**UNITED STATES****SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC20549**

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**Form 10-Q**

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| **x**                                          | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|------------------------------------------------|-----------------------------------------------------------------------------------------------|
| ** **                                     | ** **                                                                                    |
| **For  the Quarter Ended March 31, 2007** |
| ** **                                     | ** **                                                                                    |
| **or**                                         |
| ** **                                     | ** **                                                                                    |
| **o**                                          | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transition period from                 to                **

**Commission file number 1-33111**

**ACA CapitalHoldings, Inc.******(Exact name of registrant asspecified in its charter)

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

 

**140 BroadwayNew York, New York 10005(212) 375-2000**(Address, including zipcode, and telephone number, includingarea code, of registrant’s principal executive offices)

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90days.    Yes  x    No  o

Indicateby check mark whether the Registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Checkone):
| Large  accelerated filer  o |   | Accelerated  filer  o |   | Non-accelerated  filer  x |
|---------------------------------------|--------|---------------------------------|--------|-------------------------------------|

 

Indicateby check mark whether the Registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).    Yes  o    No  x

As of May 14, 2007, 37,414,603 shares of Common Stock,par value $0.10 per share, were outstanding.

 

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**INDEX**
|                                     | ** **                                                                                                                     | **PAGE**   |
|-------------------------------------|--------------------------------------------------------------------------------------------------------------------------------|------------|
| **PART  I - FINANCIAL INFORMATION** |                                                                                                                           |
|                                |                                                                                                                           |       |
| Item  1.                            | Financial  Statements of ACA Capital Holdings, Inc. and Subsidiaries (Unaudited)                                               |       |
|                                |                                                                                                                           |       |
|                                | Condensed  Consolidated Balance Sheets (Unaudited) — March 31, 2007 and December 31,  2006                                | 3          |
|                                |                                                                                                                           |       |
|                                | Condensed  Consolidated Statements of Operations (Unaudited) — Three months ended March  31, 2007 and 2006                | 4          |
|                                |                                                                                                                           |       |
|                                | Condensed  Consolidated Statements of Stockholders’ Equity (Unaudited) — Three months  ended March 31, 2007 and 2006 | 5          |
|                                |                                                                                                                           |       |
|                                | Condensed Consolidated  Statements of Cash Flows (Unaudited) — Three months ended March 31, 2007 and  2006                | 6          |
|                                |                                                                                                                           |       |
|                                | Notes to Unaudited  Condensed Consolidated Financial Statements                                                                | 7–19  |
|                                |                                                                                                                           |       |
| Item 2.                             | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                    | 20–53 |
|                                |                                                                                                                           |       |
| Item 3.                             | Quantitative  and Qualitative Disclosures About Market Risk                                                                    | 53         |
|                                |                                                                                                                           |       |
| Item 4.                             | Controls and  Procedures                                                                                                       | 56         |
|                                |                                                                                                                           |       |
| **PART II - OTHER  INFORMATION**    |                                                                                                                           |
|                                |                                                                                                                           |       |
| Item 1.                             | Legal Proceedings                                                                                                              | 56         |
|                                |                                                                                                                           |       |
| Item 1A.                       | Risk  Factors                                                                                                                  | 56         |
|                                |                                                                                                                           |       |
| Item 2.                             | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                   | 56         |
|                                |                                                                                                                           |       |
| Item 3.                             | Defaults  Upon Senior Securities                                                                                               | 57         |
|                                |                                                                                                                           |       |
| Item 4.                             | Submission  of Matters to a Vote of Security Holders                                                                           | 57         |
|                                |                                                                                                                           |       |
| Item 5.                             | Other Information                                                                                                              | 57         |
|                                |                                                                                                                           |       |
| Item  6.                            | Exhibits                                                                                                                       | 58         |
|                                |                                                                                                                           |       |
| **SIGNATURES**                      |                                                                                                                           |

 

2

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**PART I — FINANCIAL INFORMATION**

Item 1.        FinancialStatements of ACA Capital Holdings, Inc. and Subsidiaries (Unaudited)

**ACA CAPITAL HOLDINGS, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)AS OF MARCH 31, 2007 AND DECEMBER 31, 2006(Dollars in thousands)**
| ** **                                                                                                                                                                                                                  | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                  | ** ** | **2007**           | ** ** | **2006**              | ** ** |
| **ASSETS**                                                                                                                                                                                                                  | ** ** | ** **         | ** ** | ** **            | ** ** |
| Investments:                                                                                                                                                                                                                |       |               |       |                  |       |
| Fixed-maturity  securities available for sale at fair value, amortized cost of $5,004,901 and  $5,043,239, respectively                                                                                                     |       | $                  | 4,824,314  |                  | $          | 5,026,276 |   |
| Fixed-maturity  securities trading at fair value, amortized cost of $309,529 and $251,884,  respectively                                                                                                                    |       | 308,012            |       | 251,825               |       |
| Securities  purchased under agreements to resell                                                                                                                                                                            |       | 3,679              |       | 10,248                |       |
| Guaranteed  investment contract                                                                                                                                                                                             |       | 119,340            |       | 119,340               |       |
| Total  investments                                                                                                                                                                                                          |       | 5,255,345          |       | 5,407,689             |       |
| Cash:                                                                                                                                                                                                                       |       |               |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                                  |       | 426,026            |       | 379,905               |       |
| Restricted cash                                                                                                                                                                                                             |       | 70,221             |       | 67,061                |       |
| Total cash                                                                                                                                                                                                                  |       | 496,247            |       | 446,966               |       |
| Accrued investment  income                                                                                                                                                                                                  |       | 20,764             |       | 21,222                |       |
| Derivative assets                                                                                                                                                                                                           |       | 23,784             |       | 19,730                |       |
| Deferred policy  acquisition costs, net                                                                                                                                                                                     |       | 49,247             |       | 48,810                |       |
| Deferred debt issuance  costs, net                                                                                                                                                                                          |       | 32,440             |       | 34,104                |       |
| Receivable for  securities sold                                                                                                                                                                                             |       | 1,106              |       | 824                   |       |
| Prepaid reinsurance  premiums                                                                                                                                                                                               |       | 511                |       | 528                   |       |
| Deferred income taxes                                                                                                                                                                                                       |       | 55,171             |       | —                |       |
| Other assets                                                                                                                                                                                                                |       | 73,840             |       | 58,321                |       |
| **Total  assets**                                                                                                                                                                                                           |       | $                  | 6,008,455  |                  | $          | 6,038,194 |   |
|                                                                                                                                                                                                                        |       |               |       |                  |       |
| **LIABILITIES, MINORITY INTEREST  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                           | ** ** | ** **         | ** ** | ** **            | ** ** |
| LIABILITIES                                                                                                                                                                                                                 |       |               |       |                  |       |
| Unearned premiums                                                                                                                                                                                                           |       | $                  | 189,281    |                  | $          | 189,537 |   |
| Reserve for losses and  loss adjustment expenses                                                                                                                                                                            |       | 44,108             |       | 42,113                |       |
| Short-term debt                                                                                                                                                                                                             |       | 2,678,982          |       | 2,677,828             |       |
| Long-term debt                                                                                                                                                                                                              |       | 2,095,236          |       | 2,125,914             |       |
| Related party debt                                                                                                                                                                                                          |       | 100,000            |       | 100,000               |       |
| Securities sold under  agreements to repurchase                                                                                                                                                                             |       | 277,701            |       | 232,227               |       |
| Derivative liabilities                                                                                                                                                                                                      |       | 44,239             |       | 33,874                |       |
| Accrued interest  payable                                                                                                                                                                                                   |       | 16,264             |       | 17,900                |       |
| Accrued expenses and  other liabilities                                                                                                                                                                                     |       | 59,110             |       | 61,855                |       |
| Payable for securities  purchased                                                                                                                                                                                           |       | 50,813             |       | 9,628                 |       |
| Current income tax  payable                                                                                                                                                                                                 |       | 8,856              |       | 7,056                 |       |
| Deferred income taxes                                                                                                                                                                                                       |       | —             |       | 258                   |       |
| Total  liabilities                                                                                                                                                                                                          |       | 5,564,590          |       | 5,498,190             |       |
|                                                                                                                                                                                                                        |       |               |       |                  |       |
| MINORITY INTEREST                                                                                                                                                                                                           |       | 19,189             |       | 30,190                |       |
|                                                                                                                                                                                                                        |       |               |       |                  |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                                                                              |       |               |       |                  |       |
|                                                                                                                                                                                                                        |       |               |       |                  |       |
| STOCKHOLDERS’ EQUITY                                                                                                                                                                                                   |       |               |       |                  |       |
| Common stock of  100,000,000 shares authorized at March 31, 2007 and December 31, 2006;  37,414,603 and 37,375,123 shares issued and outstanding at March 31, 2007 and  December 31, 2006, respectively; par value of $0.10 |       | 3,741              |       | 3,737                 |       |
| Gross paid-in and  contributed capital                                                                                                                                                                                      |       | 440,266            |       | 438,935               |       |
| Treasury stock at cost  — 851,847 shares at March 31, 2007 and December 31, 2006                                                                                                                                       |       | (12,088            | )          | (12,088               | )          |
| Notes receivable from  stockholders                                                                                                                                                                                         |       | (3,121             | )          | (3,121                | )          |
| Deferred compensation                                                                                                                                                                                                       |       | (580               | )          | (870                  | )          |
| Accumulated other  comprehensive income — net of deferred income tax of $(53,822) and $(1,760)  at March 31, 2007 and December 31, 2006, respectively                                                                  |       | (99,988            | )          | (3,308                | )          |
| Retained earnings                                                                                                                                                                                                           |       | 96,446             |       | 86,529                |       |
| Total  stockholders’ equity                                                                                                                                                                                            |       | 424,676            |       | 509,814               |       |
| **Total liabilities, minority  interest and stockholders’ equity**                                                                                                                                                     |       | $                  | 6,008,455  |                  | $          | 6,038,194 |   |

 

See notes to unaudited condensedconsolidated financial statements.

3

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**ACA CAPITAL HOLDINGS, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)FOR THE THREE MONTHS ENDED MARCH 31, 2007 AND 2006(Dollars and shares in thousands, except per share amounts)**
| ** **                                                   | ** ** | **Three months ended** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                   | ** ** | **March 31,**               | ** ** |
| ** **                                                   | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| REVENUES:                                                    |       |                             |       |   |   |
| Gross premiums  written                                      |       | $                                | 5,041      |   | $ | 4,788 |   |
| Less premiums  ceded                                         |       | (131                             | )          | (125 | ) |
| Net premiums  written                                        |       | 4,910                            |       | 4,663 |   |
| Decrease in  unearned premium reserve - net                  |       | 239                              |       | 219 |   |
| Premiums earned                                              |       | 5,149                            |       | 4,882 |   |
| Net insured  credit swap revenue                             |       | 3,699                            |       | 14,180 |   |
| Net investment  income                                       |       | 89,920                           |       | 77,712 |   |
| Net realized and  unrealized losses on investments           |       | (3,708                           | )          | (1,967 | ) |
| Net realized and  unrealized gains on derivative instruments |       | 2,080                            |       | 3,642 |   |
| Other net credit  swap revenue                               |       | 12,306                           |       | 2,913 |   |
| Fee income                                                   |       | 6,332                            |       | 4,118 |   |
| Other income                                                 |       | 56                               |       | 51 |   |
| Total revenues                                               |       | 115,834                          |       | 105,531 |   |
|                                                         |       |                             |       |   |   |
| EXPENSES:                                                    |       |                             |       |   |   |
| Loss and loss  adjustment expenses                           |       | 1,373                            |       | 2,021 |   |
| Policy  acquisition costs                                    |       | 1,477                            |       | 1,392 |   |
| Other operating  expenses                                    |       | 16,153                           |       | 10,613 |   |
| Interest expense                                             |       | 76,408                           |       | 66,419 |   |
| Depreciation and  amortization                               |       | 2,259                            |       | 2,492 |   |
| Total expenses                                               |       | 97,670                           |       | 82,937 |   |
| Income of  minority interest                                 |       | (879                             | )          | (1,155 | ) |
| Income before  income taxes                                  |       | 17,285                           |       | 21,439 |   |
| Provision for  income tax expense                            |       | 5,868                            |       | 7,292 |   |
| Net income                                                   |       | $                                | 11,417     |   | $ | 14,147 |   |
|                                                         |       |                             |       |   |   |
| **Share  and Per Share Data**                                |       |                             |       |   |   |
| Earnings per  share                                          |       |                             |       |   |   |
| Basic                                                        |       | $                                | 0.31       |   | $ | 0.62 |   |
| Diluted                                                      |       | $                                | 0.31       |   | $ | 0.47 |   |
|                                                         |       |                             |       |   |   |
| Weighted average  shares outstanding                         |       |                             |       |   |   |
| Basic                                                        |       | 36,540                           |       | 22,806 |   |
| Diluted                                                      |       | 37,120                           |       | 30,044 |   |

 

See notes to unaudited condensedconsolidated financial statements.

4

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**ACA CAPITAL HOLDINGS, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (UNAUDITED)****FOR THE THREE MONTHSENDED MARCH 31, 2007 AND 2006****(Dollars in thousands,except for share amounts)**
| ** **                                                                                   | ** ** | ** **               | ** ** | **Common Stock** | ** ** | **Gross  Paid in and** | ** ** | ** **      | ** ** | **Notes  Receivable** | ** ** | ** ** | ** ** | **Accumulated  Other** | ** ** | ** **        | ** ** | **Total**    | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|----------------------------------|------------|-----------------|------------|-----------------------|------------|------------|------------|------------------------|------------|-------------------|------------|--------------|------------|
| ** **                                                                                   | ** ** | **Preferred Stock** | ** ** | ** **            | ** ** | **Par**                          | ** ** | **Contributed** | ** ** | **Treasury**          | ** ** | **from**   | ** ** | **Deferred**           | ** ** | **Comprehensive** | ** ** | **Retained** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                                   | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**                       | ** ** | **Value**       | ** ** | **Capital**           | ** ** | **Stock**  | ** ** | **Stockholders**       | ** ** | **Compensation**  | ** ** | **Income**   | ** ** | **Earnings** | ** ** | **Equity** | ** ** |
| BALANCE—January 1,  2006                                                           |       | 2,786,857                |       | $                     | 226,460    |                             | 6,442,950  |            | $          | 644                   |       | $          | 125,184    |                   | $          | (5,500            | )          | $            | (1,355     | ) | $ | (2,030 | ) | $ | 11,132 |   | $ | 29,778 |   | $ | 384,313 |   |
| Comprehensive income:                                                                        |       |                     |       |                  |       |                             |       |            |       |                  |       |       |       |                   |       |              |       |         |       |   |   |   |   |
| Net  income                                                                                  |       | —                   |       | —                |       | —                           |       | —          |       | —                |       | —     |       | —                 |       | —            |       | —       |       | 14,147 |   | 14,147 |   |
| Change  in unrealized gain on investments, net of change in deferred income tax of  $1,748   |       | —                   |       | —                |       | —                           |       | —          |       | —                |       | —     |       | —                 |       | —            |       | 3,247        |       | — |   | 3,247 |   |
| Change  in derivative hedges, net of change in deferred income tax of $75                    |       | —                   |       | —                |       | —                           |       | —          |       | —                |       | —     |       | —                 |       | —            |       | 140          |       | — |   | 140 |   |
| Total comprehensive  income                                                                  |       | —                   |       | —                |       | —                           |       | —          |       | —                |       | —     |       | —                 |       | —            |       | —       |       | — |   | 17,534 |   |
| Vesting  of Series B senior conv. prf stock to CEO                                      |       | —                   |       | —                |       | —                           |       | —          |       | —                |       | —     |       | —                 |       | 290               |       | —       |       | — |   | 290 |   |
| Stock  based compensation-stock options                                                      |       | —                   |       | —                |       | —                           |       | —          |       | 226                   |       | —     |       | —                 |       | —            |       | —       |       | — |   | 226 |   |
| Discharge  of note receivable from stockholders                                              |       | —                   |       | —                |       | —                           |       | —          |       | —                |       | —     |       | 546                    |       | —            |       | —       |       | — |   | 546 |   |
| BALANCE—March 31,  2006                                                            |       | 2,786,857                |       | $                     | 226,460    |                             | 6,442,950  |            | $          | 644                   |       | $          | 125,410    |                   | $          | (5,500            | )          | $            | (809       | ) | $ | (1,740 | ) | $ | 14,519 |   | $ | 43,925 |   | $ | 402,909 |   |
|                                                                                         |       |                     |       |                  |       |                             |       |            |       |                  |       |       |       |                   |       |              |       |         |       |   |   |   |   |
| BALANCE—January 1,  2007                                                           |       | —                   |       | $                     | —     |                             | 37,375,123 |            | $          | 3,737                 |       | $          | 438,935    |                   | $          | (12,088           | )          | $            | (3,121     | ) | $ | (870 | ) | $ | (3,308 | ) | $ | 86,529 |   | $ | 509,814 |   |
| Effect of adoption of  FIN 48                                                                |       | —                   |       | —                |       | —                           |       | —          |       | —                |       | —     |       | —                 |       | —            |       | —       |       | (1,500 | ) | (1,500 | ) |
| Comprehensive income:                                                                        |       |                     |       |                  |       |                             |       |            |       |                  |       |       |       |                   |       |              |       |         |       |   |   |   |   |
| Net income                                                                                   |       | —                   |       | —                |       | —                           |       | —          |       | —                |       | —     |       | —                 |       | —            |       | —       |       | 11,417 |   | 11,417 |   |
| Change in unrealized  loss on investments, net of change in deferred income tax of $(51,370) |       | —                   |       | —                |       | —                           |       | —          |       | —                |       | —     |       | —                 |       | —            |       | (95,402      | )          | — |   | (95,402 | ) |
| Change in derivative  hedges, net of change in deferred income tax of $(692)                 |       | —                   |       | —                |       | —                           |       | —          |       | —                |       | —     |       | —                 |       | —            |       | (1,285       | )          | — |   | (1,285 | ) |
| Foreign exchange  unrealized gain                                                            |       | —                   |       | —                |       | —                           |       | —          |       | —                |       | —     |       | —                 |       | —            |       | 7            |       | — |   | 7 |   |
| Total comprehensive  income                                                                  |       | —                   |       | —                |       | —                           |       | —          |       | —                |       | —     |       | —                 |       | —            |       | —       |       |   |   | (85,263 | ) |
| Vesting  of CEO restricted common stock                                                      |       | —                   |       | —                |       | —                           |       | —          |       | —                |       | —     |       | —                 |       | 290               |       | —       |       | — |   | 290 |   |
| Offering  costs                                                                              |       | —                   |       | —                |       | —                           |       | —          |       | (161                  | )          | —     |       | —                 |       | —            |       | —       |       | — |   | (161 | ) |
| Stock  based compensation—restricted stock                                              |       | —                   |       | —                |       | —                           |       | —          |       | 222                   |       | —     |       | —                 |       | —            |       | —       |       | — |   | 222 |   |
| Stock  based compensation—stock options                                                 |       | —                   |       | —                |       | —                           |       | —          |       | 863                   |       | —     |       | —                 |       | —            |       | —       |       | — |   | 863 |   |
| Exercise  of common stock options                                                            |       | —                   |       | —                |       | 39,480                           |       | 4               |       | 407                   |       | —     |       | —                 |       | —            |       | —       |       | — |   | 411 |   |
| BALANCE—March 31, 2007                                                             |       | —                   |       | $                     | —     |                             | 37,414,603 |            | $          | 3,741                 |       | $          | 440,266    |                   | $          | (12,088           | )          | $            | (3,121     | ) | $ | (580 | ) | $ | (99,988 | ) | $ | 96,446 |   | $ | 424,676 |   |

 

See notes to unaudited condensedconsolidated financial statements.

5

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**ACA CAPITALHOLDINGS, INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)FOR THE THREE MONTHS ENDED MARCH 31, 2007 AND 2006**

**(Dollars inthousands)**
| ** **                                                                         | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $          | 11,417     |       | $          | 14,147 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |       |       |       |       |
| Depreciation and  amortization                                                     |       | 1,947      |       | 2,492      |       |
| Accrual of  discount and amortization of premium on investment—net            |       | (33        | )          | (70        | )          |
| Income of  minority interest                                                       |       | 879        |       | 1,155      |       |
| Net realized  losses on fixed-maturity securities-available-for-sale               |       | 2,205      |       | 1,968      |       |
| Net realized and  unrealized losses on fixed-maturity securities- trading          |       | 1,504      |       | —     |       |
| Net realized and  unrealized gains on derivative instruments                       |       | (2,080     | )          | (3,642     | )          |
| Net realized and  unrealized (gains) losses on net insured credit swap revenue     |       | 15,063     |       | (4,116     | )          |
| Net realized and  unrealized gains on other net credit swap revenue                |       | (8,138     | )          | (194       | )          |
| Share based  compensation expense                                                  |       | 1,085      |       | 226        |       |
| Discharge of  note receivable from shareholders                                    |       | —     |       | 546        |       |
| Deferred compensation                                                              |       | 290        |       | 290        |       |
| Purchase of  securities under agreement to resell                                  |       | 6,569      |       | —     |       |
| Purchases of  fixed-maturity securities-trading                                    |       | (86,369    | )          | —     |       |
| Proceeds from  sales of fixed-maturity securities- trading                         |       | 28,416     |       | —     |       |
| Securities sold  under agreement to repurchase                                     |       | 45,474     |       | —     |       |
|                                                                               |       |       |       |       |       |
| Changes in  assets and liabilities:                                                |       |       |       |       |       |
| Income taxes  payable                                                              |       | 1,800      |       | 150        |       |
| Deferred income  tax expense                                                       |       | 1,092      |       | 3,409      |       |
| Prepaid  reinsurance premiums                                                      |       | 17         |       | 122        |       |
| Derivative  liabilities                                                            |       | (684       | )          | 16,674     |       |
| Accrued expenses  and other liabilities                                            |       | (17,532    | )          | (7,490     | )          |
| Deferred policy  acquisition costs                                                 |       | (437       | )          | (693       | )          |
| Unearned premium  reserve                                                          |       | (256       | )          | (23,954    | )          |
| Loss and loss  adjustment expenses                                                 |       | 1,995      |       | 1,695      |       |
| Interest payable                                                                   |       | (1,636     | )          | 637        |       |
| Interest  receivable                                                               |       | 458        |       | (1,164     | )          |
| Other                                                                              |       | (1,422     | )          | 6,104      |       |
| Net cash  provided by operating activities                                         |       | 1,624      |       | 8,292      |       |
|                                                                               |       |       |       |       |       |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                             |       |       |       |       |       |
| Net deposit of  restricted cash                                                    |       | (3,160     | )          | (4,026     | )          |
| Purchases of  fixed maturity securities available for sale                         |       | (251,053   | )          | (247,905   | )          |
| Proceeds from  sales of fixed maturity securities available for sale               |       | 57,140     |       | 59,226     |       |
| Proceeds from  maturities of fixed maturity securities available for sale          |       | 271,245    |       | 232,267    |       |
| Net purchase of  property and equipment                                            |       | (401       | )          | (197       | )          |
| Net cash  provided by investing activities                                         |       | 73,771     |       | 39,365     |       |
|                                                                               |       |       |       |       |       |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                             |       |       |       |       |       |
| Proceeds from  issuance of commercial paper—net                               |       | 1,154      |       | 1,001      |       |
| Paydown on  long-term debt                                                         |       | (30,678    | )          | (39,298    | )          |
| Payment of  issuance costs for debt                                                |       | —     |       | (154       | )          |
| Proceeds from  exercise of common stock                                            |       | 411        |       | —     |       |
| Offering costs                                                                     |       | (161       | )          | —     |       |
| Net cash used in  financing activities                                             |       | (29,274    | )          | (38,451    | )          |
| NET INCREASE IN CASH  AND CASH EQUIVALENTS                                         |       | 46,121     |       | 9,206      |       |
|                                                                               |       |       |       |       |       |
| CASH AND CASH  EQUIVALENTS—beginning of period                                |       | 379,905    |       | 174,420    |       |
| CASH AND CASH  EQUIVALENTS—end of period                                      |       | $          | 426,026    |       | $          | 183,626 |   |
|                                                                               |       |       |       |       |       |
| SUPPLEMENTAL CASH FLOW  DISCLOSURES:                                               |       |       |       |       |       |
| Federal and  local income taxes paid                                               |       | $          | 3,076      |       | $          | 3,108 |   |
| Interest paid                                                                      |       | $          | 78,043     |       | $          | 65,782 |   |

 

See notes to unaudited condensedconsolidated financial statements.

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**ACACAPITAL HOLDINGS, INC. AND SUBSIDIARIESNOTES TO UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTSMARCH 31, 2007**

**1.  BUSINESS, ORGANIZATION ANDOPERATIONS**

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 public finance capital markets, as wellas providing asset management services. The Company’s principal activities include financial guaranty insuranceof public finance obligations, structured credit risk assumption throughinsured credit derivatives and collateralized debt obligation assetmanagement.  ACA conducts its businessthrough three principal wholly-owned indirect subsidiaries.  Its financial guaranty insurance business isconducted through ACA Financial Guaranty Corporation (“ACA Financial Guaranty”),a Maryland domiciled insurance company. ACA Financial Guaranty is licensed to conduct financial guarantyinsurance business, which provides credit enhancement on public finance andother debt obligations, in all 50 states, the District of Columbia, Guam, theU.S. Virgin Islands and Puerto Rico. Standard & Poor’s Rating Services (“S&P”) has assigned afinancial strength rating of “A” to ACA Financial Guaranty.  ACA Financial Guaranty also provides thecredit support for the Company’s Structured Credit business activities.  The Company conducts its CDO Asset Managementbusiness primarily through ACA Service L.L.C. and ACA Management, L.L.C.  This business encompasses the origination (incollaboration with investment banks), structuring and management ofcollateralized debt obligations (including collateralized loan obligations andother similarly securitized asset 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’s business is composed of three distinctcontinuing lines of business or segments. They are Public Finance, Structured Credit and CDO AssetManagement.  A fourth line of business,Other, includes business in areas and markets in which the Company is no longeractive.  Although the Public Finance andStructured Credit businesses are reported in separate segments, together theyform the Company’s financial guaranty insurance business.  Public Finance primarily provides financialguaranty insurance policies guaranteeing the timely payment of scheduledprincipal and interest on public finance and other debt obligations.  Structured Credit structures and sells creditprotection, principally in the form of insured credit default swaps (“CDS”),against a variety of asset classes in the institutional fixed incomemarkets.  CDO Asset Management focuses onCDO origination, structuring and management. The Company will at times assume risk in the CDOs it manages throughinvestment in some portion of the capital structure.

ACA was originally incorporated in Delaware onJanuary 3, 1997.  OnNovember 22, 2002, ACA changed its jurisdiction of incorporation fromDelaware to Bermuda.  During 2004, theBoard of Directors determined that re-domesticating to Delaware would eliminatecertain adverse consequences of remaining in Bermuda, facilitate ACA’s accessto U.S. capital markets, simplify its tax filings, accounting and operations,and reduce the costs of compliance with two sets of filing obligations and laws(as ACA stockholders are U.S. entities and individuals).  On September 15, 2004, therefore, ACAre-domesticated from Bermuda to Delaware through a process called a “discontinuation”under Bermuda law and “domestication” under Delaware law. As a result, itbecame a Delaware domiciled holding company and changed its name from AmericanCapital Access Holdings, Ltd. to its current name.

On November 9, 2006, the Company priced itsinitial public offering of 6,875,000 shares of newly issued common stock and23,541 shares of existing common stock. The Company realized gross proceeds of $13 per share on the newly issuedcommon stock, or $89.4 million.  Netproceeds to the Company were $79.2 million, after issuance costs.  On November 10, 2006, the Company’scommon stock commenced trading on the New York Stock Exchange under the symbol “ACA.” In conjunction with the initial public offering, the Company’s seniorconvertible preferred stock, convertible preferred stock and series B seniorconvertible preferred stock all converted to common stock concurrently with theclosing of our offering on November 15, 2006 at their conversion ratios of6,000:1 shares, 6,000:1 shares and 6:1 shares, respectively.

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**2.  SUMMARY OF SIGNIFICANTACCOUNTING POLICIES**

These unaudited condensed consolidated financialstatements have been prepared pursuant to the rules and regulations of theSecurities and Exchange Commission (“SEC”) regarding interim financialreporting.  Accordingly, they do notinclude all of the information and footnotes required by accounting principlesgenerally accepted in the United States of America (“GAAP”) for completefinancial statements and should be read in conjunction with the Company’sAnnual Report on Form 10-K for the year ended December 31, 2006 (“Form10-K”), filed with the SEC on April 2, 2007. These unaudited condensed consolidated financial statements include alladjustments, consisting only of normal recurring adjustments, that we consider necessaryfor the fair presentation of our financial position and results of operationsfor these periods.  The preparation offinancial statements in conformity with GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting periods.  Actualresults could differ from those estimates. Operating results for the three months ended March 31, 2007 are notnecessarily indicative of the results that may be expected for the year endedDecember 31, 2007.

In August 2006, the Company’sBoard of Directors authorized a dividend of stock in order to effect asix-for-one stock split.  All prior shareand per share amounts have been restated to reflect the stock split.

**3.  RELEVANT RECENT ACCOUNTINGPRONOUNCEMENTS**

On April 18, 2007, the FinancialAccounting Standards Board (“FASB”) released an exposure draft entitled “*Accounting for Financial Guarantee Contracts—an interpretation of FASBStatement No. 60*” (the “Proposed Statement”).  While FASB Statement No. 60, “*Accounting and Reporting by Insurance Enterprises*,” sets outaccounting standards for property and casualty and life insurance enterprises,it has historically not specifically considered financial guarantyinsurance.  This new interpretation isintended to address the specific attributes of this type of insurance.  The principal items addressed in the exposuredraft relate to revenue recognition, the establishment of claim reserves anddisclosures around such reserves.  The ProposedStatement would be effective for financial statements issued for fiscal yearsbeginning after December 31, 2007. While certain provisions of the Proposed Statementare still being analyzed, management believes that the cumulative effect ofinitially applying the Proposed Statement could be material to our financialstatements. Until the final interpretation is issued by the FASB, the Companycontinues to apply the accounting policies as disclosed in its Form 10-K.

In February 2007,the FASB issued Financial Accounting Standard (“FAS”) 159, “*The Fair Value Option for Financial Assets and Financial Liabilities*”(“FAS 159”).  FAS 159 permits reporting entities to chooseto remeasure many financial instruments and certain other items at fair valuethat are not currently required to be measured at fair value.  The fair value option may be appliedinstrument by instrument, is irrevocable and is applied only to entire instrumentsand not to portions of instruments.  FAS159 also establishes presentation and disclosure requirements designed tofacilitate comparisons between entities that choose different measurementattributes for similar types of assets and liabilities. FAS 159 is effectivefor fiscal years that begin after November 15, 2007.  Early adoption is permitted as of thebeginning of a fiscal year that begins on or before November 15, 2007provided that the entity also elects to apply the provisions of FAS 157, whichare described above.  This early adoptionelection must be made within 120 days of the beginning of the fiscal year ofadoption provided the entity has not yet issued interim period financialstatements.  Management is currentlyevaluating the potential impact, if any, which the adoption of FAS 159 willhave on the Company’s financial statements.

On January 1, 2007, theCompany adopted FAS 155, “*Accounting for CertainHybrid Financial Instruments*” (“FAS 155”), an amendment ofFAS 133, *“Accounting for Derivative Instruments andCertain Hedging Activities”* (“FAS 133”) and FAS 140, “*Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities*” (“FAS 140”).  The implementation of this statement did nothave a material impact on the Company’s financial statements.

On January 1, 2007, theCompany adopted FASB Interpretation No. (“FIN”) 48, “*Accounting forUncertainty in Income Taxes—an Interpretation of FASB Statement No. 109*”(“FIN 48”). The adoption of FIN 48 resulted in a decrease to stockholders’equity as of January 1, 2007 of $1.5 million (see Note 6).

8

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.

In September 2006,the FASB issued FAS 157, “*Fair ValueMeasurements*” (“FAS 157”). FAS 157 enhances existing guidance for measuring assets and liabilitiesusing fair value, such as emphasizing that fair value is a market-basedmeasurement, not an entity-specific measurement, and sets out a fair valuehierarchy with the highest priority being quoted prices in active markets.  FAS 157 is effective for financial statementsissued for fiscal years beginning after November 15, 2007, and interimperiods within those fiscal years. Management is currently evaluating the potential impact, if any, whichthe adoption of FAS 157 will have on the Company’s financial statements.

In September 2006,the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”), “*Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in Current Year Financial Statements*,”which provides interpretive guidance on how the effects of the carryover orreversal of prior year misstatements should be considered in quantifying acurrent year misstatement.  Theprovisions of SAB 108 were put in effect at December 31, 2006.  The adoption of this statement did not have amaterial impact on the Company’s financial statements.

In April 2006, theFASB issued Staff Position (“FSP”) FIN 46(R)-6, “*Determining the Variability to Be Considered inApplying FASB Interpretation No. 46(R)*”  (“FSP FIN 46(R)-6”),FSP FIN 46(R)-6 addresses whether certain arrangements associated withvariable interest entities (VIEs) should be treated as variable interests orconsidered as creators of variability, and indicates that the variability to beconsidered shall be on based on an analysis of the design of the entity. FSPFIN 46(R)-6 was adopted on June 15, 2006.  The adoption of this statement did not have amaterial impact on the Company’s financial statements.

In March 2006, theFASB issued FAS 156, “*Accounting forServicing of Financial Assets*” (“FAS 156”), an amendment of FAS140.  FAS 156 requires that allseparately recognized servicing assets and servicing liabilities be initiallymeasured at fair value, if practicable, and permits for subsequent measurementusing either fair value measurement with changes in fair value reflected inearnings or the amortization and impairment requirements of FAS 140.  The subsequent measurement of separatelyrecognized servicing assets and servicing liabilities at fair value eliminatesthe necessity for entities that manage the risks inherent in servicing assetsand servicing liabilities with derivatives to qualify for hedge accountingtreatment and eliminates the characterization of declines in fair value asimpairments or direct write-downs. FAS 156 is effective for an entity’s first fiscal year beginningafter September 15, 2006.  Theimplementation of this statement did not have a material impact on theCompany’s financial statements.

In September 2005,Statement of Position (“SOP”) 05-1, “*Accounting by InsuranceEnterprises for Deferred Acquisition Costs in Connection With Modifications orExchanges of Insurance Contracts*”, (“SOP 05-1”), wasissued.  This SOP provides guidance onaccounting by insurance enterprises for deferred acquisition costs on internalreplacement of insurance and investment contracts other than those specificallydescribed in FAS No. 97, “*Accounting and Reportingby Insurance Enterprises for Certain Long-Duration Contracts and for RealizedGains and Losses from the Sale of Investments*”.  SOP 05-01 is effective for internalreplacements occurring in fiscal years beginning after December 15,2006.  The adoption of this SOP did nothave a material impact on the Company’s financial statements.

**4.  CDO ASSET MANAGEMENTBUSINESS**

One of the ways the Companyparticipates in the structured finance market is through structuring andmanaging CDOs originated in collaboration with investment banks.  CDOs can be issued in funded, unfunded orpartially funded form.  Funded CDOs issuedebt instruments and purchase investment assets, while unfunded CDOssynthetically acquire assets and issue liabilities (i.e., assets andliabilities are in derivative form). Partially funded CDOs are a combination ofthese two forms.  From an accountingperspective, funded and partially funded CDOs are determined to be VIEs.  Each time such CDOs are formed, the Companyperforms an analysis to determine whether it is the primary beneficiary andthus required to consolidate the CDO under the provisions of FSPFIN 46(R)-6.

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The following table lists each ofthe Company’s CDOs outstanding as of March 31, 2007 (dollars in millions):
| ** **                      | ** ** | **Year**   | ** ** | ** **        | ** ** | ** **                        | ** ** | ** **                  | ** ** | ** **       | ** ** | **Original**             | ** ** | ** **        | ** ** | **First**             | ** ** | ** **   | ** ** |
|---------------------------------|------------|------------|------------|-------------------|------------|-----------------------------------|------------|-----------------------------|------------|------------------|------------|--------------------------|------------|-------------------|------------|-----------------------|------------|--------------|------------|
| ** **                      | ** ** | **Deal**   | ** ** | **Transaction**   | ** ** | ** **                        | ** ** | **Notional**                | ** ** | ** **       | ** ** | **Investment in**   | ** ** | **Retained**      | ** ** | **Optional**          | ** ** | **Maturity** | ** ** |
| **CDO name**               | ** ** | **Closed** | ** ** | **Type**          | ** ** | **Collateral Type (1)** | ** ** | **Deal Size (3)** | ** ** | **Consolidated** | ** ** | **Retained Equity** | ** ** | **Equity %** | ** ** | **Call Date(4)** | ** ** | **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       |       |
| ACA ABS 2007-1                  |       | 2007       |       | Partially  funded |       | Investment  Grade                 |       | 1,500                       |       | No               |       | 1.4                      |       | 5                 |       | 3/2010                |       | 5/2047       |       |
| Millbrook                       |       | 2007       |       | Unfunded          |       | Investment  Grade                 |       | 62                          |       | No               |       | —                   |       | —            |       | 3/2010                |       | 10/2052      |       |
| **Total Asset-Backed CDOs**     |       |       |       |              |       |                              |       | 13,204                      |       |             |       | 133.8                    |       |              |       |                  |       |         |       |
|                            |       |       |       |              |       |                              |       |                        |       |             |       |                     |       |              |       |                  |       |         |       |
| **Corporate  Credit CDOs:**     |       |       |       |              |       |                              |       |                        |       |             |       |                     |       |              |       |                  |       |         |       |
| 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                 |       | 67                          | (2)        | No               |       | —                   |       | —            |       | N/A                   |       | 6/2015       |       |
| Argon 57                        |       | 2006       |       | Funded            |       | Investment  Grade                 |       | 67                          | (2)        | No               |       | —                   |       | —            |       | N/A                   |       | 6/2013       |       |
| Tribune                         |       | 2006       |       | Unfunded          |       | Investment  Grade                 |       | 356                         | (5)        | No               |       | —                   |       | —            |       | N/A                   |       | 9/2016       |       |
| Dolomite                        |       | 2007       |       | Unfunded          |       | Investment  Grade                 |       | 66                          | (2)        | No               |       | —                   |       | —            |       | N/A                   |       | 7/2014       |       |
| **Total Corporate Credit CDOs** |       |       |       |              |       |                              |       | 2,556                       |       |             |       | 47.0                     |       |              |       |                  |       |         |       |
|                            |       |       |       |              |       |                              |       |                        |       |             |       |                     |       |              |       |                  |       |         |       |
| **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**                       | ** ** | ** ** | ** ** | ** **        |       |                              |       | **$**                       | **16,710** |             |       |                     | **$**      | **188.0**         |       | ** **            |       |         |       |   |   |

 

Note:As of March 27, 2007, the Company’s risk under corporate credit CDO ACA CDS2001-1 expired.

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

(2)             The original notional deal sizes for Argon 49and Argon 57 were € 50 million each, and that for Dolomite was €49 million and $1 million. For purposes of this chart, we have convertedthe amounts to U.S. dollars at the prevailing currency exchange rate onMarch 31, 2007.

(3)             Notional deal size is defined as totalliabilities at the deal’s inception.

(4)             Cash flow CDOs are generally callable once perquarter 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.

(5)             Tribune is comprised of 13 distinct tradessome of which are denominated in Euros or Yen. For purposes of this chart, we have converted this amount to U.S.dollars at the prevailing currency exchange rates on March 31, 2007.

As of March 31, 2007 and December 31,2006, consolidated liabilities include non-recourse debt from consolidated CDOsof $4,683.4 million and $4,711.8 million, respectively.  Also, as of March 31, 2007 andDecember 31, 2006, investments include CDO related fixed maturitysecurities and guaranteed investment contracts of $4,447.5 million and$4,656.0 million, respectively, and cash of $333.9 and $265.0 million,respectively.

**5.  NET INSURED CREDIT SWAPREVENUE AND OTHER NET CREDIT SWAP REVENUE**

Net insured credit swap revenueincludes insured credit swap premiums received for credit protection theCompany has sold under its insured credit swaps as well as realized andunrealized gains and losses related to those transactions.  Realizedlosses arise upon the occurrence of credit events requiring payment by theCompany under the related credit swap and, additionally, realized gains orlosses could occur if a transaction is terminated in advance of its scheduledtermination date.  Unrealized gains and losses represent the adjustmentsfor changes in fair value that are recorded in each reporting period, under FAS133.  The fair value of the Company’s insured credit swaps are recorded aseither a derivative liability or derivative asset in the consolidated balancesheets.

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The following table disaggregatesnet insured credit swap revenue into its component parts for the three monthsended March 31, 2007 and 2006: 
|                                                   | ** ** | **Three months ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|
| ** **                                        | ** ** | **March 31,**               | ** ** |
| ** **                                        | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| ** **                                        | ** ** | **(in thousands)**          | ** ** |
| Net insured  credit swap revenue                  |       |                             |       |   |   |
| Insured credit swap premiums earned               |       | $                                | 18,762     |   | $ | 10,064 |   |
| Unrealized gains (losses) on insured credit swaps |       | (15,063                          | )          | 3,895 |   |
| Realized gains on insured credit swaps            |       | —                           |       | 221 |   |
| Total net insured  credit swap revenue            |       | $                                | 3,699      |   | $ | 14,180 |   |

 

Other net credit swap revenueincludes revenues received from a partially funded CDS CDO which sells creditprotection under credit swaps for which it receives fixed quarterly fees aswell as the residual returns on two synthetic equity participations. Other net credit swap revenue also includes net realized and unrealized gainsand losses associated with these transactions, if any.  These revenues areincluded in the Company’s consolidated statement of operations.

The following table disaggregatesother net credit swap revenue into its component parts for the three monthsended March 31, 2007 and 2006:
|                                      | ** ** | **Three months ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|
| ** **                           | ** ** | **March 31,**               | ** ** |
| ** **                           | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| ** **                           | ** ** | **(in thousands)**          | ** ** |
| Other net credit  swap revenue       |       |                             |       |   |   |
| Credit swap fees earned              |       | $                                | 4,168      |   | $ | 2,719 |   |
| Unrealized gains on credit swaps     |       | 8,138                            |       | 194 |   |
| Total other net credit  swap revenue |       | $                                | 12,306     |   | $ | 2,913 |   |

 

**6.  INCOME TAXES**

Effective January 1, 2007, the Company adopted theprovisions of FIN 48.  As a result of theimplementation of FIN 48, the Company recorded a $1.5 million reserve foruncertain tax positions and a corresponding decrease to the 2007 openingretained earnings.  The Company’seffective tax rate would be increased if $1.5 million of unrecognized taxexpense were recognized.  It is unlikelythat the unrecognized tax expense will significantly change in the next 12months.

The Company files income tax returns in the U.S.federal jurisdiction, and various states and foreign jurisdictions.  With few exceptions, the Company is no longersubject to U.S. federal, state and local, or non-U.S. income tax examinationsby tax authorities for years before 2003.

The Company records interest and penalties related tounrecognized tax benefits in income taxes. $470,000 in accrued interest and penalties is included in the $1.5million reserve for uncertain tax positions related to our adoption of FIN 48.

Our tax provision for interim periods is determinedusing an estimate of our annual effective tax rate.  The 2007 effective tax rate is estimated tobe lower than the 35% statutory rate primarily due to the Company’s investmentin securities exempt from federal income tax.

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**7.  LITIGATION**

In May 2006, the Companypaid a judgment in the amount of $3.7 million in satisfaction of a damagesaward in connection with an employment contract dispute with a former executiveof the Company plus accrued interest through the date of payment.  Also in May 2006, the Company settledthe former executive’s attorney’s fees at an additional amount of$0.6 million.  The Company hadrecorded a reserve of $4.2 million to cover these costs inDecember 2005.  A judicialsatisfaction of the judgment has been filed and the Company has no additionalliability with respect to this matter.

The Company is not aware of anypending or threatened litigation that it believes could reasonably be likely toresult in a material adverse effect on the Company’s financial position,results of operations or cash flows.

**8.  SEGMENT INFORMATION**

The Company’s reportable segmentsare as follows:

(1)          Structured Credit, which structures and sells credit protection, principally inthe form of insured CDS, against a variety of asset classes in theinstitutional fixed income markets;

(2)          Public Finance, which provides insurance guaranteeing the timely payment ofprincipal and interest on public finance and other debt obligations;

(3)          CDO Asset Management, which originates, structures and manages assets,primarily corporate obligations or asset-backed securities, in funded,partially funded or synthetic CDOs; and

(4)          Other, which primarily includes trade credit insurance business and financialguaranty insurance on certain other sectors, each of which the Company is nolonger engaged in.

The Company’s reportable segmentsare strategic business units that offer different products and services.  They are managed separately since eachbusiness requires different marketing strategies, personnel skill sets andtechnology.

Where determinable, the Companyspecifically assigns assets to each segment, otherwise, the Company allocatesassets based on estimates.  In general,allocation percentages for assets are determined based on each line’s estimatedcapital utilization from a rating agency perspective.

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The accounting policies of thesegments are the same as those described in the summary of significantaccounting policies.  The Companyevaluates segment performance based on its income (loss) before incometaxes.  Reportable segment results arepresented net of material inter-segment transactions.  The following tables summarize the Company’soperations and allocation of assets as of and for the three months endedMarch 31, 2007 and 2006 (dollars in thousands):
| ** **                                                   | ** ** | **Three months ended March 31, 2007** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **Structured**                                                 | ** ** | **Public** | ** ** | **CDO Asset** | ** ** | ** ** | ** ** | **Consolidated** | ** ** |
| ** **                                                   | ** ** | **Credit**                                                     | ** ** | **Finance** | ** ** | **Management** | ** ** | **Other** | ** ** | **Totals** | ** ** |
| REVENUES:                                                    |       |                                                           |       |   |   |   |   |   |   |   |   |
| Gross premiums written                                       |       | $                                                              | 87         |   | $ | 4,672 |   | $ | — |   | $ | 282 |   | $ | 5,041 |   |
|                                                         |       |                                                           |       |   |   |   |   |   |   |   |   |
| Premiums earned                                              |       | $                                                              | 87         |   | $ | 4,878 |   | $ | — |   | $ | 184 |   | $ | 5,149 |   |
| Net insured credit swap revenue                              |       | 4,645                                                          |       | 1,146 |   | (2,092 | ) | — |   | 3,699 |   |
| Net investment income                                        |       | 5,745                                                          |       | 4,277 |   | 78,846 |   | 1,052 |   | 89,920 |   |
| Net realized and unrealized losses on investments            |       | (1,512                                                         | )          | (29 | ) | (2,160 | ) | (7 | ) | (3,708 | ) |
| Net realized and unrealized gains on derivative  instruments |       | (4                                                             | )          | — |   | 2,084 |   | — |   | 2,080 |   |
| Other net credit swap revenue                                |       | (37                                                            | )          | — |   | 12,343 |   | — |   | 12,306 |   |
| Fee and other income                                         |       | 115                                                            |       | 91 |   | 6,182 |   | — |   | 6,388 |   |
| Total revenues                                               |       | 9,039                                                          |       | 10,363 |   | 95,203 |   | 1,229 |   | 115,834 |   |
|                                                         |       |                                                           |       |   |   |   |   |   |   |   |   |
| EXPENSES:                                                    |       |                                                           |       |   |   |   |   |   |   |   |   |
| Loss and loss adjustment expenses                            |       | —                                                         |       | 1,025 |   | — |   | 348 |   | 1,373 |   |
| Policy acquisition costs                                     |       | —                                                         |       | 1,463 |   | — |   | 14 |   | 1,477 |   |
| Other operating expenses                                     |       | 6,290                                                          |       | 2,907 |   | 6,945 |   | 11 |   | 16,153 |   |
| Interest expense                                             |       | 3,290                                                          |       | 386 |   | 72,640 |   | 92 |   | 76,408 |   |
| Depreciation and amortization                                |       | 138                                                            |       | 114 |   | 2,007 |   | — |   | 2,259 |   |
| Total expenses                                               |       | 9,718                                                          |       | 5,895 |   | 81,592 |   | 465 |   | 97,670 |   |
| Income of  minority interest                                 |       | 83                                                             |       | — |   | (962 | ) | — |   | (879 | ) |
| Income before income taxes                                   |       | (596                                                           | )          | 4,468 |   | 12,649 |   | 764 |   | 17,285 |   |
| Provision for income tax expense                             |       | (202                                                           | )          | 1,517 |   | 4,294 |   | 259 |   | 5,868 |   |
| Net income                                                   |       | $                                                              | (394       | ) | $ | 2,951 |   | $ | 8,355 |   | $ | 505 |   | $ | 11,417 |   |
|                                                         |       |                                                           |       |   |   |   |   |   |   |   |   |
| Segment Assets                                               |       | $                                                              | 351,608    |   | $ | 552,466 |   | $ | 4,984,141 |   | $ | 120,240 |   | $ | 6,008,455 |   |

 
| ** **                                                   | ** ** | **Three months ended March 31, 2006** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **Structured**                                                 | ** ** | **Public** | ** ** | **CDO Asset** | ** ** | ** ** | ** ** | **Consolidated** | ** ** |
| ** **                                                   | ** ** | **Credit**                                                     | ** ** | **Finance** | ** ** | **Management** | ** ** | **Other** | ** ** | **Totals** | ** ** |
| REVENUES:                                                    |       |                                                           |       |   |   |   |   |   |   |   |   |
| Gross premiums written                                       |       | $                                                              | 278        |   | $ | 4,082 |   | $ | — |   | $ | 428 |   | $ | 4,788 |   |
|                                                         |       |                                                           |       |   |   |   |   |   |   |   |   |
| Premiums earned                                              |       | $                                                              | 296        |   | $ | 4,177 |   | $ | — |   | $ | 409 |   | $ | 4,882 |   |
| Net insured credit swap revenue                              |       | 12,740                                                         |       | 662 |   | 778 |   | — |   | 14,180 |   |
| Net investment income                                        |       | 852                                                            |       | 3,871 |   | 72,095 |   | 894 |   | 77,712 |   |
| Net realized and unrealized losses on investments            |       | (136                                                           | )          | (736 | ) | (926 | ) | (169 | ) | (1,967 | ) |
| Net realized and unrealized gains on derivative  instruments |       | —                                                         |       | — |   | 3,642 |   | — |   | 3,642 |   |
| Other net credit swap revenue                                |       | (14                                                            | )          | — |   | 2,927 |   | — |   | 2,913 |   |
| Fee and other income                                         |       | 130                                                            |       | 98 |   | 3,941 |   | — |   | 4,169 |   |
| Total revenues                                               |       | 13,868                                                         |       | 8,072 |   | 82,457 |   | 1,134 |   | 105,531 |   |
|                                                         |       |                                                           |       |   |   |   |   |   |   |   |   |
| EXPENSES:                                                    |       |                                                           |       |   |   |   |   |   |   |   |   |
| Loss and loss adjustment expenses                            |       | —                                                         |       | 1,376 |   | — |   | 645 |   | 2,021 |   |
| Policy acquisition costs                                     |       | —                                                         |       | 1,272 |   | — |   | 120 |   | 1,392 |   |
| Other operating expenses                                     |       | 3,917                                                          |       | 2,112 |   | 4,584 |   | — |   | 10,613 |   |
| Interest expense                                             |       | 83                                                             |       | 403 |   | 65,848 |   | 85 |   | 66,419 |   |
| Depreciation and amortization                                |       | 206                                                            |       | 188 |   | 2,098 |   | — |   | 2,492 |   |
| Total expenses                                               |       | 4,206                                                          |       | 5,351 |   | 72,530 |   | 850 |   | 82,937 |   |
| Income of minority interest                                  |       | —                                                         |       | — |   | (1,155 | ) | — |   | (1,155 | ) |
| Income before  income taxes                                  |       | 9,662                                                          |       | 2,721 |   | 8,772 |   | 284 |   | 21,439 |   |
| Provision for income tax expense                             |       | 3,286                                                          |       | 925 |   | 2,984 |   | 97 |   | 7,292 |   |
| Net income                                                   |       | $                                                              | 6,376      |   | $ | 1,796 |   | $ | 5,788 |   | $ | 187 |   | $ | 14,147 |   |
|                                                         |       |                                                           |       |   |   |   |   |   |   |   |   |
| Segment Assets                                               |       | $                                                              | 43,914     |   | $ | 454,213 |   | $ | 5,167,487 |   | $ | 95,582 |   | $ | 5,761,196 |   |

 

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**9.  STOCK PLANS AND STOCK BASEDCOMPENSATION**

In 2001, the Company adopted theAmerican Capital Access Holdings, Incorporated Omnibus Incentive CompensationPlan (the “Prior Plan”) under which 2,188,584 shares of the Company’s commonshares were reserved for issuance to employees, directors and consultants.  In 2003, the Company’s Board of Directorsapproved the increase of the number of shares reserved for issuance by72,954.  In 2004, the Board of Directorsapproved the ACA Capital 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 previously distributedunder the Prior Plan) to 4,241,538.  InAugust 2006, the Board of Directors approved the Amended and Restated 2006Stock Incentive Plan, to become effective upon completion of the IPO (the “2006Plan”) which increased the total options available under the 2006 Plan,including all shares subject to existing awards thereunder pursuant to thePrior Plan and the 2004 Plan, to 6,327,972. The 2006 Plan became effective November 9, 2006.  The 2006 Plan permits the grant ofnonqualified and qualified stock options, incentive stock options, restrictedstock, stock units, unrestricted stock, dividend equivalent and cash-basedawards.  The objectives of the 2006 Planare to optimize the profitability and growth of the Company through annuallong-term incentives that are consistent and linked with the Company’s goals.

Unless otherwise providedby the Company, depending upon which version of plan the options were grantedunder, each option vests ratably either annually over 3 years or every 6 monthsover 31¤2 years, beginning at the date of grant.

On September 30, 2004, theCompany granted 335,214 restricted shares at a fair market value of $10.38 pershare, to the Company’s president and chief executive officer (the “Executive”).  The total value at the grant date of therestricted stock totaled $3.5 million. The restricted stock vests one-third per year over a three-year periodprovided the Executive has been continuously employed by the Company or asubsidiary throughout the applicable vesting period.  In both the first three months of 2007 and2006, the vested portion of the restricted stock totaled $0.3 million, whichwas recognized in the Company’s consolidated statement of operations.

In December 2004, the FASBissued FAS 123(R), “*Shared Based Payments*”(“FAS 123(R)”) that requires compensation cost related to share-based paymenttransactions to be recognized in an issuer’s financial statements.  The compensation cost, with limitedexceptions, is measured based on the grant-date fair value of the equity or liabilityinstrument issued.  FAS 123(R) replacesFAS 123, “*Accounting for Stock Based Compensation”*(“FAS 123”) and supersedes Accounting Principles Board (“APB”) Opinion No. 25,“*Accounting for Stock Issue to Employees*”(“APB 25”).

Effective January 1, 2006,the Company adopted FAS 123(R) using the prospective application aspermitted by FAS 123(R).  Under thisapplication, we are required to record compensation expense for all awardsgranted after the date of adoption. Awards granted prior to the date of adoption of FAS 123(R) continueto be accounted for under APB 25. Compensation cost is recognized over the periods that an employeeprovides service in exchange for the award. The Company recordedstock-based compensation expense of $1.1 million and $0.2 million for the threemonths ended March 31, 2007 and 2006, respectively, $0.1 million and $0 millionof which, respectively, was deferred related to policy acquisition costs. TheCompany recorded a tax benefit of $0.4 million and $0.1 million forthe three months ended March 31, 2007 and 2006, respectively.

The fair value of the stockoptions granted was estimated on the date of grant using a Black-Scholes optionvaluation model that uses the assumptions noted in the following table.  The risk-free rate is based on the U.S.Treasury yield curve in effect at the time of grant.  The expected term (estimated period of timeoutstanding) of the stock options granted was estimated using the simplifiedmethod, in which the expected

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term equals the average of the graded vesting term andthe contractual term.  Expectedvolatility was estimated based on the historical volatility of comparablepublic companies for a period equal to the stock option’s expected term, endingon the day of grant, and calculated on a monthly basis.
| ** **               | ** ** | **March 31,** | ** ** | **March 31,** | ** ** |
|--------------------------|------------|--------------------|------------|--------------------|------------|
| ** **               | ** ** | **2007**           | ** ** | **2006**           | ** ** |
| Expected life  (years)   |       | 6.00               |       | 6.00               |       |
| Risk free  interest rate |       | 4.71               | %          | 4.55               | %          |
| Volatility               |       | 25.00              | %          | 25.00              | %          |
| Dividend yield           |       | 0.00               | %          | 0.00               | %          |

 

Utilizing these assumptions, theweighted-average per-share fair value of stock options granted in the firstthree months of 2007 and 2006 was $5.19 and $4.45, respectively.

A summary of option activity forthe three months ended March 31, 2007 and 2006 is as follows:
|                                   | ** ** | **2007**     | ** ** | **2006**                                                   | ** ** |
|-----------------------------------|------------|--------------|------------|------------------------------------------------------------|------------|
| ** **                        | ** ** | **Activity** | ** ** | **Weighted  Average  Exercise Price  Per Share** | ** ** | **Activity** | ** ** | **Weighted  Average  Exercise Price  Per Share** | ** ** |
| Outstanding,  beginning of period |       | 3,897,048    |       | $                                                          | 11.50      |   | 3,042,306 |   | $ | 10.53 |   |
| Granted                           |       | 448,000      |       | $                                                          | 14.63      |   | 1,017,000 |   | $ | 12.66 |   |
| Exercised                         |       | (39,480      | )          | $                                                          | 10.41      |   | — |   | — |   |
| Forfeited                         |       | (98,226      | )          | $                                                          | 12.16      |   | (26,538 | ) | $ | 10.64 |   |
| Expired                           |       | —       |       | —                                                     |       | — |   | — |   |
| Outstanding, end  of period       |       | 4,207,342    |       | $                                                          | 11.83      |   | 4,032,768 |   | $ | 11.07 |   |
| Options vested, end of  period    |       | 2,119,783    |       | $                                                          | 11.05      |   | 2,031,336 |   | $ | 10.57 |   |

 

As of March 31, 2007, there was$9.1 million of total unrecognized compensation cost related to nonvestedshare-based compensation awards granted under our stock option plans.  This cost is expected to be recognized over aweighted average period of 3.16 years.

During the first quarter of 2007,the Company granted 106,500 shares of restricted stock.  As of March 31, 2007, the Company had 346,654shares of unvested restricted stock outstanding under the 2006 Plan. With theexception of 6,154 shares of restricted stock granted to certain independent directorsof the Company, which vest pro rata, annually over three years, these sharesvest pro-rata, annually over 4 years, as long as the grantee is still with theCompany.

The table summarizes informationregarding fully vested share options as of March 31, 2007:
| (Dollars in thousands, except per share amount) | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------|------------|------------|------------|
| Number of  options vested                                                     |       | 2,119,783  |       |
| Weighted average  exercise price per share                                    |       | $          | 11.05      |   |
| Aggregate  intrinsic value (excess market price over exercise price)          |       | $          | 23,430     |   |
| Weighted average  remaining contractual term of options (in years)            |       | 5.37       |       |

 

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The following table summarizesinformation concerning outstanding and exercisable options at March 31,2007:
|                                             | ** ** | **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** | ** ** |
|   $9.01-$10.51                    |       | 1,856,815                    |       | 5.48                         |       | $ | 10.33 |   | 1,403,105 |   | $ | 10.31 |   |
| $10.52-$12.01                               |       | 96,000                       |       | 7.87                         |       | $ | 11.63 |   | 55,453 |   | $ | 11.63 |   |
| $12.02-$13.51                               |       | 1,814,527                    |       | 8.16                         |       | $ | 12.70 |   | 661,225 |   | $ | 12.58 |   |
| $13.52-$15.01                               |       | 440,000                      |       | 9.77                         |       | $ | 14.63 |   | — |   | — |   |
|                                        |       | 4,207,342                    |       | 7.14                         |       | $ | 11.83 |   | 2,119,783 |   | $ | 11.05 |   |

 

Prior to the adoption of FAS123(R), the Company applied APB 25 to account for its stock-based compensationawards and provided the required pro forma disclosures of FAS 123.  The following table illustrates the effect onnet income and earnings per share had compensation expense for stock-basedcompensation awards been recorded in the three months ended March 31, 2007 and2006, based on the fair value method under FAS 123.
| ** **                                                                                                                                                        | ** ** | **Three months ended** | ** ** | **Three months ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| **(In thousands, except per share amounts)**                                                                                             | ** ** | **March 31, 2007**     | ** ** | **March 31, 2006**     | ** ** |
| Net income, as  reported                                                                                                                                          |       | $                                | 11,417     |                             | $          | 14,147 |   |
| 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 |       | (76                              | )          | (106                             | )          |
| Pro forma net  income                                                                                                                                             |       | $                                | 11,341     |                             | $          | 14,041 |   |
| Basic earnings  per share                                                                                                                                         |       |                             |       |                             |       |
| As reported                                                                                                                                                       |       | $                                | 0.31       |                             | $          | 0.62 |   |
| Pro forma                                                                                                                                                         |       | $                                | 0.31       |                             | $          | 0.62 |   |
| Diluted earnings  per share                                                                                                                                       |       |                             |       |                             |       |
| As reported                                                                                                                                                       |       | $                                | 0.31       |                             | $          | 0.47 |   |
| Pro forma                                                                                                                                                         |       | $                                | 0.31       |                             | $          | 0.47 |   |

 

**10.  INVESTMENTS**

The Company accounts for itsinvestments in fixed maturity securities in accordance with the FAS 115, “*Accounting for Certain Investments in Debt and EquitySecurities*” (“FAS 115”) and Emerging Issues Task Force (“EITF”)Issue  99-20, “*Recognition of InterestIncome and Impairment on Purchased and Retained Beneficial Interests inSecuritized Financial Assets.*” Management determines the appropriate classification of securities atthe time of purchase.  As ofMarch 31, 2007 and December 31, 2006, all investments in fixed maturitysecurities, with the exception of the Company’s investments in itsCredit-Focused Absolute Return Fixed Income Fund (the “Credit Fund”) (seeNote 11), were designated as available-for-sale and were carried at fairvalue.  Fixed maturity securities in theCompany’s Credit Fund are designated as trading securities and are also carriedat fair value.  The difference betweenfair value and amortized cost of available-for-sale securities is included inthe accumulated other comprehensive income component of stockholders’ equity,net of applicable deferred income tax. Changes in fair value of trading securities are included in netincome.  The fair value of thesesecurities is based on independent market quotations or, when such quotationsare not readily available because the securities are infrequently traded in thepublic market, from internal valuation models. These models include estimates, made by management, which utilizecurrent

16

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market information. The valuation results from these models could differ materially from amountsrealizable in an open market sale or exchange.

The Company’s process foridentifying declines in the fair value of investments that are other thantemporary involves consideration of several factors.  These factors include (i) the durationof a significant decline in value, (ii) the liquidity, business prospectsand overall 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 value 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.

The Company recognized$2.6 million and $0.9 million of other than temporary impairmentswithin the CDO VIE portfolio during the three months ended March 31, 2007 and2006, respectively.

The following table shows thegross unrealized losses and fair value of our fixed maturity securitiesavailable for sale with unrealized losses that are not deemed to be other-than-temporarilyimpaired, aggregated by investment category and length of time that individualsecurities have been in a continuous unrealized loss position, atMarch 31, 2007.
| ** **                                           | ** ** | **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                            |       | $                                      | 30,937     |                                 | $          | (532      | )          | $ | 1,840 |   | $ | (55 | ) | $ | 32,777 |   | $ | (587 | ) |
| Federal-agency  securities                           |       | 66,399                                 |       | (558                                 | )          | 4,478     |       | (69 | ) | 70,877 |   | (627 | ) |
| Obligations of  states and political subdivisions    |       | 6,353                                  |       | (46                                  | )          | 52,401    |       | (886 | ) | 58,754 |   | (932 | ) |
| Corporate  securities                                |       | 15,000                                 |       | (163                                 | )          | 55,770    |       | (1,937 | ) | 70,770 |   | (2,100 | ) |
| Asset-backed  securities                             |       | 949                                    |       | —                               |       | 5,350     |       | (61 | ) | 6,299 |   | (61 | ) |
| Mortgage-backed  securities                          |       | 28,058                                 |       | (217                                 | )          | 96,021    |       | (2,356 | ) | 124,079 |   | (2,573 | ) |
| Total non-VIE  securities                            |       | 147,696                                |       | (1,516                               | )          | 215,860   |       | (5,364 | ) | 363,556 |   | (6,880 | ) |
| Available for  sale-VIE—asset-backed securities |       | 2,069,566                              |       | (178,262                             | )          | 461,157   |       | (15,960 | ) | 2,530,723 |   | (194,222 | ) |
| Total available for  sale-non-VIE                    |       | $                                      | 2,217,262  |                                 | $          | (179,778  | )          | $ | 677,017 |   | $ | (21,324 | ) | $ | 2,894,279 |   | $ | (201,102 | ) |

 

The unrealized losses on thenon-VIE Company’s investments were generally caused by interest rateincreases.  Because the decline in marketvalue of these securities was attributable to changes in interest rates and notcredit quality, and because the Company has the ability and intent to holdthese investments until a recovery of fair value, which may be maturity, we donot consider these investments to be other-than-temporarily-impaired atMarch 31, 2007.

A substantial portion of theunrealized loss in VIE asset-backed securities is related to collateralizedresidential mortgage backed securities (“RMBS”), including both sub-prime andmid-prime quality mortgages.  The lastquarter of 2006 and first quarter of 2007 saw significant disruption andconsolidation in the sub-prime mortgage market, with some mortgage originatorsbeing purchased or exiting the business. This disruption translated intodecreased liquidity and wider spreads across the market, decreasing the marketvalue of the portfolios.  In particular,securities backed by mortgages from what are currently perceived as originatorswith weaker underwriting standards experienced a decrease in price in late 2006and the first quarter of 2007, even when the credit performance of thesecurities had not suffered.  Anadditional factor weighing on the market valuations for the Company’s positionsis the limited liquidity associated with the seasoned securities which havealready received or are about to receive a significant return ofprincipal.  Since the Company, atMarch 31, 2007, believed that it would be able to collect amounts due onits RMBS positions

17

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and has the ability and intent to hold these investmentsuntil a recovery of fair value, which may be at their maturities, we did notconsider these investments to be other-than-temporarily impaired atMarch 31, 2007.

Included above are 869 fixedmaturity securities, 166 in the non-VIE portfolios, and 703 in the VIEportfolios.  At March 31, 2007,there were 115 fixed maturity securities of whose amortized cost exceeded itsrespective fair value by greater than 20%. Over 99% of the securities in both the non-VIE portfolio and the VIE portfoliosare rated investment grade.  Managementhas assessed these and other factors and concluded that there were no otherthan temporarily impaired fixed maturity securities included in the above tableas of March 31, 2007.

**11.  CREDIT-FOCUSED ABSOLUTE RETURNFIXED INCOME FUND**

In May 2006, the Companylaunched the Credit Fund to leverage its expertise in the capital and creditmarkets and as an asset manager.  Thefund invests in fixed income securities, particularly in the asset-backedsector.  Through March 31, 2007, theCredit Fund had received capital contributions of $35.0 million, of whichthe Company had invested $26.4 million and third parties had invested$8.6 million.  In addition to receivinga return on its investment in the Credit Fund, the Company is paid a managementfee to select and manage the assets of the fund for the Credit Fund’s thirdparty investors.  For accountingpurposes, the Credit Fund is consolidated in the Company’s financial statementsas of March 31, 2007 and its financial results are recorded in theStructured Credit line of business.  Asof March 31, 2007, the Credit Fund had total assets of$313.5 million, including investments in fixed-maturity securities tradingof $308.0 million, and total liabilities and minority interest of $287.0million, including securities sold under agreements to repurchase of$277.7 million, included in the Company’s condensed consolidated balancesheet.

**12.  SENIOR CONVERTIBLE PREFERREDSTOCK**

In April 2006, the Company issued25 shares of senior convertible preferred stock to its existing stockholdersrepresenting the 5% “liquidation accretion” premium earned from the date ofissuance through September 30, 2004. The transaction was accounted for as a dividend.  A value of $2.0 million, based on theMarch 31, 2006 book value, was re-classified from retained earnings tosenior convertible preferred stock to record the dividend.

**13.  STOCK SPLIT**

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 received five additionalshares of common stock for each share of common stock held by such stockholderon that date.  Funds were reclassifiedfrom the additional paid in capital account to the common stock account in anamount equal to the par value of the incremental shares issued under the stocksplit.  Upon the conversion of thevarious classes of the Company’s preferred stock, each holder of convertiblepreferred stock, senior convertible preferred stock and series B seniorconvertible preferred stock was issued, in the case of convertible preferredstockholders and senior convertible preferred stockholders, 6,000 shares foreach share of preferred stock held by such holder and, in the case of theseries B senior convertible preferred stockholders, 6 shares of each shareof preferred stock held by such holder. All earnings per share andrelated stock option information presented inthese financial statements and accompanying footnotes have been retroactivelyadjusted to reflect the increased number of shares resulting from this action.

On November 9, 2006, ACA Capital priced its initialpublic offering of common stock.  The Company sold 6,875,000 shares ofcommon stock in the offering, at $13.00 per share, with net proceeds to ACACapital of $79.2 million, including $0.2 million of offering costs recorded inthe first three months of 2007.  The transaction closed on November 15,2006.  ACA Capital is listed on the New York Stock Exchange under thesymbol “ACA.”  Upon the closing of itsinitial public offering of common stock, the Company converted 154 shares ofsenior convertible 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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**14.  SUBSEQUENT EVENTS**

The Company entered into a new credit agreement datedas of April 26, 2007 with a syndicate of banks. The new credit agreement provides for a three-year senior unsecuredrevolving credit facility in an aggregate principal amount of up to$150 million.  The Company mayborrow cash under the new credit facility bearing interest based on either (i)LIBOR plus an applicable margin depending on our leverage ratio (the ratio ofdebt to capital reflected in our then most current consolidated financialstatements), or (ii) the greatest of the federal funds effective rate orprime rate in effect, plus 50 basis points. The Company pays a facility fee between 0.08% up to 0.15% per annum ofthe total commitments under the new credit facility depending on our leverageratio.  In addition, the Company alsoagreed to pay a utilization fee at a rate of 0.125% per annum on the averagedaily amount of the outstanding principal under the new credit facility, butonly payable when such outstanding principal amount exceeds 50% of thecommitments under the revolving credit facility.

This new revolving credit facility replaces theCompany’s prior 364-day $75 million senior unsecured revolving credit facilitydated as of May 1, 2006.  The Company hadno amounts outstanding under the prior credit facility as of March 31,2007.

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**Item 2.****    Management’s Discussion and Analysis of FinancialCondition and Results of Operations**

*Thefollowing discussion relates to our consolidated financial statements andshould be read in conjunction with the financial statements and notes theretoappearing elsewhere in this report. Statements contained in this “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” thatare not historical facts may be considered forward-looking statements withinthe meaning of the Private Securities Litigation Reform Act of 1995, and aresubject to the safe harbor created by that Act. When used in filings with theSEC, in our press releases, investor presentations, and in oral statements madeby or with the approval of one of our executive officers, the words or phraseslike “believe”, “anticipate”, “project”, “plan”, “expect”, “intend”, “may”, “willlikely result”, “looking forward” or “will continue”, or variations of suchwords and similar expressions are intended to identify such forward-lookingstatements.  These forward-lookingstatements are not guarantees of future performance and are subject to risks,uncertainties and assumptions, including, among other things, information setforth in our periodic reports filed with the SEC.  In making these statements, we are notundertaking to address or update these factors in future filings orcommunications regarding our business or results except as required by law. Inlight of these risks, uncertainties and assumptions, the forward-looking eventsdiscussed in this report might not occur. There may also be other risks that weare unable to predict at this time. Any of these risks and uncertainties maycause actual results to differ materially from the results discussed in theforward-looking statements.*

**Overview**

We are a holdingcompany 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. We conduct our financial guaranty insurancebusinesses through ACA Financial Guaranty Corporation, our “A” rated, regulatedinsurance subsidiary.  Approximately 85%of our assets on an unconsolidated basis represent our 100% indirect ownershipinterest in ACA Financial Guaranty. ACA Financial Guaranty 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 primarily conduct our asset management businessthrough ACA Management, L.L.C., a wholly-owned indirect subsidiary of ACAFinancial Guaranty.  Additionally, inJanuary 2007, we obtained a license from the FSA to conduct a Europeanasset management business, which will be done through our wholly-owned indirectsubsidiary ACA Capital Management (U.K.) Pte. Limited.  As of March 31, 2007, we had creditexposure of $57.0 billion and our assets under management for thirdparties were $16.3 billion.

Our financialresults include three principal operating lines of business: Structured Creditand Public Finance, which are both financial guaranty insurance lines ofbusiness, and our CDO Asset Management business. We have a fourth line ofbusiness, Other, which encompasses specified insurance transactions in areas inwhich we are no longer active, including industry loss warranty transactions,trade credit reinsurance and insurance of certain asset-backed securitizations,principally, manufactured housing. Our lines of business constitute segmentsfor accounting purposes.

Through ourStructured Credit line of business, we select, structure and sell creditprotection, principally in the form of insured credit swaps, against a varietyof asset classes in the institutional fixed income markets.  At March 31, 2007, Structured Creditalso included 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 StructuredCredit, our principal revenues are net insured credit swap revenue and netinvestment income, which includes amounts received from the Credit Fund and itsallocated portion of corporate-wide investment income. Generally, we receiveinsured credit swap premiums in quarterly installments over the life of therelated swaps which is typically in the range of 5 to 7 years. The principalexpenses of this line of business are its allocated portion of corporate-wideoperating expenses, interest expense and depreciation and amortization. It alsoincurs direct interest expense related to the financing of our consolidatedCredit Fund’s purchased investments. We enter into our insured credit swapswith intent

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that they remainoutstanding for the entire term of the contract.  These insured credit swaps are accounted forat fair value because they do not qualify for the financial guarantee scopeexception under FAS No. 133, “*Accounting for Derivative Instruments andCertain Hedging Activities*”, as amended (“FAS 133”).  Changes in the fair value of these contractsare required to be marked to market under the requirements of FAS 133 and arerecorded, together with the related fixed quarterly premium payments payable tous under the insured credit swaps, under the caption net insured credit swaprevenue.  Since our insured credit swaptransactions are generally not actively traded securities and have noobservable market price, we utilize comprehensive internally developed modelsto estimate changes in fair value. We expect the fair values of these insuredcredit swaps to fluctuate primarily based on changes in credit spreads and thecredit quality of the underlying referenced entities. When we hold theseinsured credit swaps for the entire term of the contract, the cumulativechanges in fair value will net to zero at the end of the term, provided that wedo not incur credit losses on the contract. In certain circumstances, we mayagree with a counterparty to terminate an insured credit swap transaction priorto its maturity (such as on request of the counterparty or for risk managementpurposes, such as in connection with a deterioration of the underlyingportfolio) and may experience realized gains or losses in connection with theearly termination of such transactions.

In our PublicFinance line of business, we primarily provide financial guaranty insurancepolicies guaranteeing the timely payment of principal and interest on publicfinance and other debt obligations. Our principal revenues in this line ofbusiness are premiums earned on our financial guaranty insurance policies andits allocated portion of corporate-wide investment income. The principalexpenses of this line of business include its allocated portion ofcorporate-wide operating expenses, interest expense and depreciation andamortization. We also incur loss and loss adjustment expenses, related to thenon-derivative exposure we insure, and policy acquisition costs, which areexpenses that vary with and are directly attributable to the generation ofinsurance premiums and are deferred and recognized over the period in which therelated premiums are earned. Typically, public finance premiums are received byus on an up front basis. However, under current accounting standards, they arerecognized into income over the term of the underlying instrument.

In our CDO AssetManagement line of business, we focus on CDO origination, structuring and assetmanagement. Our principal revenues in this line of business are investmentincome, management fees, warehouse income, other credit swap revenue andpremiums for credit swaps on insured equity tranches of unfunded synthetic CDOs. Also included is an allocated portion of corporate-wide investmentincome. The principal direct expenses are interest expense related to the CDOdebt issued by us and the amortization of related capitalized debt issuancecosts. This line of business also receives an allocated portion ofcorporate-wide operating expenses, interest expense and depreciation andamortization. Several of our CDOs are consolidated in our financial statementsbecause we have been determined to be the primary beneficiary under FIN 46(R),*“Consolidation of Variable Interest Entities**—an interpretation of ARB No. 51 analyses*”. See “—Resultsof Operations—CDO Asset Management—Supplementary Information” for a discussionon the accounting issues associated with consolidation.

Our Other line ofbusiness includes business in areas and markets in which we are no longeractive. Principal direct items are premiums earned, loss and loss adjustmentexpenses and policy acquisition costs. This line of business also was allocateda portion of investment income and interest expense in the first quarters of2007 and 2006. 

We believe it ismore meaningful to analyze our financial performance on an annual, rather thana quarterly, basis in order to give our lines of business flexibility to selectonly those opportunities that meet our risk-adjusted return expectations. Webelieve this maximizes our profitability and allows our lines of business toavoid unfavorable pricing, credit spreads and general market conditions thatmay occur in any particular quarter. Furthermore, during any given year weenter into a limited number of transactions in each of our lines of businessand do not set corporate goals based on closing a specified number oftransactions in any particular quarter or year. The transactions in which weparticipate are often highly negotiated and often take a significant period oftime from start to finish, up to one year in Public Finance and up to ninemonths for a CDO. Accordingly, our financial performance can vary significantlyfrom quarter to quarter and the operating results for any quarter are notindicative of results for any future period.

Additionally,management reviews our performance using a measure known as net economicincome. Management believes that analyzing net economic income supplements the understandingof our results of

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operations byhighlighting income attributable to our ongoing operating performance. See “—NetEconomic Income.”

**Critical Accounting Policies andEstimates**

We prepare ourfinancial statements in accordance with accounting principles generallyaccepted in the United States of America (GAAP). The following accountingpolicies and estimates are viewed by us to be critical because they requiresignificant judgment on our part. Financial results could be materiallydifferent if alternate methodologies were used or if we modified ourassumptions.

*Financial Guaranty RevenueRecognition*

*PremiumsEarned—*Premiums on financial guaranty insurance products inthe form of traditional insurance policies are typically received on an upfront basis, although certain policies pay premium in periodic installments.The vast majority of our Public Finance business is conducted through theissuance of traditional policies. Traditional policies are those that meet thescope exception of the guidance of FAS 133, paragraph 10d, as amendedby FAS 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.Installment premiums are earned over each installment period, which isgenerally one year or less. Up front premiums are earned in proportion to theexpiration of risk, which is par. Premium is allocated to each par maturity (*e.g.*, principal payment) included in aninsured bond and earned on a straight-line basis for the period the relatedinsured risk is outstanding. Unearned premiums represent that portion ofpremiums which is applicable to coverage of risk to be provided in the futureon policies in-force. When an insured issue is retired or defeased prior to theend of the expected period of coverage, the remaining unearned premiums, lessany amount credited to the refunding issue insured by us, are recognized asearned premium. The amounts earned from refundings were approximately$0.6 million and $0.2 million, for the quarters ended March 31,2007 and 2006, respectively.

On April 18, 2007,the FASB released an exposure draft entitled “*Accountingfor Financial Guarantee Contracts—an interpretation of FASB Statement No. 60*”(the “Proposed Statement”).  While FASB StatementNo. 60, “*Accounting and Reporting by Insurance Enterprises”,*sets out accounting standards for property and casualty and lifeinsurance enterprises, it has historically not specifically consideredfinancial guaranty insurance.  This newinterpretation is intended to address the specific attributes of this type ofinsurance.  The principal items addressedin the exposure draft relate to revenue recognition, the establishment of claimreserves and disclosures around such reserves. The Proposed Statement would be effective for financial statementsissued for fiscal years beginning after December 31, 2007.  While certain provisions of the Proposed Statementare still being analyzed, management believes that the cumulative effect ofinitially applying the Proposed Statement could be material to our financialstatements.  Until the finalinterpretation is issued and effective, we will continue to apply theaccounting policies as disclosed in our audited financial statements as ofDecember 31, 2006 and 2005 and for the years ended December 31, 2006, 2005 and2004. The comment period for the exposure draft ends June 18, 2007.

*NetInsured Credit Swap Revenue*—ACA Financial Guaranty insuresthe obligations of ACA’s affiliated special purpose entities under insuredcredit swaps, pursuant to which we sell credit protection. The related insuredcredit swap premiums are included in net insured credit swap revenue and aregenerally received in quarterly fixed payments over the life of the relatedswaps. 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. We do not believe that our insured creditswaps meet the scope exception of FAS 133, paragraph 10d, as amended byFAS 149, because there is no contractual requirement that the protectionpurchaser be exposed to the underlying risk.

Net insured creditswap revenue includes insured credit swap premiums received and realized andunrealized gains and losses on such credit swaps.

*DerivativeContracts.  * All derivative instruments arerecognized in our consolidated balance sheet as either assets or liabilitiesdepending on the fair value to us as a credit protection seller as of thedetermination date. All derivative instruments are measured at estimated fairvalue. We value derivative contracts based on quoted market prices, whenavailable. However, if quoted prices are not available, the fair value isestimated using valuation models specific to the type of credit protection.Valuation models

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include the use ofmanagement estimates and current market information. We utilize bothproprietary and vendor based models (including rating agency models) and avariety of market data to provide the best estimate of fair value. Some of themore significant types of market data that influence our models include, butare not limited to, credit ratings, interest rates, credit spreads, defaultprobabilities and recovery rates. If management’s underlying assumptions forevaluating fair value prove to be inaccurate, there could be material changesin our consolidated operating results.

*PolicyAcquisition Costs.  * Policy acquisition costsinclude those expenses that relate primarily to and vary with premiumproduction. Such costs are comprised primarily of premium taxes, personnel andpersonnel related expenses of individuals involved in underwriting, and certainrating-agency and legal fees for municipal and non-derivative structuredfinance business. Anticipated claims and claim adjustment expenses areconsidered in determining the recoverability of acquisition costs. Netacquisition costs are deferred and amortized over the period in which therelated premiums are earned. In connection with its review of certainaccounting standards for financial guaranty insurance contracts, the FASB is consideringpotential changes relating to deferred policy acquisition costs. See “—CriticalAccounting Policies and Estimates—Financial Guaranty Revenue Recognition—PremiumsEarned” for further explanation of 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-specificreserves and non-specific reserves, including cost of settlement, on the obligationsACA Financial Guaranty has incurred. In determining our accounting policy forloss reserves, we rely primarily on FAS 60, *“Accounting and Reporting by InsuranceEnterprises”* (“FAS 60”). However, FAS 60 was adopted when the financial guaranty industry wasjust beginning. As a result, FAS 60 did not contemplate the specific attributesof financial guaranty insurance as distinct from other forms of insurance. Inparticular, financial guaranty insurance is considered a short-durationinsurance product; however, it has features that are more akin to long-durationcontracts in that the term of some insured obligations can be as long as30 years or more and the contracts are generally irrevocable. Under FAS60, accounting for losses differs for short-duration and long-durationcontracts. Because of this inconsistency, we also apply FAS 5, “*Accounting for Contingencies*” (“FAS 5”) inthe determination of our loss reserves. 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. The Proposed Statementincludes guidance on the establishment of claim reserves and disclosure aroundsuch reserves.  Until the final interpretationis issued and effective, we will continue to apply the accounting policies asdisclosed in our audited financial statements as of December 31, 2006 and 2005and for the years ended December 31, 2006, 2005 and 2004.  The comment period for the exposure draftends June 18, 2007.  See “—CriticalAccounting Policies and Estimates—Financial Guaranty RevenueRecognition—Premiums Earned” for further explanation of potential changes.

The financialguaranty insurance policies we issue insure scheduled payments of principal andinterest due on various types of financial obligations against a paymentdefault on such payments by the issuers of the obligations. Active surveillanceof our insured portfolio tracks the performance of insured obligations fromperiod to period. We establish loss and loss adjustment expenses, or LAE,reserves based on surveillance group reports, the latest available industrydata, and analysis of historical default and recovery experience for therelevant sectors of the fixed-income market. Together the case reserves andnon-specific reserves represent management’s estimate of incurred losses on ournon-derivative insured portfolio exposures.

Case specificreserves are reserves created on those obligations identified as currently orlikely to be in default, and represent the present value, discounted at theU.S. Treasury Note rate applicable to the term of the underlying insuredobligations, of the expected LAE payments, net of estimated recoveries (undersalvage, subrogation or other recovery rights). Gross case-specific reserves,net of estimated recoveries, were $21.3 million and $20.2 million asof March 31, 2007 and December 31, 2006, respectively. We take intoaccount a number of variables that depend primarily on the nature of theunderlying 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

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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.

Our non-specificreserve was derived from the calculation of expected loss, which we estimateusing a Monte Carlo simulation. A Monte Carlo simulation is a technique that iscommonly used to estimate the probability of certain mathematical outcomes. Itrandomly selects values to create scenarios of outcomes and this randomselection process is repeated many times to create multiple scenarios. Eachtime a value is randomly selected, it forms one possible scenario and outcome.Together, these scenarios give a range of possible outcomes, some of which aremore probable and some less probable. By definition, the average solution willgive the most likely potential outcome. Our risk management team typically runsat least 100,000 trials in order to determine future expected losses. The modeluses the current ratings and default frequency (net of recovery) applied toeach transaction with outstanding exposure to determine the expectedprobability distribution of loss. Default frequency and recovery amounts arepublished periodically by each of the major rating agencies. From the modeloutput, we can estimate a range of expected loss. The amount of non-specificreserve recorded in the financial statements is based on the loss ratioresulting from the calculation of total losses, including past incurred lossesand expected future losses divided by premium. For this purpose, premium isdefined as ever-to-date written premium as of March 31, 2007 plus futureinstallment premium on closed transactions. This derived loss ratio is appliedto total ever-to-date earned premiums as of March 31, 2007. Case specificreserves are subtracted from this amount to arrive at net non-specificreserves. The table below shows our case and non-specific reserves as ofMarch 31, 2007 and 2006.
| ** **              | ** ** | **As of March 31,** | ** ** | **As of December 31,** | ** ** |
|-------------------------|------------|------------------------------------|------------|---------------------------------------|------------|
| ** **              | ** ** | **2007**                           | ** ** | **2006**                              | ** ** |
| ** **              | ** ** | **(in thousands)**            | ** ** |
| Case specific  reserves |       | $                                  | 21,251     |                                  | $          | 20,232 |   |
| Non specific  reserves  |       | 22,857                             |       | 21,881                                |       |
| Total                   |       | $                                  | 44,108     |                                  | $          | 42,113 |   |

 

*InvestmentPortfolio.*   The primary components of ourinvestment portfolio are the fixed maturity securities of ACA FinancialGuaranty, 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 March 31, 2007, allinvestments in fixed maturity securities except for those related to the CreditFund were designated as available for sale and were carried at fair value.Unrealized gains and losses for available for sales securities are thedifference between fair value and amortized cost included in the accumulatedother comprehensive income component of stockholders’ equity, net of applicabledeferred income tax. As of March 31, 2007, the investments of the CreditFund were designated as trading securities and were also carried at fair value.Unrealized gains and losses for trading securities are included in net income.The fair values of our securities are based on independent market quotationsor, when such quotations are not readily available because the securities are infrequentlytraded in the public market, from internal valuation models. The valuationresults from these models could differ materially from amounts realizable in anopen market sale or exchange.

*Consolidationof Variable Interest Entities (VIEs) and Other Restricted Investments.*  From an accounting perspective, funded and partially funded CDOs are deemed tobe issued 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 46(R), “*Consolidation of Variable Interest Entities* “ (“FIN 46(R)). Prior to2005, we retained all or most of the equity position in our CDOs, and theseCDOs are therefore consolidated in our financial statements (a total of sevenCDOs are consolidated). Although the VIE is consolidated, we do not have theright to use the assets of the VIE for general operations and the debtliabilities of the VIE are without recourse to any assets other than those ofthe VIE. Our investment exposure to our CDOs is therefore limited to our equityinvestment, which is a first loss position of the CDO. In the instances that weown less than 100% of the CDO VIE’s equity, but are the primary beneficiary andthus consolidate the CDO VIE, we establish minority interests for the

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unowned portion. As ofMarch 31, 2007 and December 31, 2006, consolidated liabilities includednon-recourse debt from consolidated CDOs of $4,683.4 million and $4,711.8million, respectively. Also, as of March 31, 2007 and December 31, 2006,consolidated assets included investment in fixed maturity securities of$4,447.5 million and $4,656.0 million,respectively, and cash of $333.9 and $265.0 million, respectively, related toCDOs.

Beginning in 2005,we have retained a lesser share of the equity position of our newly issuedCDOs. Based on analyses under FIN 46(R), we are not deemed to be the primarybeneficiary of these VIEs. As a result, these CDOs are not consolidated in ourfinancial statements. Rather, our non-majority investment is recorded as aninvestment in a single fixed maturity security under the provisions of FAS 115and Emerging Issues Task Force (“EITF”) Issue No. 99-20, “*Recognition of Interest Income and Impairment onPurchased and Retained Beneficial Interests in Securitized Financial Assets*“ (“EITF 99-20”). During the first three months of 2007, we closed three CDOsand retained an equity interest in only one.  During 2006, we closed eight CDOs and purchased an equity interest infour. During 2005, we closed five CDOs and purchased equity interests in fourof the five CDOs. We were not determined to be the primary beneficiary in anyof these CDOs and therefore do not consolidate them.

In May of2006, we began managing our Credit Fund. The Credit Fund was created toleverage our expertise in the capital and credit markets and as an assetmanager. The Credit Fund invests in fixed maturity securities, particularly inthe asset-backed sector. Through March 31,2007, the Credit Fund had received capital contributions of $35.0 million,of which the Company had invested $26.4 million and third parties hadinvested $8.6 million. In addition to receiving a return on ourinvestment in the Credit Fund, we are paid a management fee to select andmanage the assets for the Credit Fund’s third party investors. Although theCredit Fund is consolidated pursuant to the requirements of FIN 46(R), we donot have the right to use the assets for general operations. See “—Results ofOperations—Structured Credit.”

**Results of Operations**

*Summary of Consolidated Results*

The followingdescribes our consolidated financial results for the quarters endedMarch 31, 2007, and 2006 and our financial condition as of March 31, 2007and December 31, 2006. In order to understand our consolidated financialresults, we perform a detailed segment by segment analysis for our lines ofbusiness and therefore, to augment the segments discussion, the followingconsolidated discussion has been prepared to describe (1) revenue andexpense items that are allocated to our four lines of business and (2) theresults of our lines of business:  Structured Credit, Public Finance, CDOAsset Management and Other.

The accountingpolicies of our lines of business are the same as those described in thesummary of “Critical Accounting Policies and Estimates” above and in our Form10-K. Our two financial guaranty insurance lines of business, Structured Creditand Public Finance, are presented as separate lines of business. Items notdirectly attributable are allocated to each operating line of business.Allocated items consist of investment income from the corporate-wide investmentportfolio of cash and investments, primarily from ACA Financial Guaranty,realized gains and losses on those investment portfolios, interest expense onthe corporate debt at the holding company level, all operating expenses,non-CDO related depreciation and amortization expenses and income taxes. Incomeand expense items that are directly attributable to a business line arerecorded as such.

The Company’sconsolidated net income for the three months ended March 31, 2007 was $11.4million, or $0.31 per diluted share, as compared to $14.1 million, or $0.47 perdiluted share, for the three months ended March 31, 2006, a decrease of $2.7million. The decline in net income was principally related to unrealizedmark-to-market valuation losses on our portfolio of Structured Credittransactions.

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The followingtable summarizes the contribution of each line of business to net consolidatedincome for the quarters ended March 31, 2007 and 2006:
| ** **                             | ** ** | **Structured  Credit**  | ** ** | **Public  Finance** | ** ** | **CDO Asset  Management** | ** ** | **Other** | ** ** | **Consolidated  Total** | ** ** |
|----------------------------------------|------------|-------------------------|------------|---------------------|------------|--------------------------------|------------|-----------|------------|-------------------------|------------|
| ** **                             | ** ** | **(in thousands)** | ** ** |
| Net income  (loss) by line of business |       |                    |       |                |       |                           |       |      |       |                    |       |
| March 31, 2007                         |       | $                       | (394       | )                   | $          | 2,951                          |       | $         | 8,355      |                    | $          | 505 |   | $ | 11,417 |   |
| March 31, 2006                         |       | $                       | 6,376      |                | $          | 1,796                          |       | $         | 5,788      |                    | $          | 187 |   | $ | 14,147 |   |

 

*StructuredCredit*

For the threemonths ended March 31, 2007, a net loss of $0.4 million was recognized comparedto net income of $6.4 million for the same period of 2006. The first quarter of2007 included a net unrealized pre-tax loss in the amount of $12.9 millionrelated to the mark to market valuation of insured credit swaptransactions.  This valuation loss wasprimarily related to insured credit swap transactions for which the underlyingexposure is pools of sub-prime residential mortgage-backed securities and the associatedwidening of credit spreads on those assets that occurred during thequarter.  The spread widening was inresponse to the pronounced increase in homeowner delinquencies with respect tosub-prime residential mortgages originated in 2006. Conversely, for the threemonths ended March 31, 2006, we recognized pre-tax net unrealized valuationgains in the amount of $3.7 million. Insured credit swap premiums earned from credit swap transactionsincreased to $17.5 million for the three months ended March 31, 2007 from $8.8million for the same period of 2006. Other operating expenses increased in the three months ended March 31,2007 compared to the same period in 2006. This increase was in connection with the additional expenses incurreddue to our status as a public company as well as additional expenses incurred,mainly personnel related, in direct support of the Structured Credit business.

*PublicFinance*

For the threemonths ended March 31, 2007, net income increased to $3.0 million from $1.8million for the same period in 2006. Growth in net income was primarily related to increased premiums earned,mark to market valuation gains on two transactions that are in the form ofinsured credit swaps and higher net investment income based on increases in ACAFinancial Guaranty’s investment portfolio. The growth in net income was partially offset by higher operatingexpenses incurred due to our status as a public company and additional expensesincurred, namely personnel related, in direct support of the Public Financebusiness. Gross premiums written increased modestly to $4.7 million for thethree months ended March 31, 2007 from $4.1 million for the same period of2006.

*CDO AssetManagement*

Net incomeincreased to $8.4 million for the three months ended March 31, 2007 from $5.8million for the same period in 2006.  Thegrowth in net income was primarily related to increased asset management fees.These increases were partially offset, however, by increased expenses relatedto our expansion of this line of business to the United Kingdom, where we openeda new office in 2006, the additional expenses incurred due to our status as apublic company and additional expenses incurred, mainly personnel related, indirect support of the CDO Asset Management business.

*Other*

Other representedan immaterial portion of our reported results for the three months ended March31, 2007 and 2006 and reflects the continued run-off of insurance contractswritten in prior years in areas in which we are no longer active.

*ItemsAllocated to Business Lines*

Within our statementof operations, we have income and expense items that are directly attributableto our lines of business and items that are indirectly attributable. Examplesof items that are directly attributable to lines of business are gross premiumswritten, premiums earned, insured credit swap revenue, net realized andunrealized gains, losses on derivatives, losses and loss adjustment expensesand

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depreciation andamortization 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 of business includenet investment income on the corporate-wide cash investment portfolios andother non-VIE entities within the consolidated group, net realized gains andlosses on those portfolio, operating expenses, interest expense related to ourcorporate debt, depreciation and amortization and income taxes. The netinvestment income and net realized gains and losses on investments related to ourCDO Asset Management and the Credit Fund are considered direct revenues. Thefollowing table summarizes the principal items in our consolidated statement ofoperations that are allocated for purposes of line of business reporting forthe three months ended March 31, 2007 and 2006. All other revenue and expenseitems included in the consolidated statement of operations are directlyattributable to a specific line of business.
| ** **                                         | ** ** | **Three Months  ended March 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| ** **                                         | ** ** | **(in thousands)**                          | ** ** |
| Net investment income                              |       |                                             |       |   |   |
| Allocated                                          |       | $                                                | 7,505      |   | $ | 5,957 |   |
| Direct to Business Lines                           |       | 82,415                                           |       | 71,755 |   |
| Total                                              |       | $                                                | 89,920     |   | $ | 77,712 |   |
| Net realized and  unrealized losses on investments |       |                                             |       |   |   |
| Allocated                                          |       | $                                                | (51        | ) | $ | (1,132 | ) |
| Direct to Business Lines                           |       | (3,657                                           | )          | (835 | ) |
| Total                                              |       | $                                                | (3,708     | ) | $ | (1,967 | ) |
| Other operating  expenses                          |       |                                             |       |   |   |
| Allocated                                          |       | $                                                | 15,631     |   | $ | 10,076 |   |
| Direct to Business Lines                           |       | 522                                              |       | 537 |   |
| Total                                              |       | $                                                | 16,153     |   | $ | 10,613 |   |
| Interest expense                                   |       |                                             |       |   |   |
| Allocated                                          |       | $                                                | 1,840      |   | $ | 1,676 |   |
| Direct to Business Lines                           |       | 74,568                                           |       | 64,743 |   |
| Total                                              |       | $                                                | 76,408     |   | $ | 66,419 |   |
| Depreciation and  amortization                     |       |                                             |       |   |   |
| Allocated                                          |       | $                                                | 379        |   | $ | 613 |   |
| Direct to Business Lines                           |       | 1,880                                            |       | 1,879 |   |
| Total                                              |       | $                                                | 2,259      |   | $ | 2,492 |   |
| Provision for  income tax expense                  |       |                                             |       |   |   |
| Allocated                                          |       | $                                                | 5,868      |   | $ | 7,292 |   |
| Direct to Business Lines                           |       | —                                           |       | — |   |
| Total                                              |       | $                                                | 5,868      |   | $ | 7,292 |   |

 

*NetInvestment Income.  * Allocated net investmentincome primarily represents the income recognized on the investment portfolioof ACA Financial Guaranty. To a much lesser degree, investment income fromother non FIN 46(R) entities within the group is included to the extent it isnot directly related to any of the lines of business. Investment incomeallocated to each line of business is based upon the estimated capital utilizedby the line of business which is derived from our rating agency capitaladequacy model. To the extent capital is outside of the insurance company, itis allocated based on an estimated utilization. For the three months ended March 31, 2007, allocated net investmentincome increased to $7.5 million from $6.0 million for the three monthsended March 31, 2006. This increase was related to growth in theinvestment portfolio from $579.6 million at March 31, 2006 to $658.5 million atMarch 31, 2007. The growth in the investment portfolio between periods wasprimarily related to positive cash flows generated by our businesses and, from$79.2 million raised from the proceeds of our initial public offering inNovember 2006 (“IPO”). 

27

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*NetRealized and Unrealized Gains and Losses on Investments.  *Allocated net unrealized and realized gains and losses on investments representthose gains and losses incurred on the investment portfolio discussed above andare similarly allocated to the lines of business. For the three months endedMarch 31, 2007, the net realized loss of $1.1 million was the result of asector reallocation of bonds within the portfolio. 

*OtherOperating Expenses.  * Allocated other operatingexpenses is comprised of all costs related to personnel, office leases andexpenses, legal, accounting and rating agencies. Allocated other operatingexpenses does not include expenses related to the consolidation of our CDOs orthe Credit Fund. Those expenses are treated as direct expenses of the CDO AssetManagement line of business and the Credit Fund (part of the Structured Creditline of business), respectively, for this purpose. For the three months endedMarch 31, 2007, allocated other operating expenses increased to $15.6million from $10.1 million for the three months ended March 31, 2006. Theincrease in expenses was attributable to additional personnel hired to supportthe businesses, of $3.8 million, and expenses in connection with the opening ofour United Kingdom and Singapore offices in 2006. 

*InterestExpense.  * Allocated interest expense is related toour holding company debt. It is allocated to our lines of business based oncapitalization of the respective lines of business as described above withrespect to net investment income.  Theincrease in allocated interest expense for the three month period ended March31, 2007 from $1.7 million in 2006 to $1.8 million in 2007 was primarilyrelated to the increase in LIBOR since this debt pays interest on a floatingrate basis.  No new debt was issued inthe first quarter of 2007 or 2006. 

*Depreciationand Amortization.  * Allocated depreciation andamortization expense is related to furniture and computer equipment, leaseholdimprovements and any costs deferred in connection with the raising of corporatedebt. Such expenses are allocated to line of business similarly to otheroperating expenses.

*IncomeTaxes.  * Income taxes are generally allocated toline of business based upon the overall corporate effective tax rate applied topre-tax income. The increase in income taxes over the three-year period is adirect result of our increased profitability.

28

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*StructuredCredit*

The followingtable summarizes the operations of our Structured Credit line of business forthe three months ended March 31, 2007 and 2006:
| ** **                                                            | ** ** | **Three Months  Ended March 31,** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                            | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** **                                                            | ** ** | **(in thousands)**                     | ** ** |
| **REVENUES**                                                          | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Gross premiums  written                                               |       | $                                           | 87         |   | $ | 278 |   |
| Premiums earned                                                       |       | $                                           | 87         |   | $ | 296 |   |
| Net insured  credit swap revenue                                      |       | 4,645                                       |       | 12,740 |   |
| Net investment  income                                                |       | 5,745                                       |       | 852 |   |
| Net realized and  unrealized losses on investments                    |       | (1,512                                      | )          | (136 | ) |
| Net realized and  unrealized gains (losses) on derivative instruments |       | (4                                          | )          | — |   |
| Other net credit  swap revenue                                        |       | (37                                         | )          | (14 | ) |
| Fee income                                                            |       | 96                                          |       | 113 |   |
| Other income                                                          |       | 19                                          |       | 17 |   |
| **Total  revenues**                                                   | ** ** | **9,039**                                   | ** ** | **13,868** | ** ** |
| **EXPENSES**                                                          | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Other operating  expenses                                             |       | 6,290                                       |       | 3,917 |   |
| Interest expense                                                      |       | 3,290                                       |       | 83 |   |
| Depreciation and  amortization                                        |       | 138                                         |       | 206 |   |
| **Total  expenses**                                                   | ** ** | **9,718**                                   | ** ** | **4,206** | ** ** |
| **Loss of  minority interest**                                        | ** ** | **83**                                      | ** ** | **—** | ** ** |
| Income before  income taxes                                           |       | (596                                        | )          | 9.662 |   |
| Provision for  income tax expense (benefit)                           |       | (202                                        | )          | 3,286 |   |
| **Net income**                                                        | ** ** | **$**                                       | **(394**   | **)** | **$** | **6,376** | ** ** |

 

*GrossPremiums Written.*   Gross premiums written withinthis line of business declined to $0.1 million for the three months ended March31, 2007 from $0.3 million for the three months ended March 31, 2006. Thisdecline occurred because transactions with respect to this line of businesshave been conducted in the form of insured credit swaps. No new traditionalinsurance contracts were written in 2007 for this line of business and thedecline relates to the decreased premium for contracts that were written inprevious years. 

*PremiumsEarned.*   The change in premiums earned over thethree month periods was directly related to the change in gross premiumswritten described above.

*NetInsured Credit Swap Revenue.*   Net insured creditswap revenue declined to $4.6 million for the three months ended March 31, 2007from $12.7 million for the same period in 2006. As set forth in the table below, insured credit swap revenue is the sumof premiums earned on our insured credit swap transactions, net realized gains(losses) which may result from time to time result from any termination orcredit events related to such transactions and unrealized gains (losses)resulting from the changes in fair value of these transactions. The firstquarter 2007 over first quarter 2006 decline in net insured credit swap revenuewas directly related to $12.9 million net unrealized mark to market lossesrecorded during 2007.  Conversely, in thefirst quarter 2006 unrealized mark to market gains were recorded.  Valuation losses in the first quarter 2007were principally related to the credit spreads associated with insured creditswap transactions for which the underlying exposure was to pools of sub-primeresidential mortgage-backed securities. Premiums earned from our insured credit swap transactions increased to$17.5 million for the three months ended March 31, 2007 from $8.8 million forthe three months ended March 31, 2006. The primary reason for the increase was the higher volume of transactionscompleted.  As of March 31, 2007, the notionalcredit exposure in this line of business increased to $50.2 billion from $18.4billion at March 31, 2006.

29

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The followingtable shows the components of net insured credit swap revenue for the threemonths ended March 31, 2007 and 2006:
|                                                    | ** ** | **Three Months  Ended March 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| ** **                                         | ** ** | **(in thousands)**                          | ** ** |
| Insured credit  swap premiums earned               |       | $                                                | 17,514     |   | $ | 8,846 |   |
| Unrealized gains  (losses) on insured credit swaps |       | (12,869                                          | )          | 3,673 |   |
| Realized gains  on insured credit swaps            |       | —                                           |       | 221 |   |
| Net insured  credit swap revenue                   |       | $                                                | 4,645      |   | $ | 12,740 |   |

 

*NetInvestment Income.*   Net investment income was $5.7million for the three months ended March 31, 2007 compared to $0.9 million forthe three months ended March 31, 2006. Of the total net investment income of$5.7 million in 2007, $4.5 million related to the Credit Fund and $1.2 millionrelated to allocated investment income. In 2006, allocated investment incomewas $0.9 million. Allocated investment income increased due to growth withinthe overall allocated investment portfolio because of net positive cash flowsfrom our businesses, which generated $46.3 million of operating cash flowsduring 2006, as well as the net proceeds from our IPO of $79.2 million.  We also increased the allocation of investmentincome to this business in 2007 based upon our expected utilization of IPOproceeds across business lines.  
|                                     | ** ** | **Three Months  Ended March 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------------|------------|
| ** **                          | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** **                          | ** ** | **(in thousands)**                     | ** ** |
| Investment  income from Credit Fund |       | $                                           | 4,545      |   | $ | — |   |
| Allocated  investment income        |       | 1,200                                       |       | 852 |   |
| Total investment  income            |       | $                                           | 5,745      |   | $ | 852 |   |

 

The Credit Fundhad net assets under management of $35.0 million as of March 31,2007.  In addition to receiving a returnon our investment in the Credit Fund, we are paid a management fee to selectand manage the assets of the fund for third parties. As of March 31, 2007, theCredit Fund had total assets of $313.5 million, including investments infixed-maturity securities trading of $308.0 million and total liabilitiesand minority interest of $287.0 million, including securities sold underagreements to repurchase of $277.7 million, all of which are included onour consolidated balance sheet.

*NetRealized and Unrealized Gains (Losses) on Investments.*  Net realized gains (losses) are derived from our investment in the Credit Fundas well as allocated amounts related to our allocated investment portfolio. Thefollowing table shows the components of net realized losses for the threemonths ended March 31, 2007 and 2006:
|                                                      | ** ** | **Three Months  Ended March 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                           | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| ** **                                           | ** ** | **(in thousands)**                          | ** ** |
| Net unrealized  and realized losses from Credit Fund |       | $                                                | (1,504     | ) | $ | — |   |
| Allocated net  realized losses                       |       | (8                                               | )          | (136 | ) |
| Net realized and  unrealized losses on investments   |       | $                                                | (1,512     | ) | $ | (136 | ) |

 

Credit Fund losses were principally unrealized and related to the fairvaluation of fixed income securities held in the portfolio.  Such securities are designated as held fortrading, and as a result mark to market valuation losses are recorded on ourstatement of operations.  

*OtherOperating Expenses.*   Other operating expensesincreased to $6.3 million for the three months ended March 31, 2007 from $3.9million for the same period in 2006. The increase for the three months

30

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ended March 31, 2007compared to 2006 is related to the allocation of additional corporate and assetbacked credit analysts in 2007 to this line of business in connection with itsgrowth in transaction volume and the opening and staffing of our Singapore office,in late 2006.

*InterestExpense.*   Interest expense results from debt costsat 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 Credit Fund in the three months ended March 31,2007 was $3.2 million. Allocated interest expense totaled $0.1 million in eachof the three months ended March 31, 2007 and 2006.

*Lossof Minority Interest.*   Loss of minority interestis related to our investment in the Credit Fund. While we consolidate the fund,we are not the sole equity investor in the fund.  Loss related to the portion of the CreditFund not owned by us in 2007 was $0.1 million.

*PublicFinance*

The followingtable summarizes the operations of our Public Finance line of business for thethree months ended March 31, 2007 and 2006:
| ** **                                         | ** ** | **Three Months  Ended March 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| ** **                                         | ** ** | **(in thousands)**                          | ** ** |
| **REVENUES**                                       | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Gross premiums  written                            |       | $                                                | 4,672      |   | $ | 4,082 |   |
| Premiums earned                                    |       | $                                                | 4,878      |   | $ | 4,177 |   |
| Net insured  credit swap revenue                   |       | 1,146                                            |       | 662 |   |
| Net investment  income                             |       | 4,277                                            |       | 3,871 |   |
| Net realized and  unrealized losses on investments |       | (29                                              | )          | (736 | ) |
| Fee income                                         |       | 74                                               |       | 98 |   |
| Other income                                       |       | 17                                               |       | — |   |
| **Total  revenues**                                | ** ** | **10,363**                                       | ** ** | **8,072** | ** ** |
| **EXPENSES**                                       | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Loss and loss  adjustment expenses                 |       | 1,025                                            |       | 1,376 |   |
| Policy  acquisition costs                          |       | 1,463                                            |       | 1,272 |   |
| Other operating  expenses                          |       | 2,907                                            |       | 2,112 |   |
| Interest expense                                   |       | 386                                              |       | 403 |   |
| Depreciation and  amortization                     |       | 114                                              |       | 188 |   |
| **Total  expenses**                                | ** ** | **5,895**                                        | ** ** | **5,351** | ** ** |
| (Income) loss of  minority interest                |       | —                                           |       | — |   |
| Income before  income taxes                        |       | 4,468                                            |       | 2,721 |   |
| Provision for  income tax expense                  |       | 1,517                                            |       | 925 |   |
| **Net  income**                                    | ** ** | **$**                                            | **2,951**  | ** ** | **$** | **1,796** | ** ** |

 

*GrossPremiums Written.*   Public Finance gross premiumswritten totaled $4.7 million for the three months ended March 31, 2007 comparedto $4.1 million for the three months ended March 31, 2006. Overall, thetightening of credit spreads in our target market, which is the low investmentgrade and high non-investment grade segment of the municipal bond market thatwe experienced in 2006 continued to occur in the first quarter of 2007 andeffect our volume of transactions closed. As spreads remain at historically tight levels, and in order to meet ourrisk-adjusted return expectations, we continue to be highly selective in ourunderwriting decisions. Because we are a net retainer of the risks weunderwrite, gross premiums written approximate net premiums written.

*PremiumsEarned.*   Premiums earned were $4.9 million for thethree months ended March 31, 2007 compared to $4.2 million for the same periodin 2006. Premiums earned from refundings were $0.6 million and $0.2 million forthe three months ended March 31, 2007 and 2006, respectively.  Essentially, premiums

31

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earned before refundingswas flat when comparing the first quarter of 2007 to 2006.  This is primarily due to the fact that grosspar exposure has remained relatively flat at approximately $6.1 billion.

*NetInsured Credit Swap Revenue.*   Net insured creditswap revenue was $1.1 million for the three months ended March 31, 2007compared to $0.7 million for the same period in 2006. 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 tomarket. The unrealized gains or losses resulting from the fair valuation ofthese transactions are included in net insured credit swap revenue. An unrealizedgain of $1.0 million and $0.5 million was included in insured credit swaprevenue for the three months ended March 31, 2007 and 2006, respectively.

*NetInvestment Income.*   Net investment income totaled$4.3 million for the three months ended March 31, 2007 and $3.9 million for thethree months ended March 31, 2006. The entire amount of net investment incomefor the Public Finance line of business is derived from the allocation ofinvestment income. Allocated investment income increased due to growth withinthe overall allocated investment portfolio because of net positive cash flowsfrom our businesses, which generated $46.3 million of operating cash flowsduring 2006, as well as the net proceeds from our IPO of $79.2 million.  

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

*Provisionfor Loss and Loss Adjustment Expenses.*   Theprovision for loss and loss adjustment expenses was $1.0 million for the threemonths ended March 31, 2007 compared to $1.4 million for the three months endedMarch 31, 2006. The following table shows the components of the provision forloss and loss adjustment expenses for the three months ended March 31, 2007 and2006:  
|                                                        | ** ** | **Three Months  Ended March 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                             | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| ** **                                             | ** ** | **(in thousands)**                          | ** ** |
| Incurred Losses Related To              |       |                                             |       |   |   |
| Case specific and LAE reserves                         |       | $                                                | 49         |   | $ | 510 |   |
| Non-specific reserves                                  |       | 976                                              |       | 866 |   |
| Total provision  for loss and loss adjustment expenses |       | $                                                | 1,025      |   | $ | 1,376 |   |

 

The decline inincurred losses was primarily related to reduced loss adjustment expensesincurred in the first quarter of 2007. Loss adjustment expenses are costs associated with insured credits thatare in varying stages of work-out. Non-specific reserves are based on theapplication of our reserving model and take into account transactionalcharacteristics such as rating, sector and assumed recoveries. The decrease innon-specific reserves was a result of the increase in premiums earned andapplication of our non-specific reserve model.

*NetPolicy Acquisition Costs*.   Net policy acquisitioncosts totaled $1.5 million for the three months ended March 31, 2007 comparedto $1.3 million for the same period in 2006. Generally, such costs vary inaccordance with the changes in premiums earned during each period.

*OtherOperating Expenses*.   Other operating expenses were$2.9 million for the three months ended March 31, 2007 compared to $2.1 millionfor the three months ended March 31, 2006. These costs are non-policy acquisitionrelated costs and are allocated. The increase of $0.8 million was primarilyrelated to increased head count to support the business.

*InterestExpense*.   Interest expense was $0.4 million forthe each of three months ended March 31, 2007 and March 31, 2006.  Interest expense results from the allocatedinterest cost associated with corporate debt at our holding company.

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*CDOAsset Management*

The followingtable summarizes the operations of our CDO Asset Management line of businessfor the three months ended March 31, 2007 and 2006:
| ** **                                                   | ** ** | **Three Months  Ended March 31,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                   | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| ** **                                                   | ** ** | **(in thousands)**                          | ** ** |
| **REVENUES**                                                 | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Net insured credit swap  revenue                             |       | $                                                | (2,092     | ) | $ | 778 |   |
| Net investment income                                        |       | 78,846                                           |       | 72,095 |   |
| Net realized and  unrealized losses on investments           |       | (2,160                                           | )          | (926 | ) |
| Net realized and  unrealized gains on derivative instruments |       | 2,084                                            |       | 3,642 |   |
| Other net credit swap  revenue                               |       | 12,343                                           |       | 2,927 |   |
| Fee income                                                   |       | 6,163                                            |       | 3,923 |   |
| Other income                                                 |       | 19                                               |       | 18 |   |
| **Total revenues**                                           | ** ** | **95,203**                                       | ** ** | **82,457** | ** ** |
| **EXPENSES**                                                 | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Other operating  expenses                                    |       | 6,945                                            |       | 4,584 |   |
| Interest expense                                             |       | 72,640                                           |       | 65,848 |   |
| Depreciation and  amortization                               |       | 2,007                                            |       | 2,098 |   |
| Total expenses                                               |       | 81,592                                           |       | 72,530 |   |
| Income of minority  interest                                 |       | (962                                             | )          | (1,155 | ) |
| Income before income  taxes                                  |       | 12,649                                           |       | 8,772 |   |
| Provision for income  tax expense                            |       | 4,294                                            |       | 2,984 |   |
| Net income                                                   |       | $                                                | 8,355      |   | $ | 5,788 |   |
|                                                         |       |                                             |       |   |   |
| CDO assets under management (end of year, in millions)       |       | $                                                | 16,296     |   | $ | 11,362 |   |

 

*NetInsured Credit Swap Revenue*.   Net insured creditswap revenue was $(2.1) million for the three months ended March 31, 2007compared to $0.8 million for the three months ended March 31, 2006. As setforth in the table below, net insured credit swap revenue is the sum ofpremiums earned, net realized gains (losses), which may result from time totime from any termination or credit events related to such transactions andunrealized gains (losses) resulting from the changes in fair value of thesetransactions. We receive insured credit swap premiums from two synthetic CDOswe closed in 2003 and 2002 in which our insurance subsidiary, ACA FinancialGuaranty, insured the equity tranche of each CDO. Because these were the onlytwo transactions generating insured credit swap premiums over the two quarters,the amounts were similar.   The following table shows the componentsof net insured credit swap revenue for the three months ended March 31, 2007and 2006:
|                                            | ** ** | **Three Months  Ended March 31,** | ** ** |
|--------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                 | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| ** **                                 | ** ** | **(in thousands)**                          | ** ** |
| Insured credit  swap premiums earned       |       | $                                                | 1,088      |   | $ | 1,086 |   |
| Unrealized  losses on insured credit swaps |       | (3,180                                           | )          | (308 | ) |
| Net insured  credit swap revenue           |       | $                                                | (2,092     | ) | $ | 778 |   |

 

The unrealizedloss recorded for the three months ended March 31, 2007 resulted from one ofthe credit swap transactions which expired as of the end of the quarter.  As a result, the remaining unrealizedvaluation amount carried on our balance sheet was reversed to zero. Thevaluation or unrealized loss for the three months ended March 31, 2006 was alsorelated to the fact that these transactions were in a net

33

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valuation gain positionand as they approach maturity, those unrealized gains reverse, resulting inunrealized losses. Both transactions will expire by mid-2008. 

*NetInvestment Income*.   Net investment income was$78.8 million for the three months ended March 31, 2007 compared to $72.1million for the three months ended March 31, 2006. Net investment incomeincludes income from assets of our consolidated CDO portfolios as well asallocated amounts. No new consolidated CDOs were added in the first quarter of2007 or 2006. The portion of net investment income related to our consolidatedCDO portfolio was $77.9 million for the three months ended March 31, 2007compared to $71.6 million for the three months ended March 31, 2006. Theincrease in net investment income from 2006 to 2007 was principally related tothe increase in short-term rates, namely one and three month LIBOR over the twoquarters. The portion of net investment income allocated to the CDO AssetManagement line of business was $1.0 million in the first quarter of 2007,compared to $0.5 million in the first quarter of 2006. Allocated investmentincome increased due to growth within the overall allocated investmentportfolio because of net positive cash flows from our businesses, whichgenerated $46.3 million of operating cash flows during 2006, as well as the netproceeds from our IPO of $79.2 million.  
|                                           | ** ** | **Three Months   Ended March 31,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                | ** ** | **2007**                                               | ** ** | **2006** | ** ** |
| ** **                                | ** ** | **(in thousands)**                                | ** ** |
| Investment  Income from consolidated CDOs |       | $                                                      | 77,871     |   | $ | 71,618 |   |
| Allocated net  investment income          |       | 975                                                    |       | 477 |   |
| Total net  investment income              |       | $                                                      | 78,846     |   | $ | 72,095 |   |

 

*NetRealized and Unrealized Gains (Losses) on Investments*.  Net realized 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 realizedlosses for the three months ended March 31, 2007 and 2006.
|                                                    | ** ** | **Three Months  Ended March 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| ** **                                         | ** ** | **(in thousands)**                          | ** ** |
| Net realized  losses from CDOs                     |       | $                                                | (2,155     | ) | $ | (835 | ) |
| Allocated net  realized losses                     |       | (5                                               | )          | (91 | ) |
| Net realized and  unrealized losses on investments |       | $                                                | (2,160     | ) | $ | (926 | ) |

 

Net realizedlosses from CDOs include losses from other than temporary impairments, or OTTI,in the amounts of $2.6 million for the three months ended March 31, 2007compared to $0.9 million for the three months ended March 31, 2006. OTTI isrecognized when the fair value of investments in fixed maturity securities isreported below amortized cost for stated periods of time. In the case ofasset-backed securities, of which the vast majority of our CDO portfolio iscomprised, the market value decline is also coupled with a decline in futureexpected cash flows. OTTI write-downs in each of the three month periods wereassociated with certain mortgage-backed securities which experienced declinesin value and projected cash flows.

*NetRealized and Unrealized Gains (Losses) on Derivative Instruments.*  The following table illustrates the type of derivative instruments reported inthis line item:
|                                                                    | ** ** | **Three Months  Ended March 31,** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                         | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| ** **                                                         | ** ** | **(in thousands)**                          | ** ** |
| Interest rate  swaps                                               |       | $                                                | 1,670      |   | $ | 3,430 |   |
| Interest rate  caps                                                |       | (189                                             | )          | 212 |   |
| Trading  derivatives                                               |       | 603                                              |       | — |   |
| Total net  realized and unrealized gains on derivative instruments |       | $                                                | 2,084      |   | $ | 3,642 |   |

 

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The most significantderivative instruments reported in this line item are interest rate swaps thatare included in our consolidated CDOs. These CDOs have four such swaps and theypay fixed amounts and receive floating amounts based on three month LIBOR andpre-determined notional schedules. Unrealized valuation gains have beenrecognized on these four swaps as a result of a steady increase in short-terminterest rates over the three year period. Interest rate caps are also usedwithin consolidated CDOs to manage interest rate risk. We also recognizedincome in the amount of $0.6 million related to a leveraged loan tradingprogram that began in December 2006 and is structured in the form of atotal return swap.  Changes in the valuesof the underlying leveraged loans represent unrealized gains or losses to usuntil such time that the loans may be sold. Income received under the totalreturn swap is also included in net realized and unrealized gains on derivativeinstruments.

*OtherNet Credit Swap Revenue*.   Other net credit swaprevenue was $12.3 million for the three months ended March 31, 2007 compared to$2.9 million for the three months ended March 31, 2006. As set forth in thetable below, other net credit swap revenue is the sum of credit swap feesearned, net realized gains (losses) which may result from time to time resultfrom any termination of such transactions and any credit events and unrealizedgains (losses) resulting from the changes in fair value of these transactions.Most of this revenue resulted from credit swap fees from a partially fundedconsolidated synthetic CDO, in which the underlying instruments are creditswaps sold by the CDO to third parties. Also included as revenue in the firstquarters of 2007 and 2006 are amounts of $2.3 million and $0.8 million,respectively, that represent distributions to us as equity holder of twosynthetic CDOs.  The following tableshows the components of other net credit swap revenue for the three monthsended March 31, 2007 and 2006:
|                                      | ** ** | **Three Months  Ended March 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| ** **                           | ** ** | **(in thousands)**                          | ** ** |
| Credit swap fees                     |       | $                                                | 3,921      |   | $ | 2,733 |   |
| Unrealized gains  on credit swaps    |       | 8,422                                            |       | 194 |   |
| Total other net  credit swap revenue |       | $                                                | 12,343     |   | $ | 2,927 |   |

 

Net unrealizedgains related to changes in value were recorded for each period.  The unrealized gain recorded for the threemonths ended March 31, 2007 was almost entirely related to the change in thevalue of two credit swap transactions we entered into in late 2006 whereby wepurchased protection related to our exposure to subprime residential mortgagebacked securities. We have exposure to certain classes of residential mortgagedbacked securities, or RMBS, through equity we own in our CDOs. In particular,as of March 31, 2007 we have equity exposure of $59.5 million to RMBS backed bysubprime mortgages originated in 2006 in six of our mezzanine asset-backed CDOsthat invest in RMBS rated below A-/A3. In December 2006, we made the decision to purchase credit protectionin the form of two credit swaps referencing representative market indices tomoderate the impact to us of impairments related to 2006 vintage subprimeresidential mortgage exposure.  We didthis in light of the recent negative developments that we have noted in thisasset class. Specifically, the relaxed underwriting standards of certainsub-prime originators in 2006 have led to significantly higher early stagedelinquencies. Market participants have speculated that these RMBS mayultimately represent the worst performing sub-prime bonds on record todate.  In light of the uncertainty in themarket around this vintage of RMBS, we determined it prudent to purchase thecredit swaps. The aggregate notional amount of credit protection purchased was$37.0 million. The annual cash expense for the protection is approximately $0.9million and is also recorded in other net credit swap revenue. Additionally, wehave equity exposure of $37.4 million to three CDOs which invest in RMBS thathave some exposure to 2006 vintage subprime collateral rated at or above A-/A3.

*FeeIncome*.   Fee income is principally related toquarterly management fees, warehouse fees and structuring fees received inconnection with our unconsolidated CDOs. Total fee income for CDO AssetManagement was $6.2 million for the three months ended March 31, 2007 comparedto $3.9 million for the three months ended March 31, 2006. The increase was theresult of increased assets under management which grew to $16.3 billion atMarch 31, 2007 from $11.4 billion at March 31, 2006. During the first quarterof 2007, we revised our previous estimate of accrued warehouse fees as theresult of a renegotiation

35

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of a deal’s terms duringthe quarter.  For the three months endedMarch 31, 2006, warehouse fees recorded were in connection with two transactionsclosing during that quarter.  In general,structuring fees and warehouse fees are highly negotiated and vary fromtransaction to transaction. The following table shows the components of feeincome for the three months ended March 31, 2007 and 2006:
|                        | ** ** | **Three Months  Ended March 31,** | ** ** |
|------------------------|------------|---------------------------------------------|------------|
| ** **             | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** **             | ** ** | **(in thousands)**                     | ** ** |
| Asset management  fees |       | $                                           | 6,303      |   | $ | 2,891 |   |
| Warehousing fees       |       | (140                                        | )          | 1,032 |   |
| Total fee income       |       | $                                           | 6,163      |   | $ | 3,923 |   |

 

*OtherOperating Expenses*.   Other operating expensestotaled $6.9 million for the three months ended March 31, 2007 compared to $4.6million for the three months ended March 31, 2006. Other operating expenses ismade up of direct expenses of consolidated CDOs and includes items such asongoing rating agency fees, trustee fees, accounting fees and other directexpenses related to the maintenance of the CDO. Also included in otheroperating expenses are allocated expenses. The following table shows thecomponents of other operating expenses for the three months ended March 31,2007 and 2006:
|                               | ** ** | **Three Months  Ended March 31,** | ** ** |
|-------------------------------|------------|---------------------------------------------|------------|
| ** **                    | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** **                    | ** ** | **(in thousands)**                     | ** ** |
| Direct operating  expenses    |       | $                                           | 529        |   | $ | 535 |   |
| Allocated  operating expenses |       | 6,416                                       |       | 4,049 |   |
| Total operating  expenses     |       | $                                           | 6,945      |   | $ | 4,584 |   |

 

The first quarterof 2007 increase compared to the first quarter 2006 in allocated expenses wasrelated to two principal items.  First,our status as a publicly traded company in November 2006 caused an increase incertain corporate expenses.  Additionally, we incurred expenses for ournew office in the United Kingdom, established in the second half of 2006.  This office was established in connectionwith the expansion of our asset management business in Europe. 

*InterestExpense*.   Interest expense totaled $72.6 millionfor the three months ended March 31, 2007 compared to $65.8 million for thethree months ended March 31, 2006. Interest expense is made up of the allocatedportion of interest expense on corporate debt issued by our holding company, debtissued in connection with the purchase of certain of our CDO equity positions(CDO debt: operating) and debt issued by our consolidated CDOs (CDO debt:non-recourse). The following table shows the components of interest expense forthe three months ended March 31, 2007 and 2006:
|                         | ** ** | **Three Months  Ended March 31,** | ** ** |
|-------------------------|------------|---------------------------------------------|------------|
| ** **              | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** **              | ** ** | **(in thousands)**                     | ** ** |
| Interest expense   |       |                                        |       |   |   |
| Corporate debt          |       | $                                           | 1,252      |   | $ | 1,099 |   |
| CDO debt:  operating    |       | 1,891                                       |       | 1,785 |   |
| CDO debt:  non-recourse |       | 69,497                                      |       | 62,964 |   |
| Total interest  expense |       | $                                           | 72,640     |   | $ | 65,848 |   |

 

All outstandingdebt pays interest based on a floating rate above one or three month LIBOR. Theincrease in interest expense was primarily related to the rise in LIBOR overthe respective three month periods of 2007 and 2006.  No new debt was issued in the first quarterof 2007. Interest expense also includes interest expense on debt incurred tofinance our CDO equity investments. We had $110.9 million 

36

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of debt related to thefinancing of CDO equity and the allocation of interest payments on debt issuedto four trust preferred vehicles.

*Depreciationand Amortization*.   Depreciation and amortizationwas relatively flat over the three months ended March 31, 2007 and 2006.  Depreciation and amortization is comprised ofthe recognition of costs deferred in connection with our consolidated CDOs aswell as allocated amounts. Depreciation and amortization related toconsolidated CDOs totaled $1.8 million for the three months ended March 31,2007 and $1.9 million for the three months ended March 31, 2006. 

*(Income)from Minority Interest*.   (Income) from minorityinterest totaled $(1.0) million for the three months ended March 31, 2007 and$(1.2) million for the three months ended March 31, 2006. (Income) loss fromminority income results from the fact that we consolidate two CDOs in which weown less than 100% of the equity. Minority interest reflected in the statementof operations represents the share of the (income) or loss of the CDO thatrepresents the third party equity ownership. In both three month periods, thetwo CDOs recognized net income and as a result we recorded minority interest(income) to reduce our net income. 

*CDO Asset Management—SupplementaryInformation*

*Consolidationof VIEs.  * From an accounting perspective, fundedand partially funded CDOs are deemed to be issued out of Variable InterestEntities (VIEs). As such, each time a CDO is formed through the issuance ofdebt instruments to third parties and the purchase of investment assets, weperform an analysis to determine whether we are the primary beneficiary andthus required to consolidate the CDO under the provisions of FIN 46(R). Priorto 2005, we retained all or most of the equity position in our CDOs, and theseCDOs are therefore consolidated in our financial statements (a total of sevenCDOs are consolidated). Although these VIEs are consolidated, we do not havethe right to use the assets of the VIEs for general operations and the debtliabilities of the VIEs are without recourse to any assets other than those ofthe VIEs. Our investment exposure to our CDOs is therefore limited to ourretained equity, which is the first loss position of the CDO. In thetransactions in which we own less than 100% of the CDO VIE’s equity, but aredeemed to be the primary beneficiary and thus consolidate the CDO VIE, weestablish minority interests for the portion not owned. Total non-recourse debtof the CDOs included on our balance sheet at both March 31, 2007 andDecember 31, 2006 was $4.7 billion. Fixed maturity securities, a guaranteed investment contract and cashrelated to consolidated CDOs included on our balance sheet at March 31, 2007and December 31, 2006 were $4.8 billion and $5.1 billion,respectively.

Beginning in 2005,we have retained a lesser share of the equity position of our newly issuedCDOs. Based on our analysis of FIN 46(R) we are not deemed to be theprimary beneficiary and, as a result, these CDOs are not consolidated in ourfinancial statements. Rather, our non-majority investment is recorded as aninvestment in a single fixed maturity security under the provisions ofFAS 115 and EITF 99-20. During the first three months of 2007, we closedthree CDOs and retained equity interest in only one. During 2005 and 2006, weclosed sixteen CDOs and purchased equity interests in nine. The fair value ofour total investment in unconsolidated CDOs at March 31, 2007 was$20.0 million, not including synthetic CDOs in which we take derivativeexposure but make no investment. We do not anticipate consolidating new CDOs inthe future given our intention to buy minority portions.

CDOs can be issuedin funded, unfunded or partially funded form. Funded CDOs issue debtinstruments and purchase investment assets, while unfunded CDOs syntheticallyacquire assets and issue liabilities synthetically (*i.e.*, assets and liabilities are in derivative form).Partially funded CDOs are a combination of these two forms. From an accountingperspective, funded and partially funded CDOs are deemed issued out of VIEs.

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The following table summarizes our outstanding CDO transactions as ofMarch 31, 2007:
| **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      |       | $                      | 212        |             | Yes        |                                                   | $          | 18.0                        |       | 100                                    |       | 8/2005             |       | 8/2037 |   |
| ACA ABS 2003-1                   |       | 2003                   |       | Funded                |       | Investment  Grade      |       | 402                    |       | Yes              |       | 18.0                                                   |       | 100                         |       | 6/2007                                 |       | 6/2038             |       |
| Grenadier Funding                |       | 2003                   |       | Funded                |       | High-Grade             |       | 1,489                  |       | Yes              |       | 22.5                                                   |       | 100                         |       | 8/2008                                 |       | 8/2038             |       |
| ACA ABS 2003-2                   |       | 2003                   |       | Funded                |       | Investment  Grade      |       | 728                    |       | Yes              |       | 33.5                                                   |       | 100                         |       | 12/2007                                |       | 12/2038            |       |
| ACA ABS 2004-1                   |       | 2004                   |       | Funded                |       | Investment  Grade      |       | 393                    |       | Yes              |       | 10.0                                                   |       | 61                          |       | 7/2007                                 |       | 7/2039             |       |
| Zenith Funding                   |       | 2004                   |       | Funded                |       | High-Grade             |       | 1,498                  |       | Yes              |       | 13.0                                                   |       | 52                          |       | 12/2009                                |       | 12/2039            |       |
| ACA ABS 2005-1                   |       | 2005                   |       | Funded                |       | Investment  Grade      |       | 429                    |       | No               |       | 4.4                                                    |       | 24                          |       | 4/2008                                 |       | 4/2040             |       |
| ACA ABS 2005-2                   |       | 2005                   |       | Funded                |       | Investment  Grade      |       | 412                    |       | 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             |       | 1,472                  |       | No               |       | 1.5                                                    |       | 10                          |       | 7/2010                                 |       | 4/2046             |       |
| ACA Aquarius  2006-1             |       | 2006                   |       | Partially  funded     |       | Investment  Grade      |       | 1,999                  |       | No               |       | —                                                 |       | —                      |       | 9/2010                                 |       | 9/2046             |       |
| ACA ABS 2006-1                   |       | 2006                   |       | Funded                |       | Investment  Grade      |       | 747                    |       | 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             |       |
| ACA ABS 2007-1                   |       | 2007                   |       | Partially  Funded     |       | Investment  Grade BBB  |       | 1,500                  |       | No               |       | 1.4                                                    |       | 5                           |       | 3/2010                                 |       | 5/2047             |       |
| Millbrook                        |       | 2007                   |       | Unfunded              |       | Investment             |       | 62                     |       | No               |       | —                                                 |       | —                      |       | 3/2010                                 |       | 10/2052            |       |
| **Total  Asset-Backed CDOs**     |       |                   |       |                  |       |                   |       | 12,843                 |       |             |       | 133.8                                                  |       |                        |       |                                   |       |               |       |
| ** **                       |       |                   |       |                  |       |                   |       |                   |       |             |       |                                                   |       |                        |       |                                   |       |               |       |
| **Corporate  Credit CDOs:**      | ** ** | ** **             | ** ** | ** **            | ** ** | ** **             | ** ** | ** **             | ** ** | ** **       | ** ** | ** **                                             | ** ** | ** **                  | ** ** | ** **                             | ** ** | ** **         | ** ** |
| 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      |       | 1,000                  |       | No               |       | 25.0                                                   |       | 100                         |       | N/A                                    |       | 3/2008             |       |
| Argon 49                         |       | 2005                   |       | Funded                |       | Investment  Grade      |       | 67                     | (3)        | No               |       | —                                                 |       | —                      |       | N/A                                    |       | 6/2015             |       |
| Argon 57                         |       | 2006                   |       | Funded                |       | Investment  Grade      |       | 67                     | (3)        | No               |       | —                                                 |       | —                      |       | N/A                                    |       | 6/2013             |       |
| Tribune                          |       | 2006                   |       | Unfunded              |       | Investment  Grade      |       | 356                    | (4)        | No               |       | —                                                 |       | —                      |       | N/A                                    |       | 9/2016             |       |
| Dolomite                         |       | 2007                   |       | Unfunded              |       | Investment  Grade      |       | 66                     | (3)        | No               |       | —                                                 |       | —                      |       | N/A                                    |       | 7/2014             |       |
| **Total  Corporate Credit CDOs** |       |                   |       |                  |       |                   |       | 2,511                  |       |             |       | 47.0                                                   |       |                        |       |                                   |       |               |       |
| ** **                       |       |                   |       |                  |       |                   |       |                   |       |             |       |                                                   |       |                        |       |                                   |       |               |       |
| **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  |       | 341                    |       | No               |       | —                                                 |       | —                      |       | 7/2009                                 |       | 7/2018             |       |
| ACA CLO 2006-2                   |       | 2006                   |       | Funded                |       | Non-Investment  Grade  |       | 301                    |       | No               |       | 2.2                                                    |       | 10                          |       | 1/2011                                 |       | 1/2021             |       |
| **Total  Leveraged Loan CDOs**   |       |                   |       |                  |       |                   |       | 942                    |       |             |       | 7.2                                                    |       |                        |       |                                   |       |               |       |
| **Total**                        | ** ** | ** **             | ** ** | ** **            | ** ** | ** **             | ** ** | **$**                  | **16,296** | ** **       | ** ** | ** **                                             | **$**      | **188.0**                   | ** ** | ** **                             | ** ** | ** **         | ** ** | ** ** | ** ** |

 

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*Note: Asof March 27, 2007, the Company’s risk under corporate credit CDO ACA CDS 2001-1expired.*

(1)    Investment grade collateralis rated “BBB-” or better; however certain of our investment grade CDOs includethe ability to invest a minority portion (20% or less) in non-investment gradeassets. High-grade is “A-” or better.

(2)    Cash flow CDOs aregenerally callable once per quarter by a majority or greater vote of the equityholders on a specific date as negotiated, which is referred to as the FirstOptional Call Date.

(3)    Argon 49, Argon 57 andDolomite are denominated in Euros. For purposes of this chart, we haveconverted the amounts to U.S. dollars at the prevailing currency exchangerate on March 31, 2007. 

(4)    Tribune is comprised of 13distinct trades some of which are denominated in Euros or Yen. For purposes ofthis chart, we have converted this amount to U.S. dollars at the prevailingcurrency exchange rates on March 31, 2007.

*Accountingfor a Consolidated CDO as Compared to an Unconsolidated CDO.  *When we consolidate a typical funded CDO, for accounting purposes, the CDOissuing vehicle is treated essentially as our wholly owned operatingsubsidiary. “Funded” means that at the CDO’s closing, it issues liabilities inthe form of debt and equity and the assets are purchased out of a warehousefacility with the proceeds from the issuance. The following shows the balancesheet impact of consolidating a hypothetical $400 million 

38

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asset-backed CDO at theclosing date, assuming we 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 |   |

 

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(1)             Thepurchaser of the equity. For illustration purposes we assume the purchase ofequity is made with cash, although we sometimes finance our purchases ofequity.

(2)             Theentity that earns management fees.

For purposes ofthis hypothetical CDO, we assume we do not earn warehouse or structuring fees,which we do on a number of our CDOs. This example also excludes the effects ofany mark to market adjustments on derivatives contained within the CDO vehicle.Following the closing of this hypothetical CDO, we record the activity of theCDO on our assets and liabilities, as well as ongoing expenses of the CDO asfollows, 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:
|  | **One Year 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 |   |

 

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(1)             Basedon a hypothetical investment rate of 6.83%.

39

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(2)             Basedon a hypothetical liability cost of 5.70%.

The presentationabove would be proper from a U.S. GAAP reporting perspective. When managementconsiders the financial performance of the CDO in relation to the economicbenefit to the Company, management considers the income that the CDO generatesin 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 our financial statements because of the U.S. GAAPrules of consolidation.

Conversely, if wewere to close the same hypothetical CDO, but only purchase 10% of the equity,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 |       | —                  |       |
|                               |            |                         |            |  |

 

After one year,assuming the same return rates as in the consolidated example above but beganhaving only purchased 10% of the equity, our statement of operations wouldinclude 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      |   |

 

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

We would view thecomponent 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      |   |

 

Managementevaluates the revenue generation of our CDO Asset Management line of businesson an unconsolidated basis as an alternative measure since management believesit is important to evaluate the revenue associated with each aspect of thebusiness that relates to our investment or our contractual rights to paymentand exclude those revenues that relate to other investors’ economic rights.

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The table belowsets forth the economic impact of our CDOs assuming all CDOs wereunconsolidated for the first quarter of 2007 and 2006.  Investors should neither place undue relianceon this presentation nor use it as a substitute for our segment financial statementswhich are prepared in accordance with U.S. GAAP. This presentation should beutilized only as a supplemental measure of financial performance in evaluatingour CDO Asset Management line of business.
|                                                                           | ** ** | **Three Months Ended March 31,**                  | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                | ** ** | **2007**                                                              | ** ** | **2006** | ** ** |
| ** **                                                                | ** ** | **(in thousands, except where  otherwise noted)** | ** ** |
| Assets under  management (in millions)                                    |       | $                                                                     | 16,296     |   | $ | 11,362 |   |
| Management and  other fees(1)                                             |       | 9,188                                                                 |       | 5,946 |   |
| Warehouse and  structuring fees(2)                                        |       | (140                                                                  | )          | 1,032 |   |
| Equity  returns(3)                                                        |       | 5,119                                                                 |       | 5,433 |   |
| CDO Asset  Management revenue, unconsolidated basis                       |       | $                                                                     | 14,167     |   | $ | 12,411 |   |
| Reconciliation  to CDO Asset Management pre-tax income:                   |       |                                                                  |       |   |   |
| CDO Asset  Management revenue, unconsolidated basis                       |       | $                                                                     | 14,167     |   | $ | 12,411 |   |
| Net realized and  unrealized gains (losses) on CDO related derivatives(4) |       | 6,724                                                                 |       | 3,528 |   |
| Allocated  investment income(5)                                           |       | 975                                                                   |       | 474 |   |
| Allocated  expenses(5)(5a)                                                |       | (6,416                                                                | )          | (4,049 | ) |
| Allocated  interest expenses(5)(5b)                                       |       | (1,251                                                                | )          | (1,099 | ) |
| Allocated  depreciation(5)(5c)                                            |       | (212                                                                  | )          | (219 | ) |
| Allocated  realized gains (losses)(5)(5d)                                 |       | (7                                                                    | )          | (91 | ) |
| Interest  expense—operating(6)                                       |       | (1,891                                                                | )          | (1,785 | ) |
| Minority  interest (mark to market portion)(7)                            |       | (61                                                                   | )          | (326 | ) |
| Loan Trading  Program(8)                                                  |       | 602                                                                   |       | — |   |
| Other                                                                     |       | 19                                                                    |       | (72 | ) |
| Total CDO Asset  Management pre-tax income-U.S. GAAP                      |       | $                                                                     | 12,649     |   | $ | 8,772 |   |

 

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(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 of netunrealized gains and losses included in net insured credit swap revenue, netrealized and unrealized gains (losses) on derivative instruments and other netcredit swap revenue. This adjustment (subtracts) adds back mark to market gains(losses) on derivatives and realized gains (losses) on warehouse facilitiesbecause they represent non-cash adjustments that are expected to reversethemselves over time as the related contracts mature or expire.

(5)    Represents adjustments forthe 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 expensesequal total segment expense less allocated amounts. Direct CDO expenses were$0.5 million in the first quarter of 2007 and $0.5 million 

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in the first quarter of 2006. When we consider the results related toour managed CDOs, allocated expenses are excluded and must be added back inorder to reconcile to segment based income before taxes.

(5b)  Represents a portion of our corporatedebt interest expense allocated to this line of business.  This allocated interest expense, combinedwith CDO debt-operating and CDO debt-non-recourse interest expense, equalstotal segment interest expense.

(5c)  Represents a portion of corporatedepreciation and amortization expense allocated to this line of business.  Direct amortization of debt issuance costs ofconsolidated CDOs is included above as a reduction of equity returns (see note3 above) and totaled $1.8 million in the first quarter of 2007 and$1.9 million in the first quarter of 2006 

(5d)   Represents a portion of our corporaterealized (losses) gains allocated to this line of business. Direct net realizedlosses including impairments were $2.2 million in the first quarter of2007 and $0.8 million in the first quarter of 2006.  These direct realized losses are includedabove as a reduction of our equity return. 

(6)    Represents interest expenseincurred in connection with the financing of our equity purchases. We viewthese costs as indirect costs of our CDO Asset Management business and excludethem when we consider direct results of this line of business. Therefore,management subtracts them to arrive at segment income before taxes.

(7)    Represents the minority interestportion of net unrealized gains (losses) on derivatives for two consolidatedCDOs in which we own less than 100% of the equity. We exclude this item when weexamine the results related to our managed CDOs.

(8)    Represents return and unrealizedgains (losses) on a leveraged loan trading program that is structured in theform of a total return swap. We exclude this item when we examine the resultsrelated to our managed CDOs.

*CDO Structures and Related RevenueRecognition*

The impact of aCDO on our financial statements depends on the structure of the CDO (fullyfunded, partially funded or unfunded), whether or not the CDO is consolidatedand the nature of the underlying assets and liabilities.

Fully funded CDOscontain investments in interest bearing financial assets such as fixed maturitysecurities or guaranteed investment contracts. We have six fully fundedconsolidated CDOs and one partially funded consolidated CDO. The assets andliabilities of these CDOs are included on our balance sheets. The incomegenerated by the investments is reflected in net investment income in theconsolidated statements of operations. The debt liabilities issued in the formof notes pay interest that is included in interest expense in the consolidatedstatements of operations. A management fee is paid by the CDO to ACA Managementbut is eliminated in consolidation. Our return on our equity investment is thenet of the CDO’s revenues (interest income) and expenses, including themanagement fee paid to ACA Management.

Partially fundedsynthetic, or CDS, CDOs sell credit protection on referenced assets by enteringinto credit swaps with various protection buyers in the market. The CDO alsoissues securities, both liabilities and equity, in order to use the proceedsfrom the sale of these securities to collateralize the CDO’s obligations underits credit swaps, except with respect to the most senior tranche of the CDO’scredit exposure, in connection with which a partially funded CDO typicallypurchases credit protection rather than issuing funded liability securities.The proceeds of the securities issued by the partially funded CDO are investedin a guaranteed investment contract, or GIC. We consolidate one partiallyfunded CDS CDO. From this consolidated CDO, we consolidate investment income,relating to the return on the GIC, and interest expense in connection with theliability securities issued by the CDO. We also consolidate derivative incomerelating to net revenues from the fixed fees payable to the CDO under the termsof the credit swaps pursuant to which the CDS CDO sold credit protection onreferenced assets and the fixed fees payable by the CDO on the creditprotection that it purchased. This income is reflected in the consolidatedstatements of operations as other net credit swap revenue. This income is usedto pay the interest on the liabilities of the CDO and other expenses of theCDO, including the management fee. Similar to the fully funded and consolidatedCDOs, all management fees in this partially funded CDS CDO are paid to ACAManagement, but eliminated in consolidation. Our return on our equityinvestment is the net of the CDO’s revenues (interest income and other creditswap income) and the CDO’s expenses, including the management fee paid to ACAManagement.

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For funded andpartially funded unconsolidated CDOs, we reflect management fees and investmentincome in our consolidated statements of operations. As of March 31, 2007,we have 13 funded and partially funded CDOs that are not consolidated. In theseinstances, the investment income recorded is only on the equity investment madeby us as compared to all of the assets in a consolidated CDO. Partially funded,unconsolidated CDOs in which we invest in the funded equity securities arereflected in our financial statements in the same way as funded unconsolidatedCDOs.

We originated afully synthetic, or unfunded, CDS CDO in each of 2002 and 2003. In thesetransactions, we act as asset manager, and, through ACA Financial Guaranty,insure the equity or first loss position of the CDO. No variable interestentities, or VIEs, exist in these structures; rather, the sponsoring investmentbank acts as the counterparty to the various credit swaps that constitute theassets and liabilities of the synthetic CDO. CDOs that do not use VIEs are not subject to consolidation under FIN46(R). For our various roles in the unfunded CDS CDOs, we receive structuringfees, management fees, premium and residual equity returns. On our consolidatedstatements of operations, these revenues are reflected as fee income, netinsured credit swap revenue and other net credit swap revenue. Net insuredcredit swap revenue also includes the changes in fair value of the relatedcredit swaps. Our combined equity position in our two unfunded CDS CDOs, whichis the aggregate notional balance of our credit swaps insuring the equitytranches of these two CDOs, was $47.5 million at December 31, 2006.   At March 31, 2007, one of the transactionsmatured, thereby reducing our exposure to $25.0 million.

In certain fundedCDOs, we issued liabilities in the form of notes in order to fund our equitypurchases. These borrowings were accomplished through the issuance ofnon-recourse notes by our subsidiaries. These notes are insured as to the repaymentof principal and interest by ACA Financial Guaranty. The premium on the policyinsuring the notes payable to ACA Financial Guaranty is payable by oursubsidiary that invested in the preferred shares. These subsidiaries and ACAFinancial Guaranty are wholly owned by us and therefore this inter-companypremium eliminates in consolidation.

In structuring ourCDOs, we collaborate with sponsoring investment banks to develop the type ofCDO, either fully funded, partially funded or unfunded, to meet the demand ofmarket participants. At any given time, different types of CDOs may beattractive to different potential investors. Whether a CDO is consolidated is afunction of the amount of our equity position in the CDO and the relatedaccounting rules. See “—CDO Asset Management—SupplementaryInformation-Consolidation of VIEs.” Whether or not a CDO will be consolidatedonto our financial statements is not a factor that we consider in determiningthe types of CDOs that we agree to manage.

While in earlytransactions we either invested in or sold credit protection through insuredcredit swaps on 100% of the equity tranches of our CDOs, and thereforeconsolidate those CDOs (to the extent the accounting rules require suchconsolidation), beginning in 2005 we have been able to assume reduced amountsof equity in the CDOs that we manage and therefore have not been consolidatingCDOs originated since that time. We do not anticipate consolidating new CDOs inthe 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 of unrealized mark to market adjustmentsthat are recorded in Accumulated Other Comprehensive Income, have exceeded oureconomic exposure in the form of our equity investment in the past and couldexceed our economic exposure in the future. These valuation adjustments reversethemselves over time, to the extent the gains or losses are not realized bysales or other than temporary impairments. We may have realized losses from theassets (from sales and OTTI) in our consolidated CDOs and those losses couldexceed the amount of our equity exposure. These losses are recorded in ourconsolidated statement of operations as realized losses. When there arerealized losses in the CDO asset portfolios, other CDO investors will bearthose losses to the extent the losses exceed our equity exposure to that CDO.When this occurs, the financial statement impact of the realized losses isoffset at CDO maturity, when the associated non-recourse liabilities arewritten off. For example, if we had a $400 million CDO in which we owned100% of the $20 million in equity in the form of preference shares, wewould consolidate the CDO, including all of its income, expenses, gains, lossesand mark to market valuations. Third party investors would own the$380 million in debt securities issued by the CDO. The maximum economicloss we could 

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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*

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 March 31, 2007, all of the exposurein this line of business 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. The following table summarizes the resultsof our Other line of business the three months ended March 31, 2007 and 2006:
| ** **                                         | ** ** | **Three Months   Ended March 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                               | ** ** | **2006** | ** ** |
| ** **                                         | ** ** | **(in thousands)**                                | ** ** |
| **REVENUES**                                       | ** ** | ** **                                             | ** ** | ** ** | ** ** |
| Gross premiums  written                            |       | $                                                      | 282        |   | $ | 428 |   |
| Premiums earned                                    |       | 184                                                    |       | 409 |   |
| Net investment  income                             |       | 1,052                                                  |       | 894 |   |
| Net realized and  unrealized losses on investments |       | (7                                                     | )          | (169 | ) |
| **Total  revenues**                                | ** ** | **1,229**                                              | ** ** | **1,134** | ** ** |
|                                               |       |                                                   |       |   |   |
|                                               | ** ** | ** **                                             | ** ** | ** ** | ** ** |
| **EXPENSES**                                       | ** ** | ** **                                             | ** ** | ** ** | ** ** |
| Loss and loss  adjustment expenses                 |       | 348                                                    |       | 645 |   |
| Policy  acquisition costs                          |       | 14                                                     |       | 120 |   |
| Other operating  expenses                          |       | 11                                                     |       | — |   |
| Interest expense                                   |       | 92                                                     |       | 85 |   |
| Depreciation and  amortization                     |       | —                                                 |       | — |   |
| **Total  expenses**                                | ** ** | **465**                                                | ** ** | **850** | ** ** |
| **(Income)  loss of minority interest**            |       | —                                                 |       | — |   |
| Income before  income taxes                        |       | 764                                                    |       | 284 |   |
| Provision for  income tax expense                  |       | 259                                                    |       | 97 |   |
| **Net income**                                     | ** ** | **$**                                                  | **505**    | ** ** | **$** | **187** | ** ** |

 

*TotalRevenues.  * Total revenues primarily comprised ofnet premiums earned and net investment income, continue to decline for thisline of business due to the fact that it has been in run-off since 2005.Premiums earned declined to $0.2 million in the first quarter of 2007 from $0.4million in the first quarter of 2006. Our exposure in the trade credit business, a component of this line ofbusiness, continues to rapidly decline. Premiums earned for the other insurancecontracts accounted for in this line of business also continue to decline.  We still continue to receive a small amountof installment premium for in-force asset-backed securitizations, principallymanufactured housing, that were insured several years ago.

*NetInvestment Income.*   Net investment income was $1.1million in the first quarter of 2007 and $0.9 million in the first quarter of2006. Net investment income is derived from the allocation of income from ACAFinancial 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.

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*Lossesand Loss Adjustment Expenses.*   We continue torecord losses for the trade credit business. Like premium, losses incurred onthese contracts continued to decline as the underlying exposures run off. Thisloss activity has been within management’s expectations.

In 1999, weinsured 12 securitized manufactured housing bonds with a collective balance of$213.3 million. In response to an increase in the level of realized lossesobserved in the mortgages underlying four of these securitizations, we establisheda case specific 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 March 31, 2007, our case specific reserve was $21.3million. 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.Three of the bonds in our securitized manufactured housing portfolioexperienced losses in 2006, 2005 and 2004. A fourth bond incurred losses in2006. Losses incurred for these securitizations totaled $0.3 million in thefirst quarter of 2007, all related to normal accretion of the existing reservewhich is reported at the discounted value. In the first quarter of 2006, lossesincurred were $0.3 million and also represented accretion.

**Net Economic Income**

In managing ourbusiness and assessing growth and profitability from a strategic and financialplanning perspective, our management and Board of Directors consider U.S. GAAPnet income results as well as a measurement called net economic income. Webelieve that net economic income enhances the understanding of our results ofoperations by highlighting income attributable to our ongoing operatingperformance. However, net economic income is not a measurement of financialperformance or liquidity under U.S. GAAP. It should not be considered inisolation 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 neteconomic income as net income excluding the after-tax effects of:

·                     unrealizedgains (losses) on derivatives included in:

·                     net insuredcredit swap revenue;

·                     net realizedand unrealized gains (losses) on derivative instruments; and

·                     other netcredit swap revenue;

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

·                     the portionof interest expense related to the principal payments on borrowings that werefinanced with derivatives.

Unrealized gains(losses) on derivatives are excluded because (i) they widely vary withchanges in the credit market and interest rate environment and are notnecessarily indicative of the performance of our underlying businesses and(ii) the Company intends to hold the positions to the derivative contracts’expiration, at which time the mark to market values would revert to zero, tothe extent no realized derivative gains or losses had occurred. Realized gains(losses) on non-CDO investments are excluded because our investment strategy isfocused on the preservation of capital and generation of current income asopposed to the generation of trading gains and losses. We include the unrealizedgains (losses) on derivatives and investments generated by trading activity, ifany. Also excluded is a portion of interest expense on borrowings that werefinanced with interest rate swaps to pay the up front issuance costs of some ofour consolidated CDOs. FAS 133 requires that all payments made under theinterest rate swaps, representing both principal and interest, be recorded asinterest expense.  In order toapproximate the economic expense on these borrowings, the portion of interestexpense that is excluded is related to what would be principal payments ifthese borrowings had been financed with debt obligations.

We had after-taxunrealized gains (losses) of ($9.8) million in the first quarter of 2007, and$2.5 million in the first quarter of 2006 on our insured credit swaps includedin net insured credit swap revenue. We had after-tax unrealized gains of $0.9million in the first quarter of 2007, and $2.2 million in 2006 on 

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our derivatives includedin net realized and unrealized gains (losses) on derivative instruments. We hadunrealized gains (losses) of $5.5 million in the first quarter of 2007 and $0.1million in the first quarter of 2006 on our credit swaps included in other netinsured credit swap revenue.  We hadrealized gains (losses) of $(0.0) million in the first quarter of 2007 and$(0.7) million in the first quarter of 2006 on our non-CDO investments. Lastly,we had after-tax expenses of $0.8 million in the first quarter of 2007 and $1.0million in the first quarter of 2006, which effectively constituted principalpayments on our interest rate swaps.

**Liquidityand Capital Resources**

We are a holdingcompany, and as such, have no direct operations of our own. Our liquidity, bothon a short-term basis (for the next 12 months) and a long-term basis (beyondthe next 12 months) is dependent upon how much of our initial publicoffering proceeds we retain at the holding company level, the ability of ouroperating subsidiaries, which excludes our consolidated CDO entities, to paydividends or make other payments to us, and our ability to incur indebtednessand otherwise access the capital markets. As of March 31, 2007, we held atour holding company approximately $19.9 million of the approximately $79.2million in net proceeds from our IPO. For further discussion regarding thebalance of proceeds after March 31, 2007, see Part II, Item 2 of thisreport. Our principal liquidity requirement is the payment of interest on ourdebt and operating expenses. Our outstanding indebtedness is described under “—Indebtedness.” We may also incur additional indebtedness in the future to fund acquisitions,working capital, growth in our business or for other general corporatepurposes.  We also may require liquidityto make periodic capital investments in our operating subsidiaries. We do notcurrently intend to pay dividends. In the ordinary course of our business, weevaluate our liquidity needs and capital resources in light of holding companyexpenses and debt-related expenses. Based on the amount of dividends we expectto receive from our subsidiaries, existing cash, including the remainingproceeds from 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 offactors including market conditions, insurance and rating agencies actions andgeneral economic conditions as well as other items described in our riskfactors in our Form 10-K.  Consequently,although management believes that we will continue to have sufficient liquidityto meet our debt service and other obligations over the long term, we cannotguarantee that we will not be required to seek external debt or equityfinancing in order to meet our operating expenses and debt service obligations.

As discussedabove, one source of our liquidity, for the next 12 months and for thelonger term, will be amounts paid by our operating subsidiaries as dividends tous. ACA Financial Guaranty is our principal subsidiary through which we operateall our lines of business. ACA Financial Guaranty is subject to restrictionsunder state insurance law on its ability to pay dividends. In December 2005,the Maryland Insurance Commissioner approved ACA Financial Guaranty’s requestto pay a dividend in an amount equal to the interest payments on$40 million of the $80 million of our trust preferred issuanceoutstanding through the year ended December 31, 2006.  The Maryland Insurance Commissioner alsoapproved interest payments by ACA Financial Guaranty on the$10 million surplus note due in the 2006 fiscal year.  Accordingly, during 2006 ACA FinancialGuaranty paid dividends of $2.7 million for the ultimate benefit of itsparent, ACA Capital, and $0.8 million in interest on the surplusnote.  Approval of the Maryland InsuranceCommissioner to make dividend and surplus note interest payments due in 2007 onthe $40 million of trust preferred securities and the $10 million surplus note,respectively, was received by us in December 2006.  As of March 31, 2007, ACA Financial Guarantypaid dividends of $0.9 million and $0.2 million in interest on the surplusnote.  We have not received dividendsfrom our operating subsidiaries other than ACA Financial Guaranty.

If S&P was toreduce ACA Financial Guaranty’s financial strength rating to below the “A”category, we would be severely limited in our ability to insure additionalmunicipal bonds or insure additional Structured Credit transactions. Inaddition, if the financial strength rating was reduced below “A-”, we could berequired to provide collateral in the form of cash or securities to backcertain of our Structured Credit transactions. In the case of certain insuredcredit swaps, if the underlying portfolio deteriorates below a pre-agreedpoint, we are generally required to post collateral in an amount that is thelesser of the amount by which actual losses exceed this pre-agreed point andthe amount of any negative mark to market value of the insured credit swap. Ifany of these events occurred, it could materially hurt our financial 

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performance and liquidityand severely strain our capital resources. See “Part I, Item3—Quantitative and Qualitative Disclosures About Market Risk.”

Liquidity at ouroperating subsidiaries is used to pay operating expenses, claim payments andincome taxes. Positive cash flow at ACA Financial Guaranty is only available topay operating expenses of other operating subsidiaries subject to the approvalof the Maryland Insurance Commissioner. In addition, certain of our operatingsubsidiaries may be required to post collateral in connection with creditderivatives. We had $63.4 million of collateral posted related to sevensynthetic equity transactions in our CDO Asset Management and Structured Creditbusinesses as of March 31, 2007. However, in 2007, we expect $40.0 millionin collateral held to be released in connection with the scheduled expirationof the related contracts.  At March 31,2007 none of the $40.0 million was released. On an ongoing basis, our sourcesof funds at our operating subsidiaries primarily result from premiums written,asset management fees, investment income and proceeds from the sale andredemption of investments. Cash is used primarily to pay losses and lossexpenses, policy acquisition costs, other operating expenses and interestexpenses. Our cash flow from operations generally represents the differencebetween premiums collected along with the investment income realized, andinvestment earnings realized and the losses and loss expenses paid, policyacquisition and other operating expenses and investment losses realized.  Cash flow from operations may differsubstantially from net income. As of March 31, 2007, we have invested allcash flow that is not required for operating purposes. Management believes thatour subsidiaries’ operating needs generally can be met from operating cash flowfor at least the next 12 months.

See “—Indebtedness.”

*Cash Flows for the Three MonthsEnded March 31, 2007*

For the threemonths ended March 31, 2007, we generated positive net operating cash flowof $1.6 million, primarily related to income from operations and investmentincome.  This amount is net of our$10.0 million investment in our Credit Fund in the first quarter of2007.  In the first three months of 2007,we had net proceeds from invested assets of $73.8 million principally fromthe maturity of fixed maturity securities available for sale, primarily in ourconsolidated CDOs.  We had net cashoutflows of $29.5 million related to financing activities, which includedthe paydown of $30.7 million of long-term debt, primarily in our consolidatedCDOs.  As of March 31, 2007, we hadcontributed $59.3 million of the proceeds from our initial public offering toour subsidiaries.  As of March 31,2007, we had a cash balance of $426.0 million.

*Cash Flows for the Three MonthsEnded March 31, 2006*

For the threemonths ended March 31, 2006, we generated positive net operating cash flowof $8.3 million, primarily related to income from operations andinvestment income. During the same period, we invested a net cash amount of$39.4 million. We had net cash outflows of $38.5 million throughfinancing activities, which included the paydown of $39.3 million of long-termdebt, primarily related to our consolidated CDOs.  As of March 31, 2006, we had a cashbalance of $183.6 million.

**Capital Expenditures**

We did not makesignificant capital expenditures for or during the three months ended March 31,2007 and 2006. We do not anticipate significant capital expenditures for theremainder of 2007.

**Off-Balance Sheet Arrangements**

We do not have any“off-balance sheet arrangements” (as such term is defined in Item 303 ofRegulation S-K of the General Rules and Regulations under theSecurities Act of 1933, as amended) that are reasonably likely to have acurrent or future effect on our financial condition, changes in financialcondition, revenues or expenses, results of operations, liquidity, capitalexpenditures or capital resources. We do, however, have off-balance sheetexposure in the form of our financial guaranty exposure or par in force. Par inforce as of March 31, 2007 was $57.0 billion and includes exposure to PublicFinance, Structured Credit and CDO Asset Management and other transactions inwhich ACA Financial Guaranty has issued insurance policies. Par in force as ofMarch 31, 2006, was $25.3 billion.

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**Contractual Obligations**

The followingtable summarized our contractual obligations as of March 31, 2007(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                            |       | 110,942                 |       | —            |       | —                  |       | 102,527                 |       | 8,415                       |       |
| CDO debt—non-recourse, net of discounts(2)    |       | 4,683,377               |       | 2,678,982         |       | 102,328                 |       | —                  |       | 1,902,067                   |       |
| Total debt                                         |       | 4,874,218               |       | 2,678,982         |       | 102,328                 |       | 102,527                 |       | 1,990,381                   |       |
| Securities sold  under agreements to repurchase(3) |       | 277,701                 |       | 277,701           |       | —                  |       | —                  |       | —                      |       |
| Lease  obligations                                 |       | 37,911                  |       | 2,717             |       | 9,521                   |       | 5,525                   |       | 20,148                      |       |
| Loss reserves(4)                                   |       | 44,108                  |       | 5,977             |       | 4,662                   |       | 3,559                   |       | 29,910                      |       |
| Total                                              |       | $                       | 5,233,938  |              | $          | 2,965,377               |       | $                       | 116,511    |                        | $          | 111,611 |   | $ | 2,040,439 |   |

 

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(1)     Does not include anypotential borrowings under our credit facility, for which there were nooutstanding borrowings as of March 31, 2007, 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.

(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)     The loss and lossadjustment expenses payments due by period in the table above are based uponthe present value of loss and loss adjustment expenses estimates as ofMarch 31, 2007 and are not contractual liabilities with specified times ofpayment. Our contractual liability is to provide benefits under our policies.As a result, our calculation of loss and loss adjustment expenses payments dueby period is subject to the same uncertainties associated with determining thelevel of unpaid loss and loss adjustment expenses reserves generally and to theadditional uncertainties arising from the difficulty of predicting when claims(including claims that have not yet been reported to us) will be paid. Actualpayments of losses and loss adjustment expenses by period will vary, perhapsmaterially, from the above table to the extent that current estimates of lossand loss adjustment expenses vary from actual ultimate claims and amounts andas a result of variations between expected and actual payout patterns. 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.

**Restricted Balances**

Our insurancesubsidiary, ACA Financial Guaranty, has assets on deposits with variousregulatory authorities. At March 31, 2007, 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 $69.1 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. As of March 31, 2007 none of the $40.0 million wasreleased. We also hold $1.1 million in collateral, through one of ourconsolidated CDOs, for the benefit of the CDO debt holders.

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**Indebtedness**

*Credit Facilities*

*$75 million Credit Facility*

We had a $75million 364-day senior unsecured revolving credit facility (the “Prior CreditFacility”) with a syndicate of banks, which was replaced with the New CreditFacility (defined below) in April 2007. As of March 31, 2007, no amounts wereoutstanding under the Prior Credit Facility nor had there been any borrowingsunder the facility.  The Prior CreditFacility required us to maintain a net worth not less than the sum of (i)$298,500,000, (ii) 60% of our cumulative Consolidated Net Income (as defined inthe credit agreement for the Prior Credit Facility) for each fiscal quarter(beginning with the fiscal quarter ending March 31, 2006), and (iii) 60% of thenet cash proceeds of any offering of common equity consummated after thefacility’s closing date.  We were furtherrequired to not permit our debt to capital ratio to be greater than 35% at anytime and to maintain a minimum financial strength rating from S&P of “A-”for ACA Financial Guaranty.  As of March31, 2007, we met all of these requirements.

*$150million Credit Facility*

On April 26, 2007,we entered into a $150 million three-year senior unsecured revolving creditfacility (the “New Credit Facility”) with a syndicate of banks.  The New Credit Facility replaced the PriorCredit Facility discussed above.

The New CreditFacility provides for borrowings by us on a revolving basis up to an aggregateof $150 million at any one time outstanding and includes a $25 millionsub-commitment for the issuance of letters of credit and a $20 millionsub-commitment for the making of swingline loans.  At our request and subject to the terms andconditions of the credit agreement for the New Credit Facility, the maximumamount of facility commitments may be increased up to $250 million at thelenders’ discretion.

We may elect fromtime to time an interest rate per annum for the borrowings under the New CreditFacility equal to either (a) an annual benchmark rate, which will be equal tothe greatest of (i) the prime rate in effect and (ii) the federal fundseffective rate, plus 50 basis points or (b) the Eurodollar rate plus anApplicable Margin (as defined in the credit agreement for the New CreditFacility) corresponding to our leverage ratio (the ratio of debt to capitalreflected in our then most current consolidated financial statements). Allswingline loans shall bear interest at a rate per annum equal to the annualbenchmark rate. In the case of competitive bid loans, interest per annum isfixed and specified by the lender making such competitive loan.

We will also payan Applicable Facility Fee (as defined in the credit agreement for the NewCredit Facility) on the commitments in effect under the New Credit Facility(whether used or unused) corresponding to our leverage ratio. In addition, wewill pay utilization fees on the average daily amount of total amountoutstanding under the New Credit Facility when such amount outstanding exceeds50% of the commitments under the facility, a fronting fee on the average dailyamount of the undrawn amount under all letters of credit and other fees foreach letter of credit issued under the facility.  These fees are payable quarterly in arrears.

The terms of theNew Credit Facility include various restrictive covenants.  These covenants include restrictions onindebtedness, liens, fundamental changes, sales of assets, certain payments,and transactions with affiliates.  TheNew Credit Facility also includes a covenant requiring us to maintain a networth not less than the sum of (i) $400,000,000, (ii) 50% of our cumulativeConsolidated Net Income (as defined in the credit agreement for the New CreditFacility) for each fiscal quarter (beginning with the fiscal quarter endingJune 30, 2007) and (iii) 50% of the net cash proceeds of any offering of commonequity consummated after the facility’s closing date.  We must further not permit our debt tocapital ratio to be greater than 35% at any time and must maintain a minimumfinancial strength rating from S&P of “A-” for ACA Financial Guaranty.  The nature of these covenants is similar toor more favorable than the covenants contained in the Prior Credit Facility.

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The New CreditFacility contains various events of default customary for investment grade loanfacilities of this type (subject to certain materiality thresholds and graceperiods), including failure to pay principal and interest on loans when due, afailure to reimburse under, or pay fees in connection with, letters of creditwhen due, breach of covenants, default in payment of principal or interest inrespect of certain material indebtedness, including the acceleration of suchmaterial indebtedness, bankruptcy or insolvency, including in respect ofcertain significant subsidiaries, entry of certain enforceable judgments nototherwise stayed, and the occurrence of a change of control.  The nature of these events of default issimilar to or more favorable than those contained in the Prior Credit Facility.  If an event of default occurs, all of ourobligations under the New Credit Facility could be accelerated by the requiredlenders.  In the case of bankruptcy orinsolvency, acceleration of our obligations under the New Credit Facility isautomatic.

*Trust Preferred Securities*

We issued floatingrate junior subordinated deferrable interest debentures, structured as trustpreferred 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 term of30 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 9.46% at March 31, 2007. Theeffective interest rate of these securities is calculated based on three-monthLIBOR plus a margin of 3.35% to 4.10% per annum subject to certain interestrate caps during the lives of the securities.

The indenturesgoverning the debentures limit our ability to pay dividends and incur otherindebtedness. Events of default under the indentures include failure to maketimely principal or interest payments, continuation of a breach of theindentures 60 days after proper notice, bankruptcy, liquidation and dissolution.

*Other Financings*

To the extent wepurchase equity in our CDOs, we may issue notes to finance such purchases.These notes are debt obligations secured by our equity interest in the CDO andinsured as to the repayment of principal and interest by ACA FinancialGuaranty. The notes generally may be redeemed prior to the scheduled maturitydate at our option.

InMarch 2005, one of our subsidiaries, ACA Parliament, L.L.C. (“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 theaforementioned term note, totaled $110.9 million and $112.0 millionas of March 31, 2007 and December 31, 2006, respectively.

**Investment Portfolio**

As of March 31,2007, our investment portfolio consisted of $5.1 billion of fixed maturitysecurities, of which $4.3 billion were from VIEs that we consolidate underFIN 46(R), $22.5million from our unconsolidated CDOs, $501.2 million wereheld in our insurance company investment portfolio and $308.0 million werefrom our Credit Fund.  The vast majorityof our fixed maturity securities are designated as available for sale inaccordance with FAS 115. The remaining fixed maturity securities aredesignated as part of a trading portfolio. These securities were purchased inconnection with the launching of our Credit Fund.  Fixed maturity securities available for saleare reported at fair value in accordance with FAS 115, and the change infair value is reported as part of accumulated other comprehensive income instockholders’ equity while changes in the fair value of trading securities arerecorded in the income statement. Other than temporary impairments on our VIEand non-VIE investments are recorded in net income as realized losses.

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The following table summarizes our investmentportfolio as of March 31, 2007: 
| ** **                                      | ** ** | **Amortized  Cost**     | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| ** **                                      | ** ** | **(in thousands)** | ** ** |
| Available for  sale-non-VIE:                    |       |                    |       |                         |       |                          |       |                           |       |
| U.S. treasury securities                        |       | $                       | 41,321     |                         | $          | 101                           |       | $                              | (587       | ) | $ | 40,835 |   |
| Federal-agency securities                       |       | 71,504                  |       | —                       |       | (627                          | )          | 70,877                         |       |
| Obligations of sales and political subdivisions |       | 133,013                 |       | 667                          |       | (932                          | )          | 132,748                        |       |
| Corporate securities                            |       | 95,683                  |       | 417                          |       | (2,101                        | )          | 93,999                         |       |
| Asset-backed securities                         |       | 14,306                  |       | 73                           |       | (61                           | )          | 14,318                         |       |
| Mortgage-backed securities                      |       | 145,915                 |       | 60                           |       | (2,573                        | )          | 143,402                        |       |
| Total non-VIE  securities                       |       | 501,742                 |       | 1,318                        |       | (6,881                        | )          | 496,179                        |       |
| Available for  sale VIE asset-backed securities |       | 4,503,159               |       | 19,199                       |       | (194,223                      | )          | 4,328,135                      |       |
| Total available  for sale                       |       | 5,004,901               |       | 20,517                       |       | (201,104                      | )          | 4,824,314                      |       |
| Held for  trading- Credit Fund:                 |       |                    |       |                         |       |                          |       |                           |       |
| Securities held for trading- assets             |       | 309,529                 |       | 347                          |       | (1,864                        | )          | 308,012                        |       |
| Securities held for trading- liabilities        |       | —                  |       | —                       |       | —                        |       | —                         |       |
| Total held for  trading- Credit fund            |       | 309,529                 |       | 347                          |       | (1,864                        | )          | 308,012                        |       |
| Total                                           |       | $                       | 5,314,430  |                         | $          | 20,864                        |       | $                              | (202,968   | ) | $ | 5,132,326 |   |

 

The amortized costand estimated fair value of fixed maturity securities available for sale andheld for trading as of March 31, 2007, by contractual maturity, are shownbelow. Expected maturities will differ from contractual maturities becauseborrowers may have the right to call or prepay obligations with or withoutpenalties. 
| ** **                             | ** ** | **Non- VIE Securities** | ** ** | **VIE Securities**        | ** ** | **Total**           | ** ** |
|----------------------------------------|------------|-----------------------------------|------------|--------------------------------|------------|---------------------|------------|
| ** **                             | ** ** | **Amortized  Cost**               | ** ** | **Estimated  Fair Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| ** **                             | ** ** | **(in thousands)**           | ** ** |
| Available for  sale(1):                |       |                              |       |                           |       |                |       |   |   |   |   |   |   |
| Due in one year or less                |       | $                                 | 21,022     |                           | $          | 20,965              |       | $ | 31,001 |   | $ | 31,277 |   | $ | 52,023 |   | $ | 52,242 |   |
| Due after one year through five years  |       | 81,339                            |       | 80,720                         |       | 108,810             |       | 109,602 |   | 190,149 |   | 190,322 |   |
| Due after five years through ten years |       | 159,864                           |       | 158,632                        |       | 383,998             |       | 387,515 |   | 543,862 |   | 546,147 |   |
| Due after ten years                    |       | 239,517                           |       | 235,862                        |       | 3,979,350           |       | 3,799,741 |   | 4,218,867 |   | 4,035,603 |   |
| Total available  for sale              |       | 501,742                           |       | 496,179                        |       | 4,503,159           |       | 4,328,135 |   | 5,004,901 |   | 4,824,314 |   |
| Held for  trading- Credit Fund(1):     |       |                              |       |                           |       |                |       |   |   |   |   |   |   |
| Due after ten years                    |       | —                            |       | —                         |       | 309,529             |       | 308,012 |   | 309,529 |   | 308,012 |   |
| Total held for  trading                |       | —                            |       | —                         |       | 309,529             |       | 308,012 |   | 309,529 |   | 308,012 |   |
| Total                                  |       | $                                 | 501,742    |                           | $          | 496,179             |       | $ | 4,812,688 |   | $ | 4,636,147 |   | $ | 5,314,430 |   | $ | 5,132,326 |   |

 

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(1)          Actualmaturities could differ from contractual maturities because borrowers have theright to call or prepay certain obligations which may or may not include callor prepayment penalties.

Fair value of thefixed maturity securities is based upon quoted market prices provided by eitherindependent pricing services or, when such prices are not available, byreference to broker or underwriter bid indications.

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We review ourinvestment portfolio on at least a quarterly basis for possible impairmentlosses.

The followingtable summarizes the ratings distributions of the fixed maturity securities inour investment portfolio and the investment portfolio of our consolidated VIEsas of March 31, 2007 and December 31, 2006: 
| ** **                            | ** ** | **As of**               | ** ** | **As of**                  | ** ** |
|---------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| **Rating**(1)                         | ** ** | **March 31, 2007** | ** ** | **December 31, 2006** | ** ** |
| ** **                            | ** ** | **(in thousands)**      | ** ** |
| AAA or  equivalent                    |       | $                            | 364,091    |                            | $          | 346,352 |   |
| AA                                    |       | 63,851                       |       | 55,687                          |       |
| A                                     |       | 40,588                       |       | 52,125                          |       |
| BBB                                   |       | 21,494                       |       | 24,213                          |       |
| Below investment  grade and non-rated |       | 6,155                        |       | 11,205                          |       |
| Total non-VIE  securities             |       | 496,179                      |       | 489,582                         |       |
| VIE securities                        |       | 4,328,135                    |       | 4,536,694                       |       |
| Held for  trading- Credit Fund        |       | 308,012                      |       | 251,825                         |       |
| Total                                 |       | $                            | 5,132,326  |                            | $          | 5,278,101 |   |

 

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(1)Ratings are represented by the lower of the S&P and Moody’s InvestorsService classifications.

The followingtable summarizes the unrealized losses in our investment portfolio by type ofsecurity and the length of time such securities have been in a continuousunrealized loss position as of March 31, 2007:
| ** **                                           | ** ** | **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                            |       | $                                      | 30,937     |                                 | $          | (532      | )          | $ | 1,840 |   | $ | (55 | ) | $ | 32,777 |   | $ | (587 | ) |
| Federal-agency  securities                           |       | 66,399                                 |       | (558                                 | )          | 4,478     |       | (69 | ) | 70,877 |   | (627 | ) |
| Obligations of  states and political subdivisions    |       | 6,353                                  |       | (46                                  | )          | 52,401    |       | (886 | ) | 58,754 |   | (932 | ) |
| Corporate  securities                                |       | 15,000                                 |       | (163                                 | )          | 55,770    |       | (1,937 | ) | 70,770 |   | (2,100 | ) |
| Asset-backed  securities                             |       | 949                                    |       | —                               |       | 5,350     |       | (61 | ) | 6,299 |   | (61 | ) |
| Mortgage-backed  securities                          |       | 28,058                                 |       | (217                                 | )          | 96,021    |       | (2,356 | ) | 124,079 |   | (2,573 | ) |
| Total non-VIE  securities                            |       | 147,696                                |       | (1,516                               | )          | 215,860   |       | (5,364 | ) | 363,556 |   | (6,880 | ) |
| Available for  sale-VIE—asset-backed securities |       | 2,069,566                              |       | (178,262                             | )          | 461,157   |       | (15,960 | ) | 2,530,723 |   | (194,222 | ) |
| Total available for  sale-non-VIE                    |       | $                                      | 2,217,262  |                                 | $          | (179,778  | )          | $ | 677,017 |   | $ | (21,324 | ) | $ | 2,894,279 |   | $ | (201,102 | ) |

The unrealized losses on the Company’s non-VIEinvestments were caused by interest rate increases.  Because the decline in market value of thesesecurities is attributable to changes in interest rates and not credit quality,and because the Company has the ability and intent to hold these investmentsuntil a recovery of fair value, which may be maturity, it does not considerthese investments to be other-than-temporarily-impaired at March 31, 2007.

A substantial portion of the unrealized loss in VIE asset-backedsecurities is related to collateralized residential mortgage backed securities,including both sub-prime and mid-prime quality mortgages.  The last quarter of 2006 and first quarter of2007 saw significant disruption and consolidation in the sub-prime 

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mortgage market, with some mortgage originators beingpurchased or exiting the business. This disruption translated into decreasedliquidity and wider spreads across the market, decreasing the market value ofthe portfolios.  In particular,securities backed by mortgages from what are currently perceived as originatorswith weaker underwriting standards experienced a decrease in price in late 2006and the first quarter of 2007, even when the credit performance of thesecurities had not suffered.  Anadditional factor weighing on the market valuations for the Company’s positionsis the limited liquidity associated with the seasoned securities which havealready received or are about to receive a significant return ofprincipal.  Since the Company, atMarch 31, 2007, believed that it would be able to collect amounts due onits RMBS positions and has the ability and intent to hold these investmentsuntil a recovery of fair value, which may be at their maturities, we did notconsider these investments to be other-than-temporarily impaired atMarch 31, 2007.

Included above are 869 fixed maturity securities, 166 in the non-VIEportfolios, and 703 in the VIE portfolios. At March 31, 2007, there were 115 fixed maturity securities ofwhose amortized cost exceeded its respective fair value by greater than20%.  Over 99% of the securities in boththe non-VIE portfolio and the VIE portfolios are rated investment grade.  Management has assessed these and otherfactors and concluded that there were no other than temporarily impaired fixedmaturity securities included in the above table as of March 31, 2007.

**Item 3. Quantitative andQualitative Disclosures About Market Risk**

*Market Risk*

Market riskrepresents the potential for losses that may result from changes in the valueof a financial instrument as a result of changes in market conditions. Theprimary market risks that impact our financial instruments are due to interestrates, credit spreads, asset correlation, asset-backed security prepayments,CDO reinvestment and CDO commercial paper refunding. Each of these risks andthe specific types of financial instruments which they impact are describedbelow. Senior managers in our risk management department are responsible formonitoring risk limits and applying risk measurement methodologies. Theestimation of potential losses arising from adverse changes in marketconditions is a key element in managing market risk. We use various systems,models and stress test scenarios to monitor and manage market risk. Thesemodels include estimates made by management that use current and historic marketinformation. The valuation results from these models could differ materiallyfrom amounts that actually are realized in the market. See “—CriticalAccounting Policies and Estimates—Investment Portfolio” and “—CriticalAccounting Policies and Estimates—Derivative Contracts” in Part I, Item 2.

*Interest Rate Risk*

Interest rate riskis the risk that the fair value of our interest rate sensitive assets orliabilities will change with changes in market interest rates. We own bothfixed rate and floating rate bonds in our non-CDO corporate-wide investmentportfolios and consolidated CDO portfolios. Also, our unconsolidated CDO equityinvestments have fair values that are sensitive to yield curve movements.

We use interestrate swaps and caps to hedge differences in the cash flow of assets andliabilities within many of our CDOs. These hedges also act to reduce the netsensitivity to fair value changes. We do not hedge the interest rate risk ofour non-CDO corporate-wide investment portfolios since we prefer the incomefrom this portfolio be predominantly fixed coupon. As interest rates go up ordown, the yield of that investment portfolio will be fairly stable, however,the fair value will fluctuate and the fluctuation can be material. While thisportfolio holds both fixed-and floating-rate debt obligations, it ispredominantly fixed rate. Conversely, our funded CDO assets are primarilycomprised of floating rate securities. While the values of these securities aregenerally not sensitive to interest rate movements, the associated yields aresensitive to changes in interest rates.

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The followingtable 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  March 31, 2007** | ** ** | **+100 bps  per annum  Shift** | ** ** | **-100 bps  per annum  Shift** | ** ** |
|-------------------------------|------------|-------------------------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| ** **                    | ** ** | **(in millions)**                                | ** ** |
|                          |       |                                                  |       |                                     |       |                                     |       |
| Non-CDO  investment portfolio |       | $                                                     | 496.2      |                                     | (25.4      | )                                        | $          | 28.0 |   |
| CDOs (1)                      |       | 4,447.5                                               |       | (17.5                                    | )          | 16.5                                     |       |
| Interest rate  swaps          |       | (14.9                                                 | )          | 12.8                                     |       | (13.4                                    | )          |
|                          |       | $                                                     | 5,048.1    |                                     | (30.1      | )                                        | $          | 31.1 |   |

 

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 (1) Includes guaranteed investment contractbalance of $119.3 million.

*Credit Spread Risk*

Credit spread riskis the risk that the fair value of our credit sensitive assets or other riskexposure will change with changes in the credit spreads of the referencedentities. Roughly speaking, the “credit spread” is the additional yield abovethe risk-free benchmark yield that a borrower must pay to its lenders. Thecredit spread increases as the perceived risk of default of the borrowerincreases. Fluctuations of credit spreads behave like movements in the marketyield curve (interest rate risk) for simple fixed-income investments and impactfixed- and floating-rate debt equally. Our credit swap exposure in ourStructured Credit and CDO Asset Management transactions is generally moresensitive to movements in credit spreads than to movements in interest ratessince the mathematical models that determine fair value use changing spreads asa signal of a changing likelihood of default in the future.

The followingtable 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  March 31, 2007** | ** ** | **+25 bps  per annum  Credit Spread Shift** | ** ** | **-25 bps  per annum  Credit Spread Shift** | ** ** |
|-------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                    | ** ** | **(in millions)**                                | ** ** |
| Non-CDO  investment portfolio |       | $                                                     | 496.2      |                                                            | $          | (7.4                                                            | )          | $ | 7.4 |   |
| CDOs (1)                      |       | 4,447.5                                               |       | (34.3                                                           | )          | 33.5                                                            |       |
| Structured  Credit            |       | (8.8                                                  | )          | (8.5                                                            | )          | 4.4                                                             |       |
|                          |       | $                                                     | 5,054.2    |                                                            | $          | (50.2                                                           | )          | $ | 45.3 |   |

 

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(1) Includes guaranteed investment contract balance of$119.3 million.

We chose stressesof plus or minus 25 basis points per annum for the credit spread risksensitivity, as opposed to a larger value, since many of the underlying spreadsare less than 100 basis points per annum.

*Asset Correlation Risk*

For a hypotheticalportfolio of debt instruments, the correlation among the positions does notaffect the fair value of the portfolio. For portfolios of debt instruments thatare divided into risk layers (*i.e.*,“AAA” through equity) or tranches, however, the correlation among the riskpositions is significant because higher correlations could lead to greater orlower risk of default based on the position of the given risk layer. Such risk existsprimarily in our CDO Asset Management and Structured Credit businesses. Theindustry measures this correlation as “asset correlation,” which is defined asthe correlation 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.

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The followingtable shows the change in fair value for these two business activities withsignificant asset correlation risk. We employ proprietary cash flow, assetcorrelation, and stochastic default models to derive these values. 
| **Business Activity** | ** ** | **Fair Value at  March 31, 2007** | ** ** | **+5% Shift in Asset  Correlation** | ** ** | **-5% Shift in Asset  Correlation** | ** ** |
|----------------------------|------------|-------------------------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                 | ** ** | **(in millions)**                                | ** ** |
| CDOs (1)                   |       | $                                                     | 4,447.5    |                                               | $          | 0.1                                                |       | $ | (0.2 | ) |
| Structured  Credit         |       | (8.8                                                  | )          | (23.8                                              | )          | 4.7                                                |       |
|                       |       | $                                                     | 4,558.0    |                                               | $          | (23.7                                              | )          | $ | 4.5 |   |

 

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(1) Includes guaranteed investment contract balance of$119.3 million.

*Other Market Risks*

In addition to theabove-mentioned risks, the ultimate return we realize on our equity investmentsin our CDOs is impacted by several other market risks. These risks are ABSprepayment risk, reinvestment risk and commercial paper refunding risk. Becauseour equity exposure behaves like a floating-rate obligation, our equity returndepends on the leverage of the transaction (total portfolio size divided by theequity tranche size). Early prepayments on the ABS underlying the CDO woulddeliver the transaction and, thus, diminish the returns to the equity holders.This risk is mitigated somewhat by the fact that the majority of the underlyingCDO ABS pay interest based on floating rate, making them less sensitive toprepayments. Our non-CDO corporate-wide investment portfolios could also beimpacted by prepayments. We limit this exposure by imposing limits on theamount of such securities held in these portfolios.

Many of our CDOtransactions are currently in the “reinvestment period.” This means that as theasset-backed securities or the leveraged loans return principal to the CDOportfolios, we re-invest the principal proceeds rather than repay CDO debt.Since the CDO liability cost is frozen at inception (either as a fixed coupon,or, more typically, as a fixed spread to LIBOR), we, as equity investor bearthe risk that reinvestment spreads will decrease. Conversely, increasingreinvestment spreads benefit our equity investment.

In two of ourconsolidated CDO transactions, the senior liability (of approximately$1.3 billion in each as at March 31, 2007) is comprised of commercialpaper. Hence, our balance sheet carries approximately $2.7 billion ofshort-term debt or commercial paper as at September 30, 2006 that werefund, on average, monthly. The typical yield cost of this commercial paper(including dealer cost) is LIBOR-flat. Our risk is that future issuances maygive the commercial paper a positive spread to LIBOR. There is no guaranteethat investors will continue to buy this CDO commercial paper at LIBOR-flat. Alternatively,this future commercial paper funding could fall below LIBOR. We manage thisrefunding risk by negotiating into the CDO transaction, caps on the spread toLIBOR. As a result, the commercial paper, or CP, yield cannot exceed LIBOR +40basis points per annum due to the presence of put option contracts. An increasein the spread above LIBOR directly impacts our equity investment. When the CPspread widens (tightens), we receive lesser (greater) cash distributions.

*Credit Fund*

We view the marketrisks (principally interest rate and credit spread risk) in the Credit Fund asnot material to our financial position as of March 31, 2007. While the CreditFund is consolidated for financial reporting purposes, our net investment inthe fund at March 31, 2007 is $26.4 million. Total invested assets of the fundwere approximately $308.0 million at March 31, 2007.  The fund hedgesinterest rate risk on its fixed rate assets to remain close to market neutralwith respect to interest rate risk.  At March 31, 2007, the weightedmodified duration of the portfolio was less than one year.  Additionally,at March 31, 2007, the vast majority of the bonds held in the fund werefloating interest rate payers which have minimal interest 

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raterisk.  Finally, assets held in the fund as of March 31, 2007 had anaverage credit quality of AAA, thereby substantially reducing credit spreadrisk.

**Item 4. Controls and Procedures**

*Evaluation of Disclosure Controls and Procedures*.As of the end of the period covered by this report, an evaluation was carriedout by our management, with the participation of the Chief Executive Officerand Chief Financial Officer, of the effectiveness of our disclosure controlsand procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934, as amended).  Based on that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that these disclosurecontrols and procedures were effective as of the end of the period covered bythis report.

*Changes in Internal Controls Over FinancialReporting*. No change in our internal control over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) under the SecuritiesExchange Act of 1934, as amended) occurred during the period covered by thisreport that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

**PART II- OTHER INFORMATION**

**Item 1. Legal Proceedings**

In the normalcourse of business, we may become involved in various claims and legalproceedings, including claims involving employee-related matters. We are notaware of any pending or threatened material litigation which we believe couldreasonably be likely to result in a material adverse effect on us or ourfinancial position, results of operations and cash flows.

**Item 1A. Risk Factors**

In addition to the other information in this report,the factors discussed in “Risk Factors” in our Form 10-K, should be carefullyconsidered in evaluating the Company and its businesses. The risks anduncertainties described in our Form 10-K are not the only ones facing theCompany and its subsidiaries.  Additionalrisks and uncertainties, not presently known to us or otherwise, may alsoimpair our business operations. If any of the risks described our Form 10-K orsuch other risks actually occur, our business, financial condition or resultsof operations could be materially and adversely affected.

**Item 2. Unregistered Sales ofEquity Securities and 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., BearStearns & Co. Inc., Stephens Inc. and Keefe, Bruyette & Woods, Inc.Our offering did not terminate before any securities were sold, but as of thedate of the filing of this report, our offering had terminated and 6,875,000shares of 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 $10.2 million. The net offering proceeds to us afterdeducting these expenses was approximately $79.2 million.

Of the $79.2 million raised for the account of theCompany, as of December 31, 2006, $10.0 million and approximately $4.9million were contributed to ACA Financial Guaranty and ACA Capital Management(U.K.), respectively, to support the continuing growth of ACA FinancialGuaranty and the start-up costs of ACA Capital Management (U.K.), an additional$21.8 million was invested in certain Company-managed investment vehicles,including the Credit Fund and approximately $5.7 million was used to purchaseequity in certain of the Company’s recent CDOs. In first quarter 2007, wecontributed an additional $10.0 million to one of our subsidiaries to fund anadditional investment in the Credit Fund, purchased $2.5 million in equity of aCDO and refinanced an intercompany note in the amount of $4.3 million. Thebalance of approximately $20.1 million has been retained at the holdingcompany. We 

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continue to expect thatthe remainder of the proceeds from the IPO will be used for investments, asworking capital and for general corporate purposes. Pending such uses, thebalance of the approximately $20.1 million is currently invested by us inshort-term investments.

**Item 3. Defaults Upon SeniorSecurities**

None.

**Item 4. Submission of Matters toa Vote of Security Holders**

None.

**Item 5. Other Information**

None.

**Item 6. Exhibits**
|        |   |                                                                                                                                                     |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
|                     | **ACA CAPITAL HOLDINGS, INC.**                  |
|---------------------|-------------------------------------------------|
|                | (Registrant)                                    |
|                |                                            |
|                |                                            |
| Date: May 15,  2007 | /s/ Alan S. Roseman                             |
|                | Alan S. Roseman                                 |
|                | President and Chief Executive Officer |
|                | (Principal Executive Officer)                   |
|                |                                            |
|                |                                            |
| Date: May 15,  2007 | /s/ Edward U. Gilpin                            |
|                | Edward U. Gilpin                                |
|                | Executive Vice President and Chief Financial    |
|                | Officer                                         |
|                | (Principal Financial Officer)                   |

 

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