s role as asset manager of the CDO collateral and are typicallyreceived and earned on a quarterly basis. Structuring fees are payments for theCompany’s role in structuring a CDO prior to its close. Structuring fees aretypically contingent on the closing of the CDO and as such are earned upon thetransaction close. Warehouse income represents remuneration for the selectionand management of CDO collateral prior to a transaction closing. Warehouseincome is earned over the life of the particular warehousing period.

With respect to its Public Finance business, theCompany also collects fees in connection with waivers and consents granted tobond obligors as well as reimbursement of certain costs incurred with insuringmunicipal secondary-market transactions, primarily rating agency costs. Thesefees are recognized by the Company as fee income, while the associated costsare recognized as other operating expenses, when the transaction has beenclosed.

***Losses and LossAdjustment Expenses***—Financial guaranty loss andloss adjustment expense reserves are established on the Company’snon-derivative exposure in an amount equal to the Company’s estimate ofidentified or case-specific reserves and non-specific reserves, including costof settlement, on the obligations ACA Financial Guaranty has incurred. Indetermining its accounting policy for loss reserves, the Company reliesprimarily on FAS 60, “*Accounting andReporting by Insurance Enterprises*” (“FAS 60”). However, FAS 60 wascreated when the financial guaranty industry was just beginning. As a result,FAS 60 did not contemplate the specific attributes of financial guarantyinsurance as distinct from other forms of insurance. In particular, financialguaranty insurance is considered a short-duration insurance product, however,it has features that are more akin to long-duration contracts in that the termof some insured obligations can be as long as 30 years or more and thecontracts are generally irrevocable. Under FAS 60, accounting for lossesdiffers for short-duration and long-duration contracts. Because of thisinconsistency, the Company also applies FAS 5, “*Accounting for Contingencies*” (“FAS 5”), in thedetermination of its loss reserves. Specifically, FAS 5 requires theestablishment of reserves when it is probable that a liability has beenincurred at the reporting date, but only to the extent the loss can bereasonably estimated. The Company understands that methods of determiningnon-specific reserves vary within the financial guaranty industry. FASB isconsidering whether additional accounting guidance is necessary to address thefinancial guaranty industry. It is possible that as a result of FASB’sdeliberations, the financial guaranty industry, including the Company, may haveto change aspects of its accounting policies in this regard. Any proposed andfinal documents are expected to be issued later in 2007.

Case specific reserves are those obligationsidentified as currently or likely to be in default, and represent the presentvalue, discounted at the U.S. Treasury Note rate applicable to the term of theunderlying insured obligations, of the expected loss and loss adjustment expense(“LAE”) payments, net of estimated recoveries (under salvage, subrogation orother recovery rights). Gross case-specific reserves, net of estimatedrecoveries, were $20.2 million and $17.7 million as of December 31,2006 and 2005, respectively.

The non-specific reserve is derived from thecalculation of expected loss, which is estimated using a Monte Carlosimulation. A Monte Carlo simulation is a technique that is commonly used toestimate the probability of certain mathematical outcomes. It randomly selectsvalues to create scenarios of outcomes and this random selection process isrepeated many times to create multiple scenarios. Each time a value is 

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randomly selected, itforms one possible scenario and outcome. Together, these scenarios give a rangeof possible outcomes, some of which are more probable and some less probable.By definition, the average solution will give the most likely potentialoutcome. The Company’s risk management team typically runs at least 100,000trials in order to determine future expected losses. The model uses the currentratings and default frequency (net of recovery) applied to each transactionwith outstanding exposure to determine the expected probability distribution ofloss. Default frequency and recovery amounts are published periodically by eachof the major rating agencies. From the model output, the Company can estimate arange of expected loss. The amount of non-specific reserve recorded in thefinancial statements is based on the loss ratio resulting from the calculationof total losses, including past incurred losses and expected future lossesdivided by premium. For this purpose, premium is defined as ever to datewritten premium through December 31, 2006 plus future installment premiumon closed transactions. This derived loss ratio is applied to ever to dateearned premiums through December 31, 2006. Case specific reserves aresubtracted from this amount to arrive at net non-specific reserves. At December 31,2006 and 2005, non-specific reserves were $21.9 million and$16.6 million, respectively. These reserves were for our Public Financeinsured exposure.

Management periodically evaluates the estimates forlosses and LAE and any resulting changes are reflected in current yearearnings. Management believes the reserving methodology and resulting reservesare adequate to cover the ultimate net cost of claims. However, the reservesare based upon estimates and there can be no assurance that any ultimateliability will not exceed such estimates.

***Policy AcquisitionCosts***—Policy acquisition costs include thoseexpenses that relate primarily to and vary with premium production. Such costsare comprised primarily of premium taxes, personnel and personnel-relatedexpenses of individuals involved in marketing and underwriting, and certainrating-agency and legal fees for municipal and non-derivative structuredfinance business. The present value of anticipated claims and claim adjustmentexpenses are considered in determining the recoverability of acquisition costs(see Note 7). Net acquisition costs are deferred and amortized over theperiod in which the related premiums are earned. No costs are deferred inconnection with the Company’s insured credit swap transactions.

***Deferred DebtIssuance Costs***—Costs to issue debt, including debtof consolidated CDOs, are deferred and amortized over the estimated life of thedebt, which normally ranges from five to ten years. Such costs include debtplacement fees, legal fees, rating agency fees and external advisory fees. Theamortization of these costs is included in depreciation and amortizationexpense.

***Intangibles***—TheCompany purchased all of the outstanding common stock of ACA Financial Guarantyon September 24, 1997. The acquisition was accounted for as a purchase andthe price was allocated to the fair market value of the investments acquired of$15.1 million. In addition to the investments acquired, the Company paid$5.5 million for 54 certificates of authority (licenses) to transactfinancial guaranty insurance in 50 states, the District of Columbia, Guam, theU.S. Virgin Islands and Puerto Rico. The licenses through 2001 were beingamortized over a 40-year life, beginning with ACA Financial Guaranty’scommencement of operations on September 24, 1997.

Effective January 1, 2002, the Company adoptedFAS No. 142, “*Goodwill and OtherIntangible Assets*” (“FAS 142”). FAS 142 requires that anentity no longer amortize intangible assets that have an indefinite life butrather test for impairment losses on an annual basis. The Company believes theselicenses have an indefinite life and therefore ceased amortizing themcommensurate with its adoption of FAS 142. The Company’s annual assessmentfor impairment involves a two-step process whereby an initial assessment forpotential impairment is performed, followed by a measurement of the amount ofimpairment, if any. In its measurement for impairment the Company alsoconsidered triggering events in terms of FAS 144, which would more likely thannot reduce the fair market value. As of December 31, 2006, the Company hadnot recorded an impairment loss. The unamortized balance of these licenses atDecember 31, 2006 and 2005 was $4.9 million.

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***Income Taxes***—The Companyrecognizes deferred tax assets and liabilities for the expected future taxconsequences of events that have been included in the consolidated financialstatements or tax returns.

Deferred tax assets andliabilities are determined based on the difference between the financialstatement and tax bases of assets and liabilities using enacted tax rates ineffect for the year in which the differences are expected to reverse. Theeffect on tax assets and liabilities of a change in tax rates is recognized inincome in the period that includes the enactment date. The Company provides avaluation allowance on its gross deferred tax assets when it is more likelythan not that such assets will not be realized. A valuation allowance wasestablished in 2006 in the amount of $1.6 million relating to the portion ofthe tax benefits attributable to certain net operating losses. The Company didnot provide a valuation allowance as of December 31, 2005 (seeNote 11).

***Stock Compensation Plan***—EffectiveJanuary 1, 2006, the Company adopted FAS No. 123(R), “*Share Based Payments*” (“FAS 123(R)”). FAS 123(R) is arevision of FAS 123, “*Accounting for Stock BasedCompensation*” (“FAS 123”) and supersedes Accounting Principles Board(“APB”) Opinion No. 25, “*Accounting for StockIssued to Employees*” (“APB No. 25”), FAS 123(R) requiresthe Company to expense the grant date fair value of employee stock options andother forms of stock based compensation over the period that an employeeprovides service in exchange for the award. Effective January 1, 2006, theCompany adopted the requirements of FAS 123(R) using the prospectiveapplication as permitted by FAS 123(R), accordingly, prior period amounts havenot been restated. Under this application, the Company is required to recordcompensation expense for all awards granted after the date of adoption. Awardsgranted prior to the date of adoption of FAS 123(R) continue to beaccounted for under APB 25, the Company’s prior accounting method for stockbased compensation. For the year ended December 31, 2006, the Companyrecognized compensation expense under FAS 123(R) of $0.9 million relatedto stock options and $0.1 million related to restricted stock. For the yearsended December 31, 2006, 2005 and 2004, the vested portion of therestricted stock granted to the Company’s president and chief executive officeron September 30, 2004 totaled $1.2 million, $1.2 million and$0.3 million, respectively, which was recognized under APB No. 25 inthe Company’s consolidated statements of operations. The total value at thegrant date of the restricted stock totaled $3.5 million. The restrictedstock vests as follows: 33.33% vested on September 30, 2005; 33.33% willvest on September 30, 2006; and the remaining 33.34% will vest on September 30,2007, provided he has been continuously employed by the Company or a subsidiarythroughout the applicable vesting period (see Note 17).

Priorto the adoption of FAS 123(R), the Company applied APB No. 25 to accountfor its stock-based compensation awards and provided the required pro formadisclosures of FAS 123. The following table illustrates the effect on netincome and earnings per share had compensation expense for all stock-basedcompensation awards been recorded in the years ended December 31, 2006,2005 and 2004 based on the fair value method under FAS 123 (see Note 15)(dollars in thousands, except per share amounts):

| ** **                                                                                                                                                            | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                                            | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income (loss) as  reported                                                                                                                                        |       | $                                           | 58,708     |   | $ | 28,760 |   | $ | (3,789 | ) |
| Add: Stock based  employee compensation expense included in reported net income, net of related  tax effects                                                          |       | 849                                         |       | — |   | — |   |
| Deduct: Stock based  compensation expense determined under fair value method for awards granted  prior to the adoption of FAS 123(R), net of related tax effects |       | (312                                        | )          | (293 | ) | (26 | ) |
| Pro forma net income  (loss)                                                                                                                                          |       | $                                           | 59,245     |   | $ | 28,467 |   | $ | (3,815 | ) |
| Basic earnings (loss)  per share                                                                                                                                      |       |                                        |       |   |   |   |   |
| As reported                                                                                                                                                           |       | $                                           | 2.38       |   | $ | 1.26 |   | $ | (0.61 | ) |
| Pro forma                                                                                                                                                             |       | $                                           | 2.40       |   | $ | 1.25 |   | $ | (0.62 | ) |
| Diluted earnings (loss) per share                                                                                                                                     |       |                                        |       |   |   |   |   |
| As reported                                                                                                                                                           |       | $                                           | 1.89       |   | $ | 0.96 |   | $ | (0.61 | ) |
| Pro forma                                                                                                                                                             |       | $                                           | 1.91       |   | $ | 0.95 |   | $ | (0.62 | ) |

 

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***Earnings Per Share***—Basicand diluted earnings per share are calculated by dividing net income availableto stockholders by the applicable weighted average number of shares outstandingduring the year (see Note 24). In August 2006, the Company’s Board ofDirectors authorized a dividend of stock in order to effect a six-for-one stocksplit. All prior share and per share amounts have been restated to reflect thestock split. Additionally, in conjunction with the initial public offering, theCompany’s senior convertible preferred stock, convertible preferred stock andseries B senior convertible preferred stock all converted to common stockconcurrently with the closing of our offering on November 15, 2006 attheir conversion ratios of 6,000:1 shares, 6,000:1 shares and 6:1 shares,respectively (see Notes 1 and 17).

All potentially dilutive securities, includingunexercised stock options and convertible securities, other than participatingconvertible stock, are excluded from the basic earnings per share calculation. Participatingconvertible stock consisted of series A, B and C senior convertible preferredstock. The participating convertible stockholders participated equally with thecommon stockholders in dividends declared. However, holders of participatingconvertible stock were not required to fund Company losses, nor were thecontractual principal of these securities reduced as a result of lossesincurred by the Company. In accordance with FAS 128, the dilutive convertiblesecurities (i.e., the senior convertible preferred stock and convertiblepreferred stock classes of securities) converted at November 15, 2006 areincluded in the denominator for the period prior to actual conversion. Thecommon shares issued upon November 15, 2006 conversion are included in thedenominator for the period after the date of conversion. Consequently, sharesassumed issued are weighted for the period the convertible securities wereoutstanding, and common shares actually issued are weighted for the period theshares were outstanding.

In accordance with EITF 03-6, “*Participating Securities and the Two-Class Methodunder FASB Statement No. 128, ‘Earnings Per Share*,” theparticipating preferred stock were considered participating securitiesrequiring the use of the two-class method for computation of basic earnings pershare. The two-class method for each period reflects the cash dividends paidper share class of stock, if any, plus the amount of allocated undistributedearnings per share computed using the participation percentage which reflectsthe dividend rights of each class of stock. The shares of participatingconvertible stock were considered to be participating convertible securitiessince the shares of series A, B and C senior convertible preferred stock wereconvertible on a share-for-share basis into shares of common stock. Dilutedearnings per share were computed assuming the conversion of the series A, B andC senior convertible preferred stock into shares of common stock as of thebeginning of each period the stock was outstanding.

***Securities Purchased under Agreements to Resell andSecurities Sold under Agreements to Repurchase***—Securitiespurchased under agreements to resell and securities sold under agreements torepurchase are treated as collateralized financing transactions and are recordedat the amounts at which the securities were acquired or sold plus accruedinterest. These items are related to the Company’s Credit Fund activities (theCompany’s Credit Fund is defined and explained in more detail in Note 12). TheCompany’s policy is to take possession of securities purchased under agreementsto resell. The market value of the underlying securities, which collateralizethe related receivable on agreements to resell, is monitored to ensure that themarket value exceeds contractually stated levels of principal at all times. Ifthe seller defaults on its obligation to repay the Company, and the fair valueof the collateral decline, realization of the collateral by the Company may bedelayed or limited. Securities owned that are financed under repurchaseagreements are carried at market value, with unrealized gains and lossesreflected in net realized and unrealized gains (losses) on investments in theconsolidated statements of operations. Obligations under securities sold underagreement to repurchase bear interest that approximates LIBOR and at December 31,2006, had settlement dates less than 30 days.

**3.   RELEVANTRECENT ACCOUNTING PRONOUNCEMENTS**

In September 2005, Statement of Position (“SOP”) 05-1,“*Accounting by Insurance Enterprises for DeferredAcquisition Costs in Connection With Modifications or Exchanges of Insurancecontracts*”, 

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(“SOP 05-1”), wasissued. This SOP provides guidance on accounting by insurance enterprises fordeferred acquisition costs on internal replacement of insurance and investmentcontracts other than those specifically described in FAS No. 97, “*Accounting and Reporting by Insurance Enterprises for CertainLong-Duration Contracts and for Realized Gains and Losses from the Sale ofInvestments*’’. SOP 05-01 is effective for internal replacementsoccurring in fiscal years beginning after December 15, 2006. Managementbelieves the impact, if any, as a result of the adoption of SOP 05-1, willnot be material to the Company’s financial statements.

In February 2006, the FASB issued FAS 155, “Accountingfor Certain Hybrid Financial Instruments” (“FAS 155”), an amendment ofFAS 133 and FAS 140, “Accounting for Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities” (“FAS 140”). FAS 155 (i) permitsfair value remeasurement for any hybrid financial instrument that contains anembedded derivative that otherwise would require bifurcation, (ii) clarifieswhich interest-only strips and principal-only strips are not subject to therequirements of FAS 133, (iii) clarifies that concentrations ofcredit risk in the form of subordination are not embedded derivatives, and (iv) amendsFAS 140 to eliminate the exemption from applying the requirements ofFAS 133 on a qualifying special-purpose entity from holding a derivativefinancial instrument that pertains to a beneficial interest other than anotherderivative financial instrument. Additionally, on November 8, 2006, theDerivatives Implementation Group of the FASB released Issue No. B40, “Embedded Derivatives:Application of Paragraph 13(b) to Securitized Interests in PrepayableFinancial Assets.”  This issue provides additional guidance on theimplementation of FAS 155 as it relates to certain types of securitizations ofprepayable financial assets. In December 2006, the FASB amended Issue No. B40and revised the effective date of this Issue to instruments issued on June 30,2007 or later. FAS 155 is effective for all financial instruments acquiredor issued after the beginning of an entity’s first fiscal year that beginsafter September 15, 2006. The Company will adopt FAS 155 on January 1,2007. The implementation of this statement is not expected to have a materialimpact on the Company’s financial statements.

In March 2006, the FASB issued FAS 156, “*Accounting for Servicing of Financial Assets*”(“FAS 156”), an amendment of FAS 140. FAS 156 requires that all separatelyrecognized servicing assets and servicing liabilities be initially measured atfair value, if practicable, and permits for subsequent measurement using eitherfair value measurement with changes in fair value reflected in earnings or theamortization and impairment requirements of FAS 140. The subsequentmeasurement of separately recognized servicing assets and servicing liabilitiesat fair value eliminates the necessity for entities that manage the risksinherent in servicing assets and servicing liabilities with derivatives toqualify for hedge accounting treatment and eliminates the characterization ofdeclines in fair value as impairments or direct write-downs. FAS 156 iseffective for an entity’s first fiscal year beginning after September 15,2006. The implementation of this statement is not expected to have a materialimpact on the Company’s financial statements.

In April 2006, the FASB issued Staff Position (“FSP”)FIN 46(R)-6, “*Determining theVariability to Be Considered in Applying FASB Interpretation No. 46(R)*” (“FSP FIN 46(R)-6”), FSP FIN 46(R)-6 addresses whether certainarrangements associated with variable interest entities (VIEs) should betreated as variable interests or considered as creators of variability, andindicates that the variability to be considered shall be on based on ananalysis of the design of the entity. FSP FIN 46(R)-6 was adopted on June 15,2006. The adoption of this statement did not have a material impact on theCompany’s financial statements.

In July 2006, the FASB issued FASB InterpretationNo. (“FIN”) 48, “*Accounting forUncertainty in Income Taxes—an Interpretation of FASB Statement No. 109*”(“FIN 48”). FIN 48 prescribes a recognition threshold and measurementattribute for the financial statement recognition and measurement of a taxposition taken or expected to be taken in a tax return. The Interpretation alsoprovides guidance on de-recognition, classification, interest and penalties,accounting in interim periods, disclosure, and transition. 

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FIN 48 is effectivein fiscal years beginning after December 15, 2006. The provisions ofFIN 48 are to be applied to all tax positions upon initial adoption, withthe cumulative effect adjustment reported as an adjustment to the openingbalance of retained earnings. Management expects that the adoption of FIN 48will result in a decrease to stockholders’ equity as of January 1, 2007 ofapproximately $1.0 to $1.5 million.

In September 2006, the FASB issued FAS 157, “*Fair Value Measurements*” (“FAS 157”).FAS 157 enhances existing guidance for measuring assets and liabilities usingfair value, such as emphasizing that fair value is a market-based measurement,not an entity-specific measurement, and sets out a fair value hierarchy withthe highest priority being quoted prices in active markets. FAS 157 iseffective for financial statements issued for fiscal years beginning afterNovember 15, 2007, and interim periods within those fiscal years.Management is currently evaluating the potential impact, if any, which theadoption of FAS 157 will have on the Company’s financial statements.

In February 2007, the FASB issued FAS 159, *“The Fair Value Option for Financial Assets and Financial Liabilities”*(“FAS 159”)*.*FAS159 permits reporting entities to choose to remeasure many financialinstruments and certain other items at fair value that are not currentlyrequired to be measured at fair value. The fair value option may be appliedinstrument by instrument, is irrevocable and is applied only to entireinstruments and not to portions of instruments. FAS 159 also establishespresentation and disclosure requirements designed to facilitate comparisonsbetween entities that choose different measurement attributes for similar typesof assets and liabilities. FAS 159 is effective for fiscal years that beginafter November 15, 2007. Early adoption is permitted as of the beginningof a fiscal year that begins on or before November 15, 2007 provided thatthe entity also elects to apply the provisions of FAS 157, which are describedabove. This early adoption election must be made within 120 days of thebeginning of the fiscal year of adoption provided the entity has not yet issuedinterim period financial statements. Management is currently evaluating thepotential impact, if any, which the adoption of FAS 159 will have on theCompany’s financial statements.

In January and February 2005, the SEC staffdiscussed with several financial guaranty industry participants the differencein loss reserve recognition practices in the industry. In June 2005, atthe request of the SEC, the FASB added a project to their agenda to review andcodify accounting standards for financial guaranty insurance contracts as theyrelate to loss reserving policies and later added a review of accountingpolicies in the financial guaranty insurance industry as they relate to premiumrecognition and deferred policy acquisition costs. Proposed guidance isexpected to be released in early 2007 with the final guidance expected to beissued later in the year. When the FASB issues final guidance, the financialguaranty insurance industry, including the Company, may have to change certainaspects of its relevant accounting policies. Until a final standard isreleased, the Company cannot predict how the FASB will resolve this issue andthe resulting impact on its financial statements. Further, until the issue isresolved, the Company will continue to apply the accounting policies asdisclosed in its audited financials statements as of December 31, 2006 and2005 and for the years ended December 31, 2006, 2005 and 2004 (seeNote 2).

In September 2006, the SEC issued StaffAccounting Bulletin No. 108 (“SAB 108”), “*Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements*,” which provides interpretiveguidance on how the effects of the carryover or reversal of prior yearmisstatements should be considered in quantifying a current year misstatement.The provisions of SAB 108 were put in effect at December 31, 2006. Theadoption of this statement did not have a material impact on the Company’sfinancial statements.

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**4.**                 CDO ASSETMANAGEMENT BUSINESS

One of the ways the Company participates in thestructured finance market is through structuring and managing CDOs originatedin collaboration with investment banks. CDOs can be issued in funded, unfundedor partially funded form. Funded CDOs issue debt instruments and purchaseinvestment assets, while unfunded CDOs synthetically acquire assets and issueliabilities (i.e., assets and liabilities are in derivative form). Partiallyfunded CDOs are a combination of these two forms. From an accountingperspective, funded and partially funded CDOs are determined to be VIEs. Eachtime such CDOs are formed, the Company performs an analysis to determinewhether it is the primary beneficiary and thus required to consolidate the CDO underthe provisions of FSP FIN 46(R)-6.

Thefollowing table lists each of the Company’s CDOs outstanding as of December 31,2006 (dollars in millions):

| ** **                      | ** ** | **Year**   | ** ** | ** **       | ** ** | ** **           | ** ** | **Notional**                | ** ** | ** **  | ** ** | **Original**           | ** ** | ** **          | ** ** | **First**         | ** ** | ** **            |
|---------------------------------|------------|------------|------------|------------------|------------|----------------------|------------|-----------------------------|------------|-------------|------------|------------------------|------------|---------------------|------------|-------------------|------------|-----------------------|
| ** **                      | ** ** | **Deal**   | ** ** | **Transaction**  | ** ** | ** **           | ** ** | **Deal**                    | ** ** | ** **  | ** ** | **Investment in** | ** ** | **Retained**        | ** ** | **Optional**      | ** ** | **Maturity**          |
| **CDO name**               | ** ** | ** ** | ** ** | **Closed**       | ** ** | **Type**             | ** ** | **Collateral Type(1)** | ** ** | **Size(2)** | ** ** | **Consolidated**       | ** ** | **Retained Equity** | ** ** | **Equity %** | ** ** | **Call Date(3)** | ** ** | **Date** |
| **Asset-Backed  CDOs:**         | ** ** | ** ** | ** ** | ** **       | ** ** | ** **           | ** ** | ** **                  | ** ** | ** **  | ** ** | ** **             | ** ** | ** **          | ** ** | ** **        | ** ** | ** **            |
| ACA ABS 2002-1                  |       | 2002       |       | Funded           |       | Investment Grade     |       | $404                        |       | Yes         |       | $18.0                  |       | 100                 |       | 8/2005            |       | 8/2037                |
| ACA ABS 2003-1                  |       | 2003       |       | Funded           |       | Investment Grade     |       | 400                         |       | Yes         |       | 18.0                   |       | 100                 |       | 6/2007            |       | 6/2038                |
| Grenadier Funding               |       | 2003       |       | Funded           |       | High-Grade           |       | 1,500                       |       | Yes         |       | 22.5                   |       | 100                 |       | 8/2008            |       | 8/2038                |
| ACA ABS 2003-2                  |       | 2003       |       | Funded           |       | Investment Grade     |       | 725                         |       | Yes         |       | 33.5                   |       | 100                 |       | 12/2007           |       | 12/2038               |
| ACA ABS 2004-1                  |       | 2004       |       | Funded           |       | Investment Grade     |       | 450                         |       | Yes         |       | 10.0                   |       | 61                  |       | 7/2007            |       | 7/2039                |
| Zenith Funding                  |       | 2004       |       | Funded           |       | High-Grade           |       | 1,511                       |       | Yes         |       | 13.0                   |       | 52                  |       | 12/2009           |       | 12/2039               |
| ACA ABS 2005-1                  |       | 2005       |       | Funded           |       | Investment Grade     |       | 452                         |       | No          |       | 4.4                    |       | 24                  |       | 4/2008            |       | 4/2040                |
| ACA ABS 2005-2                  |       | 2005       |       | Funded           |       | Investment Grade     |       | 450                         |       | No          |       | 2.1                    |       | 10                  |       | 9/2009            |       | 12/2044               |
| Khaleej II                      |       | 2005       |       | Partially funded |       | Investment Grade     |       | 750                         |       | No          |       | 4.5                    |       | 14                  |       | 9/2009            |       | 9/2040                |
| Lancer Funding                  |       | 2006       |       | Funded           |       | High-Grade           |       | 1,500                       |       | No          |       | 1.5                    |       | 10                  |       | 7/2010            |       | 4/2046                |
| ACA Aquarius 2006-1             |       | 2006       |       | Partially funded |       | Investment Grade     |       | 2,000                       |       | No          |       | —                 |       | —              |       | 9/2010            |       | 9/2046                |
| ACA ABS 2006-1                  |       | 2006       |       | Funded           |       | Investment Grade     |       | 750                         |       | No          |       | 1.4                    |       | 5                   |       | 12/2009           |       | 6/2041                |
| ACA ABS 2006-2                  |       | 2006       |       | Funded           |       | Investment Grade     |       | 750                         |       | No          |       | 3.5                    |       | 11                  |       | 1/2011            |       | 1/2047                |
| **Total Asset-Backed CDOs**     |       |       |       |             |       |                 |       | 11,642                      |       |        |       | 132.4                  |       |                |       |              |       |                  |
|                            |       |       |       |             |       |                 |       |                        |       |        |       |                   |       |                |       |              |       |                  |
| **Corporate  Credit CDOs:**     |       |       |       |             |       |                 |       |                        |       |        |       |                   |       |                |       |              |       |                  |
| ACA CDS 2001-1                  |       | 2002       |       | Unfunded         |       | Investment Grade     |       | 1,000                       |       | No          |       | 22.5                   |       | 100                 |       | N/A               |       | 4/2007                |
| ACA CDS 2002-1                  |       | 2002       |       | Partially funded |       | Investment Grade     |       | 1,000                       |       | Yes         |       | 22.0                   |       | 100                 |       | N/A               |       | 7/2007                |
| ACA CDS 2002-2                  |       | 2003       |       | Unfunded         |       | Investment Grade     |       | 1,000                       |       | No          |       | 25.0                   |       | 100                 |       | N/A               |       | 3/2008                |
| Argon 49                        |       | 2005       |       | Funded           |       | Investment Grade     |       | 66                          | (4)        | No          |       | —                 |       | —              |       | N/A               |       | 6/2015                |
| Argon 57                        |       | 2006       |       | Funded           |       | Investment Grade     |       | 66                          | (4)        | No          |       | —                 |       | —              |       | N/A               |       | 6/2013                |
| Tribune                         |       | 2006       |       | Unfunded         |       | Investment Grade     |       | 334                         | (5)        | No          |       | —                 |       | —              |       | N/A               |       | 9/2016                |
| **Total Corporate Credit CDOs** |       |       |       |             |       |                 |       | 3,466                       |       |        |       | 69.5                   |       |                |       |              |       |                  |
|                            |       |       |       |             |       |                 |       |                        |       |        |       |                   |       |                |       |              |       |                  |
| **Leveraged  Loan CDOs:**       |       |       |       |             |       |                 |       |                        |       |        |       |                   |       |                |       |              |       |                  |
| ACA CLO 2005-1                  |       | 2005       |       | Funded           |       | Non-Investment Grade |       | 300                         |       | No          |       | 5.0                    |       | 21                  |       | 10/2009           |       | 10/2017               |
| ACA CLO 2006-1                  |       | 2006       |       | Funded           |       | Non-Investment Grade |       | 350                         |       | No          |       | —                 |       | —              |       | 7/2009            |       | 7/2018                |
| ACA CLO 2006-2                  |       | 2006       |       | Funded           |       | Non-Investment Grade |       | 300                         |       | No          |       | 2.2                    |       | 10                  |       | 1/2011            |       | 1/2021                |
| **Total Leveraged Loan CDOs**   |       |       |       |             |       |                 |       | 950                         |       |        |       | 7.2                    |       |                |       |              |       |                  |
|                            |       |       |       |             |       |                 |       |                        |       |        |       |                   |       |                |       |              |       |                  |
| **Total**                       |       |       |       |             |       |                 |       | **$16,058**                 |       |        |       | **$209.1**             |       |                |       |              |       |                  |
|                                 |            |            |            |                  |            |                      |            |                             |            |             |            |                        |            |                     |            |                   |            |                       |  |  |

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(1)                Investment grade collateral is rated “BBB-”or better; however certain of our investment grade CDOs include the ability toinvest a minority portion (20% or less) in non-investment grade assets. High-gradeis “A-” or better.

(2)                Notional deal size is defined astotal  face value of liabilities at thedeal’s inception.

(3)                Cash flow CDOs are generally callable onceper quarter by a majority or greater vote of the equity holders following theconclusion of the reinvestment period, which is referred to as the FirstOptional Call Date.

(4)                Argon 49 and Argon 57 are denominated inEuros. For purposes of this chart, we have converted the amounts toU.S. dollars at the prevailing currency exchange rate on December 31,2006.

(5)                Tribune is comprised of 13 distinct tradessome of which are denominated in Euros or Yen. For purposes of this chart, wehave converted this amount to U.S. dollars at the prevailing currency exchangerates on December 31, 2006.

As of December 31,2006 and 2005, consolidated liabilities include non-recourse debt fromconsolidated CDOs of $4,711.8 million and $4,833.2 million,respectively. Also, as of December 31, 2006 and 2005, consolidated assetsincludes investment in fixed maturity securities of $4,536.7 million and$4,810.9 million, respectively, and cash of $265.0 and $125.2 million,respectively, related to CDOs.

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In connection with itsengagement as asset manager, the Company typically retains a portion of theequity in such CDOs. Prior to June 2004, the Company retained the entireor the majority of the equity position in its funded CDOs and they areconsolidated in the financial statements. A total of seven consolidated CDOswere issued in 2002 through 2004; comprised of six asset-backed securities (“ABS”)CDOs and one partially funded corporate credit swap CDO. The funded portions ofthis latter CDO are reflected as a guaranteed investment contract and debt inthe Company’s consolidated financial statements, while the unfunded portionsare treated as credit swaps or derivative contracts under FAS 133. CDOdebt outstanding in the Company’s consolidated financial statements representsnon-recourse debt to the Company that is supported only by the associatedassets of the CDO. Likewise, the Company does not have the right to use VIEassets for general operations. The Company’s ultimate exposure in respect tolosses on the assets purchased by a CDO is limited to the amount of its equityinvestment in that CDO. In those instances where the Company owns less than100% of the CDO VIE’s equity, but is the primary beneficiary and thusconsolidates the CDO VIE, it establishes minority interests for the un-ownedportion. Two of the six ABS CDOs mentioned above include minority interests. TheCompany receives insurance premiums, asset management and structuring fees, andequity residual flows from the VIEs that are eliminated in consolidation.

During 2005 and 2006, theCompany retained less than a majority share of the equity position in each ofits five and eight, respectively, newly issued CDOs (five fully funded ABSCDOs, two partially funded ABS CDOs, three corporate credit CDOs, and threecollateralized loan obligations) and based on FIN 46(R) analyses is notdeemed to be the primary beneficiary. As a result, these CDOs are notconsolidated in the Company’s financial statements. Rather, the Company’snon-majority investment is recorded as an investment in a single fixed maturitysecurity under the provisions of FAS 115 and EITF 99-20. The total investmentin these CDOs is included in consolidated assets at December 31, 2006 was$72.1 million. Additionally, the Company has been engaged to act as assetmanager to third-party CDOs not originated and structured by the Company forwhich it receives asset management fees.

As part of its CDO AssetManagement business, the Company enters into warehouse facility agreements forthe purpose of accumulating securities for potential CDO transactions. Ingeneral, though the specific structures may vary, the warehouse facility is alegal agreement designed to provide for CDO VIE purchases of the warehousedassets at their original cost from a third-party, plus the losses or minus thegains of any interest rate hedges on the fixed rate securities during the warehousingperiod, as applicable. The Company enters into these agreements to ensure thatassets selected will ultimately be delivered with the desired credit spread tomeet the return objectives of the CDO. On closure of the CDO transaction (andwarehousing period), the VIE uses the proceeds from the issuance of notes topurchase the warehoused assets. The Company generally receives a fee formanaging the warehoused assets. From an accounting perspective, when theCompany is the primary beneficiary of the CDO VIE and thus required toconsolidate it, the warehouse facility agreement represents a forwardcommitment to purchase assets that is marked to market under the provisions ofFAS 133 and FAS 149. This does not apply when the Company is not deemed tobe the primary beneficiary of the CDO VIE, which was applicable for all of theCompany’s CDOs closed in 2006 and 2005. During 2004, the Company recognized netrealized losses of $(0.6) million and net unrealized losses of $(0.6) millionunder warehouse facility agreements. No such gains or losses were recognized ineither 2006 or 2005. Warehouse fees received by the Company totaled$5.0 million, $2.4 million and $1.4 million in 2006, 2005 and2004, respectively, and are included in fee income.

The impact of a CDO on theCompany’s consolidated financial statements depends on the structure of the CDO(fully funded, partially funded or unfunded), whether or not the CDO isconsolidated and the nature of the underlying assets and liabilities.

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Fully funded CDOs containinvestments in interest bearing financial assets such as fixed maturitysecurities or guaranteed investment contracts. The Company has six fully fundedand one partially funded CDO that are consolidated. The assets and liabilitiesof these CDOs are included in the Company’s consolidated balance sheets. Theincome generated by the investments is reflected in net investment income inthe consolidated statements of operations. The debt liabilities issued in theform of notes pay interest that is also included in interest expense in theconsolidated statements of operations. A management fee is paid by the CDO toACA Management, L.L.C. that is eliminated in consolidation. The return on theCompany’s equity is represented by the net of the CDO’s revenue (interest income)and the CDO’s expenses including management expenses paid to ACA Management,L.L.C.

Partially funded syntheticCDOs sell credit protection on referenced assets by entering into credit swapswith various protection buyers in the market. The CDO also issues securities,both liabilities and equities, in order to use the proceeds from the sale ofthese securities to collateralize the CDO’s obligations under its credit swaps,except with respect to the most senior tranche of the CDO’s credit exposure, inconnection with which a partially funded CDO typically purchases creditprotection rather than issuing funded liability securities. The proceeds of thesecurities issued by the partially funded CDO are invested in a guaranteedinvestment contract, or GIC. The Company has one partially funded CDS CDO thatis consolidated. From this consolidated CDO, the Company consolidatesinvestment income, relating to the return on the GIC, and interest expense inconnection with the liability securities issued by the CDO. The Company alsoconsolidates derivative income relating to net revenues from the fixed feespayable to the CDO under the terms of the credit swaps pursuant to which theCDS CDO sold credit protection on referenced assets and the fixed fees payableby the CDO on the credit protection that it purchased. This income is reflectedin the consolidated statements of operations as other net credit swap revenue.This income is used to pay the interest on the liabilities of the CDO and otherexpenses of the CDO, including the management fee. Similar to the fully fundedand consolidated CDOs, all management fees in this partially funded CDS CDO areeliminated in consolidation. The return on the Company’s equity is representedby the net of the CDO’s revenue (interest income and derivative income) lessthe CDO’s expenses, including management fees paid to ACA Management, L.L.C.

For funded unconsolidatedCDOs, the Company reflects management fees and investment income in itsconsolidated statements of operations. In these instances, the investmentincome recorded is only on the equity investment made by the Company ascompared to all of the assets in a consolidated CDO. Partially funded,unconsolidated CDOs in which the Company invests in the funded equitysecurities are reflected in the Company’s consolidated financial statements inthe same way as funded unconsolidated CDOs.

The Company originated afully synthetic, or unfunded, CDS CDO in each of 2002 and 2003. In thesetransactions, the Company acts as asset manager and, through ACA FinancialGuaranty, insures the equity or first loss position of the CDO. No SPEs arecreated and, therefore, no variable interest entities, or VIEs, exist in thesestructures; rather, the sponsoring investment bank acts as the counterparty inthe various credit swaps that constitute the assets and liabilities of thesynthetic CDO. CDOs that do not use SPEs are not subject to consolidation underFIN 46(R), “*Consolidation of VariableInterest Entities*.” For its various roles in the unfunded CDS CDOs,the Company receives structuring fees, management fees, premium and residualequity returns. In the Company’s consolidated statements of operations, theserevenues are reflected as fee income, net insured credit swap revenue and othernet credit swap revenue. Net insured credit swap revenue also includes thechanges in fair value of the related credit swaps. The combined equity positionof the Company in its two unfunded CDS CDOs, which is the aggregate notionalbalance of the Company’s credit swaps insuring the equity tranches of these twoCDOs, was $47.5 million at December 31, 2006 and 2005.

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In certain funded CDOs,the Company issued liabilities in the form of notes in order to fund its equitypurchases. These borrowings were accomplished through the issuance ofnon-recourse notes by subsidiaries of the Company. These notes are insured asto the repayment of principal and interest by ACA Financial Guaranty. Thepremium on the policy insuring the notes payable to ACA Financial Guaranty ispayable by the Company’s subsidiary that invested in the preferred shares.These subsidiaries and ACA Financial Guaranty are wholly owned by the Companyand therefore this inter-company premium is eliminated in consolidation.

**5.**                 NET INSUREDCREDIT SWAP REVENUE AND OTHER NET CREDIT SWAP REVENUE

Net insured credit swap revenue includes insuredcredit swap premiums received for credit protection the Company has sold underits insured credit swaps as well as realized and unrealized gains and lossesrelated to those transactions. Realized losses arise upon the occurrence ofcredit events requiring payment by the Company under the related credit swapand, additionally, realized gains or losses could occur if a transaction isterminated in advance of its scheduled termination date. Unrealized gains andlosses represent the adjustments for changes in fair value that are recorded ineach reporting period, under FAS 133. The fair value of the Company’s insuredcredit swaps are recorded as either derivative liabilities or derivative assetsin the consolidated balance sheets.

Thefollowing table disaggregates net insured credit swap revenue into itscomponent parts for the periods ended December 31, 2006, 2005 and 2004(dollars in thousands): 

| ** **                                         | ** ** | **For the year ended  December 31,** | ** ** |
|----------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net insured credit swap  revenue                   |       |                                                     |       |   |   |   |   |
| Insured credit  swap premiums earned               |       | $                                                        | 51,124     |   | $ | 27,234 |   | $ | 9,858 |   |
| Realized gains on  insured credit swaps            |       | 2,009                                                    |       | — |   | — |   |
| Unrealized gains  (losses) on insured credit swaps |       | 4,469                                                    |       | (5,663 | ) | 6,160 |   |
| Total net insured  credit swap revenue             |       | $                                                        | 57,602     |   | $ | 21,571 |   | $ | 16,018 |   |

 

Other net credit swap revenue includes revenuesreceived from a partially funded CDS CDO which sells credit protection undercredit swaps for which it receives fixed quarterly fees as well as the residualreturns on two synthetic equity participations. Other net credit swap revenuealso includes net realized and unrealized gains and losses associated withthese transactions. These revenues are included in the Company’s consolidated statementsof operations.

Thefollowing table disaggregates other net credit swap revenue into its componentparts for the periods ended December 31, 2006, 2005 and 2004 (dollars inthousands): 

| ** **                                 | ** ** | **For the year ended  December 31,** | ** ** |
|--------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                 | ** ** | **2006**                                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| Other net credit swap  revenue             |       |                                                     |       |   |   |   |   |
| Credit swap fees  earned                   |       | $                                                        | 10,286     |   | $ | 8,623 |   | $ | 8,830 |   |
| Realized losses  on credit swaps           |       | —                                                   |       | (3,295 | ) |   |   |
| Unrealized gains  (losses) on credit swaps |       | (180                                                     | )          | (1,171 | ) | 2,160 |   |
| Total other net  credit swap revenue       |       | $                                                        | 10,106     |   | $ | 4,157 |   | $ | 10,990 |   |

 

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**6.**                 INVESTMENTS

The Company accounts for its investments in fixedmaturity securities in accordance with the FAS 115 and EITF 99-20. Managementdetermines the appropriate classification of securities at the time ofpurchase. As of December 31, 2006 and 2005, all investments in fixedmaturity securities, with the exception of the Company’s investments in theCredit Fund (see Note 12), were designated as available-for-sale and werecarried at fair value. Fixed maturity securities in the Credit Fund are designatedas trading and are also carried at fair value. The difference between fairvalue and amortized cost of available-for-sale securities is included in theaccumulated other comprehensive income component of stockholders’ equity, netof applicable deferred income tax. Changes in fair value of trading securitiesare included in net income. The fair value of these securities is based onindependent market quotations or, when such quotations are not readilyavailable because the securities are infrequently traded in the public market,from internal valuation models. These models include estimates, made bymanagement, which utilize current market information. The valuation resultsfrom these models could differ materially from amounts realizable in an openmarket sale or exchange.

Theamortized cost and estimated fair value of fixed maturity securities were asfollows (dollars in thousands):

| ** **                                           | ** ** | **December 31, 2006** | ** ** |
|------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                           | ** ** | **Amortized  Cost**             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
| Available for  sale-non-VIE:                         |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| U.S. treasury  securities                            |       | $                               | 37,391     |   |   | $ | 34 |   |   |   | $ | (799 | ) |   | $ | 36,626 |   |
| Federal-agency  securities                           |       | 75,357                          |       |   | — |   |   |   | (921 | ) |   | 74,436 |   |
| Obligations of  sales and political subdivisions     |       | 133,027                         |       |   | 733 |   |   |   | (908 | ) |   | 132,852 |   |
| Corporate securities                                 |       | 101,379                         |       |   | 376 |   |   |   | (2,240 | ) |   | 99,515 |   |
| Asset-backed  securities                             |       | 12,931                          |       |   | 47 |   |   |   | (77 | ) |   | 12,901 |   |
| Mortgage-backed  securities                          |       | 136,032                         |       |   | 37 |   |   |   | (2,817 | ) |   | 133,252 |   |
| Total non-VIE Securities                             |       | 496,117                         |       |   | 1,227 |   |   |   | (7,762 | ) |   | 489,582 |   |
| Available for  sale-VIE—asset-backed securities |       | 4,547,122                       |       |   | 26,225 |   |   |   | (36,653 | ) |   | 4,536,694 |   |
| Total available  for sale                            |       | 5,043,239                       |       |   | 27,452 |   |   |   | (44,415 | ) |   | 5,026,276 |   |
| Held for trading- Credit  Fund                       |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Securities held for trading- assets                  |       | 251,884                         |       |   | 132 |   |   |   | (191 | ) |   | 251,825 |   |
| Total                                                |       | $                               | 5,295,123  |   |   | $ | 27,584 |   |   |   | $ | (44,606 | ) |   | $ | 5,278,101 |   |

 

| ** **                                           | ** ** | **December 31, 2005** | ** ** |
|------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                           | ** ** | **Amortized  Cost**             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
| Available for  sale-non-VIE:                         |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| U.S. treasury  securities                            |       | $                               | 56,911     |   |   | $ | 26 |   |   |   | $ | (1,361 | ) |   | $ | 55,576 |   |
| Federal-agency  securities                           |       | 46,952                          |       |   | 3 |   |   |   | (594 | ) |   | 46,361 |   |
| Obligations of  sales and political subdivisions     |       | 121,714                         |       |   | 463 |   |   |   | (1,299 | ) |   | 120,878 |   |
| Corporate  securities                                |       | 108,435                         |       |   | 213 |   |   |   | (2,060 | ) |   | 106,588 |   |
| Asset-backed securities                              |       | 11,496                          |       |   | — |   |   |   | (83 | ) |   | 11,413 |   |
| Mortgage-backed  securities                          |       | 149,430                         |       |   | 152 |   |   |   | (2,624 | ) |   | 146,958 |   |
| Total non-VIE Securities                             |       | 494,938                         |       |   | 857 |   |   |   | (8,021 | ) |   | 487,774 |   |
| Available for  sale-VIE—asset-backed securities |       | 4,797,143                       |       |   | 28,672 |   |   |   | (14,850 | ) |   | 4,810,965 |   |
| Total                                                |       | $                               | 5,292,081  |   |   | $ | 29,529 |   |   |   | $ | (22,871 | ) |   | $ | 5,298,739 |   |

 

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Theamortized cost and estimated fair value of fixed maturity securities at December 31,2006, by contractual maturity, is shown below (dollars in thousands): 

| ** **                              | ** ** | **Non-VIE Securities** | ** ** | **VIE Securities**    | ** ** | **Total**           | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|----------------------------|------------|---------------------|------------|
| ** **                              | ** ** | **Amortized  Cost**         | ** ** | **Estimated  Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair  Value** | ** ** |
| Available for sale:                     |       |                        |       |                       |       |                |       |   |   |   |   |   |   |
| Due in one year  or less                |       | $                           | 24,320     |                       | $          | 24,238              |       | $ | 5,000 |   | $ | 5,316 |   | $ | 29,320 |   | $ | 29,554 |   |
| Due after one  year through five years  |       | 81,838                      |       | 80,799                     |       | 144,773             |       | 145,830 |   | 226,611 |   | 226,629 |   |
| Due after five  years through ten years |       | 149,777                     |       | 148,110                    |       | 383,226             |       | 386,790 |   | 533,003 |   | 534,900 |   |
| Due after ten  years                    |       | 240,182                     |       | 236,435                    |       | 4,014,123           |       | 3,998,758 |   | 4,254,305 |   | 4,235,193 |   |
| Total available  for sale               |       | 496,117                     |       | 489,582                    |       | 4,547,122           |       | 4,536,694 |   | 5,043,239 |   | 5,026,276 |   |
| Held for trading- Credit  Fund          |       |                        |       |                       |       |                |       |   |   |   |   |   |   |
| Due after one  year through five years  |       | —                      |       | —                     |       | —              |       | — |   | — |   | — |   |
| Due after ten  years                    |       | 251,884                     |       | 251,825                    |       | —              |       | — |   | 251,884 |   | 251,825 |   |
| Total held for  trading                 |       | 251,884                     |       | 251,825                    |       | —              |       | — |   | 251,884 |   | 251,825 |   |
| Total                                   |       | $                           | 748,001    |                       | $          | 741,407             |       | $ | 4,547,122 |   | $ | 4,536,694 |   | $ | 5,295,123 |   | $ | 5,278,101 |   |

 

Actual maturities could differ from contractualmaturities because borrowers have the right to call or prepay certainobligations which may or may not include call or prepayment penalties.

Total proceeds from the sale of fixed maturitysecurities available for sale during 2006, 2005 and 2004 were $154.0 million,$188.0 million, and $349.7 million, respectively; of these amounts$47.8 million, $20.2 million and $141.2 million, respectively, wereVIE security sales. Total gross gains of $1.2 million, $0.5 million and$2.1 million and total gross losses of $2.3 million, $0.8 million and$1.2 million were realized on security sales in 2006, 2005 and 2004,respectively. Gross gains of $0.5 million, $0.1 million and$0.7 million and gross losses of $0.3 million, $0 million and$0.1 million, respectively, were related to VIE securities. In addition,the Company recognized approximately $3.0 million, $2.5 million, and$7.4 million in other than temporary declines during 2006, 2005 and 2004,respectively. Of these write-downs $3.0 million, $2.0 million and$6.9 million related to the Company’s VIE securities in 2006, 2005 and2004, respectively.

The Company’s process for identifying declines in thefair value of investments that are other than temporary involves considerationof several factors. These factors include (i) the duration of asignificant decline in value, (ii) the liquidity, business prospects andoverall financial condition of the issuer, (iii) the magnitude of thedecline, (iv) the collateral structure and other credit support, asapplicable, (v) the Company’s intent and ability to hold the investmentuntil the values recover, and (vi) for asset-backed securities, theestimated cash flows. When the analysis of the above factors results in aconclusion that a decline in fair values is other than temporary, the cost ofthe security is written down to fair value as of the reporting date and anypreviously unrealized loss is realized in the period such a determination ismade.

On November 3, 2005, the FASB issued FSPFAS 115-1 and FAS 124-1, “*The Meaning of Other-Than-Temporary Impairment and Its Application toCertain Investments.*” This FSP addresses the determination as towhen an investment is considered impaired, whether that impairment is otherthan temporary and the measurement of an impairment loss. This FSP alsoincludes accounting considerations subsequent to the recognition ofother-than-temporary impairment and requires certain disclosures aboutunrealized losses that have not been recognized as other-than-temporaryimpairments. The guidance in this FSP also 

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amends FAS 115. Weadopted this FSP effective January 1, 2006. Accordingly, we are nowrequired to assess our investments for impairment in each reporting period andto use existing guidance in assessing whether an impairment is other thantemporary. The impact of the adoption of this guidance was not material.

Thefollowing table shows the gross unrealized losses and fair value of our fixedmaturity securities available for sale with unrealized losses that are notdeemed to be other-than-temporarily impaired, aggregated by investment categoryand length of time that individual securities have been in a continuousunrealized loss position, at December 31, 2006 (dollars in thousands).

| ** **                                            | ** ** | **Less than 12 months** | ** ** | **12 months or more** | ** ** | **Total** | ** ** |
|-------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------|------------|
| ** **                                            | ** ** | **Fair**                               | ** ** | **Unrealized**                       | ** ** | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                                            | ** ** | **Value**                              | ** ** | **Loss**                             | ** ** | **Value** | ** ** | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
| ** **                                            | ** ** | **(in thousands)**                | ** ** |
| Available for  sale-non-VIE:                          |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. treasury  securities                             |       | $                                      | 14,651     |                                 |       | $         | (278       | ) |   | $ | 17,903 |   |   | $ | (521 | ) |   | $ | 32,554 |   |   | $ | (799 | ) |   |
| Federal-agency  securities                            |       | 34,974                                 |       |                                 | (140       | )         |       | 39,462 |   |   | (781 | ) |   | 74,436 |   |   | (921 | ) |   |
| Obligations of  states and political subdivisions     |       | 6,388                                  |       |                                 | (27        | )         |       | 52,603 |   |   | (881 | ) |   | 58,991 |   |   | (908 | ) |   |
| Corporate  securities                                 |       | 17,661                                 |       |                                 | (256       | )         |       | 59,601 |   |   | (1,984 | ) |   | 77,262 |   |   | (2,240 | ) |   |
| Asset-backed  securities                              |       | 1,537                                  |       |                                 | —     |      |       | 5,370 |   |   | (77 | ) |   | 6,907 |   |   | (77 | ) |   |
| Mortgage-backed  securities                           |       | 19,296                                 |       |                                 | (187       | )         |       | 98,801 |   |   | (2,630 | ) |   | 118,097 |   |   | (2,817 | ) |   |
| Total non-VIE  securities                             |       | 94,507                                 |       |                                 | (888       | )         |       | 273,740 |   |   | (6,874 | ) |   | 368,247 |   |   | (7,762 | ) |   |
| Available for  sale-VIE—asset-backed  securities |       | 1,131,953                              |       |                                 | (26,743    | )         |       | 494,760 |   |   | (9,910 | ) |   | 1,626,713 |   |   | (36,653 | ) |   |
| Total available for  sale-non-VIE                     |       | $                                      | 1,226,460  |                                 |       | $         | (27,631    | ) |   | $ | 768,500 |   |   | $ | (16,784 | ) |   | $ | 1,994,960 |   |   | $ | (44,415 | ) |   |

 

The unrealized losses on the Company’s non-VIEinvestments was generally caused by interest rate increases. Because thedecline in market value of these securities is attributable to changes ininterest rates and not credit quality, and because the Company has the abilityand intent to hold these investments until a recovery of fair value, which maybe at maturity, it does not consider these investments to beother-than-temporarily-impaired at December 31, 2006.

A substantial portion of the unrealized loss in VIEasset-backed securities is related to collateralized residential mortgagebacked securities, including both sub-prime and mid-prime quality mortgages. Thelast quarter of 2006 saw significant disruption and consolidation in thesub-prime mortgage market, with some mortgage originators being purchased orexiting the business. This disruption translated into decreased liquidity andwider spreads across the market, decreasing the market value of the portfolios.In particular, securities backed by mortgages from what are currently perceivedas originators with weaker underwriting standards experienced a decrease inprice late in 2006, even when the credit performance of the securities had notsuffered. An additional factor weighing on the market valuations for theCompany’s positions is the limited liquidity associated with the seasoned securitieswhich have already received or are about to receive a significant return ofprincipal. Since the Company, at December 31, 2006, believed that it wouldbe able to collect amounts due on its RMBS positions and has the ability andintent to hold these investments until a recovery of fair value, which may beat their maturities, we did not consider these investments to beother-than-temporarily impaired at December 31, 2006.

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Included in the tables above are 578 fixed maturitysecurities, 170 in the non-VIE portfolios, and 408 in the VIE portfolios. At December 31,2006, there were 21 fixed maturity securities each of whose amortized costexceeded its respective fair value by greater than 20%. In addition, 99% ofthese securities are rated investment grade in the non-VIE portfolios whileover 97% are rated investment grade in the VIE portfolios. Management hasassessed these and other factors and concluded that there were no other thantemporarily impaired fixed maturity securities included in the above table asof December 31, 2006.

Forthe years ended December 31, 2006, 2005 and 2004, investment income wasderived from the following sources (dollars in thousands): 

| ** **                                  | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Investment income—non-VIE:             |       |     |       |     |       |     |       |
| Income from fixed  maturity securities      |       | $        | 28,037     |     | $          | 19,300   |       | $ | 13,336 |   |
| Income from cash  equivalents               |       | 4,182    |       | 2,527    |       | 1,139    |       |
| Total investment  income-non-VIE            |       | 32,219   |       | 21,827   |       | 14,475   |       |
| Investment income VIE:                      |       |     |       |     |       |     |       |
| Income from fixed  maturity securities      |       | 294,935  |       | 225,707  |       | 110,364  |       |
| Income from cash  equivalents               |       | 6,720    |       | 4,159    |       | 932      |       |
| Income from  guaranteed investment contract |       | 6,148    |       | 4,036    |       | 1,784    |       |
| Total investment  income—VIE           |       | 307,803  |       | 233,902  |       | 113,080  |       |
| Total investment  income                    |       | 340,022  |       | 255,729  |       | 127,555  |       |
| Investment  expenses                        |       | (1,856   | )          | (1,138   | )          | (1,385   | )          |
| Net investment income                       |       | $        | 338,166    |     | $          | 254,591  |       | $ | 126,170 |   |

 

In 2002, the Company invested in a GIC through one ofits consolidated CDO VIEs. Management considers the GIC’s fair value toapproximate contract value. At both December 31, 2006 and 2005, the fairvalue and contract value of the investment contract was $119.3 million.The GIC earns interest at a rate of LIBOR less 0.02%, matures in 2007 and isissued by an affiliate of Financial Security Assurance Inc., an “AAA”rated financial guaranty company.

Fixed maturity securitieshaving an amortized cost of $4.9 million and $5.2 million were ondeposit with various regulatory authorities as required by law at December 31,2006 and 2005, respectively.

**7.**                 DEFERREDPOLICY ACQUISITION COSTS

Deferredpolicy acquisition costs (“DAC”) and the related amortization charged toexpense were as follows (dollars in thousands): 

| ** **                                | ** ** | **Years Ended  December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                | ** ** | **2006**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Balance—beginning of  year           |       | $                                       | 47,414     |   | $ | 46,556 |   | $ | 41,723 |   |
| Cost deferred during the  period:         |       |                                    |       |   |   |   |   |
| Compensation and other  acquisition costs |       | 9,447                                   |       | 8,760 |   | 8,434 |   |
| Premium taxes                             |       | 689                                     |       | 750 |   | 234 |   |
| Total costs deferred  during the period   |       | 10,136                                  |       | 9,510 |   | 8,668 |   |
| Costs amortized during  the period        |       | (8,740                                  | )          | (8,652 | ) | (3,835 | ) |
| Balance—end of year                  |       | $                                       | 48,810     |   | $ | 47,414 |   | $ | 46,556 |   |

 

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**8.**                 LOSSES

Thefollowing table provides a reconciliation of the beginning and ending reservebalances for unpaid loss expenses (dollars in thousands): 

| ** **                                                                                     | ** ** | **Years Ended  December 31,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                     | ** ** | **2006**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Reserve for unpaid losses, net of  reinsurance, beginning of year                              |       | $                                       | 34,306     |   | $ | 36,006 |   | $ | 3,812 |   |
| Add:                                                                                           |       |                                    |       |   |   |   |   |
| Provision  for unpaid losses and LAE for claims occurring in current year, net of  reinsurance |       | 6,140                                   |       | 9,830 |   | 44,229 |   |
| Provision  for unpaid losses and LAE for claims occurring in prior year, net of reinsurance    |       | 2,660                                   |       | 4,208 |   | 2,361 |   |
| Incurred losses during the current  year, net of reinsurance                                   |       | 8,800                                   |       | 14,038 |   | 46,590 |   |
| Deduct:                                                                                        |       |                                    |       |   |   |   |   |
| Loss  payments for claims occurring in the current year                                        |       | 856                                     |       | 114 |   | 11,072 |   |
| Loss  payments for claims occurring in the prior year                                          |       | 137                                     |       | 15,624 |   | 3,324 |   |
| Total  payments made during the year                                                           |       | 993                                     |       | 15,738 |   | 14,396 |   |
| Reserve  for unpaid losses, net of reinsurance end of year                                     |       | 42,113                                  |       | 34,306 |   | 36,006 |   |
| Reinsurance  recoverable on unpaid losses at end of year                                       |       | —                                  |       | — |   | — |   |
| Reserve  for unpaid losses, gross of reinsurance end of year                                   |       | $                                       | 42,113     |   | $ | 34,306 |   | $ | 36,006 |   |

 

Reserves include casespecific losses and loss adjustment expenses and non-specific losses asdescribed in Note 2. At December 31, 2006, net case specific reserveswere $20.2 million, net of estimated recoveries of $5.5 million, andnon-specific reserves were $21.9 million. At December 31, 2005, netcase specific reserves were $17.7 million, net of estimated recoveries of$8.1 million, and non-specific reserves were $16.6 million. At December 31,2004, net case specific reserves were $25.7 million, net of estimatedrecoveries of $7.7 million, and non-specific reserves were$10.3 million. Estimated recoveries represent loss payment amounts whichhave been paid by the Company that it expects to recover in future periods. Changesin non-specific reserves are reported as current year activity. Included in netcase-specific reserves in 2006 and 2005 is $23.4 million and$23.0 million, respectively, related to a portfolio of insured securitizedmanufactured housing bonds. These insurance contracts were issued in 1999. Ofthe portfolio, one bond defaulted in July of 2005, while the remainingbonds are expected to default subsequent December 31, 2006. Losses areexpected to be paid through 2033. The 2006 reserve for these bonds includes$14.0 million of adverse development offset by $13.6 million ofadditional cash flows within the bond structure that will accrue to the benefitof the Company.

Incurred losses for theyear ended December 31, 2006, 2005 and 2004, were $8.8 million,$14.0 million and $46.6 million, respectively. Incurred losses for2006, 2005 and 2004 include $2.7 million, $4.2 million and$2.4 million, respectively, of prior period development. In 2006, theCompany did not establish any new case based loss reserves. The Company didincur loss adjustment expenses in the amount of $1.2 million in connection withseveral insured municipal credits in varying stages of work-out. Additionally,the Company increased its reserve related to the portfolio of securitizedmanufactured housing bonds discussed above by $1.7 million, of which $1.0million was related to accretion. In 2005, the Company increased its reserverelated to the portfolio of securitized manufactured housing bonds discussedabove by 

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$3.4 millionwhich included approximately $1.0 million in accretion. Included in incurredlosses and loss adjustment expenses in 2004 were $21 million related tothe Company’s discontinued industry loss warranty business, $20.3 million for theinitial establishment of the reserve on the manufactured housing portfolio and$2.4 million of unfavorable development on a specific municipal case reserve.

Prior period developmentarises from changes to loss estimates recognized in the current year thatrelate to loss reserves first reported in previous calendar years and excludesthe effect of losses from the development of earned premium from previousaccident years.

Loss and loss adjustmentexpenses paid, net of reinsurance, for the years ended December 31, 2006,2005 and 2004 were $1.0 million, $15.7 million and $14.4 million,respectively. Payments made in 2005 and 2004 include $10.0 million and$11.0 million, respectively, related to two contracts in the discontinuedindustry loss warranty business. The Company had no remaining reserve orexposure on this business as of December 31, 2006 and 2005. Also includedin claim payments is $3.1 million in 2005 related to a municipal bond and$3.9 million in 2004 on two insured mortgage-backed bonds. For the 2004payment, approximately $0.8 million in salvage was received. Based on thecircumstances of the bonds’ default, the Company expects to fully recover allpayments and accordingly recorded anticipated salvage in an amount equal to netpayments made.

Case reserves are recordednet of an adjustment for the time value of money. The Company discounts casereserves using the risk free rate that is closest to the term of the expectedloss payments of the insured obligation at the date the case reserve is established.For this purpose, U.S. Treasury rates are used. At December 31, 2006, theweighted average discount factor used was 4.6% and the discount taken was$6.4 million. The $6.4 million is net of $13.2 million, which representsthe discount related to expected reimbursements against projected future losspayments. At December 31, 2005, the weighted average discount factor usedwas also 4.6% and the discount taken was $16.9 million.

**9.**                 REINSURANCE

As of and for the yearsended December 31, 2006, 2005 and 2004, amounts reinsured were as follows(dollars in thousands): 

| ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Income and expenses:                               |       |     |       |     |       |     |       |
| Written  premiums ceded (cancelled)                |       | $        | 505        |     | $          | (638     | )          | $ | (911 | ) |
| Written  premiums assumed                          |       | 706      |       | 1,026    |       | 246      |       |
| Earned  premiums ceded                             |       | 826      |       | 337      |       | 6,874    |       |
| Earned premiums assumed                            |       | 853      |       | 996      |       | 308      |       |
| Loss and loss-adjustment-expense  payments ceded   |       | —   |       | —   |       | —   |       |
| Loss and loss-adjustment-expense  payments assumed |       | —   |       | —   |       | —   |       |
| Assets and liabilities:                            |       |     |       |     |       |     |       |
| Unearned  premium reserve ceded                    |       | 528      |       | 848      |       | 1,824    |       |
| Unearned  premium reserve assumed                  |       | 474      |       | 621      |       | 591      |       |
| Loss  and loss-adjustment-expense reserves ceded   |       | —   |       | —   |       | —   |       |
| Loss  and loss-adjustment-expense reserves assumed |       | —   |       | —   |       | —   |       |
| Off balance sheet items:                           |       |     |       |     |       |     |       |
| Principal  outstanding ceded                       |       | 53,700   |       | 48,116   |       | 115,985  |       |
| Principal  outstanding assumed                     |       | 19,953   |       | 20,318   |       | 34,005   |       |
|                                                    |            |          |            |          |            |          |            |  |  |  |

 

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During 2006, 2005 and 2004, the Company reinsured aportion of its risk with other insurance companies under pro-rata,excess-of-loss, first loss and facultative reinsurance agreements.

Effective October 1, 2005, ACA Financial Guarantyentered into an excess of loss reinsurance agreement with HCC ReinsuranceCompany Limited whereby ACA Financial Guaranty cedes its first $50 millionin excess of $490 million on non-derivative, non-investment grademunicipal paid losses. This reinsurance agreement was amended effective February 1,2006 to increase the Company’s retention to $525 million.

During 2005, a facultative reinsurance agreementcovering a municipal obligation with ACE American Insurance Company (“ACE”) wascancelled. As a result of the cancellation, $0.8 million in ceded unearnedpremium reserve was returned to the Company.

In 2004, the Company had a first loss and excess ofloss reinsurance facility (the “Soft Capital Facility”) with ACE. In theaggregate, the Soft Capital Facility provided the Company with an additional$125 million for the payment of claims. The reinsurance facility providedfirst loss and excess of loss coverage.

The first loss coverage had an additional$50 million limit of liability and reinsured the Company’s in-forceportfolio subject to the sub-limits of the reinsurer’s limit of liability(defined as $20 million in 2002 and increasing to $50 million in 2005and thereafter) and upon the payment of a premium of $50 million. This$50 million in coverage was accounted for as a financing arrangement andno premiums or losses were recognized in the financial statements. In additionto the $50 million of first loss coverage, the reinsurer was liable for100% of net paid losses in excess of $175 million and after the adjusted surplus,as defined, of the Company is less than $25 million, subject to a$75 million limit of liability.

In 2003, S&P revised its criteria for allowingfinancial guarantors to take credit for soft capital reinsurance facilities. Asa result, the Soft Capital Facility no longer provided ACA Financial Guarantywith a significant benefit. Consequently during 2004, the Soft Capital Facilitywas cancelled. As a result of the cancellation, $5.6 million in cededunearned premium reserve was returned to the Company and $2.4 million indeferred commission income was earned. The Company also reassumed a previouslyceded case basis loss reserve in the amount of $1.1 million and recordedother income of $2.0 million in connection with the cancellation.

The Company also cancelled reinsurance contracts withPartner Reinsurance Company Ltd. and Royal & Sun Alliance InsurancePLC during 2004 which resulted in premiums reassumed of $0.7 million and$0.2 million, respectively.

To the extent the Company cedes a portion of itsbusiness to other non-affiliated insurance and reinsurance companies, acontingent liability exists relating to such reinsurance in the event that thereinsurer becomes unable to meet their obligations under the terms of thereinsurance agreement; the Company would be liable for such defaulted amounts. Thewere no unpaid losses and loss adjustment expenses ceded to non affiliatedinsurance and reinsurance companies at December 31, 2006 and 2005. Unearnedpremiums ceded were $0.5 million and $0.8 million at December 31,2006 and 2005, respectively.

Ceded earned premiums were $0.8 million,$0.3 million and $6.9 million in 2006, 2005 and 2004, respectively. Lossand loss adjustment expense payments ceded were $0 million in the years2006, 2005 and 2004. Reinsurance recoverable on unpaid losses was $0.0 millionat December 31, 2006, 2005 and 2004.

In 2006, 2005 and 2004,ACA Financial Guaranty assumed reinsurance premiums written of $0.7 million,$1.0 million and $0.2 million, respectively. In 2006, 2005 and 2004,assumed earned premiums were $0.9 million, $1.0 million and$0.3 million, respectively. ACA Assurance, a subsidiary whose business(trade credit and insured loss warranty) was discontinued or placed intorun-off in 2004, recorded assumed 

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writtenpremiums of $0.4 million, $3.3 million and $12.6 million andearned premiums of $1.1 million, $5.5 million and $10.4 millionin 2006, 2005 and 2004, respectively.

**10.   DEBT**

Debtoutstanding at December 31, 2006 and 2005 consisted of the following(dollars in thousands):

| ** **                           | ** ** | **December 31** | ** ** | **Maturity** | ** ** | **2006 Interest** | ** ** | **2006 Weighted  Average** | ** ** |
|--------------------------------------|------------|----------------------|------------|--------------|------------|------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **2006**             | ** ** | **2005**     | ** ** | **Date**               | ** ** | **Rate Range**             | ** ** | **Interest Rate** | ** ** |
| Zenith Funding Corp.                 |       |                 |       |         |       |                   |       |                            |       |   |   |
| Commercial Paper Notes               |       | $                    | 1,362,000  |         | $          | 1,355,400              |       | 2007                            |       | From  5.36% to 5.44% |   | 5.38% |   |
| Tranched Notes Payable               |       | 135,000              |       | 135,000      |       | 2039                   |       | LIBOR*+0.65% to 3.00% |       | LIBOR*+0.96% |   |
| ACA ABS 2004-1 Limited               |       |                 |       |         |       |                   |       |                            |       |   |   |
| Tranched Notes Payable—Floating |       | 387,646              |       | 419,277      |       | 2039                   |       | LIBOR*+0.37%  to 3.25%          |       | LIBOR*+0.59% |   |
| Tranched Note Payable—Fixed     |       | 2,628                |       | 2,795        |       | 2039                   |       | 7.70%                           |       |   |   |
| Grenadier Funding Corp.              |       |                 |       |         |       |                   |       |                            |       |   |   |
| Commercial Paper Notes               |       | 1,334,594            |       | 1,327,511    |       | 2007                   |       | From  5.30% to 5.35%            |       | 5.32% |   |
| Tranched Notes Payable               |       | 157,500              |       | 157,500      |       | 2013                   |       | LIBOR**+0.60%  to 0.95%         |       | LIBOR**+0.80% |   |
| ACA ABS 2003-1 Limited               |       |                 |       |         |       |                   |       |                            |       |   |   |
| Tranched Notes Payable               |       | 361,047              |       | 361,050      |       | 2038                   |       | LIBOR*+0.75%  to 4.50%          |       | LIBOR*+1.04% |   |
| ACA ABS 2003-2 Limited               |       |                 |       |         |       |                   |       |                            |       |   |   |
| Tranched Notes Payable—Floating |       | 666,401              |       | 666,500      |       | 2038                   |       | LIBOR*+0.50%  to 4.50%          |       | LIBOR*+0.90% |   |
| Tranched Note Payable—Fixed     |       | 7,000                |       | 7,000        |       | 2038                   |       | 5.00%                           |       |   |   |
| Tranched Note Payable—Fixed     |       | 2,980                |       | 3,000        |       | 2038                   |       | 11.50%                          |       |   |   |
| ACA CDS 2002-1 Limited               |       |                 |       |         |       |                   |       |                            |       |   |   |
| Tranched Notes Payable               |       | 100,500              |       | 100,500      |       | 2008                   |       | LIBOR*+0.55%  to 3.00%          |       | LIBOR*+1.14% |   |
| Class A Senior Interest Only    |       | 2,110                |       | 3,159        |       | 2008                   |       | 2.74%                           |       |   |   |
| ACA ABS 2002-1 Limited               |       |                 |       |         |       |                   |       |                            |       |   |   |
| Tranched Notes Payable               |       | 212,560              |       | 304,434      |       | 2034–2037         |       | LIBOR*+0.54%  to 2.60%          |       | LIBOR*+0.81% |   |
| Total VIE Debt                       |       | 4,731,966            |       | 4,843,126    |       |                   |       |                            |       |   |   |
| ACA ABS 2005-1 Funding Limited       |       | 737                  |       | 2,685        |       | 2010                   |       | LIBOR*  + 0.75%                 |       |   |   |
| ACA Parliament Funding, LLC          |       | 100,000              |       | 100,000      |       | 2010                   |       | LIBOR*  + 1.25%                 |       |   |   |
| ACA ABS 2004-1 Funding Limited       |       | 8,601                |       | 9,356        |       | 2033                   |       | LIBOR*+4.00%                    |       |   |   |
| Trust Preferred Debt                 |       | 79,899               |       | 79,899       |       | 2032–2034         |       | LIBOR*+3.35%  to 4.10%          |       | LIBOR*+3.85% |   |
| ACA Service Corporation              |       | 2,674                |       | 4,182        |       | 2013                   |       | LIBOR*  +0.80%                  |       |   |   |
|                                 |       | 4,923,877            |       | 5,039,248    |       |                   |       |                            |       |   |   |
| Less unamortized discount            |       | (20,135              | )          | (9,900       | )          |                   |       |                            |       |   |   |
| Total Debt                           |       | $                    | 4,903,742  |         | $          | 5,029,348              |       |                            |       |   |   |   |   |

----

*                     Based on three month LIBOR.

**               Based on one month LIBOR.

In March 2005, a special purpose entity createdby the Company, ACA Parliament, LLC (“ACA Parliament”), entered into aninvestment agreement with an investment trust (the “Investor”) pursuant towhich the Investor deposited $99 million (net of $1 million in costsof issuance—see Note 19) (the “Deposit Amount”) in a deposit fund that ismaintained and invested by ACA Parliament. Pursuant to the terms of theinvestment agreement, ACA Parliament is required to make quarterly interestpayments to the Investor at a rate equal to the three-month LIBOR plus 125basis points. The obligations of ACA Parliament to make such interest paymentsand to repay the Deposit Amount are guaranteed by financial guaranty insurancepolicies issued by ACA Financial Guaranty.

During 2006 and 2005, ACA Parliament loaned certain ofthe proceeds held by it under the investment agreement to certain ACAaffiliates, which in turn were used by such affiliates either (i) torefinance existing funding notes or (ii) to finance the Company’s equityparticipation in the Company’s CDO asset management business. In particular,the Company’s equity position was refinanced in each of 

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the following CDOtransactions: ACA CDS 2002-1 Funding, Limited; ACA ABS 2003-1Funding, Limited; ACA ABS 2003-2 Funding, Limited; Grenadier Funding, Limited;Lancer Funding, Ltd. and Zenith Funding, Limited. The Company financed itsequity position in each of the following CDO transactions: ACA CLO 2005-1,Limited and ACA ABS 2005-2, Limited. The Company may use some of theremaining unallocated Deposit Amount from time to time to finance the Company’sequity position in future CDO transactions. Each such equity financing issecured by a pledge of the equity purchased with the proceeds of the financingand an ACA Financial Guaranty insurance policy.

During 2005, the Company entered into two promissorynote agreements to finance its equity position in CDO deals. The first note hadan original face of $4.5 million, has a maturity of 2013 and accruesinterest payable quarterly at a rate of LIBOR plus a margin of 0.80%. Thesecond note had an original face of $3.8 million, has a maturity of 2010and accrues interest payable quarterly at a rate of LIBOR plus a margin of0.75%.

As of December 31, 2006, Grenadier Funding Corp.and Zenith Funding Corp. had issued 30-90 day commercial paper noteswith a weighted average maturity of 79 days and 80 days respectively.The rate on these notes is floating with a weighted average year end value of5.32% and 5.38%. These notes are limited recourse debt obligations of the issuers,backed solely by collateral managed by the Company. The short-term nature ofthese notes is designed to correspond with the short term rates on theunderlying collateral of the deals. The Zenith Funding Corp., ACA ABS 2004-1Limited, Grenadier Funding Ltd., ACA ABS 2003-1 Limited, ACA ABS 2003-2Limited, ACA CDS 2002-1 Limited and ACA ABS 2002-1 Limited tranchednotes are issued and collateralized through a VIE pursuant to an indentureagreement. These notes are limited recourse debt obligations of the issuersbacked solely by a pledge of collateral managed by the Company in the VIE. Thenotes may be redeemed prior to the scheduled maturity date at the option of theCompany as issuer and collateral manager, or in connection with an event ofdefault pursuant to the indenture agreement.

Interest on the ACA CDS 2002-1 Limited Class Asenior interest only note issued by the VIE is computed based on a notionalvalue of $48 million. The interest rate on this note was 5.484% until April 15,2005, 3.565% from April 15, 2005 until July 15, 2005, and 2.742% fromJuly 15, 2005 until maturity.

The Company issued floating rate junior subordinateddeferrable interest debentures, structured as trust preferred securities, of$20.6 million in 2004, bringing the total outstanding issuances to$79.9 million. The trust preferred securities have an initial stated termof 30 years with a call provision at five years from the date of eachissuance. The current interest rates on the $79.9 million of outstandingtrust preferred securities range from 8.71% to 9.47% at December 31, 2006.The effective interest rate of these securities is calculated based on 3-MonthLIBOR plus a margin of 3.35% to 4.1% per annum subject to certain interest ratecaps during the lives of the securities.

The Company entered into acredit agreement dated May 1, 2006 with J.P. Morgan Securities Inc., asArranger, JPMorgan Chase Bank, N.A. as Administrative Agent, and various otherlenders. The credit agreement provides for a 364-day senior unsecured revolvingcredit facility in an aggregate principal amount of up to $75 million. TheCompany may borrow cash under the revolving credit facility bearing interestbased on the LIBOR, or the Federal Funds/Prime Rate. The Company pays afacility fee between 0.100% up to 0.175% per annum of the total commitmentsunder the revolving credit facility. In addition, we also agreed to pay autilization fee at a rate of 0.125% per annum on the average daily amount ofthe outstanding principal under the revolving credit facility, but only payablewhen such outstanding principal amount exceeds 50% of the commitments under therevolving credit facility. We had no indebtedness outstanding under thisfacility as of December 31, 2006.

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**11.   INCOME TAXES**

In 2004, the Company re-domesticated from Bermuda toDelaware (see Note 1), which under IRS regulations will preclude it fromfiling a consolidated federal income tax return with its operating subsidiariesuntil 2008. In 2005, in an effort to reduce federal and state filing requirementsand to simplify the organization, the Company re-aligned its tax-payingstructure. As a result of the 2005 re-alignment, the Company has two federalcorporate taxpayers.

Thecomponents of income tax expense for the years ended December 31, 2006,2005 and 2004, were as follows (dollars in thousands):

| ** **                               | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current tax  expense (benefit):          |       |     |       |     |       |     |       |
| Federal                                  |       | $        | 29,502     |     | $          | 12,671   |       | $ | 3,476 |   |
| State and local                          |       | 1,864    |       | 1,707    |       | (19      | )          |
| Total current tax  expense               |       | 31,366   |       | 14,378   |       | 3,457    |       |
| Deferred federal  tax expense (benefit): |       | 1,714    |       | 719      |       | (3,322   | )          |
| Total income tax expense                 |       | $        | 33,080     |     | $          | 15,097   |       | $ | 135 |   |

 

TheCompany’s actual income tax expense for the years ended December 31, 2006,2005 and 2004, differs from the expected amount computed by applying thestatutory federal income tax rate of 35% to income before income taxes for thefollowing reasons (dollars in thousands):

| ** **                                           | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected federal  income tax expense                 |       | $        | 32,126     |     | $          | 15,350   |       | $ | (1,279 | ) |
| Tax-exempt  interest                                 |       | (1,333   | )          | (998     | )          | (427     | )          |
| Loss of foreign  entities excluded from federal tax  |       | —   |       | —   |       | 1,690    |       |
| State and local  income taxes-net of federal benefit |       | 196      |       | 1,110    |       | (13      | )          |
| Change in  valuation allowance                       |       | 1,611    |       | —   |       | —   |       |
| Other                                                |       | 480      |       | (365     | )          | 164      |       |
| Total income tax expense                             |       | $        | 33,080     |     | $          | 15,097   |       | $ | 135 |   |

 

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Thetax effects of temporary differences that give rise to deferred tax assets andliabilities at December 31, 2006 and 2005, are presented below (dollars inthousands):

| ** **                                                     | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets:                                           |       |     |       |     |       |
| Net operating losses                                           |       | $        | 6,444      |     | $          | 5,748 |   |
| Loss and loss adjustment expense reserve                       |       | 13,303   |       | 10,231   |       |
| Controlled foreign corporation book to tax basis  differences  |       | 6,014    |       | 6,990    |       |
| Other comprehensive losses on investments                      |       | 1,760    |       | —   |       |
| Unearned ceding commissions                                    |       | 2,200    |       | —   |       |
| Capital loss carryforwards                                     |       | 1,989    |       | —   |       |
| Other                                                          |       | 334      |       | 1,421    |       |
| Total gross  deferred tax assets                               |       | 32,044   |       | 24,390   |       |
| Deferred tax liabilities                                       |       |     |       |     |       |
| Deferred acquisitions costs                                    |       | 17,189   |       | 16,595   |       |
| Unearned premium reserve                                       |       | 7,992    |       | 5,072    |       |
| Unrealized gain on derivatives                                 |       | 3,794    |       | 2,420    |       |
| Other comprehensive income gains on investments                |       | —   |       | 5,369    |       |
| Other                                                          |       | 1,716    |       | 1,843    |       |
| Total gross  deferred tax liabilities                          |       | 30,691   |       | 31,299   |       |
| Net deferred tax  asset (liability) before valuation allowance |       | 1,353    |       | (6,909   | )          |
| Valuation  allowance                                           |       | (1,611   | )          | —   |       |
| Net deferred tax  liability                                    |       | $        | (258       | )        | $          | (6,909 | ) |

 

At December 31, 2006,the Company has federal net operating loss carryforwards of approximately$18.3 million that begin to expire in 2024 and are fully expired by 2026. Basedon available evidence, it is more likely than not that the deferred tax assetsrelating to the net operating loss will not be fully realized. Accordingly, avaluation allowance was established in 2006 in the amount of $1.6 millionrelating to the portion of the tax benefits attributable to certain netoperating losses.

**12.   CREDIT FUND**

In May 2006, the Company launched the Credit Fundto leverage its expertise in the capital and credit markets and as an assetmanager. The fund invests in fixed income securities, particularly in theasset-backed sector. The Credit Fund had net assets under management of$25.6 million as of December 31, 2006. ACA Financial Products, Inc.,a wholly owned indirect subsidiary of the Company, owned $17.0 million ofequity in the Credit Fund at December 31, 2006. The remaining$8.6 million of equity was owned by third party investors. In addition toreceiving a return on its investment in the Credit Fund, the Company is paid amanagement fee to select and manage the assets for the Credit Fund’sthird-party investors. For accounting purposes, the Credit Fund is consolidatedin the Company’s financial statements as of December 31, 2006 and itsfinancial results are recorded in the Structured Credit line of business. As ofDecember 31, 2006, the Credit Fund had assets of $264.6 million,including investments in fixed-maturity securities trading of$251.8 million, securities purchased under agreements to resell of$10.2 million and total liabilities and minority interest of$247.7 million, including securities sold under agreement to repurchase of$232.2 million and payable for securities purchased of $5.0 million,included in the Company’s consolidated balance sheet. The Company’sconsolidated statement of operations included net realized and unrealizedlosses on the Credit Fund of $0.2 million, interest expense of $3.7 millionand net investment income of $4.8 million for the year ended December 31,2006.

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**13.    COMMITMENTS**

The Company and itssubsidiaries lease office space for their corporate headquarters in New YorkCity and, beginning in 2006, for newly established offices in London andSingapore under noncancelable operating leases, which expire at various datesthrough 2020. In addition to base rental costs, the leases for office spaceprovide for rent escalations resulting from increased assessments for realestate taxes, utilities, and maintenance. Rent expense for 2006, 2005 and 2004was $2.4 million, $2.0 million and $2.1 million, respectively.

Futureminimum lease payments under the noncancelable operating leases at December 31,2006 were as follows (dollars in thousands): 

| **Year Ending December 31** | ** ** | ** ** | ** ** | **Operating  Leases** | ** ** |
|--------------------------------------------|------------|------------|------------|-----------------------|------------|
| 2007                                       |       |       | $          | 2,717                 |       |   |
| 2008                                       |       |       | 3,052      |                  |       |
| 2009                                       |       |       | 3,137      |                  |       |
| 2010                                       |       |       | 3,276      |                  |       |
| 2011 and  thereafter                       |       |       | 26,408     |                  |       |
| Total                                      |       |       | $          | 38,590                |       |   |

 

During the ordinary courseof business, the Company has become party to certain litigation. Other thanwith respect to the litigation described in Note 21 below, managementbelieves all other matters will be resolved with no material impact on theCompany.

In the event of a ratingsdowngrade of ACA Financial Guaranty under the terms of certain credit swaptransactions entered into by various affiliates of the Company, whoseobligations under the related credit swap transactions are insured by ACAFinancial Guaranty, collateral is required to be posted for the benefit of theswap counterparty. The obligation to post collateral is that of the particularaffiliate of ACA Financial Guaranty that entered into the swap. In the eventthe affiliate cannot satisfy its posting obligation, ACA Financial Guaranty maybe required to make a termination payment to the counterparty based on the thencurrent market value of the transaction.

**14.**   FAIR VALUE OFFINANCIAL INSTRUMENTS

The following methods andassumptions were used by the Company in estimating its fair value disclosurefor financial instruments. These determinations were based on available marketinformation and appropriate valuation methodologies. Considerable judgment isrequired to interpret market data to develop the estimates and therefore, theymay not necessarily be indicative of the amount the Company could realize in acurrent market exchange. The use of different market assumptions and/orestimation methodologies may have a material effect on the estimated fair valueamounts.

***Fixed Maturity Securities******—***The fairvalue for fixed maturity securities available-for-sale and trading shown inNote 6 is based on independent market quotations, broker quotes orvaluation models when quotations are not available.

***Guaranteed Investment Contract******—***TheContract’s fair value approximates contract value, as the interest rate isvariable at LIBOR less 0.02% and resets on an annual basis.

***Securities Purchased under Agreements to Resell andSecurities Sold under Agreements to Repurchase—***Securitiespurchased under agreements to resell and securities sold under agreements torepurchase are treated as collateralized financing transactions and arerecorded at the amounts at which the securities were acquired or sold plusaccrued interest.

***Cash and CashEquivalents***—The carrying amounts of these itemsare reasonable estimates of their fair value.

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***Accrued Investment Income******—***The fairvalue of accrued investment income is assumed to approximate carrying value.

***Unearned Premium Reserve******—***The fairvalue of the Company’s unearned premium reserve is based on the estimated costof entering into a cession of the entire portfolio with third party reinsurersunder current market conditions. This amount was determined by using thestatutory basis unearned premium reserve, net of estimated ceding commissions.

***Debt******—***Debt isprimarily based on variable rates with fair value approximating carrying value.

***Accrued interest payable******—***The fairvalue of accrued interest payable approximates carrying value.

***Present Value of Installment Premiums******—***The fairvalue for financial guarantees written (net insurance contracts written) withinstallment premiums is derived by calculating the present value of theestimated future premiums at a risk adjusted rate of 4.7% and 5.0% in 2006 and2005, respectively, net of normal ceding commissions.

***Derivatives******—***The fairvalue derived from market information and appropriate valuation methodologiesreflect the estimated amounts that the Company would receive or pay toterminate the transaction at the reporting date. The Company recognizes allderivatives as either assets or liabilities in the balance sheet and measuresthose instruments at fair value.

The carrying value and estimated fair value offinancial instruments are presented below (dollars in millions): 

| ** **                                                    | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                    | ** ** | **2006**              | ** ** | **2005** | ** ** |
| ** **                                                    | ** ** | **Carrying  Value**   | ** ** | **Estimated  Fair Value** | ** ** | **Carrying  Value** | ** ** | **Estimated  Fair Value** | ** ** |
| Assets                                                        |       |                  |       |   |   |   |   |   |   |   |   |   |   |
| Fixed maturity securities available for sale                  |       | $                     | 5,026.3    |   |   | $ | 5,026.3 |   |   | $ | 5,298.7 |   |   | $ | 5,298.7 |   |   |
| Fixed maturity securities trading                             |       | 251.8                 |       |   | 251.8 |   |   | — |   |   | — |   |   |
| Guaranteed investment contract                                |       | 119.3                 |       |   | 119.3 |   |   | 119.3 |   |   | 119.3 |   |   |
| Securities purchased under agreements to resell               |       | 10.2                  |       |   | 10.2 |   |   | — |   |   | — |   |   |
| Cash and cash equivalents                                     |       | 447.0                 |       |   | 447.0 |   |   | 224.6 |   |   | 224.6 |   |   |
| Accrued investment income                                     |       | 21.2                  |       |   | 21.2 |   |   | 17.3 |   |   | 17.3 |   |   |
| Derivative assets                                             |       | 19.7                  |       |   | 19.7 |   |   | 15.3 |   |   | 15.3 |   |   |
| Liabilities                                                   |       |                  |       |   |   |   |   |   |   |   |   |   |   |
| Debt                                                          |       | 4,903.7               |       |   | 4,903.7 |   |   | 5,029.3 |   |   | 5,029.3 |   |   |
| Unearned premium reserve of up-front premiums                 |       | 189.5                 |       |   | 162.3 |   |   | 187.8 |   |   | 150.9 |   |   |
| Securities sold under agreements to repurchase                |       | 232.2                 |       |   | 232.2 |   |   | — |   |   | — |   |   |
| Derivative liabilities                                        |       | 33.9                  |       |   | 33.9 |   |   | 46.5 |   |   | 46.5 |   |   |
| Accrued interest payable                                      |       | 17.9                  |       |   | 17.9 |   |   | 15.3 |   |   | 15.3 |   |   |
| Off-Balance Sheet  Instruments                                |       |                  |       |   |   |   |   |   |   |   |   |   |   |
| Present value of installment premiums on insurance  contracts |       |                  |       |   | 8.0 |   |   |   |   |   | 11.4 |   |   |
| Present value of  installment insured credit swap premiums    |       |                  |       |   | 250.5 |   |   |   |   |   | 119.5 |   |   |
|                                                               |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**15.   STOCKPLANS AND STOCK BASED COMPENSATION**

In 2001, the Companyadopted the American Capital Access Holdings, Incorporated Omnibus IncentiveCompensation Plan (the “Prior Plan”) under which 2,188,584 shares of theCompany’s common shares were reserved for issuance to employees, directors andconsultants. In 2003, the Company’s Board of Directors approved the increase ofthe number of shares reserved for issuance by 72,954. In 2004, the 

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Board ofDirectors approved the ACA Holdings, Inc. Amended and Restated 2004 StockIncentive Plan effective September 30, 2004 (as amended on October 4,2004, the “2004 Plan”) amending and restating the Prior Plan and increasing thetotal options available under the 2004 Plan (including those previouslydistributed under the Prior Plan) to 4,241,538. In August 2006, the Boardof Directors approved the Amended and Restated 2006 Stock Incentive Plan, tobecome effective upon completion of the IPO (the “2006 Plan”) which increasedthe total options and shares available under the 2006 Plan, including allshares subject to existing awards there under pursuant to the Prior Plan andthe 2004 Plan, to 6,327,972. The 2006 Plan became effective November 9,2006. The 2006 Plan permits the grant of nonqualified and qualified stockoptions, incentive stock options, restricted stock, stock units, unrestrictedstock, dividend equivalent and cash-based awards. As of December 31, 2006,the Company has issued stock options and restricted stock under the 2006 Plan. Theobjectives of the 2006 Plan are to optimize the profitability and growth of theCompany through annual long-term incentives that are consistent and linked withthe Company’s goals.

Unless otherwisespecified, each option vests ratably annually either over 3 years or every 6months over 3 12 years, beginning at the date ofgrant. As long as the grantee is still with the Company, if not vested by itsterms, each option fully vests upon the earliest of (i) the grantee’snormal retirement date; (ii) the grantee’s death or disability; or (iii) theoccurrence of a change of control of the Company.

On August 3, 2006,the compensation committee granted in the aggregate to certain of the Company’sofficers options to purchase 543,000 shares of common stock subject to thecompletion of the Company’s initial public offering. The options have anexercise price per share equal to the offering price per share of $13.00, havea term of ten years subject to earlier termination and vest in equalinstallments every six months over 42 months. The options were grantedeffective November 10, 2006.

In December 2004, theFASB issued FAS 123(R) that requires compensation cost related toshare-based payment transactions to be recognized in an issuer’s financialstatements. The compensation cost, with limited exceptions, is measured basedon the grant-date fair value of the equity or liability instrument issued. FAS123(R) replaces FAS 123 and supersedes APB No. 25. Effective January 1,2006, the Company adopted FAS 123(R) using the prospectiveapplication as permitted by FAS 123(R). Accordingly, prior period amountshave not been restated. Under this application, we are required to recordcompensation expense for all awards granted after the date of adoption. Awardsgranted prior to the date of adoption of FAS 123(R) continue to beaccounted for under APB No. 25. Compensation cost is recognized over theperiods that an employee provides service in exchange for the award.

In 2006, the adoption ofFAS 123(R) resulted in incremental stock-based compensation expenseof $1.0 million, $0.2 million of which was deferred related to policyacquisition costs. The incremental stock-based compensation expense causedincome before income taxes and net income to decrease by $0.8 million and$0.5 million, respectively, and basic and diluted earnings per share eachto decrease both by $0.02 per share, respectively. There was no effect on cashprovided by operating activities and cash provided by financing activitiesrelated to excess tax benefits from stock-based payment arrangements in 2006.

The fair value of thestock options granted was estimated on the date of grant using a Black-Scholesoption valuation model that uses the assumptions noted in the following table. Therisk-free rate is based on the U.S. Treasury yield curve in effect at the timeof grant. The expected term (estimated period of time outstanding) of the stockoptions granted was estimated using the simplified method, in which theexpected term equals the average of the graded vesting term and the contractualterm. Expected volatility was estimated based on the historical volatility ofcomparable public companies for a period equal to the stock option’s expectedterm, ending on the day of grant, and calculated on a monthly basis.

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| ** **              | ** ** | **2006**   | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------|------------|------------|------------|----------|------------|----------|------------|
| Dividend yield          |       | 0          | %          | 0        | %          | 0        | %          |
| Expected  volatility    |       | 25.00      | %          | 0        | %          | 0        | %          |
| Expected term in  years |       | 6          |       | 6        |       | 3        |       |
| Risk-free interest rate |       | 4.55-4.91% |       | 3.86     | %          | 3.88     | %          |

 

Utilizing theseassumptions, the weighted-average per-share fair value of stock options grantedin 2006, 2005 and 2004 was $4.51, $2.41 and $1.14, respectively.

Asummary of option activity for the years ended December 31, 2006, 2005 and2004 is as follows:

| ** **                          | ** ** | **2006  Activity** | ** ** | **2006  Weighted  Average  Exercise  Price** | ** ** | **2005  Activity** | ** ** | **2005  Weighted  Average  Exercise  Price** | ** ** | **2004  Activity** | ** ** | **2004  Weighted  Average  Exercise  Price** | ** ** |
|-------------------------------------|------------|--------------------|------------|----------------------------------------------|------------|--------------------|------------|----------------------------------------------|------------|--------------------|------------|----------------------------------------------|------------|
| Outstanding—beginning  of year |       | 3,043,650          |       |                                         | $          | 10.54              |       |                                         | 3,042,306  |               |       | $                                            | 10.51      |   |   | 2,150,070 |   |   | $ | 10.74 |   |   |
| Granted                             |       | 1,620,000          |       |                                         | 12.80      |               |       | 111,000                                      |       |               | 11.63      |                                         |       | 1,293,480 |   |   | 10.38 |   |   |
| Exercised                           |       | (663,540           | )          |                                         | 10.23      |               |       | —                                       |       |               | —     |                                         |       | — |   |   | — |   |   |
| Forfeited                           |       | (103,062           | )          |                                         | 10.95      |               |       | (109,656                                     | )          |               | 10.67      |                                         |       | (401,244 | ) |   | 11.72 |   |   |
| Outstanding—end  of year       |       | 3,897,048          |       |                                         | 11.52      |               |       | 3,043,650                                    |       |               | 10.54      |                                         |       | 3,042,306 |   |   | 10.51 |   |   |
| Options vested—end of  year    |       | 1,843,044          |       |                                         | $          | 10.83              |       |                                         | 2,018,874  |               |       | $                                            | 10.53      |   |   | 1,607,118 |   |   | $ | 10.44 |   |   |

 

During 2006, the Companypurchased 499,971 shares of its common stock with an original cost basis of$5.1 million from a former employee for $6.6 million. The Company receiveda $2.3 million recourse note, which bears interest at 5.32%, from anotherformer employee for the exercise of 221,220 stock options. Interest on thisnote compounds annually and all principal and interest on the note is due in June 2016.During 2005 and 2004, the Company purchased 7,128 shares and 174,372 shares,respectively, of its common stock from employees terminated during the year fora purchase price of $0.1 million and $2.2 million, respectively. Theshares purchased were accounted for as treasury stock.

As of December 31,2006, there was $5.0 million of total unrecognized compensation costrelated to nonvested share-based compensation awards granted under the stockoption plans. This cost is expected to be recognized over a weighted averageperiod of 2.94 years.

Thefollowing table summarizes information regarding fully vested share options asof December 31, 2006:

| **(Dollars in thousands, except per share amount)** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| Number of options  vested                                                         |       | 1,843,044  |       |
| Weighted average  exercise price per share                                        |       | $          | 10.83      |       |
| Aggregate  intrinsic value (excess market price over exercise price)              |       | $          | 8,605      |       |
| Weighted average  remaining contractual term of options (in years)                |       | 6.35       |       |

 

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Thefollowing table summarizes information concerning outstanding and exercisableoptions at December 31, 2006:

| ** **                                  | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                  | ** ** | ** **                   | ** ** | **Weighted**                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | ** **                   | ** ** | **Average**                  | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                  | ** ** | ** **                   | ** ** | **Remaining**                | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                  | ** ** | **Number**                   | ** ** | **Contractual**              | ** ** | **Exercise** | ** ** | **Number** | ** ** | **Exercise** | ** ** |
| **Range of Exercise Prices** | ** ** | ** **                   | ** ** | **Outstanding**              | ** ** | **Life (Years)** | ** ** | **Price** | ** ** | **Exercisable** | ** ** | **Price** | ** ** |
| $9.43–$10.77                           |       |                         | 1,921,806  |                         |       |   | 6.64 |   |   |   | $ | 10.33 |   |   | 1,382,564 |   |   | $ | 10.31 |   |   |
| $10.78–$12.12                          |       |                         | 96,000     |                         |       |   | 8.12 |   |   |   | $ | 11.63 |   |   | 40,540 |   |   | $ | 11.63 |   |   |
| $12.13–$13.47                          |       |                         | 1,879,242  |                         |       |   | 8.83 |   |   |   | $ | 12.74 |   |   | 419,940 |   |   | $ | 12.47 |   |   |
|                                        |       |                         | 3,897,048  |                         |       |   | 7.73 |   |   |   | $ | 11.52 |   |   | 1,843,044 |   |   | $ | 10.83 |   |   |
|                                             |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Also, in August 2006, the compensation committeegranted to certain of the Company’s officers and two of its independentdirectors 234,000 shares and 6,154 shares, respectively, of restricted commonstock subject to the completion of the Company’s initial public offering. Theofficer’s shares vest in equal installments on each of the first fouranniversaries of the grant date. The independent directors’ shares vestone-third per year over a three-year period. The shares were granted effectiveNovember 10, 2006 with a fair value of $13.00. The Company recognized FAS123(R) compensation expense of $0.1 million in 2006 related to theserestricted stock grants.

On September 30,2004, the Company granted 335,214 restricted shares at a fair market value of$10.38 per share, to the Company’s president and chief executive officer (the“Executive”). The total value at the grant date of the restricted stock totaled$3.5 million. The restricted stock vests one-third per year over a three-yearperiod provided the Executive has been continuously employed by the Company ora subsidiary throughout the applicable vesting period. In 2006, 2005 and 2004,the vested portion of the restricted stock totaled $1.2 million,$1.2 million and $0.3 million, respectively, which was recognized inthe Company’s consolidated statements of operations (see Note 17)

**16.   RETIREMENT PLAN**

The Company offers adefined contribution savings plan under Section 401(k) of theInternal Revenue Code. This plan covers substantially all employees who meetminimum age and service requirements and allows participants to defer a portionof their annual compensation on a pre-tax basis up to IRS limits. The Companymay make discretionary contributions to the plan on behalf of employees. TheCompany contributed $1.0 million, $0.5 million and $0.6 million tothe plan on behalf of employees for the years ended December 31, 2006,2005 and 2004, respectively.

**17.   PREFERREDAND COMMON STOCK**

On November 9, 2006, ACA priced its initialpublic offering of common stock. The Company sold 6,875,000 shares of commonstock in the offering, at $13.00 per share, with net proceeds to ACA of $79.3 million.The transaction closed on November 15, 2006. ACA is listed on the New YorkStock Exchange under the symbol “ACA.” Upon the closing of its initial publicoffering of common stock, the Company converted 154 shares of seniorconvertible stock to 924,000 shares of common stock, 959 shares ofconvertible preferred stock converted to 5,754,000 shares of common stock and2,785,769 shares of series B senior convertible preferred stock converted to16,714,614 shares of common stock.

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On August 3, 2006 theCompany’s Board of Directors authorized a dividend in order to effect asix-for-one stock split on the Company’s outstanding shares of common stock andon each share of common stock to be issued upon conversion of the variousclasses of preferred stock of the Company. Each stockholder of record on August 3,2006 has received five additional shares of common stock for each share ofcommon stock held by such stockholder on that date. Additional funds have beenreclassified from the additional paid in capital account to the common stockaccount to equal the amount of additional par value represented by theadditional shares which have been issued under the stock split. Upon theconversion of the various classes of the Company’s preferred stock, each holderof convertible preferred stock, senior convertible preferred stock andseries B senior convertible preferred stock was issued, in the case ofconvertible preferred stockholders and senior convertible preferredstockholders, 6,000 shares for each share of preferred stock held by suchholder and, in the case of the series B senior convertible preferredstockholders, 6 shares of each share of preferred stock held by such holder.All earnings per share and related stock option information presented in thesefinancial statements and accompanying footnotes have been retroactivelyadjusted to reflect the increased number of shares resulting from this action.

In April 2006, theCompany issued 25 shares of senior convertible preferred stock to its existingstockholders representing the 5% “liquidation accretion” premium earned fromthe date of issuance through September 30, 2004. The transaction wasaccounted for as a dividend. A value of $2.0 million, based on the March 31,2006 book value, was re-classified from retained earnings to senior convertiblepreferred stock to record the dividend.

On November 23, 2004,the Company (i) issued 13,501 shares of series C senior convertiblepreferred stock for $0.8 million to ACA’s senior management and to one ofits directors, and (ii) an additional 4,705 shares of series B seniorconvertible preferred stock for $0.3 million to one of its existingstockholders. An additional 5,000 shares of series C senior convertiblepreferred were issued to one of the Company’s directors on June 17, 2005.Each share of series C senior convertible preferred automaticallyconverted into one share of series B senior convertible preferred onNovember 30, 2005.

On September 30,2004, the Company granted 335,214 restricted shares of its series B seniorconvertible preferred stock, par value $0.10 (“the Restricted Stock”) at a fairmarket value of $10.38 per share, to the Company’s new president and chiefexecutive officer (the “Executive”). This stock is included in the amountsconverted to common stock commensurate with the closing of the Company’sinitial public offering of common stock. The total value at the grant date ofthe restricted stock totaled $3.5 million. The restricted stock vests asfollows: 33.33% vested on September 30, 2005; 33.33% will vest on September 30,2006; and the remaining 33.34% will vest on September 30, 2007, providedthe Executive has been continuously employed by the Company or a subsidiarythroughout the applicable vesting period. In 2006, 2005 and 2004, the vestedportion of the restricted stock totaled $1.2 million, $1.2 million and$0.3 million, respectively, which was recognized in the Company’sconsolidated statements of operations.

On June 4, June 28,and July 12, 2004, the Company issued 268,471, 26,847 and 11,813 shares ofseries A senior convertible preferred stock for $25.0 million,$2.5 million and $1.1 million, respectively, to existing stockholders.All of these shares were converted to series B senior convertiblepreferred stock on September 30, 2004. On the same day, the Company issuedan additional 2,247,551 shares of series B senior convertible preferredstock for $140.0 million to new stockholders. Of the capital raised in2004, $146 million was invested in the capital of ACA Financial Guarantyto increase its statutory capital to meet the redefined minimum capitalrequirements of S&P, ACA Financial Guaranty’s rating agency.

**18.   REGULATORY MATTERS**

The Maryland InsuranceAdministration (“MIA”), the insurance departments of certain other states andthe rating agencies which rate ACA Financial Guaranty have various requirementsrelating to the maintenance of certain minimum statutory capital and reserves,single risk limits and limits on non-investment grade obligations.

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As of December 31,2006, ACA Financial Guaranty’s policyholders’ surplus, as determined inaccordance with statutory accounting practices, was $273.6 million. Suchamount was in excess of the minimum capital and surplus level of$75.0 million required to satisfy a key state regulatory requirement.

Under Maryland insurancelaw, ACA Financial Guaranty may pay a dividend without the prior approval ofthe Commissioner of the MIA from earned surplus, as defined, subject to themaintenance of a minimum-capital requirement, and the dividend, which, togetherwith all dividends declared or distributed by it during the preceding twelvemonths, may not exceed the lesser 10% of its policyholders’ surplus shown onits last filed statement, or net income, as defined, for such twelve-monthperiod. Consistent with prior years, in 2007 based upon these restrictions, ACAFinancial Guaranty will need the approval of the MIA to pay any dividends.

In December 2005 and May 2005,the MIA approved ACA Financial Guaranty’s request to make dividend payments tothe Company in amounts equal to the interest payments on $40 million of theCompany’s trust preferred issuance outstanding as well as to pay interest on a$10 million surplus note issued by ACA Financial Guaranty to the Companyduring the years ended December 31, 2006 and 2005, respectively. Accordingly,ACA Financial Guaranty paid dividends of $2.7 million and $2.1 million for theultimate benefit of its parent, ACA, and $0.8 million and $0.5 million ininterest on the surplus note in 2006 and 2005, respectively.

The MIA completed itsfive-year regulatory examination of ACA Financial Guaranty with respect to theperiod ended December 31, 2003. The Report on Examination was madeavailable on the MIA’s website on January 19, 2007. There were noadjustments required to ACA Financial Guaranty’s 2006 statutory statements as aresult of this report. All adjustments to ACA Financial Guaranty’s statutorystatements required as a result of the examination were recorded in 2005.

**19.   OUTSTANDING EXPOSURE AND COLLATERAL**

ACA Financial Guarantypolicies insure the scheduled payments of principal and interest on municipalobligations and asset-backed and corporate financings. The outstandingprincipal amount of insured obligations in the insured portfolio, net ofamounts ceded aggregating $50 million at both December 31, 2006 and2005, respectively, included the following types of issues (dollars inmillions): 
|                               | ** ** | **December 31, 2006** | ** ** | **December 31, 2005**              | ** ** |
|-------------------------------|------------|---------------------------------|------------|----------------------------------------------|------------|
| ** **                    | ** ** | **Net Par  Outstanding**   | ** ** | **% of Net Par  Outstanding** | ** ** | **Net Par  Outstanding** | ** ** | **% of Net Par  Outstanding** | ** ** |
| Public:                       |       |                            |       |                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Higher education              |       |                            | $          | 1,504                                        |       |   |   | 3.3 | % |   |   | $ | 1,413 |   |   |   | 6.6 | % |   |
| Healthcare                    |       |                            | 844        |                                         |       |   | 1.8 |   |   |   | 929 |   |   |   | 4.3 |   |   |
| Tax backed                    |       |                            | 778        |                                         |       |   | 1.7 |   |   |   | 821 |   |   |   | 3.8 |   |   |
| Long-term care                |       |                            | 701        |                                         |       |   | 1.5 |   |   |   | 686 |   |   |   | 3.2 |   |   |
| General obligations           |       |                            | 465        |                                         |       |   | 1.0 |   |   |   | 600 |   |   |   | 2.8 |   |   |
| Not for profit                |       |                            | 411        |                                         |       |   | 0.9 |   |   |   | 298 |   |   |   | 1.4 |   |   |
| Transportation                |       |                            | 385        |                                         |       |   | 0.8 |   |   |   | 434 |   |   |   | 2.0 |   |   |
| Housing                       |       |                            | 278        |                                         |       |   | 0.6 |   |   |   | 280 |   |   |   | 1.3 |   |   |
| Utilities                     |       |                            | 257        |                                         |       |   | 0.6 |   |   |   | 305 |   |   |   | 1.4 |   |   |
| Other                         |       |                            | 456        |                                         |       |   | 1.0 |   |   |   | 340 |   |   |   | 1.6 |   |   |
| Total public obligations      |       |                            | 6,079      |                                         |       |   | 13.2 |   |   |   | 6,106 |   |   |   | 28.4 |   |   |
| Non-Public:                   |       |                            |       |                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Insured credit swaps          |       |                            | 39,409     |                                         |       |   | 85.3 |   |   |   | 14,639 |   |   |   | 68.2 |   |   |
| Structured finance            |       |                            | 8          |                                         |       |   | — |   |   |   | 8 |   |   |   | — |   |   |
| Other                         |       |                            | 709        |                                         |       |   | 1.5 |   |   |   | 714 |   |   |   | 3.4 |   |   |
| Total non-public  obligations |       |                            | 40,126     |                                         |       |   | 86.8 |   |   |   | 15,361 |   |   |   | 71.6 |   |   |
| Total                         |       |                            | $          | 46,205                                       |       |   |   | 100.0 | % |   |   | $ | 21,467 |   |   |   | 100.0 | % |   |

 

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Theprincipal amount of insured public obligations as of December 31, 2006 and2005, in the insured portfolio, net of amounts ceded, and the terms to finalmaturity were as follows (dollars in millions). Actual maturities could differfrom final maturities because borrowers have the right to refund or prepaycertain obligations. 
|                          | ** ** | **December 31, 2006** | ** ** | **December 31, 2005**              | ** ** |
|--------------------------|------------|---------------------------------|------------|----------------------------------------------|------------|
| ** **               | ** ** | **Net Par  Outstanding**   | ** ** | **% of Net Par  Outstanding** | ** ** | **Net Par  Outstanding** | ** ** | **% of Net Par  Outstanding** | ** ** |
| California               |       |                            | $          | 1,020                                        |       |   |   | 16.6 | % |   |   | $ | 1,141 |   |   |   | 18.7 | % |   |
| New York                 |       |                            | 643        |                                         |       |   | 10.5 |   |   |   | 545 |   |   |   | 8.9 |   |   |
| Texas                    |       |                            | 374        |                                         |       |   | 6.1 |   |   |   | 365 |   |   |   | 6.0 |   |   |
| Florida                  |       |                            | 334        |                                         |       |   | 5.4 |   |   |   | 261 |   |   |   | 4.3 |   |   |
| Pennsylvania             |       |                            | 279        |                                         |       |   | 4.6 |   |   |   | 292 |   |   |   | 4.8 |   |   |
| Other states             |       |                            | 3,429      |                                         |       |   | 56.8 |   |   |   | 3,502 |   |   |   | 57.3 |   |   |
| Total public obligations |       |                            | $          | 6,079                                        |       |   |   | 100.0 | % |   |   | $ | 6,106 |   |   |   | 100.0 | % |   |

 

Debt service on insured obligationsfor 2006 was approximately $51.0 billion. From its inception in 1997through December 31, 2006, the Company has net paid and case-specificlosses of $54.2 million on $202.3 million of net earned premium.

**20.   RELATEDPARTY TRANSACTIONS**

During 2006 and 2005, the Company received managementand structuring fee income from its non-consolidated CDOs of $18.5 million and$4.2 million, respectively (see Note 4). No CDOs were consideredrelated parties in 2004. This amount is included in fee income.

In 2002, the Company replaced one of its investmentmanagers with Stephens Capital Management (“Stephens”) and incurred investmentmanagement fees of $0.7 million, $0.1 million and $0.2 millionrelated to Stephens during 2006, 2005 and 2004, respectively. This investmentmanager is affiliated with SF Holding Corp. (f/k/a Stephens Group Inc.),which has a representative on the Company’s Board of Directors and is aninvestor in the Company. In January 2007, the investment managementagreement with Stephens was terminated.

During 2004, a Bear Stearns & Co. Inc.sponsored investment vehicle, BSMB/ACA LLC (“BSMB”) invested $105 millionin the Company in exchange for series B senior convertible preferred stock.BSMB is the private equity affiliate of the Bear, Stearns Companies, Inc.a subsidiary of Bear, Stearns & Co. Inc. During 2006 and 2005,Bear, Stearns & Co. Inc. performed investment banking servicesfor the Company on various transactions and was paid structuring and placementfees of $1.6 and $1.1 million, respectively. In March 2005, theCompany borrowed $100 million via an investment trust structure sponsoredby Bear Stearns. The Company is required to make quarterly interest payments tothe trust at a rate equal to the three-month LIBOR plus 125 basis points(see Note 10).

Pursuant to employmentcontracts approved by the Board of Directors, in 2001 key senior executivespurchased in aggregate 2,493,828 shares of common stock of the Company inexchange for $4.2 million, 10-year promissory notes payable to theCompany. The promissory notes accrue interest at the 10-year U.S.Treasury rate. The Company received principal payments in connection with thesepromissory notes of approximately $0 million and $0.1 million, during 2006and 2005, respectively. In May 2004, the previous Chief Executive Officer’spromissory note of $2.2 million was cancelled in connection with theCompany’s repurchase of his shares of the Company’s stock. The Company recordedinterest income related to the promissory notes of $0.1 million, $0.1 millionand $0.1 million, during 2006, 2005 and 2004, respectively. Interestreceivable relating to the promissory notes was $0.0 million and$0.1 million at December 31, 2006 and 2005, respectively. Pursuant tothe Amended and Restated Employment Agreements, effective September 30,2004, the Company discharged one-third of the outstanding unpaid principal andinterest 

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on thepromissory notes of those senior executives remaining with the Company on March 1,2005 and the remaining two thirds on March 1, 2006, in the amount of$0.3 million and $0.5 million respectively.

**21.   LITIGATION**

In May 2006, the Company paid a judgment in theamount of $3.7 million in satisfaction of a damages award in connectionwith an employment contract dispute with a former officer of the Company plusaccrued interest through the date of payment. Also in May 2006, theCompany settled the former officer’s attorney’s fees at an additional amount of$0.6 million. The Company had recorded a reserve of $4.2 million tocover these costs in December 2005. A judicial satisfaction of thejudgment has been filed and the Company has no additional liability withrespect to this matter.

The Company is not awareof any pending or threatened material litigation that it believes could reasonablybe likely to result in a material adverse effect on the Company’s financialposition, results of operations or cash flows.

**22.   RESTRICTED BALANCES**

As mentioned inNote 6, ACA Financial Guaranty has assets on deposits with variousregulatory authorities at December 31, 2006. Additionally, as mentioned inNote 2, in connection with its CDO Asset Management and Structured Creditbusinesses, the Company has on deposit $65.6 million for the benefit ofvarious counterparties at December 31, 2006. These funds revert back tothe Company upon the expiration of the related risk and in certain instancesmay be used to pay losses should they be incurred. The Company also holds$1.5 million in collateral at December 31, 2006, through one of itsconsolidated CDOs, for the benefit of the CDO debt holders. Restricted balancesare recorded as restricted cash on the consolidated balance sheets.

**23.   SEGMENTINFORMATION**

The Company’sreportable segments are as follows:

(1)         Structured Credit, whichstructures and sells credit protection, principally in the form of insured CDS,against a variety of asset classes in the institutional fixed income markets;

(2)         Public Finance, whichprovides insurance guaranteeing the timely payment of ultimate principal andinterest on municipal and other public finance obligations;

(3)         CDO Asset Management,which originates, structures and manages assets, primarily corporateobligations or asset-backed securities, in funded, partially funded orsynthetic CDOs; and

(4)         Other, which primarilyincludes trade credit insurance business and financial guaranty insurance oncertain other sectors, each of which the Company is no longer engaged in.

The Company’s reportable segments are strategicbusiness units that offer different products and services. They are managedseparately since each business requires different marketing strategies,personnel skill sets and technology.

Where determinable, the Company specifically assignsassets to each segment, otherwise, the Company allocates assets based onestimates. In general, allocation percentages for assets are determined basedon each line’s estimated capital utilization from a rating agency perspective.

The accounting policies ofthe segments are the same as those described in the summary of significantaccounting policies. The Company evaluates segment performance based on itsincome (loss) before income taxes. Reportable segment results are presented netof material inter-segment transactions.

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The following tablessummarize the Company’s operations and allocation of assets as of and for theyears ended December 31, 2006, 2005 and 2004 (dollars in thousands):
|                                                              | ** ** | **Year ended December 31, 2006** | ** ** |
|--------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                   | ** ** | **Structured  Credit**                               | ** ** | **Public  Finance** | ** ** | **CDO Asset  Management** | ** ** | **Other** | ** ** | **Consolidated  Totals** | ** ** |
| Revenues                                                     |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Premiums earned                                              |       | $                                                    | 795        |   | $ | 26,234 |   |   | $ | — |   |   | $ | 1,670 |   |   | $ | 28,699 |   |   |
| Net insured  credit swap revenue                             |       | 53,018                                               |       | 477 |   |   | 4,107 |   |   | — |   |   | 57,602 |   |   |
| Net investment  income                                       |       | 8,724                                                |       | 16,210 |   |   | 309,430 |   |   | 3,802 |   |   | 338,166 |   |   |
| Net realized and  unrealized losses on investments           |       | (311                                                 | )          | (688 | ) |   | (2,876 | ) |   | (159 | ) |   | (4,034 | ) |   |
| Net realized and  unrealized gains on derivative instruments |       | —                                               |       | — |   |   | 8,559 |   |   | — |   |   | 8,559 |   |   |
| Other net credit  swap revenue                               |       | —                                               |       | — |   |   | 10,106 |   |   | — |   |   | 10,106 |   |   |
| Fee and other  income                                        |       | 905                                                  |       | 550 |   |   | 23,562 |   |   | — |   |   | 25,017 |   |   |
| Total revenues                                               |       | 63,131                                               |       | 42,783 |   |   | 352,888 |   |   | 5,313 |   |   | 464,115 |   |   |
| Expenses                                                     |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loss and loss  adjustment expenses                           |       | —                                               |       | 6,461 |   |   | — |   |   | 2,339 |   |   | 8,800 |   |   |
| Policy  acquisition costs                                    |       | —                                               |       | 8,236 |   |   | — |   |   | 504 |   |   | 8,740 |   |   |
| Other operating  expenses                                    |       | 18,393                                               |       | 8,830 |   |   | 22,178 |   |   | 35 |   |   | 49,436 |   |   |
| Interest expense                                             |       | 4,060                                                |       | 1,732 |   |   | 285,604 |   |   | 361 |   |   | 291,757 |   |   |
| Depreciation and  amortization                               |       | 836                                                  |       | 808 |   |   | 7,912 |   |   | — |   |   | 9,556 |   |   |
| Total expenses                                               |       | 23,289                                               |       | 26,067 |   |   | 315,694 |   |   | 3,239 |   |   | 368,289 |   |   |
| Income of minority interest                                  |       | (271                                                 | )          | — |   |   | (3,767 | ) |   | — |   |   | (4,038 | ) |   |
| Income before income taxes                                   |       |     39,571                            |       |     16,716 |   |   |         33,427 |   |   |        2,074 |   |   |         91,788 |   |   |
| Provision for income tax                                     |       | 14,237                                               |       | 6,064 |   |   | 12,015 |   |   | 764 |   |   | 33,080 |   |   |
| Net income                                                   |       | $                                                    | 25,334     |   | $ | 10,652 |   |   | $ | 21,412 |   |   | $ | 1,310 |   |   | $ | 58,708 |   |   |
| Segment assets                                               |       | $                                                    | 305,420    |   | $ | 550,753 |   |   | $ | 5,062,069 |   |   | $ | 119,952 |   |   | $ | 6,038,194 |   |   |

 

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|                                                                       | ** ** | **Year ended December 31, 2005** | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                            | ** ** | **Structured  Credit**                               | ** ** | **Public  Finance** | ** ** | **CDO Asset  Management** | ** ** | **Other** | ** ** | **Consolidated  Totals** | ** ** |
| Revenues                                                              |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Premiums earned                                                       |       |                                                 | $          | 2,548 |   |   | $ | 23,889 |   |   | $ | — |   |   | $ | 6,906 |   |   | $ | 33,343 |   |   |
| Net insured  credit swap revenue                                      |       |                                                 | 20,542     |   |   | 13 |   |   | 1,016 |   |   | — |   |   | 21,571 |   |   |
| Net investment  income                                                |       |                                                 | 828        |   |   | 13,862 |   |   | 236,591 |   |   | 3,310 |   |   | 254,591 |   |   |
| Net realized  losses                                                  |       |                                                 | (35        | ) |   | (591 | ) |   | (2,010 | ) |   | (141 | ) |   | (2,777 | ) |   |
| Net realized and  unrealized gains (losses) on derivative instruments |       |                                                 | —     |   |   | — |   |   | 8,410 |   |   | — |   |   | 8,410 |   |   |
| Other net credit  swap revenue                                        |       |                                                 | —     |   |   | — |   |   | 4,157 |   |   | — |   |   | 4,157 |   |   |
| Fee and other income                                                  |       |                                                 | 632        |   |   | 307 |   |   | 10,351 |   |   | 9 |   |   | 11,299 |   |   |
| Total revenues                                                        |       |                                                 | 24,515     |   |   | 37,480 |   |   | 258,515 |   |   | 10,084 |   |   | 330,594 |   |   |
| Expenses                                                              |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loss and loss  adjustment expenses                                    |       |                                                 | —     |   |   | 7,459 |   |   | — |   |   | 6,579 |   |   | 14,038 |   |   |
| Policy  acquisition costs                                             |       |                                                 | —     |   |   | 6,970 |   |   | — |   |   | 1,682 |   |   | 8,652 |   |   |
| Other operating  expenses                                             |       |                                                 | 7,430      |   |   | 7,201 |   |   | 19,049 |   |   | 3,763 |   |   | 37,443 |   |   |
| Interest expense                                                      |       |                                                 | 115        |   |   | 1,663 |   |   | 212,134 |   |   | 401 |   |   | 214,313 |   |   |
| Depreciation and  amortization                                        |       |                                                 | 235        |   |   | 596 |   |   | 7,674 |   |   | 78 |   |   | 8,583 |   |   |
| Total expenses                                                        |       |                                                 | 7,780      |   |   | 23,889 |   |   | 238,857 |   |   | 12,503 |   |   | 283,029 |   |   |
| Income of minority interest                                           |       |                                                 | —     |   |   | — |   |   | (3,708 | ) |   | — |   |   | (3,708 | ) |   |
| Income (loss) before income taxes                                     |       |                                                 | 16,735     |   |   | 13,591 |   |   | 15,950 |   |   | (2,419 | ) |   | 43,857 |   |   |
| Provision for income tax                                              |       |                                                 | 5,761      |   |   | 4,678 |   |   | 5,491 |   |   | (833 | ) |   | 15,097 |   |   |
| Net income (loss)                                                     |       |                                                 | $          | 10,974 |   |   | $ | 8,913 |   |   | $ | 10,459 |   |   | $ | (1,586 | ) |   | $ | 28,760 |   |   |
| Segment assets                                                        |       |                                                 | $          | 36,062 |   |   | $ | 483,794 |   |   | $ | 5,169,575 |   |   | $ | 102,769 |   |   | $ | 5,792,200 |   |   |

 

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|                                                                       | ** ** | **Year ended December 31, 2004** | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                            | ** ** | **Structured  Credit**                               | ** ** | **Public  Finance** | ** ** | **CDO Asset  Management** | ** ** | **Other** | ** ** | **Consolidated  Totals** | ** ** |
| Revenues                                                              |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Premiums earned                                                       |       |                                                 | $          | 6,161 |   |   | $ | 13,930 |   |   | $ | — |   |   | $ | 9,742 |   |   | $ | 29,833 |   |   |
| Net insured  credit swap revenue                                      |       |                                                 | 5,617      |   |   | — |   |   | 10,401 |   |   | — |   |   | 16,018 |   |   |
| Net investment  income                                                |       |                                                 | 524        |   |   | 8,770 |   |   | 114,782 |   |   | 2,094 |   |   | 126,170 |   |   |
| Net realized  losses                                                  |       |                                                 | (10        | ) |   | (163 | ) |   | (6,335 | ) |   | (39 | ) |   | (6,547 | ) |   |
| Net realized and  unrealized gains (losses) on derivative instruments |       |                                                 | —     |   |   | — |   |   | 6,520 |   |   | — |   |   | 6,520 |   |   |
| Other net credit  swap revenue                                        |       |                                                 | —     |   |   | — |   |   | 10,990 |   |   | — |   |   | 10,990 |   |   |
| Fee and other income                                                  |       |                                                 | 644        |   |   | 4,057 |   |   | 5,184 |   |   | 143 |   |   | 10,028 |   |   |
| Total revenues                                                        |       |                                                 | 12,936     |   |   | 26,594 |   |   | 141,542 |   |   | 11,940 |   |   | 193,012 |   |   |
| Expenses                                                              |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loss and loss  adjustment expenses                                    |       |                                                 | —     |   |   | 4,310 |   |   | — |   |   | 42,280 |   |   | 46,590 |   |   |
| Policy  acquisition costs                                             |       |                                                 | —     |   |   | 2,238 |   |   | — |   |   | 1,597 |   |   | 3,835 |   |   |
| Other operating  expenses                                             |       |                                                 | 8,870      |   |   | 7,148 |   |   | 18,910 |   |   | 3,717 |   |   | 38,645 |   |   |
| Interest expense                                                      |       |                                                 | 66         |   |   | 958 |   |   | 99,882 |   |   | 231 |   |   | 101,137 |   |   |
| Depreciation and  amortization                                        |       |                                                 | 190        |   |   | 482 |   |   | 6,200 |   |   | 63 |   |   | 6,935 |   |   |
| Total expenses                                                        |       |                                                 | 9,126      |   |   | 15,136 |   |   | 124,992 |   |   | 47,888 |   |   | 197,142 |   |   |
| Loss of minority interest                                             |       |                                                 | —     |   |   | — |   |   | 476 |   |   | — |   |   | 476 |   |   |
| Income (loss) before income taxes                                     |       |                                                 | 3,810      |   |   | 11,458 |   |   | 17,026 |   |   | (35,948 | ) |   | (3,654 | ) |   |
| Provision for income tax                                              |       |                                                 | 1,448      |   |   | 4,354 |   |   | 6,470 |   |   | (12,137 | ) |   | 135 |   |   |
| Net income (loss)                                                     |       |                                                 | $          | 2,362 |   |   | $ | 7,104 |   |   | $ | 10,556 |   |   | $ | (23,811 | ) |   | $ | (3,789 | ) |   |
| Segment assets                                                        |       |                                                 | $          | 33,029 |   |   | $ | 430,063 |   |   | $ | 5,136,008 |   |   | $ | 92,861 |   |   | $ | 5,691,961 |   |   |

 

 

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**24.   EARNINGS PERSHARE**

Thefollowing table sets forth the computation of basic and diluted earnings (loss)per share for the years ended December 31, 2006, 2005 and 2004: 
|                                                         | ** ** | **2006**                                                                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| ** **                                              | ** ** | **(dollars and shares in thousands,  except per share amounts)** | ** ** |
| Numerator:                                              |       |                                                                                                |       |     |       |     |       |
| Net income (loss)                                       |       | $                                                                                                   | 58,708     |     | $          | 28,760   |       | $ | (3,789 | ) |
| Common stock  undistributed earnings (loss)             |       | $                                                                                                   | 23,308     |     | $          | 7,687    |       | $ | (3,789 | ) |
| Participating  convertible stock undistributed earnings |       | 35,400                                                                                              |       | 21,073   |       | —   |       |
| Total undistributed  earnings (loss)                    |       | $                                                                                                   | 58,708     |     | $          | 28,760   |       | $ | (3,789 | ) |
| Denominator:                                            |       |                                                                                                |       |     |       |     |       |
| Weighted average  shares outstanding—basic:        |       |                                                                                                |       |     |       |     |       |
| Common stock                                            |       | 10,086                                                                                              |       | 6,090    |       | 6,168    |       |
| Participating  convertible stock                        |       | 14,608                                                                                              |       | 16,704   |       | —   |       |
| Total—basic                                        |       | 24,694                                                                                              |       | 22,794   |       | 6,168    |       |
| Effect of diluted securities:                           |       |                                                                                                |       |     |       |     |       |
| Convertible  preferred stock                            |       | 5,837                                                                                               |       | 6,678    |       | —   |       |
| Stock options                                           |       | 501                                                                                                 |       | 414      |       | —   |       |
| Total—diluted                                      |       | 31,032                                                                                              |       | 29,886   |       | 6,168    |       |
| Basic earnings (loss) per share                         |       | $                                                                                                   | 2.38       |     | $          | 1.26     |       | $ | (0.61 | ) |
| Diluted earnings  (loss) per share                      |       | $                                                                                                   | 1.89       |     | $          | 0.96     |       | $ | (0.61 | ) |

 

As a result of the 2004 net loss, 4.74 millionweighted average shares of participating convertible stock were excluded fromthe computation of basic earnings (loss) per share. Participating convertiblestockholders do not participate in losses with the common stockholders.Additionally, 6.66 million and 0.24 million weighted average sharesof dilutive potential common stock, resulting from convertible preferred stockand stock options, respectively, were not included in the computation ofdiluted earnings (loss) per share for the year ended December 31, 2004. Inthe absence of the net loss, diluted weighted average shares would have totaled17.81 million.

The 2006, 2005 and 2004computation of diluted earnings (loss) per share did not include the effects of1.86 million, 0.30 million and 0.30 million options,respectively, to purchase shares of common stock because they would have ananti-dilutive effect on the computation.

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**25.   CONDENSEDQUARTERLY FINANCIAL DATA (UNAUDITED)**
|                                                                                                        | ** ** | **Quarter ended**                                                                              | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                             | ** ** | **March 31,  2006**                                                                            | ** ** | **June 30,  2006** | ** ** | **September 30,  2006** | ** ** | **December 31,  2006** | ** ** |
| ** **                                                                                             | ** ** | **(Dollars and shares in thousands,  except per share amounts)** | ** ** |
| Revenues                                                                                               |       |                                                                                                |       |   |   |   |   |   |   |   |   |   |   |
| Premiums earned                                                                                        |       | $                                                                                                   | 4,882      |   | $ | 8,475 |   |   | $ | 8,594 |   |   |   | $ | 6,748 |   |   |
| Net insured  credit swap revenue                                                                       |       | 14,180                                                                                              |       | 7,931 |   |   | 17,079 |   |   |   | 18,412 |   |   |
| Net investment  income                                                                                 |       | 77,712                                                                                              |       | 82,452 |   |   | 87,888 |   |   |   | 90,114 |   |   |
| Net realized and  unrealized losses on investments                                                     |       | (1,967                                                                                              | )          | (1,256 | ) |   | (752 | ) |   |   | (59 | ) |   |
| Net realized and  unrealized gains on derivative instruments        |       | 3,642                                                                                               |       | 2,497 |   |   | 755 |   |   |   | 1,665 |   |   |
| Other net credit  swap revenue                                                                         |       | 2,913                                                                                               |       | 2,631 |   |   | 2,090 |   |   |   | 2,472 |   |   |
| Fee and other  income                                                                                  |       | 4,169                                                                                               |       | 7,008 |   |   | 6,858 |   |   |   | 6,982 |   |   |
| Total revenues                                                                                         |       | 105,531                                                                                             |       | 109,738 |   |   | 122,512 |   |   |   | 126,334 |   |   |
| Expenses                                                                                               |       |                                                                                                |       |   |   |   |   |   |   |   |   |   |   |
| Loss and loss  adjustment expenses                                                                     |       | 2,021                                                                                               |       | 1,661 |   |   | 2,576 |   |   |   | 2,542 |   |   |
| Policy  acquisition costs                                                                              |       | 1,392                                                                                               |       | 2,768 |   |   | 2,638 |   |   |   | 1,942 |   |   |
| Other operating  expenses                                                                              |       | 10,613                                                                                              |       | 12,681 |   |   | 11,999 |   |   |   | 14,143 |   |   |
| Interest expense                                                                                       |       | 66,419                                                                                              |       | 70,964 |   |   | 76,095 |   |   |   | 78,279 |   |   |
| Depreciation and  amortization                                                                         |       | 2,492                                                                                               |       | 2,225 |   |   | 2,456 |   |   |   | 2,383 |   |   |
| Total expenses                                                                                         |       | 82,937                                                                                              |       | 90,299 |   |   | 95,764 |   |   |   | 99,289 |   |   |
| Income of minority interest                                                                            |       | (1,155                                                                                              | )          | (1,074 | ) |   | (897 | ) |   |   | (912 | ) |   |
| Income before  income taxes                                                                            |       | 21,439                                                                                              |       | 18,365 |   |   | 25,851 |   |   |   | 26,133 |   |   |
| Provision for  income tax                                                                              |       | 7,292                                                                                               |       | 6,323 |   |   | 9,790 |   |   |   | 9,675 |   |   |
| Net income                                                                                             |       | $                                                                                                   | 14,147     |   | $ | 12,042 |   |   | $ | 16,061 |   |   |   | $ | 16,458 |   |   |
| Share and Per  Share Data:                                                                             |       |                                                                                                |       |   |   |   |   |   |   |   |   |   |   |
| Numerator:                                                                                             |       |                                                                                                |       |   |   |   |   |   |   |   |   |   |   |
| Net income                                                                                             |       | $                                                                                                   | 14,147     |   | $ | 12,042 |   |   | $ | 16,061 |   |   |   | $ | 16,458 |   |   |
| Common stock  undistributed earnings                                                                   |       | $                                                                                                   | 3,778      |   | $ | 3,236 |   |   | $ | 4,403 |   |   |   | $ | 11,891 |   |   |
| Participating  convertible stock undistributed earnings                                                |       | 10,369                                                                                              |       | 8,806 |   |   | 11,658 |   |   |   | 4,567 |   |   |
| Total  undistributed earnings                                                                          |       | $                                                                                                   | 14,147     |   | $ | 12,042 |   |   | $ | 16,061 |   |   |   | $ | 16,458 |   |   |
| Denominator:                                                                                           |       |                                                                                                |       |   |   |   |   |   |   |   |   |   |   |
| Weighted average shares outstanding—basic                                                         |       |                                                                                                |       |   |   |   |   |   |   |   |   |   |   |
| Common stock                                                                                           |       | 16,716                                                                                              |       | 16,716 |   |   | 16,716 |   |   |   | 8,357 |   |   |
| Participating  convertible stock                                                                       |       | 6,090                                                                                               |       | 6,142 |   |   | 6,312 |   |   |   | 21,763 |   |   |
| Total—basic                                                                                       |       | 22,806                                                                                              |       | 22,858 |   |   | 23,028 |   |   |   | 30,120 |   |   |
| Effect of dilutive securities:                                                                         |       |                                                                                                |       |   |   |   |   |   |   |   |   |   |   |
| Convertible  preferred stock                                                                           |       | 6,679                                                                                               |       | 6,679 |   |   | 6,679 |   |   |   | 3,339 |   |   |
| Stock options                                                                                          |       | 559                                                                                                 |       | 548 |   |   | 529 |   |   |   | 445 |   |   |
| Total—diluted                                                                                     |       | 30,044                                                                                              |       | 30,085 |   |   | 30,236 |   |   |   | 33,904 |   |   |
| Basic earnings per share                                                                               |       | $                                                                                                   | 0.62       |   | $ | 0.53 |   |   | $ | 0.70 |   |   |   | $ | 0.55 |   |   |
| Diluted earnings  per share                                                                            |       | $                                                                                                   | 0.47       |   | $ | 0.40 |   |   | $ | 0.53 |   |   |   | $ | 0.49 |   |   |

 

135

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Thecomputation of diluted earnings per share for the quarters ended March 31,June 30, September 30 and December 31, 2006 did not include theeffect of 1.0 million, 1.0 million, 1.1 million and1.9 million, options, respectively, to purchase shares of common stockbecause their exercise prices were greater than the corresponding market valueper share of our common stock and would have an anti-dilutive effect on thecomputation. 
|                                                         | ** ** | **Quarter ended**                                                                              | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| ** **                                              | ** ** | **March 31,  2005**                                                                            | ** ** | **June 30,  2005** | ** ** | **September 30,  2005** | ** ** | **December 31,  2005** | ** ** |
| ** **                                              | ** ** | **(Dollars and shares in thousands,  except per share amounts)** | ** ** |
| Revenues                                                |       |                                                                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Premiums earned                                         |       |                                                                                                | $          | 7,157 |   |   | $ | 9,064 |   |   | $ | 8,553 |   |   |   | $ | 8,569 |   |   |
| Net insured  credit swap revenue                        |       |                                                                                                | 3,597      |   |   | 946 |   |   | 12,529 |   |   |   | 4,499 |   |   |
| Net investment  income                                  |       |                                                                                                | 53,529     |   |   | 60,945 |   |   | 66,887 |   |   |   | 73,230 |   |   |
| Net realized  gains (losses) on derivative instruments  |       |                                                                                                | 12,941     |   |   | (10,124 | ) |   | 2,360 |   |   |   | 456 |   |   |
| Other net credit  swap revenue                          |       |                                                                                                | 2,030      |   |   | 494 |   |   | 1,146 |   |   |   | 487 |   |   |
| Fee and other  income                                   |       |                                                                                                | 3,159      |   |   | 1,502 |   |   | 3,040 |   |   |   | 3,598 |   |   |
| Total revenues                                          |       |                                                                                                | 82,413     |   |   | 62,827 |   |   | 94,515 |   |   |   | 90,839 |   |   |
| Expenses                                                |       |                                                                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loss and loss  adjustment expenses                      |       |                                                                                                | 1,576      |   |   | 2,563 |   |   | 4,768 |   |   |   | 5,131 |   |   |
| Policy  acquisition costs                               |       |                                                                                                | 2,019      |   |   | 1,965 |   |   | 2,694 |   |   |   | 1,974 |   |   |
| Other operating  expenses                               |       |                                                                                                | 7,740      |   |   | 6,929 |   |   | 7,506 |   |   |   | 15,268 |   |   |
| Interest expense                                        |       |                                                                                                | 44,442     |   |   | 51,062 |   |   | 56,716 |   |   |   | 62,093 |   |   |
| Depreciation and  amortization                          |       |                                                                                                | 1,850      |   |   | 2,214 |   |   | 2,366 |   |   |   | 2,153 |   |   |
| Total expenses                                          |       |                                                                                                | 57,627     |   |   | 64,733 |   |   | 74,050 |   |   |   | 86,619 |   |   |
| (Income) loss of minority interest                      |       |                                                                                                | (1,741     | ) |   | 56 |   |   | (1,440 | ) |   |   | (583 | ) |   |
| Income (loss)  before income taxes                      |       |                                                                                                | 23,045     |   |   | (1,850 | ) |   | 19,025 |   |   |   | 3,637 |   |   |
| Provision for  income tax                               |       |                                                                                                | 8,303      |   |   | (225 | ) |   | 7,556 |   |   |   | (537 | ) |   |
| Net income (loss)                                       |       |                                                                                                | $          | 14,742 |   |   | $ | (1,625 | ) |   | $ | 11,469 |   |   |   | $ | 4,174 |   |   |
| Share and Per  Share Data:                              |       |                                                                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Numerator:                                              |       |                                                                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total income  (loss)                                    |       |                                                                                                | $          | 14,742 |   |   | $ | (1,625 | ) |   | $ | 11,469 |   |   |   | $ | 4,174 |   |   |
| Common stock  undistributed earnings (loss)             |       |                                                                                                | $          | 3,946 |   |   | $ | (1,625 | ) |   | $ | 3,062 |   |   |   | $ | 1,116 |   |   |
| Participating  convertible stock undistributed earnings |       |                                                                                                | 10,796     |   |   | — |   |   | 8,407 |   |   |   | 3,058 |   |   |
| Total  undistributed earnings (loss)                    |       |                                                                                                | $          | 14,742 |   |   | $ | (1,625 | ) |   | $ | 11,469 |   |   |   | $ | 4,174 |   |   |
| Denominator:                                            |       |                                                                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Weighted average shares outstanding—basic:         |       |                                                                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Common stock                                            |       |                                                                                                | 6,096      |   |   | 6,090 |   |   | 6,090 |   |   |   | 6,090 |   |   |
| Participating  convertible stock                        |       |                                                                                                | 16,686     |   |   | — |   |   | 16,716 |   |   |   | 16,716 |   |   |
| Total basic                                             |       |                                                                                                | 22,782     |   |   | 6,090 |   |   | 22,806 |   |   |   | 22,806 |   |   |
| Effect of dilutive securities:                          |       |                                                                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Convertible  preferred stock                            |       |                                                                                                | 6,678      |   |   | — |   |   | 6,678 |   |   |   | 6,678 |   |   |
| Stock options                                           |       |                                                                                                | 330        |   |   | — |   |   | 330 |   |   |   | 438 |   |   |
| Total—diluted                                      |       |                                                                                                | 29,790     |   |   | 6,090 |   |   | 29,814 |   |   |   | 29,922 |   |   |
| Basic earnings (loss) per share                         |       |                                                                                                | $          | 0.65 |   |   | $ | (0.27 | ) |   | $ | 0.50 |   |   |   | $ | 0.18 |   |   |
| Diluted earnings  (loss) per share                      |       |                                                                                                | $          | 0.49 |   |   | $ | (0.27 | ) |   | $ | 0.38 |   |   |   | $ | 0.14 |   |   |

 

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As a result of the net loss for the quarter ended June 30,2005, 16.68 million weighted average shares of participating convertiblestock were excluded from the computation of basic earnings (loss) per share. Participatingconvertible stockholders do not participate in losses with the commonstockholders. Additionally, 6.66 million and 0.30 million weightedaverage shares of dilutive potential common stock, resulting from convertiblepreferred stock and stock options, respectively, were not included in thecomputation of diluted earnings (loss) per share for the quarter ended June 30,2005. In the absence of the net loss, diluted weighted average shares wouldhave totaled 29.73 million.

The computation of diluted earnings (loss) per sharefor the quarters ended March 31, June 30, September 30 and December 31,2005 did not include the effect of 0.30 million options to purchase sharesof common stock because their exercise prices were greater than thecorresponding market value per share of our common stock and would have ananti-dilutive effect on the computation.

* * * * * *

**Item 9.**                        Changesin and Disagreements with Accountants on Accounting and Financial Disclosure.

None.

**Item 9A.**                Controlsand Procedures.

*Evaluationof Disclosure Controls and Procedures.*   As of theend of the period covered by this report, an evaluation was carried out by theCompany’s management, with the participation of the Chief Executive Officer andChief Financial Officer, of the effectiveness of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended). Based on that evaluation, ourChief Executive Officer and Chief Financial Officer concluded that thesedisclosure controls and procedures were effective as of the end of the periodcovered by this report. In addition, no change in our internal control overfinancial reporting (as defined in Rules 13a-15(f) and 15d-15(f) underthe Securities Exchange Act of 1934, as amended) occurred during our mostrecent fiscal quarter that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

*Management’s Assessment OfInternal Controls.*   This annual report does notinclude a report of management’s assessment regarding internal control overfinancial reporting or an attestation report of our registered publicaccounting firm due to a transition period established by rules of the SECfor newly public companies. We will be required to include management’s reporton our internal control over financial reporting and the attestation report ofour registered public accounting firm in our annual report on Form 10-Kfor the fiscal year ending December 31, 2007.

**Item 9B.**               OtherInformation.

None.

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**PART III**

**Item 10.**                 Directorsand Executive Officers and Corporate Governance.

*Directors*

The information requiredby this part of Item 10 is incorporated by reference to, and will be containedin, our definitive proxy statement, which we anticipate will be filed no laterthan April 30, 2007. Accordingly, we have omitted the information fromthis part of Item 10 pursuant to General Instruction G (3) of Form 10-K.

*Executive Officers*

Welist below our executive officers and significant employees as ofMarch 15, 2007, along with their ages, positions and biographies for atleast the past five years.
| Name                   | ** ** | **Age**                   | ** ** | **Position**                                                    |
|------------------------|------------|---------------------------|------------|-----------------------------------------------------------------|
|                   |       | (at  March 15, 2007) |       |                                                            |
| Alan S. Roseman        |       | 49                        |       | Deputy Chairman, Chief Executive Officer and  President         |
| Edward U. Gilpin       |       | 45                        |       | Director, Executive Vice  President and Chief Financial Officer |
| William T. Tomljanovic |       | 44                        |       | Executive Vice  President, Credit                               |
| Peter J. Hill          |       | 46                        |       | Executive Vice  President, Public Finance                       |
| Joseph M. Pimbley      |       | 48                        |       | Executive Vice  President, Institutional Risk Management        |
| Laura U. Schwartz      |       | 44                        |       | Senior Managing  Director, CDO Asset Management                 |
| James A. Rothman       |       | 42                        |       | Senior Managing  Director, Structured Credit                    |
| Nora J. Dahlman        |       | 42                        |       | Senior Managing  Director, General Counsel and Secretary        |

 

**Alan S. Roseman**hasserved as our Chief Executive Officer and President since he joined the Companyin May 2004. Prior to joining us, he was the Executive Vice President andCo-Chief Operating Officer, as well as a member of the Executive andUnderwriting Committees of ACE Financial Solutions from 1999 to 2004. Beforejoining ACE, he served for 11 years as Executive Vice President andGeneral Counsel, and as a member of the Executive Committee, of Capital ReCorporation, a financial guaranty reinsurance company.

**Edward U. Gilpin**hasserved as our Executive Vice President and Chief Financial Officer since hejoined the Company in December 2000. Previously, Mr. Gilpin was asenior investment banker in the Financial Institutions Group at PrudentialSecurities. Prior to that, Mr. Gilpin was the Chief Financial Officer foran “AAA” start-up venture sponsored by us and Prudential Securities and servedin various senior positions at MBIA, Inc.

**William T. Tomljanovic** is an Executive Vice President and is responsiblefor Credit. Mr. Tomljanovic joined us in 2000. Prior to his current position,Mr. Tomljanovic served from 2000 to May 2004 as head of our former customizedsolutions group, which encompassed Structured Credit and certain otherdiscontinued lines of business, and from May 2004 to February 2006 as head ofstructured finance. Previously, Mr. Tomljanovic was a Director of InvestmentBanking for Prudential Securities, responsible for originating and structuringCDOs, and served in various senior management positions with Capital ReCorporation. As previously disclosed, Mr. Tomljanovic has resigned effectiveMarch 16, 2007.

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**Peter J. Hill**is an Executive Vice President and oversees ourPublic Finance business. Prior to joining us in 2007, Mr. Hill was aManaging Director and Co-Head of Public Finance at J.P. Morgan. He alsoco-chaired J.P. Morgan’s Public Finance Engagements Committee and was a memberof the firm’s Credit Markets management team. He is a past Vice Chairman of theMunicipal Securities Rulemaking Board (“MSRB”), past Chairman of the MSRB’sNominating Committee, a past member of the Municipal Executive Committee of theBond Market Association and served on the Finance & EconomicSubcommittee of the Airports Council International.

**Joseph M. Pimbley, Ph.D.** is an Executive Vice President and is responsiblefor risk management across all of our business lines and our investmentportfolio. Prior to joining us in 2002, Dr. Pimbley was Senior VicePresident, Credit Derivative Product Manager, for the capital marketssubsidiary of the Sumitomo Mitsui Banking Corporation from 1997 to 2002 andbefore that served as Senior Risk Manager for GE Capital.

**Laura U. Schwartz** is a Senior Managing Director and is responsiblefor our CDO Asset Management business. Before being named head of the CDO AssetManagement business in 2004, Ms. Schwartz served as a senior portfoliomanager. Prior to joining us in 2002, Ms. Schwartz was a director in theAsset Backed Finance Group at Merrill Lynch from 1998 to 2002, where she wasresponsible for the origination and execution of commercial and sub-primeresidential mortgage backed securities.

**James A. Rothman** is a Senior Managing Director and is responsiblefor our Structured Credit business. Before being named head of the group in2004, Mr. Rothman served as a senior underwriter in the group. Prior tojoining us in 2001, Mr. Rothman served in various management positions atGE Capital Commercial Finance, Deutsche Bank Securities, PaineWebber and ChaseManhattan Mortgage Corporation, where he was responsible for various types ofsecuritization transactions and structured mortgage transactions.

**Nora J. Dahlman** is aSenior Managing Director and is our General Counsel and Secretary. Before beingnamed General Counsel and Secretary in 2004, she served as an Associate GeneralCounsel supporting our CDO Asset Management and Structured Credit groups. Priorto joining us in 2003, Ms. Dahlman worked on personal projects from 2001to 2003 and was First Vice President and Assistant General Counsel at Ambacfrom 1999 to 2001. Prior to joining Ambac, she was a Vice President andAttorney with Credit Lyonnais from 1997 to 1999 and before that spent severalyears in private practice as a finance associate.

*Section 16(a) BeneficialOwnership Reporting Compliance*

The information requiredby this part of Item 10 is incorporated by reference to, and will be containedin, our definitive proxy statement, which we anticipate will be filed no laterthan April 30, 2007. Accordingly, we have omitted the information fromthis part of Item 10 pursuant to General Instruction G (3) of Form 10-K.

*Code of Ethics forChief Executive Officer and Senior Financial Officers and Code of Conduct*

The Company has adopted aCode of Ethics for Chief Executive Officer and Senior Financial Officers and aCode of Conduct that applies to all employees of the Company including itsChief Executive Officer and Chief Financial Officer. A copy of each of thesecodes can be found on the Company’s Internet website at www.aca.com, as well asin print to any stockholder upon request. The Company intends to disclose onits Internet website any amendments to, or waivers from, either code that arerequired to be publicly disclosed pursuant to the rules of the SEC andNYSE.

139

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*CorporateGovernance Items*

The information requiredby this part of Item 10 is incorporated by reference to, and will be containedin, our definitive proxy statement, which we anticipate will be filed no laterthan April 30, 2007. Accordingly, we have omitted the information fromthis part of Item 10 pursuant to General Instruction G (3) of Form 10-K.

**Item 11.**                 ExecutiveCompensation.

The information requiredby this Item is incorporated by reference to, and will be contained in, ourdefinitive proxy statement, which we anticipate will be filed no later than April 30,2007. Accordingly, we have omitted the information from this Item pursuant toGeneral Instruction G (3) of Form 10-K.

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters.

The information requiredby this Item is incorporated by reference to, and will be contained in, ourdefinitive proxy statement, which we anticipate will be filed no later than April 30,2007. Accordingly, we have omitted the information from this Item pursuant toGeneral Instruction G (3) of Form 10-K.

**Item 13.**                 CertainRelationships and Related Transactions.

The information requiredby this Item is incorporated by reference to, and will be contained in, ourdefinitive proxy statement, which we anticipate will be filed no later than April 30,2007. Accordingly, we have omitted the information from this Item pursuant toGeneral Instruction G (3) of Form 10-K.

**Item 14.**                 PrincipalAccounting Fees and Services.

The information requiredby this Item is incorporated by reference to, and will be contained in, ourdefinitive proxy statement, which we anticipate will be filed no later than April 30,2007. Accordingly, we have omitted the information from this Item pursuant toGeneral Instruction G (3) of Form 10-K.

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**PART IV**

**Item 15.**                 Exhibits,Financial Statement Schedules, and Reports on Form 10-K.

**(a) Documentsfiled as a part of this report:**

1.    *Financial Statements*

The consolidated financial statements included inItem 8 above are filed as part of this Annual Report on Form 10-K.

2.   *Financial Statement Schedules*
| Report of Independent Registered Public  Accounting Firm |   |                                                                       |
|----------------------------------------------------------|--------|----------------------------------------------------------------------------|
| Schedule I                                               |   | —Summary of Investments Other Than Investments in  Related Parties    |   | (Page S-1) |
| Schedule II                                              |   | —Condensed Financial Information of Registrant  (Parent Company Only) |   | (Pages S-2 to S-5) |
| Schedule III                                             |   | —Supplementary Insurance Information                                  |   | (Page S-6) |
| Schedule IV                                         |   | —Reinsurance                                                          |   | (Page S-7) |
|                                                          |        |                                                                            |  |  |  |  |

 

3.   *Exhibits*
| Exhibit  Number | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                        |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1             |       | Certificate of Incorporation of the Company, as  amended (Filed as Exhibits 3.1-3.1.7 to the Company’s Registration  Statement on Form S-1, File No. 333-133949 and Exhibit 3.1  to the Company’s Current Report on Form 8-K filed with the  Commission on November 15, 2006 and incorporated herein by reference). |
| 3.2             |       | Bylaws of the Company,  as amended (Filed as Exhibits 3.2-3.2.2 to the Company’s Registration  Statement on Form S-1, File No. 333-133949 and  incorporated herein by reference).                                                                                                                                                       |
| 3.2.1           |       | Third Amendment to the  Bylaws of the Registrant dated March 23, 2007.                                                                                                                                                                                                                                                                            |
| 4.1             |       | Specimen common stock  certificate (Filed as Exhibit 4.2 to the Company’s Registration  Statement on Form S-1, File No. 333-133949 and  incorporated herein by reference).                                                                                                                                                         |
| 4.3             |       | Amended and Restated  Registration Rights Agreement, as amended (Filed as Exhibits 4.3-4.3.2  to the Company’s Registration Statement on Form S-1, File  No. 333-133949 and incorporated herein by reference).                                                                                                                          |
| 4.4             |       | Stockholders Agreement,  as amended (Filed as Exhibits 4.4-4.4.2 to the Company’s Registration  Statement on Form S-1, File No. 333-133949 and  Exhibit 99.1 to the Company’s Current Report on Form 8-K  filed with the Commission on November 15, 2006 and incorporated herein  by reference).                    |
| 10.1            |       | Credit Agreement dated  May 1, 2006 among ACA Holdings, Inc., J.P. Morgan Securities Inc.  and JPMorgan Chase Bank, N.A. (Filed as Exhibit 10.1 to the Company’s  Registration Statement on Form S-1, File No. 333-133949  and incorporated herein by reference).                                                        |
| 10.2            |       | Investment Agreement,  dated as of March 11, 2005, between ACA Parliament Funding, L.L.C. and  Premium Asset Trust, With Respect to Premium Asset Trust, ACA Trust  Series I (Filed as Exhibit 10.2 to the Company’s Registration  Statement on Form S-1, File No. 333-133949 and  incorporated herein by reference).    |

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| 10.3  |   | Indenture, dated as of  December 29, 2004, between ACA Holdings, Inc., and Wilmington Trust  Company (Filed as Exhibit 10.3 to the Company’s Registration Statement  on Form S-1, File No. 333-133949 and incorporated  herein by reference).                                                                   |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.4  |   | Indenture, dated as of  October 29, 2003, between American Capital Access Holdings, Limited, and  U.S. Bank National Association (Filed as Exhibit 10.4 to the Company’s  Registration Statement on Form S-1, File No. 333-133949  and incorporated herein by reference).                                            |
| 10.5  |   | Indenture, dated as of  May 15, 2003, between American Capital Access Holdings, Limited, and  U.S. Bank National Association (Filed as Exhibit 10.5 to the Company’s  Registration Statement on Form S-1, File No. 333-133949  and incorporated herein by reference).                                                |
| 10.6  |   | Indenture, dated as of  December 4, 2002, between American Capital Access Holdings, Limited, and  State Street Bank and Trust Company of Connecticut, National Association  (Filed as Exhibit 10.6 to the Company’s Registration Statement on  Form S-1, File No. 333-133949 and incorporated herein  by reference). |
| 10.7  |   | Amended and Restated  Employment Agreement, between the Company and Alan S. Roseman, dated as of  November 9, 2006 (Filed as Exhibit 10.5 to the Company’s Quarterly  Report on Form 10-Q for the quarterly period ended  September 30, 2006 and incorporated herein by reference).*                                 |
| 10.8  |   | Amended and Restated  Employment Agreement between the Company and Edward U. Gilpin, dated as of  November 9, 2006 (Filed as Exhibit 10.6 to the Company’s Quarterly  Report on Form 10-Q for the quarterly period ended  September 30, 2006 and incorporated herein by reference).*                                 |
| 10.9  |   | Amended and Restated  Employment Agreement, dated as of September 30, 2004, between the  Company and William Tomljanovic, as amended (Filed as Exhibits 10.9-10.9.1  to the Company’s Registration Statement on Form S-1, File  No. 333-133949 and incorporated herein by reference).*                                    |
| 10.10 |   | Employment Agreement,  dated as of September 30, 2004, between the Company and Laura Schwartz  (Filed as Exhibit 10.10 to the Company’s Registration Statement on  Form S-1, File No. 333-133949 and incorporated herein  by reference).*                                                                            |
| 10.11 |   | Employment Agreement,  dated as of September 30, 2004, between the Company and James Rothman  (Filed as Exhibit 10.11 to the Company’s Registration Statement on  Form S-1, File No. 333-133949 and incorporated herein  by reference).*                                                                             |
| 10.12 |   | Amended and Restated  2004 Stock Incentive Plan, as amended (Filed as Exhibits 10.12-10.12.1  to the Company’s Registration Statement on Form S-1, File  No. 333-133949 and incorporated herein by reference).*                                                                                                                |
| 10.13 |   | Omnibus Equity Incentive  Compensation Plan (Filed as Exhibit 10.13 to the Company’s Registration  Statement on Form S-1, File No. 333-133949 and  incorporated herein by reference).*                                                                                                                                    |
| 10.14 |   | Fixed Income Investment  Management Agreement, dated as of October 1, 2004, between ACA Financial  Guaranty Corporation and J.P. Morgan Investment Management Inc. (Filed as  Exhibit 10.14 to the Company’s Registration Statement on Form S-1,  File No. 333-133949 and incorporated herein by reference).         |

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| 10.15 |   | Fixed Income Investment  Management Agreement, dated as of March 26, 2002, between ACA Financial  Guaranty Corporation and Stephens Inc. (Filed as Exhibit 10.15 to the  Company’s Registration Statement on Form S-1, File No. 333-133949  and incorporated herein by reference).               |
|-------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.16 |   | Indemnity Agreement,  dated as of May 10, 2005, between ACA Holdings, Inc. and Douglas  Jacobs (Filed as Exhibit 10.16 to the Company’s Registration Statement  on Form S-1, File No. 333-133949 and incorporated  herein by reference).                                                    |
| 10.17 |   | Indemnity Agreement,  dated as of May 10, 2005, between ACA Holdings, Inc. and William  Lacy (Filed as Exhibit 10.17 to the Company’s Registration Statement on  Form S-1, File No. 333-133949 and incorporated herein  by reference).                                                      |
| 10.18 |   | Amended and Restated  2006 Stock Incentive Plan (Filed as Exhibit 10.18 to the Company’s  Registration Statement on Form S-1, File No. 333-133949  and incorporated herein by reference).*                                                                                                            |
| 10.19 |   | Form of Amended and  Restated Incentive Stock Option Agreement (Filed as Exhibit 10.19 to the  Company’s Registration Statement on Form S-1, File No. 333-133949  and incorporated herein by reference).*                                                                                        |
| 10.20 |   | Form of Amended and  Restated Non-Qualified Stock Option Agreement (Filed as Exhibit 10.20 to  the Company’s Registration Statement on Form S-1, File  No. 333-133949 and incorporated herein by reference).*                                                                                    |
| 10.21 |   | Form of Restricted  Stock Award Agreement (Filed as Exhibit 10.21 to the Company’s  Registration Statement on Form S-1, File No. 333-133949  and incorporated herein by reference).*                                                                                                             |
| 10.22 |   | Office Building Lease  between ACA Financial Guaranty Corporation and 140 BW LLC, dated as of  December 7, 2006 (Filed as Exhibit 10.7 to the Company’s Quarterly  Report on Form 10-Q for the quarterly period ended  September 30, 2006 and incorporated herein by reference).                 |
| 10.23 |   | Sublease between ACA  Financial Guaranty Corporation and Platinum Technology  International, Inc., dated October 19, 2006 (Filed as  Exhibit 10.8 to the Company’s Quarterly Report on Form 10-Q  for the quarterly period ended September 30, 2006 and incorporated  herein by reference). |
| 10.24 |   | Employment Agreement,  dated as of September 30, 2004, between the Company and Joseph Pimbley.*                                                                                                                                                                                                                      |
| 21.1  |   | List of Subsidiaries.                                                                                                                                                                                                                                                                                                     |
| 23.1  |   | Consent of Deloitte  & Touch LLP.                                                                                                                                                                                                                                                                                     |
| 24.1  |   | Power of Attorney  (included on signature page).                                                                                                                                                                                                                                                                          |
| 31.1  |   | Chief Executive  Officer—Certification Pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002.                                                                                                                                                                                                              |
| 31.2  |   | Chief Financial  Officer—Certification Pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002.                                                                                                                                                                                                              |
| 32.1  |   | Chief Executive  Officer—Certification Pursuant to 18 U.S.C. Section 1350, as Adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.+                                                                                                                                                         |

143

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| 32.2 |   | Chief Financial  Officer—Certification Pursuant to 18 U.S.C. Section 1350, as Adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.+ |
|------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|

----

*                    Managementcontract or compensatory plan, contract or arrangement required to be filed asan exhibit pursuant to Item 15(b) of Form 10-K.

+                Furnishedherewith.

144

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.
| Date:  March 30, 2007 | /s/ ALAN S.  ROSEMAN                                                                |
|----------------------------|-------------------------------------------------------------------------------------|
|                       | Alan S. Roseman                                                                     |
|                       | President and Chief Executive Officer (Principal  Executive Officer)                |
|                       |                                                                                |
| Date: March 30, 2007  | /s/ EDWARD U.  GILPIN                                                               |
|                       | Edward U. Gilpin                                                                    |
|                       | Executive Vice President and Chief Financial Officer  (Principal Financial Officer) |

 

KNOW ALL PERSONS BY THESE PRESENTS, that each personwhose signature appears below constitutes and appoints Alan S. Roseman andEdward U. Gilpin, and each of them, his true and lawful attorneys-in-fact, eachwith full power of substitution and resubstitution, for him and in his name,place and stead, in any and all capacities, to sign any amendments to thisreport on Form 10-K and to file the same, with exhibits thereto andother documents in connection therewith, with the Securities and ExchangeCommission, granting unto said attorneys-in-fact and agents, and each of them,full power and authority to do and perform each and every act and thingrequisite and necessary to be done in and about the premises, as fully to allintents and purposes as might or could be done in person, hereby ratifying andconfirming all that said attorneys-in-fact and agents or any of them, or theirsubstitutes, may lawfully do or cause to be done by virtue hereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities and on the dates indicated.
| Signature               | ** ** | **Title**                                                                    | ** ** | **Date**             |
|-------------------------|------------|------------------------------------------------------------------------------|------------|----------------------|
| /s/ ALAN S.  ROSEMAN    |       | Chief Executive Officer, President and Deputy                                |       | March 30,  2007 |
| Alan  S. Roseman        |       | Chairman  of the Board (Principal Executive Officer)                         |       |                 |
| /s/ EDWARD U.  GILPIN   |       | Executive Vice President, Chief Financial Officer                            |       | March 30,  2007 |
| Edward  U. Gilpin       |       | and  Director (Principal Financial Officer and Principal Accounting Officer) |       |                 |
| /s/ DAVID E.  KING      |       | Chairman of the Board of Directors                                           |       | March 30,  2007 |
| David  E. King          |       |                                                                         |       |                 |
| /s/ DAVID M.  BARSE     |       | Director                                                                     |       | March 30,  2007 |
| David  M. Barse         |       |                                                                         |       |                 |
| /s/ JOHN G.  BERYLSON   |       | Director                                                                     |       | March 30,  2007 |
| John  G. Berylson       |       |                                                                         |       |                 |
| /s/ DOUGLAS L.  JACOBS  |       | Director                                                                     |       | March 30,  2007 |
| Douglas  L. Jacobs      |       |                                                                         |       |                 |
| /s/ ROBERT  JUNEJA      |       | Director                                                                     |       | March 30,  2007 |
| Robert  Juneja          |       |                                                                         |       |                 |
| /s/ WILLIAM H.  LACY    |       | Director                                                                     |       | March 30,  2007 |
| William  H. Lacy        |       |                                                                         |       |                 |
| /s/ WARREN A.  STEPHENS |       | Director                                                                     |       | March 30,  2007 |
| Warren  A. Stephens     |       |                                                                         |       |                 |

 

145

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**ACACapital Holdings, Inc.  Schedule I  Summary of Investments—Other thanInvestments in Related Parties  As of December 31, 2006 (Dollars inThousands)**
| Type of Investment                                      | ** ** | ** ** | ** ** | **Cost (Amortized)** | ** ** | **Value** | ** ** | **Amount At Which   Shown In The   Balance Sheet** | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|---------------------------|------------|-----------|------------|---------------------------------------------------------------------------------------|------------|
| Fixed Maturities:                                                 |       |       |       |                      |       |      |       |                                                                                  |       |   |   |
| Bonds:                                                            |       |       |       |                      |       |      |       |                                                                                  |       |   |   |
| United States  Government and government agencies and authorities |       |       | $          | 112,748                   |       |      | $          | 111,062                                                                               |       |   | $ | 111,062 |   |   |
| States,  municipalities and political subdivisions                |       |       | 133,027    |                      |       | 132,852   |       |                                                                                  | 132,852    |   |   |
| Public Utilities                                                  |       |       | 3,949      |                      |       | 3,851     |       |                                                                                  | 3,851      |   |   |
| All other  corporate bonds                                        |       |       | 246,215    |                      |       | 241,639   |       |                                                                                  | 241,639    |   |   |
| VIE Asset Backed  Securities                                      |       |       | 4,547,122  |                      |       | 4,536,694 |       |                                                                                  | 4,536,694  |   |   |
| Certificates of  Deposit                                          |       |       | 178        |                      |       | 178       |       |                                                                                  | 178        |   |   |
| Trading  Securities                                               |       |       | 251,884    |                      |       | 251,825   |       |                                                                                  | 251,825    |   |   |
| Total fixed  maturities                                           |       |       | 5,295,123  |                      |       | 5,278,101 |       |                                                                                  | 5,278,101  |   |   |
| Securities  purchased under agreements to resell                  |       |       | 10,248     |                      |       | 10,248    |       |                                                                                  | 10,248     |   |   |
| VIE Guaranteed  investment contract                               |       |       | 119,340    |                      |       | 119,340   |       |                                                                                  | 119,340    |   |   |
| Total Investments                                                 |       |       | $          | 5,424,711                 |       |      | $          | 5,407,689                                                                             |       |   | $ | 5,407,689 |   |   |

 

S-1

----

**ACA Capital Holdings, Inc.Schedule IICondensed Financial Information of RegistrantCONDENSED BALANCE SHEETSParent Company Only(Dollars in Thousands)**
|                                                                                                                                                                                                                                                                     | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                          | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                          | ** ** | ** **            | ** ** | ** ** | ** ** |
| Investments in  subsidiaries and affiliates, at equity in net assets                                                                                                                                                                                                |       | $                     | 533,866    |   | $ | 440,075 |   |
| Cash and cash  equivalents                                                                                                                                                                                                                                          |       | 40,429                |       | 184 |   |
| Receivable from  affiliates                                                                                                                                                                                                                                         |       | 1,369                 |       | 8,206 |   |
| Deferred debt  issuance costs                                                                                                                                                                                                                                       |       | 2,083                 |       | 2,161 |   |
| Notes receivable  from affiliates                                                                                                                                                                                                                                   |       | 10,000                |       | 10,000 |   |
| Other assets                                                                                                                                                                                                                                                        |       | 2,744                 |       | 4,524 |   |
| Total assets                                                                                                                                                                                                                                                        |       | $                     | 590,491    |   | $ | 465,150 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                      | ** ** | ** **            | ** ** | ** ** | ** ** |
| LIABILITIES                                                                                                                                                                                                                                                         |       |                  |       |   |   |
| Debt                                                                                                                                                                                                                                                                |       | $                     | 79,899     |   | $ | 79,899 |   |
| Accrued interest  payable                                                                                                                                                                                                                                           |       | 551                   |       | 493 |   |
| Accrued expenses  and other liabilities                                                                                                                                                                                                                             |       | 227                   |       | 445 |   |
| Total liabilities                                                                                                                                                                                                                                                   |       | 80,677                |       | 80,837 |   |
| STOCKHOLDERS’  EQUITY                                                                                                                                                                                                                                          |       |                  |       |   |   |
| Senior  convertible preferred stock—0 and 220 shares authorized, 0 shares and 129 shares  issued and outstanding at December 31, 2006 and 2005, respectively                                                                                         |       | —                |       | 7,339 |   |
| Convertible  preferred stock—0 and 1,500 shares authorized, 0 and 959 shares issued and  outstanding at December 31, 2006 and 2005, respectively                                                                                                          |       | —                |       | 54,858 |   |
| Series B  senior convertible preferred stock—0 and 3,000,000 shares authorized, 0 and  2,785,769 shares issued and outstanding at December 31, 2006 and 2005,  respectively                                                                          |       | —                |       | 164,263 |   |
| Common stock of  100,000,000 shares authorized at December 31, 2006 and 12,000,000 shares  authorized at December 31, 2005; 37,375,123 and 6,442,950 shares issued  and outstanding at December 31, 2006 and 2005, respectively; par value  of $0.10 |       | 3,737                 |       | 644 |   |
| Gross paid-in and  contributed capital                                                                                                                                                                                                                              |       | 438,935               |       | 125,184 |   |
| Treasury stock at  cost—851,847 shares and 351,876 shares at December 31, 2006 and 2005,  respectively                                                                                                                                                    |       | (12,088               | )          | (5,500 | ) |
| Notes receivable  from stockholders                                                                                                                                                                                                                                 |       | (3,121                | )          | (1,355 | ) |
| Deferred  compensation                                                                                                                                                                                                                                              |       | (870                  | )          | (2,030 | ) |
| Accumulated other  comprehensive income (loss) net of deferred income tax of $(1,760) and $5,369  at December 31, 2006 and 2005, respectively                                                                                                                  |       | (3,308                | )          | 11,132 |   |
| Retained earnings                                                                                                                                                                                                                                                   |       | 86,529                |       | 29,778 |   |
| Total  stockholders’ equity                                                                                                                                                                                                                                    |       | 509,814               |       | 384,313 |   |
| Total liabilities and  stockholders’ equity                                                                                                                                                                                                                    |       | $                     | 590,491    |   | $ | 465,150 |   |

 

See Supplemental Notes.

S-2

----

**ACA Capital Holdings, Inc.Schedule IICondensed Financial Information of RegistrantCONDENSED STATEMENT OF INCOMEParent Company Only(Dollars in Thousands)**
|                                                                       | ** ** | **For the years ended December 31,** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Revenues:**                                                         | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net investment  income                                                |       | $                                                             | 573        |   | $ | 95 |   | $ | 178 |   |
| Total revenues                                                        |       | 573                                                           |       | 95 |   | 178 |   |
| **Expenses:**                                                         | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Other operating expenses                                              |       | 1,842                                                         |       | 1,264 |   | 778 |   |
| Interest expense                                                      |       | 6,338                                                         |       | 5,114 |   | 3,279 |   |
| Depreciation and  amortization                                        |       | 78                                                            |       | 114 |   | 56 |   |
| Total expenses                                                        |       | 8,258                                                         |       | 6,492 |   | 4,113 |   |
| Equity in  earnings (loss) of subsidiaries and affiliates, net of tax |       | 65,675                                                        |       | 32,662 |   | (543 | ) |
| Income (loss) before income taxes                                     |       | 57,990                                                        |       | 26,265 |   | (4,478 | ) |
| Provision for  income tax benefit                                     |       | (718                                                          | )          | (2,495 | ) | (689 | ) |
| **Net  income (loss)**                                                |       | $                                                             | 58,708     |   | $ | 28,760 |   | $ | (3,789 | ) |

 

See Supplemental Notes.

S-3

----

**ACA CapitalHoldings, Inc.Schedule IICondensed Financial Information of RegistrantCONDENSED STATEMENTS OF CASH FLOWSParent Company Only(Dollars in Thousands)**
|                                                                                                    | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                         | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Cash flows from operating activities:                                                              |       |                                        |       |   |   |   |   |
| Net income (loss)                                                                                  |       | $                                           | 58,708     |   | $ | 28,760 |   | $ | (3,789 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities:          |       |                                        |       |   |   |   |   |
| Severance expense  related to former Executive Stock Option Exercise      |       | 1,306                                       |       | — |   | — |   |
| Equity in net (income)  loss of affiliates                                                         |       | (65,675                                     | )          | (32,662 | ) | 543 |   |
| Increase (decrease) in  intercompany payable balances                                              |       | 6,837                                       |       | (1,032 | ) | 5,209 |   |
| Share based compensation                                                                           |       | 1,007                                       |       | — |   | — |   |
| Deferred compensation                                                                              |       | 1,160                                       |       | 1,160 |   | (3,190 | ) |
| Dividends received from  subsidiaries                                                              |       | —                                      |       | 5,114 |   | 3,279 |   |
| Increase (decrease) in  accrued expenses and other liabilities                                     |       | (218                                        | )          | 445 |   | — |   |
| Discharge of notes  receivable from stockholders                                                   |       | 496                                         |       | 264 |   | — |   |
| Increase in accrued  interest payable                                                              |       | 58                                          |       | 6 |   | 87 |   |
| Amortization of debt  issuance costs                                                               |       | 78                                          |       | 78 |   | 55 |   |
| Increase in taxes  receivable                                                                      |       | —                                      |       | (1,368 | ) | — |   |
| Other                                                                                              |       | 1,780                                       |       | (855 | ) | 1,277 |   |
| Net cash provided by  (used in) by operating activities                                            |       | 5,537                                       |       | (90 | ) | 3,471 |   |
| Cash flows from investing activities:                                                              |       |                                        |       |   |   |   |   |
| Capital contributions to  subsidiaries                                                             |       | (42,556                                     | )          | — |   | (188,110 | ) |
| Notes receivable from  affiliates                                                                  |       | —                                      |       | — |   | (9,120 | ) |
| Net cash used in  investing activities                                                             |       | (42,556                                     | )          | — |   | (197,230 | ) |
| Cash flows from financing activities:                                                              |       |                                        |       |   |   |   |   |
| Proceeds from issuance  of debt                                                                    |       | —                                      |       | — |   | 20,619 |   |
| Net proceeds from common  stock initial public offering                                            |       | 79,330                                      |       | — |   | — |   |
| Payment of deferred debt  issuance costs                                                           |       | —                                      |       | — |   | (603 | ) |
| Proceeds from issuance  of preferred stock, net of issuance cost                                   |       | —                                      |       | 311 |   | 163,891 |   |
| Change in notes  receivable from stockholders                                                      |       | —                                      |       | 37 |   | 344 |   |
| Purchase of treasury  stock                                                                        |       | (2,066                                      | )          | (74 | ) | (4 | ) |
| Net cash provided by  financing activities                                                         |       | 77,264                                      |       | 274 |   | 184,247 |   |
| Net increase (decrease)  in cash and cash equivalents                                              |       | 40,245                                      |       | 184 |   | (9,512 | ) |
| Cash and cash  equivalents at beginning of year                                                    |       | 184                                         |       | — |   | 9,512 |   |
| Cash and cash  equivalents at end of year                                                          |       | $                                           | 40,429     |   | $ | 184 |   | $ | — |   |
| Supplemental cash flow disclosures:                                                                |       |                                        |       |   |   |   |   |
| Income taxes paid  (received)                                                                      |       | $                                           | (5         | ) | $ | 414 |   | $ | 10 |   |
| Interest paid                                                                                      |       | $                                           | 6,280      |   | $ | 5,108 |   | $ | 3,192 |   |
| Supplemental disclosure of Non Cash Financing  Activities:                                         |       |                                        |       |   |   |   |   |
| Common Stock acquired in  exchange for note receivable                                             |       | $                                           | 2,262      |   | $ | — |   | $ | 2,200 |   |
| Share redemptions related to exercised options by  former employee                                 |       | $                                           | 4,522      |   | $ | — |   | $ | — |   |

 

See Supplemental Notes.

S-4

----

**ACA CapitalHoldings, Inc.Schedule IICondensed Financial Information of RegistrantNOTES TO FINANCIAL STATEMENTSParent Company Only**

**1.   CondensedFinancial Statements**

The Parent Companycondensed financial statements should be read in conjunction with the Company’sconsolidated financial statements and the notes thereto prepared in accordancewith accounting principles generally accepted in the United States of America (“U.S.GAAP”), which are included elsewhere in this registration statement.

**2.   SignificantAccounting Policies**

The Parent Company carriesits investment in subsidiaries under the equity method.

**3.   Long TermObligations**

As ofDecember 31, 2006 and 2005, the Parent Company issued trust preferred debtsecurities of $79.9 million. The trust preferred securities have a stated termof 30 years with a call provision of five years from the date of each issuance.The current interest rates on the outstanding securities range from 8.71% to9.47% at December 31, 2006. The effective interest rate of thesesecurities is calculated based on 3-Month LIBOR plus a margin of 3.35% to4.1% per annum subject to certain interest rate caps during the lives of thesecurities.
|             | **Issue**  | ** **              | ** ** | **December 31,  2006** | ** ** | **December 31,  2005** | ** ** | **Issue Date** | ** ** | **Maturity Date** | ** ** | **Interest Rate Spread as of  December 31, 2006** | ** ** |
|-------------|------------|-------------------------|------------|-----------------------------|------------|-----------------------------|------------|---------------------|------------|------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **  | ** ** | **(in thousands)** | ** ** | **(in thousands)**     | ** ** | ** **                  | ** ** | ** **          | ** ** | ** **             | ** ** |
| I-PreTS I   |       |                    | $          | 18,042                      |       |                        |       | $                   | 18,042     |                   |       | December 4, 2002                                                           |       | December 2032 |   | 3 Month LIBOR + 4.00 | % |
| I-PreTS II  |       |                    | 20,619     |                        |       |                        | 20,619     |                |       | May 15, 2003      |       | May 2033                                                                   |       | 3 Month LIBOR + 4.10 | % |
| I-PreTS III |       |                    | 20,619     |                        |       |                        | 20,619     |                |       | October 29, 2003  |       | October 2033                                                               |       | 3 Month LIBOR + 3.95 | % |
| I-PreTS IV  |       |                    | 20,619     |                        |       |                        | 20,619     |                |       | December 29, 2004 |       | December 2034                                                              |       | 3 Month LIBOR + 3.35 | % |
| Total       |       |                    | $          | 79,899                      |       |                        |       | $                   | 79,899     |                   |       |                                                                            |       |   |   |   |   |

 

S-5

----

**ACACapital Holdings, Inc.Schedule IIISupplementary Insurance InformationAs of and for the Years Ended December 31, 2006, 2005 and 2004(Dollars in thousands)**

| ** **              | ** ** | **2006**   | ** ** |
|-------------------------|------------|------------|------------|
| **Segment**             | ** ** | ** ** | ** ** | **Deferred  Policy  Acquisition  Costs** | ** ** | **Unearned  Premium  Reserve** | ** ** | **Reserve for  Loss & LAE  Expense** | ** ** | **Net  Investment  Income** | ** ** | **Net  Premium  Written** | ** ** | **Net  Premiums  Earned** | ** ** | **Loss & LAE  Expense** | ** ** | **Acquisition  Costs** | ** ** | **Other  Operating  Expenses** | ** ** |
| Public Finance          |       |       | $          | 48,640 |   |   | $ | 189,061 |   |   | $ | 22,482 |   |   |   | $ | 16,210 |   |   | $ | 29,206 |   |   | $ | 26,234 |   |   |   | $ | 6,461 |   |   |   | $ | 8,236 |   |   |   | $ | 8,830 |   |   |
| CDO Asset Management(1) |       |       | —     |   |   | — |   |   | — |   |   |   | 309,430 |   |   | — |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 22,178 |   |   |
| Structured Credit(1)    |       |       | —     |   |   | — |   |   | — |   |   |   | 8,724 |   |   | 706 |   |   | 795 |   |   |   | — |   |   |   | — |   |   |   | 18,393 |   |   |
| Other                   |       |       | 170        |   |   | 476 |   |   | 19,631 |   |   |   | 3,802 |   |   | 905 |   |   | 1,670 |   |   |   | 2,339 |   |   |   | 504 |   |   |   | 35 |   |   |
| Total                   |       |       | $          | 48,810 |   |   | $ | 189,537 |   |   | $ | 42,113 |   |   |   | $ | 338,166 |   |   | $ | 30,817 |   |   | $ | 28,699 |   |   |   | $ | 8,800 |   |   |   | $ | 8,740 |   |   |   | $ | 49,436 |   |   |
|                         |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **              | ** ** | ** ** | ** ** | **2005**                                 | ** ** |
|-------------------------|------------|------------|------------|------------------------------------------|------------|
| **Segment**             | ** ** | ** ** | ** ** | **Deferred  Policy  Acquisition  Costs** | ** ** | **Unearned  Premium  Reserve** | ** ** | **Reserve for  Loss & LAE  Expense** | ** ** | **Net  Investment  Income** | ** ** | **Net  Premium  Written** | ** ** | **Net  Premiums  Earned** | ** ** | **Loss & LAE  Expense** | ** ** | **Acquisition  Costs** | ** ** | **Other  Operating  Expenses** | ** ** |
| Public Finance          |       |       | $          | 46,942                                   |       |   | $ | 186,408 |   |   | $ | 16,807 |   |   |   | $ | 13,862 |   |   | $ | 34,877 |   |   | $ | 23,889 |   |   |   | $ | 7,459 |   |   |   | $ | 6,970 |   |   |   | $ | 7,201 |   |   |
| CDO Asset Management(1) |       |       | —     |                                     |       | — |   |   | — |   |   |   | 236,591 |   |   | — |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 19,049 |   |   |
| Structured Credit(1)    |       |       | —     |                                     |       | 90 |   |   | — |   |   |   | 828 |   |   | 2,638 |   |   | 2,548 |   |   |   | — |   |   |   | — |   |   |   | 7,430 |   |   |
| Other                   |       |       | 472        |                                     |       | 1,241 |   |   | 17,499 |   |   |   | 3,310 |   |   | 4,403 |   |   | 6,906 |   |   |   | 6,579 |   |   |   | 1,682 |   |   |   | 3,763 |   |   |
| Total                   |       |       | $          | 47,414                                   |       |   | $ | 187,739 |   |   | $ | 34,306 |   |   |   | $ | 254,591 |   |   | $ | 41,918 |   |   | $ | 33,343 |   |   |   | $ | 14,038 |   |   |   | $ | 8,652 |   |   |   | $ | 37,443 |   |   |

 

| ** **              | ** ** | **2004**   | ** ** |
|-------------------------|------------|------------|------------|
| **Segment**             | ** ** | ** ** | ** ** | **Deferred  Policy  Acquisition  Costs** | ** ** | **Unearned  Premium  Reserve** | ** ** | **Reserve for  Loss & LAE  Expense** | ** ** | **Net  Investment  Income** | ** ** | **Net  Premium  Written** | ** ** | **Net  Premiums  Earned** | ** ** | **Loss & LAE  Expense** | ** ** | **Acquisition  Costs** | ** ** | **Other  Operating  Expenses** | ** ** |
| Public Finance          |       |       | $          | 45,956 |   |   | $ | 176,351 |   |   | $ | 12,520 |   |   |   | $ | 8,770 |   |   | $ | 29,780 |   |   | $ | 13,930 |   |   |   | $ | 4,310 |   |   |   | $ | 2,238 |   |   |   | $ | 7,148 |   |   |
| CDO Asset Management(1) |       |       | —     |   |   | — |   |   | — |   |   |   | 114,782 |   |   | — |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 18,910 |   |   |
| Structured Credit(1)    |       |       | —     |   |   | — |   |   | — |   |   |   | 524 |   |   | 4,670 |   |   | 6,161 |   |   |   | — |   |   |   | — |   |   |   | 8,870 |   |   |
| Other                   |       |       | 600        |   |   | 3,789 |   |   | 23,486 |   |   |   | 2,094 |   |   | 11,032 |   |   | 9,742 |   |   |   | 42,280 |   |   |   | 1,597 |   |   |   | 3,717 |   |   |
| Total                   |       |       | $          | 46,556 |   |   | $ | 180,140 |   |   | $ | 36,006 |   |   |   | $ | 126,170 |   |   | $ | 45,482 |   |   | $ | 29,833 |   |   |   | $ | 46,590 |   |   |   | $ | 3,835 |   |   |   | $ | 38,645 |   |   |
|                         |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Because CDO AssetManagement and Structured Credit transactions are in the form of credit defaultswaps and are derivatives under SFAS 133, any loss activity is recorded inthe caption, “Net realized and unrealized gains (losses) on derivatives.”  Revenues received are recorded as premiumbecause our insurance subsidiary, ACA Financial Guaranty, provides creditprotection to the buyers under these contracts pursuant to its role asfinancial guarantor.

 

S-6

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**ACACapital Holdings, Inc.Schedule IVReinsuranceFor the Years Ended December 31, 2006, 2005 and 2004(Dollars in thousands)**

| ** **           | ** ** | **Gross Amount** | ** ** | **Ceded** | ** ** | **Assumed** | ** ** | **Net** | ** ** | **Percentage of Amount  Assumed to Net** | ** ** |
|----------------------|------------|-----------------------|------------|-----------|------------|-------------|------------|---------|------------|--------------------------------------------------------------|------------|
| 2006 Earned  Premium |       |                  | $          | 28,672    |       |        | $          | (826    | )          |                                                         | $          | 853 |   |   | $ | 28,699 |   |   | 2.97 | % |   |
| 2005 Earned  Premium |       |                  | $          | 32,684    |       |        | $          | (337    | )          |                                                         | $          | 996 |   |   | $ | 33,343 |   |   | 2.99 | % |   |
| 2004 Earned Premium  |       |                  | $          | 36,399    |       |        | $          | (6,874  | )          |                                                         | $          | 308 |   |   | $ | 29,833 |   |   | 1.03 | % |   |

 

S-7

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**EXHIBITINDEX**
| 3.2.1 |   | Third Amendment to the Bylaws of the Registrant  dated March 23, 2007.                                                                                       |
|-------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.24 |   | Employment Agreement,  dated as of September 30, 2004, between the Registrant and Joseph Pimbley.  *                                                         |
| 21.1  |   | List of Subsidiaries.                                                                                                                                             |
| 23.1  |   | Consent of Deloitte  & Touch LLP.                                                                                                                             |
| 31.1  |   | Chief Executive  Officer—Certification Pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002.                                                      |
| 31.2  |   | Chief Financial  Officer—Certification Pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002.                                                      |
| 32.1  |   | Chief Executive  Officer—Certification Pursuant to 18 U.S.C. Section 1350, as Adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.+ |
| 32.2  |   | Chief Financial  Officer—Certification Pursuant to 18 U.S.C. Section 1350, as Adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.+ |

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*                    Managementcontract or compensatory plan contract or arrangement required to be filed asan exhibit pursuant to Item 15(b) of Form 10-K.

+                Furnishedherewith.

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