**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

 

**Form10-Q**

** **
| **x**      | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|------------|------------|-----------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                    |
| ** ** | ** ** | **For  the Quarter Ended September 30, 2007**                                                 |
| ** ** | ** ** | ** **                                                                                    |
| ** ** | ** ** | **or**                                                                                        |
| ** ** | ** ** | ** **                                                                                    |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For thetransition period from                to**

 

**Commissionfile number 1-33111**

 

**ACACapital Holdings, Inc.**

(Exact name of registrantas specified in its charter)

 

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

 

**140Broadway**

**NewYork, New York 10005**

**(212)375-2000**

(Address, including zipcode, and telephone number, including

area code, of registrant’sprincipal executive offices)

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90days.    Yes  x      No  o

 

Indicate by check mark whether the Registrant is a large acceleratedfiler, an accelerated 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 |
|---------------------------------------|--------|---------------------------------|--------|-------------------------------------|

 

Indicate by check mark whether the Registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).  Yes  o  No  x

 

As of November 9, 2007 34,851,780shares of Common Stock, par value $0.10 per share, were outstanding.

 

 

----

 

**INDEX**

 
| ** **                         | ** ** | ** **                                                                                                                        | ** ** | ** ** |
|------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------|------------|------------|
| ** **                         | ** ** | ** **                                                                                                                        | ** ** | ** ** |
| **PART I - FINANCIAL INFORMATION** | ** ** | ** **                                                                                                                        |
| ** **                         | ** ** | ** **                                                                                                                        | ** ** | ** ** |
| Item  1.                           |       | Financial  Statements of ACA Capital Holdings, Inc. and Subsidiaries (Unaudited)                                                  |       | 3          |
|                               |       |                                                                                                                              |       |       |
|                               |       | Report of Independent Registered Public Accounting  Firm                                                                          |       | 3          |
|                               |       |                                                                                                                              |       |       |
|                               |       | Condensed  Consolidated Balance Sheets (Unaudited) — September 30, 2007 and December 31,  2006                               |       | 5          |
|                               |       |                                                                                                                              |       |       |
|                               |       | Condensed  Consolidated Statements of Operations (Unaudited) — Three and nine months  ended September 30, 2007 and 2006      |       | 6          |
|                               |       |                                                                                                                              |       |       |
|                               |       | Condensed  Consolidated Statements of Stockholders’ Equity (Unaudited) — Nine months  ended September 30, 2007 and 2006 |       | 7          |
|                               |       |                                                                                                                              |       |       |
|                               |       | Condensed  Consolidated Statements of Cash Flows (Unaudited) — Nine months ended  September 30, 2007 and 2006                |       | 8          |
|                               |       |                                                                                                                              |       |       |
|                               |       | Notes to  Unaudited Condensed Consolidated Financial Statements                                                                   |       | 9          |
|                               |       |                                                                                                                              |       |       |
| Item 2.                            |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                       |       | 23         |
|                               |       |                                                                                                                              |       |       |
| Item 3.                            |       | Quantitative  and Qualitative Disclosures About Market Risk                                                                       |       | 53         |
|                               |       |                                                                                                                              |       |       |
| Item 4.                            |       | Controls and  Procedures                                                                                                          |       | 55         |
|                               |       |                                                                                                                              |       |       |
| **PART II - OTHER  INFORMATION**   |       |                                                                                                                              |
|                               |       |                                                                                                                              |       |       |
| Item 1.                            |       | Legal Proceedings                                                                                                                 |       | 55         |
|                               |       |                                                                                                                              |       |       |
| Item 1A.                      |       | Risk  Factors                                                                                                                     |       | 56         |
|                               |       |                                                                                                                              |       |       |
| Item 2.                            |       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                      |       | 58         |
|                               |       |                                                                                                                              |       |       |
| Item 3.                            |       | Defaults Upon  Senior Securities                                                                                                  |       | 59         |
|                               |       |                                                                                                                              |       |       |
| Item 4.                            |       | Submission of  Matters to a Vote of Security Holders                                                                              |       | 59         |
|                               |       |                                                                                                                              |       |       |
| Item 5.                            |       | Other Information                                                                                                                 |       | 59         |
|                               |       |                                                                                                                              |       |       |
| Item  6.                           |       | Exhibits                                                                                                                          |       | 59         |
|                               |       |                                                                                                                              |       |       |
| ** **                         | ** ** | ** **                                                                                                                        |       |       |
| **SIGNATURES**                     |       | 60                                                                                                                                |

 

2

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**PART I —FINANCIAL INFORMATION**

 

Item1.        Financial Statements of ACA CapitalHoldings, Inc. and Subsidiaries (Unaudited)

 

REPORT OF INDEPENDENTREGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directorsand Stockholders of

ACA Capital Holdings,Inc.

New York, New York

 

We have reviewed theaccompanying condensed consolidated balance sheet of ACA Capital Holdings, Inc.and subsidiaries (the “Corporation”) as of September 30, 2007, and the relatedcondensed consolidated statements of operations for the three-month and nine-monthperiods then ended, and of stockholders’ equity and cash flows for thenine-month periods then ended. These interim financial statements are theresponsibility of the Corporation’s management.

 

We conducted our reviewin accordance with the standards of the Public Company Accounting OversightBoard (United States). A review of interim financial information consistsprincipally of applying analytical procedures and making inquiries of personsresponsible for financial and accounting matters. It is substantially less inscope than an audit conducted in accordance with the standards of the PublicCompany Accounting Oversight Board (United States), the objective of which isthe expression of an opinion regarding the financial statements taken as awhole. Accordingly, we do not express such an opinion.

 

Based on our review, weare not aware of any material modifications that should be made to suchcondensed consolidated interim financial statements for them to be inconformity with accounting principles generally accepted in the United Statesof America.

 

As discussed in Note 5 tothe condensed consolidated interim financial statements, the financialstatements include derivative assets and derivative liabilities valued at$152.4 million (3% of net assets) and $1,897.2 million (33% of netliabilities), respectively, as of September 30, 2007, whose fair values havebeen estimated by management in the absence of readily determinable fairvalues. Management’s estimates are based on market quotes from dealers orinternal models, which utilize current market information. Additionally, asdiscussed in Note 10, the financial statements include investments valued at$2,772.6 million (56% of net assets) as of September 30, 2007, whose fairvalues have been estimated by management in the absence of readily determinablefair values. Management’s estimates are based on market quotes from dealers orinternal models, which utilize current market information.

 

As discussed in Note 16to the condensed consolidated interim financial statements, on November 9, 2007Standard & Poor’s Rating Services (“S&P”) placed its financial strengthrating of ACA Financial Guaranty Corporation (“ACA FG”), a wholly ownedsubsidiary of the Company, on “CreditWatch with negative implications”. ShouldS&P ultimately downgrade ACA FG’s financial strength rating below “A-”,under the existing terms of the Company’s insured credit swap transactions, thecompany would be required to post collateral based on the fair value of theinsured credit swaps as of the

 

3

----

 

date of posting. The failure to post collateral would be an event ofdefault, resulting in a termination payment in an amount approximately equal tothe collateral call. This termination payment would give rise to a claim underthe related ACA FG insurance policy. Based on current fair values, neither theCompany nor ACA Financial Guaranty would have the ability to post suchcollateral or make such termination payments.

 

We have previously audited, in accordance with the standards of thePublic Company Accounting Oversight Board (United States), the consolidatedbalance sheet of ACA Capital Holdings, Inc. and subsidiaries as of December 31,2006, and the related consolidated statements of operations, stockholders’equity, and cash flows for the year then ended (not presented herein); and inour report dated March 30, 2007, we expressed an unqualified opinion on thoseconsolidated financial statements. In our opinion, the information set forth inthe accompanying condensed consolidated balance sheet as of December 31, 2006is fairly stated, in all material respects, in relation to the consolidatedbalance sheet from which it has been derived.

 

/s/ Deloitte Touche LLP

New York, New York

November 19, 2007

 

4

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**ACACAPITAL HOLDINGS, INC. AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)**

 

**AS OFSEPTEMBER 30, 2007 AND DECEMBER 31, 2006**

 

**(Dollarsin thousands)**

** **
| ** **                                                                                                                                                                                                                                                                                                                       | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                       | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                                                                       | ** ** | ** **             | ** ** | ** **            | ** ** |
| Investments:                                                                                                                                                                                                                                                                                                                     |       |                   |       |                  |       |
| Fixed-maturity  securities available for sale at fair value, amortized cost of $3,808,777 and  $5,043,239, respectively                                                                                                                                                                                                          |       | $                      | 3,373,228  |                  | $          | 5,026,276 |   |
| Fixed-maturity  securities trading at fair value, amortized cost of $133,333 and $251,884,  respectively                                                                                                                                                                                                                         |       | 125,176                |       | 251,825               |       |
| Securities  purchased under agreements to resell                                                                                                                                                                                                                                                                                 |       | 1,000                  |       | 10,248                |       |
| Guaranteed  investment contract                                                                                                                                                                                                                                                                                                  |       | —                 |       | 119,340               |       |
| Total  investments                                                                                                                                                                                                                                                                                                               |       | 3,499,404              |       | 5,407,689             |       |
| Cash:                                                                                                                                                                                                                                                                                                                            |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                                                                                       |       | 283,240                |       | 379,905               |       |
| Restricted cash                                                                                                                                                                                                                                                                                                                  |       | 51,488                 |       | 67,061                |       |
| Total cash                                                                                                                                                                                                                                                                                                                       |       | 334,728                |       | 446,966               |       |
| Accrued  investment income                                                                                                                                                                                                                                                                                                       |       | 15,805                 |       | 21,222                |       |
| Derivative  assets                                                                                                                                                                                                                                                                                                               |       | 152,382                |       | 19,730                |       |
| Deferred policy  acquisition costs, net                                                                                                                                                                                                                                                                                          |       | 50,839                 |       | 48,810                |       |
| Deferred debt  issuance costs, net                                                                                                                                                                                                                                                                                               |       | 17,477                 |       | 34,104                |       |
| Receivable for  securities sold                                                                                                                                                                                                                                                                                                  |       | 4,339                  |       | 824                   |       |
| Prepaid  reinsurance premiums                                                                                                                                                                                                                                                                                                    |       | 464                    |       | 528                   |       |
| Deferred income  taxes                                                                                                                                                                                                                                                                                                           |       | 781,668                |       | —                |       |
| Other assets                                                                                                                                                                                                                                                                                                                     |       | 95,558                 |       | 58,321                |       |
| **Total  assets**                                                                                                                                                                                                                                                                                                                |       | $                      | 4,952,664  |                  | $          | 6,038,194 |   |
|                                                                                                                                                                                                                                                                                                                             |       |                   |       |                  |       |
| **LIABILITIES,  MINORITY INTEREST AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                | ** ** | ** **             | ** ** | ** **            | ** ** |
| LIABILITIES                                                                                                                                                                                                                                                                                                                      |       |                   |       |                  |       |
| Unearned  premiums                                                                                                                                                                                                                                                                                                               |       | $                      | 196,842    |                  | $          | 189,537 |   |
| Reserve for  losses and loss adjustment expenses                                                                                                                                                                                                                                                                                 |       | 42,878                 |       | 42,113                |       |
| Short-term debt                                                                                                                                                                                                                                                                                                                  |       | 2,675,308              |       | 2,677,828             |       |
| Long-term debt                                                                                                                                                                                                                                                                                                                   |       | 672,140                |       | 2,125,914             |       |
| Related party  debt                                                                                                                                                                                                                                                                                                              |       | 100,000                |       | 100,000               |       |
| Securities sold  under agreements to repurchase                                                                                                                                                                                                                                                                                  |       | 104,124                |       | 232,227               |       |
| Derivative  liabilities                                                                                                                                                                                                                                                                                                          |       | 1,897,207              |       | 33,874                |       |
| Accrued interest  payable                                                                                                                                                                                                                                                                                                        |       | 7,584                  |       | 17,900                |       |
| Accrued expenses  and other liabilities                                                                                                                                                                                                                                                                                          |       | 82,816                 |       | 61,855                |       |
| Payable for  securities purchased                                                                                                                                                                                                                                                                                                |       | 37,457                 |       | 9,628                 |       |
| Current income  tax payable                                                                                                                                                                                                                                                                                                      |       | 10,080                 |       | 7,056                 |       |
| Deferred income  taxes                                                                                                                                                                                                                                                                                                           |       | —                 |       | 258                   |       |
| Total  liabilities                                                                                                                                                                                                                                                                                                               |       | 5,826,436              |       | 5,498,190             |       |
| MINORITY  INTEREST                                                                                                                                                                                                                                                                                                               |       | 9,520                  |       | 30,190                |       |
|                                                                                                                                                                                                                                                                                                                             |       |                   |       |                  |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                                                                                                                                                                                   |       |                   |       |                  |       |
|                                                                                                                                                                                                                                                                                                                             |       |                   |       |                  |       |
| STOCKHOLDERS’  EQUITY                                                                                                                                                                                                                                                                                                       |       |                   |       |                  |       |
| Common stock of  100,000,000 shares authorized at September 30, 2007 and December 31, 2006;  37,444,873 and 37,375,123 shares issued at September 30, 2007 and December  31, 2006, respectively; and 34,505,126 and 36,523,276 shares outstanding at  September 30, 2007 and December 31, 2006, respectively; par value of $0.10 |       | 3,744                  |       | 3,737                 |       |
| Gross paid-in  and contributed capital                                                                                                                                                                                                                                                                                           |       | 442,299                |       | 438,935               |       |
| Treasury stock  at cost —2,939,747 and 851,847 shares at September 30, 2007 and December 31,  2006, respectively                                                                                                                                                                                                            |       | (27,084                | )          | (12,088               | )          |
| Notes receivable  from stockholders                                                                                                                                                                                                                                                                                              |       | (3,121                 | )          | (3,121                | )          |
| Deferred  compensation                                                                                                                                                                                                                                                                                                           |       | —                 |       | (870                  | )          |
| Accumulated  other comprehensive loss — net of deferred income tax of $(140,737) and  $(1,760) at September 30, 2007 and December 31, 2006, respectively                                                                                                                                                                    |       | (261,216               | )          | (3,308                | )          |
| Retained  earnings (deficit)                                                                                                                                                                                                                                                                                                     |       | (1,037,914             | )          | 86,529                |       |
| Total  stockholders’ equity                                                                                                                                                                                                                                                                                                 |       | (883,292               | )          | 509,814               |       |
| **Total  liabilities, minority interest and stockholders’ equity**                                                                                                                                                                                                                                                          |       | $                      | 4,952,664  |                  | $          | 6,038,194 |   |

 

See notes to unauditedcondensed consolidated financial statements.

 

5

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**ACACAPITAL HOLDINGS, INC. AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)**

 

**FOR THETHREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006**

 

**(Dollarsand shares in thousands, except per share amounts)**

** **
| ** **                                                            | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                            | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                            | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| REVENUES:                                                             |       |                             |       |                            |       |   |   |   |   |
| Gross premiums  written                                               |       | $                                | 7,113      |                            | $          | 5,570 |   | $ | 27,632 |   | $ | 26,085 |   |
| Less premiums  ceded                                                  |       | (380                             | )          | (189                            | )          | (1,141 | ) | (375 | ) |
| Net premiums  written                                                 |       | 6,733                            |       | 5,381                           |       | 26,491 |   | 25,710 |   |
| Increase in  unearned premium reserve - net                           |       | (1,205                           | )          | 3,213                           |       | (7,369 | ) | (3,759 | ) |
| Premiums earned                                                       |       | 5,528                            |       | 8,594                           |       | 19,122 |   | 21,951 |   |
| Net insured  credit swap revenue                                      |       | (1,627,460                       | )          | 17,079                          |       | (1,667,944 | ) | 39,190 |   |
| Net investment  income                                                |       | 87,471                           |       | 87,888                          |       | 268,018 |   | 248,052 |   |
| Net realized and  unrealized gains (losses) on investments            |       | 19,514                           |       | (752                            | )          | (94,336 | ) | (3,975 | ) |
| Net realized and  unrealized gains (losses) on derivative instruments |       | (2,397                           | )          | 755                             |       | 2,939 |   | 6,894 |   |
| Other net credit  swap revenue                                        |       | 2,794                            |       | 2,090                           |       | 18,951 |   | 7,634 |   |
| Fee income                                                            |       | 9,562                            |       | 6,516                           |       | 23,490 |   | 17,589 |   |
| Other income                                                          |       | 57                               |       | 342                             |       | 412 |   | 446 |   |
| Total revenues                                                        |       | (1,504,931                       | )          | 122,512                         |       | (1,429,348 | ) | 337,781 |   |
|                                                                  |       |                             |       |                            |       |   |   |   |   |
| EXPENSES:                                                             |       |                             |       |                            |       |   |   |   |   |
| Loss and loss  adjustment expenses                                    |       | 7,254                            |       | 2,576                           |       | 10,486 |   | 6,258 |   |
| Policy  acquisition costs                                             |       | 1,515                            |       | 2,638                           |       | 6,034 |   | 6,798 |   |
| Other operating  expenses                                             |       | 14,553                           |       | 11,999                          |       | 46,270 |   | 35,293 |   |
| Interest expense                                                      |       | 70,943                           |       | 76,095                          |       | 223,688 |   | 213,478 |   |
| Depreciation and  amortization                                        |       | 2,103                            |       | 2,456                           |       | 6,640 |   | 7,173 |   |
| Total expenses                                                        |       | 96,368                           |       | 95,764                          |       | 293,118 |   | 269,000 |   |
| (Income) loss of  minority interest                                   |       | 1,590                            |       | (897                            | )          | (554 | ) | (3,126 | ) |
| Income (loss)  before income taxes                                    |       | (1,599,709                       | )          | 25,851                          |       | (1,723,020 | ) | 65,655 |   |
| Provision for  income tax expense (benefit)                           |       | (558,685                         | )          | 9,790                           |       | (600,077 | ) | 23,405 |   |
| Net income  (loss)                                                    |       | $                                | (1,041,024 | )                               | $          | 16,061 |   | $ | (1,122,943 | ) | $ | 42,250 |   |
| ** **                                                            | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Share  and Per Share Data**                                         | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Earnings (loss)  per share                                            |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                 |       | $                                | (29.42     | )                               | $          | 0.70 |   | $ | (31.05 | ) | $ | 1.85 |   |
| Diluted                                                               |       | $                                | (29.42     | )                               | $          | 0.53 |   | $ | (31.05 | ) | $ | 1.40 |   |
|                                                                  |       |                             |       |                            |       |   |   |   |   |
| Weighted average  shares outstanding                                  |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                 |       | 35,390                           |       | 23,028                          |       | 36,165 |   | 22,897 |   |
| Diluted                                                               |       | 35,390                           |       | 30,236                          |       | 36,165 |   | 30,129 |   |

 

See notes to unauditedcondensed consolidated financial statements.

 

6

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**ACACAPITAL HOLDINGS, INC. AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY(UNAUDITED)**

 

** FORTHE NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006**

 

**(Dollarsin thousands, except for share amounts)**

** **
| ** **                                                                                     | ** ** | ** **               | ** ** | ** **            | ** ** | ** **                | ** ** | ** ** | ** ** | **Gross**       | ** ** | ** **   | ** ** | **Notes**        | ** ** | ** **       | ** ** | **Accumulated**        | ** ** | ** **    | ** ** | ** **             | ** ** |
|------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|---------------------------|------------|------------|------------|-----------------|------------|--------------|------------|------------------|------------|------------------|------------|------------------------|------------|---------------|------------|------------------------|------------|
| ** **                                                                                     | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Paid in and** | ** ** | ** ** | ** ** | **Receivable**  | ** ** | ** **   | ** ** | **Other**        | ** ** | **Retained**     | ** ** | **Total**              | ** ** |
| ** **                                                                                     | ** ** | ** **               | ** ** | ** **            | ** ** | ** **                | ** ** | **Par**    | ** ** | **Contributed** | ** ** | **Treasury** | ** ** | **from**         | ** ** | **Deferred**     | ** ** | **Comprehensive**      | ** ** | **Earnings**  | ** ** | **Stockholders’** | ** ** |
| ** **                                                                                     | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**                | ** ** | **Value**  | ** ** | **Capital**     | ** ** | **Stock**    | ** ** | **Stockholders** | ** ** | **Compensation** | ** ** | **Income (Loss)** | ** ** | **(Deficit)** | ** ** | **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                                                                                     |       | —                   |       | —                |       | —                    |       | —     |       | —          |       | —       |       | —           |       | —           |       | —                 |       | 42,250        |       | 42,250                 |       |
| Change in  unrealized gain on investments, net of change in deferred income tax of  $1,904     |       | —                   |       | —                |       | —                    |       | —     |       | —          |       | —       |       | —           |       | —           |       | 2,670                  |       | —        |       | 2,670                  |       |
| Change in  derivative hedges, net of change in deferred income tax of $(15)                    |       | —                   |       | —                |       | —                    |       | —     |       | —          |       | —       |       | —           |       | —           |       | (27                    | )          | —        |       | (27                    | )          |
| Foreign exchange  unrealized loss                                                              |       |                     |       |                  |       |                      |       |       |       |            |       |         |       |             |       |             |       | (18                    | )          |          |       | (18                    | )          |
| Total  comprehensive income                                                                    |       | —                   |       | —                |       | —                    |       | —     |       | —          |       | —       |       | —           |       | —           |       | —                 |       | —        |       | 44,875                 |       |
| Vesting of  Series B senior convertible preferred stock to CEO                            |       | —                   |       | —                |       | —                    |       | —     |       | —          |       | —       |       | —           |       | 870              |       | —                 |       | —        |       | 870                    |       |
| Exercise of stock  options by former executives                                                |       | —                   |       | —                |       | 663,540                   |       | 66         |       | 8,024           |       | —       |       | —           |       | —           |       | —                 |       | —        |       | 8,090                  |       |
| Common stock  purchased from former executive                                                  |       | —                   |       | —                |       | —                    |       | —     |       | —          |       | (6,588       | )          | —           |       | —           |       | —                 |       | —        |       | (6,588                 | )          |
| Stock based  compensation-stock options                                                        |       | —                   |       | —                |       | —                    |       | —     |       | 578             |       | —       |       | —           |       | —           |       | —                 |       | —        |       | 578                    |       |
| Issuance of note  receivable from stockholder                                                  |       | —                   |       | —                |       | —                    |       | —     |       | —          |       | —       |       | (2,262           | )          | —           |       | —                 |       | —        |       | (2,262                 | )          |
| Discharge of note  receivable from stockholders                                                |       | —                   |       | —                |       | —                    |       | —     |       | —          |       | —       |       | 496              |       | —           |       | —                 |       | —        |       | 496                    |       |
| Senior  convertible preferred stock dividend                                                   |       | 25                       |       | 1,957                 |       | —                    |       | —     |       | —          |       | —       |       | —           |       | —           |       | —                 |       | (1,957        | )          | —                 |       |
| BALANCE—September  30, 2006                                                               |       | 2,786,882                |       | $                     | 228,417    |                      | 7,106,490  |       | $          | 710             |       | $            | 133,786    |             | $          | (12,088          | )          | $                      | (3,121     | )             | $          | (1,160                 | )          | $ | 13,757 |   | $ | 70,071 |   | $ | 430,372 |   |
|                                                                                           |       |                     |       |                  |       |                      |       |       |       |            |       |         |       |             |       |             |       |                   |       |          |       |                   |       |
| 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  loss:                                                                           |       |                     |       |                  |       |                      |       |       |       |            |       |         |       |             |       |             |       |                   |       |          |       |                   |       |
| Net loss                                                                                       |       | —                   |       | —                |       | —                    |       | —     |       | —          |       | —       |       | —           |       | —           |       | —                 |       | (1,122,943    | )          | (1,122,943             | )          |
| Change in  unrealized loss on investments, net of change in deferred income tax of  $(135,070) |       | —                   |       | —                |       | —                    |       | —     |       | —          |       | —       |       | —           |       | —           |       | (250,844               | )          | —        |       | (250,844               | )          |
| Change in  derivative hedges, net of change in deferred income tax of $(3,907)                 |       | —                   |       | —                |       | —                    |       | —     |       | —          |       | —       |       | —           |       | —           |       | (7,256                 | )          | —        |       | (7,256                 | )          |
| Foreign exchange  unrealized gain                                                              |       | —                   |       | —                |       | —                    |       | —     |       | —          |       | —       |       | —           |       | —           |       | 192                    |       | —        |       | 192                    |       |
| Total  comprehensive loss                                                                      |       | —                   |       | —                |       | —                    |       | —     |       | —          |       | —       |       | —           |       | —           |       | —                 |       | —        |       | (1,380,851             | )          |
| Vesting of CEO  restricted common stock                                                        |       | —                   |       | —                |       | —                    |       | —     |       | —          |       | —       |       | —           |       | 870              |       | —                 |       | —        |       | 870                    |       |
| Stock repurchases                                                                              |       | —                   |       | —                |       | —                    |       | —     |       | —          |       | (14,996      | )          | —           |       | —           |       | —                 |       | —        |       | (14,996                | )          |
| Offering costs                                                                                 |       | —                   |       | —                |       | —                    |       | —     |       | 63              |       | —       |       | —           |       | —           |       | —                 |       | —        |       | 63                     |       |
| Stock based  compensation—restricted stock                                                |       | —                   |       | —                |       | —                    |       | —     |       | 734             |       | —       |       | —           |       | —           |       | —                 |       | —        |       | 734                    |       |
| Stock based  compensation—stock options                                                   |       | —                   |       | —                |       | —                    |       | —     |       | 1,845           |       | —       |       | —           |       | —           |       | —                 |       | —        |       | 1,845                  |       |
| Exercise of  common stock options                                                              |       | —                   |       | —                |       | 69,750                    |       | 7          |       | 722             |       | —       |       | —           |       | —           |       | —                 |       | —        |       | 729                    |       |
| BALANCE—September  30, 2007                                                               |       | —                   |       | $                     | —     |                      | 37,444,873 |       | $          | 3,744           |       | $            | 442,299    |             | $          | (27,084          | )          | $                      | (3,121     | )             | $          | —                 |       | $ | (261,216 | ) | $ | (1,037,914 | ) | $ | (883,292 | ) |

 

See notes to unauditedcondensed consolidated financial statements.

 

7

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**ACACAPITAL HOLDINGS, INC. AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)**

 

**FOR THENINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006**

 

**(Dollarsin thousands)**

** **
| ** **                                                                                | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income  (loss)                                                                        |       | $          | (1,122,943 | )          | $          | 42,250 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |       |       |       |       |
| Depreciation and  amortization                                                            |       | 6,640      |       | 7,173      |       |
| Accrual of  discount and amortization of premium on investment—net                   |       | 504        |       | (171       | )          |
| Income of  minority interest                                                              |       | 554        |       | 3,126      |       |
| Net realized  gain on sale of CDO equity investment                                       |       | (39,577    | )          | —     |       |
| Net realized  losses on fixed-maturity securities-available-for-sale                      |       | 124,062    |       | 3,857      |       |
| Net realized and  unrealized losses on fixed-maturity securities- trading                 |       | 9,301      |       | 118        |       |
| Net realized  loss on other invested assets                                               |       | 550        |       | —     |       |
| Net realized and  unrealized gains on derivative instruments                              |       | (2,939     | )          | (6,894     | )          |
| Net realized and  unrealized (gains) losses on net insured credit swap revenue            |       | 1,738,453  |       | (4,167     | )          |
| Net realized and  unrealized (gains) losses on other net credit swap revenue              |       | (15,536    | )          | 149        |       |
| Net foreign  exchange loss                                                                |       | 152        |       | —     |       |
| Share based  compensation expense                                                         |       | 2,579      |       | 578        |       |
| Discharge of  note receivable from shareholders                                           |       | —     |       | 496        |       |
| Deferred  compensation                                                                    |       | 870        |       | 870        |       |
| Securities  purchased under agreements to resell -net                                     |       | 9,248      |       | (32,066    | )          |
| Purchases of  fixed-maturity securities-trading                                           |       | (227,186   | )          | (82,792    | )          |
| Proceeds from  sales of fixed-maturity securities- trading                                |       | 245,460    |       | (145,118   | )          |
| Proceeds from  maturities of fixed-maturity securities- trading                           |       | 89,285     |       | —     |       |
| Securities sold  under agreements to repurchase - net                                     |       | (128,103   | )          | 235,679    |       |
|                                                                                      |       |       |       |       |       |
| Changes in  assets and liabilities:                                                       |       |       |       |       |       |
| Income taxes  payable                                                                     |       | 3,024      |       | 82         |       |
| Deferred income  tax expense                                                              |       | (631,361   | )          | 3,219      |       |
| Prepaid  reinsurance premiums                                                             |       | 64         |       | 249        |       |
| Derivative  liabilities                                                                   |       | 14,631     |       | (2,871     | )          |
| Accrued expenses  and other liabilities                                                   |       | (5,532     | )          | (6,785     | )          |
| Deferred policy  acquisition costs                                                        |       | (2,029     | )          | (420       | )          |
| Unearned premium  reserve                                                                 |       | 7,305      |       | 3,511      |       |
| Loss and loss  adjustment expenses                                                        |       | 765        |       | 5,072      |       |
| Interest payable                                                                          |       | (4,560     | )          | 1,583      |       |
| Interest receivable                                                                       |       | 1,315      |       | (4,373     | )          |
| Other                                                                                     |       | (12,585    | )          | (1,193     | )          |
| Net cash  provided by operating activities                                                |       | 62,411     |       | 21,162     |       |
|                                                                                      |       |       |       |       |       |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                    |       |       |       |       |       |
| Net release  (deposit) of restricted cash                                                 |       | 15,573     |       | (7,334     | )          |
| Purchases of  fixed maturity securities available for sale                                |       | (694,504   | )          | (786,738   | )          |
| Redemption of  guaranteed investment contract                                             |       | 119,340    |       | —     |       |
| Proceeds from  sales of fixed maturity securities available for sale                      |       | 86,109     |       | 89,843     |       |
| Proceeds from  maturities of fixed maturity securities available for sale                 |       | 730,888    |       | 827,751    |       |
| Deconsolidation  of CDOs, net of equity sale proceeds                                     |       | (34,336    | )          | —     |       |
| Net purchase of  property and equipment                                                   |       | (4,360     | )          | (298       | )          |
| Net cash  provided by investing activities                                                |       | 218,710    |       | 123,224    |       |
|                                                                                      |       |       |       |       |       |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                    |       |       |       |       |       |
| Paydown of  commercial paper—net                                                     |       | (2,520     | )          | 5,228      |       |
| Paydown on  long-term debt                                                                |       | (364,062   | )          | (107,014   | )          |
| Purchase of  treasury stock                                                               |       | (14,996    | )          | (760       | )          |
| Proceeds from  issuance of equity in Credit Fund                                          |       | 3,000      |       | 8,600      |       |
| Proceeds from  exercise of stock options                                                  |       | 729        |       | —     |       |
| Offering costs                                                                            |       | 63         |       | —     |       |
| Net cash used in  financing activities                                                    |       | (377,786   | )          | (93,946    | )          |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS                                     |       | (96,665    | )          | 50,440     |       |
|                                                                                      |       |       |       |       |       |
| CASH AND CASH  EQUIVALENTS—beginning of period                                       |       | 379,905    |       | 174,420    |       |
| CASH AND CASH  EQUIVALENTS—end of period                                             |       | $          | 283,240    |       | $          | 224,860 |   |
|                                                                                      |       |       |       |       |       |
| SUPPLEMENTAL  CASH FLOW DISCLOSURES:                                                      |       |       |       |       |       |
| Federal and  local income taxes paid                                                      |       | $          | 28,601     |       | $          | 20,236 |   |
| Interest paid                                                                             |       | $          | 222,375    |       | $          | 211,894 |   |
|                                                                                      |       |       |       |       |       |
| SUPPLEMENTAL  DISCLOSURES OF NON-CASH OPERATING ACTIVITIES:                               |       |       |       |       |       |
| Impact on assets  and liabilities due to CDO deconsolidation                              |       |       |       |       |       |
| Cash and cash  equivalents                                                                |       | $          | (34,336    | )          | $          | — |   |
| Interest  receivable                                                                      |       | $          | (4,102     | )          | $          | — |   |
| Derivative  assets                                                                        |       | $          | (792       | )          | $          | — |   |
| Deferred debt  issuance costs                                                             |       | $          | (11,905    | )          | $          | — |   |
| Receivable for  securities sold                                                           |       | $          | (72        | )          | $          | — |   |
| Other assets                                                                              |       | $          | 431        |       | $          | — |   |
| Derivative  liabilities                                                                   |       | $          | 16,320     |       | $          | — |   |
| Interest payable                                                                          |       | $          | 5,756      |       | $          | — |   |
|                                                                                      |       |       |       |       |       |
| SUPPLEMENTAL  DISCLOSURES OF NON-CASH INVESTING ACTIVITIES:                               |       |       |       |       |       |
| Impact on assets  and liabilities due to CDO deconsolidation                              |       |       |       |       |       |   |   |
| Fixed maturity  securities available for sale                                             |       | $          | (1,021,435 | )          | $          | — |   |
|                                                                                      |       |       |       |       |       |
| SUPPLEMENTAL  DISCLOSURES OF NON-CASH FINANCING ACTIVITIES:                               |       |       |       |       |       |
| Common stock  acquired in exchange for note receivable                                    |       | $          | —     |       | $          | 2,262 |   |
| Impact on assets  and liabilities due to CDO deconsolidation                              |       |       |       |       |       |   |   |
| Long-term debt                                                                            |       | $          | 1,089,712  |       | $          | — |   |

 

See notes to unauditedcondensed consolidated financial statements.

 

8

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**ACACAPITAL HOLDINGS, INC. AND SUBSIDIARIES**

 

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

 

**SEPTEMBER30, 2007**

 

**1. BUSINESS, ORGANIZATION AND OPERATIONS**

 

ACA CapitalHoldings, Inc. (“ACA” or the “Company”), is a Delaware domiciled holdingcompany that provides financial guaranty insurance products to participants inthe global credit derivatives markets, structured finance capital markets andpublic finance capital markets, as well as asset management services.  TheCompany’s principal activities include financial guaranty insurance of publicfinance obligations, structured credit risk assumption through insured creditderivatives and collateralized debt obligation asset management.  ACAconducts its business through three principal wholly-owned indirectsubsidiaries.  Its financial guaranty insurance business is conductedthrough ACA Financial Guaranty Corporation (“ACA Financial Guaranty”), aMaryland domiciled insurance company.  ACA Financial Guaranty is licensedto conduct financial guaranty insurance business, which provides creditenhancement on public finance and other debt obligations, in all 50 states, theDistrict of Columbia, Guam, the U.S. Virgin Islands and Puerto Rico.  ACAFinancial Guaranty also provides the credit support for the Company’sStructured Credit business activities.  The Company conducts itsU.S.-based CDO Asset Management business 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”).  InJanuary 2007, the Company’s wholly-owned indirect subsidiary, ACA CapitalManagement (U.K.) Pte. Limited, became authorized and regulated by theFinancial Services Authority as an investment manager to manage CDOs in theUnited Kingdom and most of Europe.

 

The Company’s business iscomposed of three distinct continuing lines of business or segments.  Theyare Public Finance, Structured Credit and CDO Asset Management.  A fourthline of business, Other, includes business in areas and markets in which theCompany is no longer active.  Although the Public Finance and StructuredCredit businesses are reported in separate segments, together they form theCompany’s financial guaranty insurance business.  Public Finance primarilyprovides financial guaranty insurance policies guaranteeing the timely paymentof scheduled principal and interest on public finance and other debtobligations.  Structured Credit structures and sells credit protection,principally in the form of insured credit default swaps (“CDS” or “credit swaps”),against a variety of asset classes in the institutional fixed incomemarkets.  CDO Asset Management focuses on CDO origination, structuring andmanagement.  The Company will at times assume risk in the CDOs it managesthrough investment in some portion of the capital structure.

 

ACA was originallyincorporated in Delaware on January 3, 1997.  On November 22,2002, ACA changed its jurisdiction of incorporation from Delaware toBermuda.  During 2004, the Board of Directors determined thatre-domesticating to Delaware would eliminate certain adverse consequences ofremaining in Bermuda, facilitate ACA’s access to U.S. capital markets, simplifyits tax filings, accounting and operations, and reduce the costs of compliancewith 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 its initial public offering of 6,875,000 shares of newlyissued common stock and 23,541 shares of existing common stock.  TheCompany realized gross proceeds of $13 per share on the newly issued commonstock, or $89.4 million.  Net proceeds to the Company were $79.2 million,after issuance costs.  On November 10, 2006, the Company’s commonstock 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.

 

Standard & Poor’sRating Services (“S&P”) has assigned a financial strength rating of “A” toACA Financial Guaranty.  On November 9, 2007, S&P placed its “A”rating of ACA Financial Guaranty on CreditWatch with negative implications (seeNote 16).

 

**2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

These unaudited condensedconsolidated financial statements have been prepared pursuant to the rules andregulations of the Securities and Exchange Commission (“SEC”) regarding interimfinancial reporting.  Accordingly, they do not include all of theinformation and footnotes required by accounting principles generally acceptedin the United States of America (“GAAP”) for complete financial statements andshould be read in conjunction with the Company’s Annual Report on Form 10-K forthe year ended December 31, 2006 (“Form 10-K”), filed with the SEC onApril 2, 2007.  These unaudited condensed consolidated financialstatements include all adjustments, consisting only of normal recurringadjustments, that we consider necessary for the fair presentation of ourfinancial position and results of operations for these periods.  Thepreparation of financial statements in conformity 

 

9

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with GAAP requires management to make estimates and assumptions thataffect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reportingperiods.  Actual results could differ from those estimates. Operating results for the three and nine months ended September 30, 2007 arenot necessarily indicative of the results that may be expected for the yearended December 31, 2007.

 

In August 2006, theCompany’s Board of Directors authorized a dividend of stock in order to effecta six-for-one stock split.  All prior share and per share amounts havebeen restated to reflect the stock split.

 

*Valuationof Insured Credit Swap Transactions* — The Company values itsinsured credit swap transactions either by obtaining market quotes from dealersor through the application of the Company’s valuation model.  During thequarter ended June 30, 2007, the Company refined its valuation model toestimate fair value of its insured credit swap transactions.  The changewas implemented to be more consistent with models that the Company understandsother market participants utilize, including many of ACA’s insured credit swapcounterparties.  The relatively young market for credit swaps hascontinued to evolve over time and, while there is still substantial variance invaluation models among market participants, the trend is toward increasingconvergence in this area.  Under its refined model, the Company fully usesmarket spread data as a proxy for default probabilities in the determination offair value.  For transactions in which the underlying exposure is tocorporate credits, the Company uses individual market spreads as proxies fordefaults as they are readily available. Historically, for syntheticasset-backed transactions individual spread data has not been as readilyavailable and the Company used current weighted average portfolio spreads as aproxy for individual spreads where necessary. However, in the third quarter of2007, individual spreads were obtained for all transactions, includingsynthetic asset-backed transactions. The Company will continue to useindividual market spread data when available. The Company believes that itsrefined model will inherently increase the volatility of these valuations, butprovide a better estimate of the cost or benefit of unwinding the relatedtransaction.

 

**3. RELEVANT RECENT ACCOUNTING PRONOUNCEMENTS**

 

On April 18, 2007, theFinancial Accounting Standards Board (“FASB”) released an exposure draftentitled “*Accounting for Financial GuaranteeInsurance Contracts—An Interpretation of FASB Statement No. 60*” (the“Proposed Statement”).  While FASB Statement No. 60, “*Accounting and Reporting by Insurance Enterprises*”,sets out accounting standards for property and casualty and life insuranceenterprises, it has historically not specifically considered financial guarantyinsurance.  This new interpretation is intended to address the specificattributes of this type of insurance.  The principal items addressed inthe exposure draft relate to revenue recognition, the establishment of claimreserves and disclosures around such reserves.  In response to exposuredraft comments the FASB received from financial guaranty insurance financialstatement preparers, reviewers and users, the FASB is expected to issue arevised exposure draft in the first quarter of 2008. The proposed scope andeffective date of this revised exposure draft are not known at this time. Whilecertain provisions of the Proposed Statement are still being analyzed,management believes that the cumulative effect of initially applying theProposed Statement or potential revisions could be material to the Company’sfinancial statements.  Until the final interpretation is issued by theFASB, the Company continues to apply the accounting policies as disclosed inits Form 10-K.

 

In February 2007,the FASB issued Financial Accounting Standard (“FAS”) 159, “*The Fair Value Option for Financial Assets andFinancial Liabilities*” (“FAS 159”).  FAS 159 permits reportingentities to choose to remeasure many financial instruments and certain otheritems at fair value that are not currently required to be measured at fairvalue.  The fair value option may be applied instrument by instrument, isirrevocable and is applied only to entire instruments and not to portions ofinstruments.  FAS 159 also establishes presentation and disclosurerequirements designed to facilitate comparisons between entities that choosedifferent measurement attributes for similar types of assets and liabilities.FAS 159 is effective for fiscal years that begin after November 15,2007.  The Company did not elect to early adopt FAS 159.  Managementis currently evaluating the potential impact, if any, which the adoption of FAS159 will have on the Company’s financial statements.

 

On January 1, 2007, theCompany adopted FAS 155, “*Accountingfor Certain Hybrid Financial Instruments*” (“FAS 155”), an amendmentof FAS 133,*“Accounting for DerivativeInstruments and Certain Hedging Activities”* (“FAS 133”) and FAS 140,“*Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities*” (“FAS 140”). The implementation of this statement did not have a material impact on theCompany’s financial statements.

 

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

 

In September 2006,the FASB issued FAS 157, “*Fair ValueMeasurements*” (“FAS 157”).  FAS 157 enhances existingguidance for measuring assets and liabilities using fair value, such asemphasizing that fair value is a market-based measurement, not anentity-specific measurement, and sets out a fair value hierarchy with thehighest priority being quoted prices in active markets.  FAS 157 iseffective for financial statements issued for fiscal years beginning afterNovember 15, 2007, and interim periods within those fiscal years. Management does not expect the adoption of FAS 157 to have a material impact onthe Company’s financial statements.

 

In September 2006,the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”), “*Considering the Effects of Prior Year*

 

10

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*Misstatements when QuantifyingMisstatements in Current Year Financial Statements*”, whichprovides interpretive guidance on how the effects of the carryover or reversalof prior year misstatements should be considered in quantifying a current yearmisstatement.  The provisions of SAB 108 were put in effect atDecember 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 in Applying FASBInterpretation No. 46(R)*” (“FSP FIN 46(R)-6”).  FSPFIN 46(R)-6 addresses whether certain arrangements associated with variableinterest entities (VIEs) should be treated as variable interests or consideredas creators of variability, and indicates that the variability to be consideredshall be on based on an analysis of the design of the entity.  FSP FIN46(R)-6 was adopted on June 15, 2006.  The adoption of this statementdid not have a material 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 all separately recognized servicingassets and servicing liabilities be initially measured at fair value, ifpracticable, and permits for subsequent measurement using either fair valuemeasurement with changes in fair value reflected in earnings or theamortization and impairment requirements of FAS 140.  The subsequentmeasurement of separately recognized servicing assets and servicing liabilitiesat fair value eliminates the necessity for entities that manage the risksinherent in servicing assets and servicing liabilities with derivatives toqualify for hedge accounting treatment and eliminates the characterization ofdeclines in fair value as impairments or direct write-downs.  FAS 156is effective for an entity’s first fiscal year beginning afterSeptember 15, 2006.  The implementation of this statement did not havea material impact on the Company’s financial statements.

 

In September 2005,Statement of Position (“SOP”) 05-1, “*Accountingby Insurance Enterprises for Deferred Acquisition Costs in Connection WithModifications or Exchanges of Insurance Contracts*”, (“SOP 05-1”),was issued.  This SOP provides guidance on accounting by insuranceenterprises for deferred acquisition costs on internal replacement of insuranceand investment contracts other than those specifically described in FASNo. 97, “*Accounting and Reporting byInsurance Enterprises for Certain Long-Duration Contracts and for RealizedGains and Losses from the Sale of Investments* “.  SOP 05-1is effective for internal replacements occurring in fiscal years beginningafter December 15, 2006.  The adoption of this SOP did not have amaterial impact on the Company’s financial statements.

 

**4. CDO ASSET MANAGEMENT BUSINESS**

 

One of the ways theCompany participates in the structured finance market is through structuringand managing CDOs originated in collaboration with investment banks.  CDOscan be issued in funded, unfunded or partially funded form.  Funded CDOsissue debt 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 accounting perspective, funded and partiallyfunded CDOs are determined to be VIEs.  Each time such CDOs are formed,the Company performs an analysis to determine whether it is the primarybeneficiary and thus required to consolidate the CDO under the provisions ofFSP FIN 46(R)-6. Upon the occurrence of a reconsideration event inaccordance with FIN 46(R)-6, such as the sale or disposal of all or part of theCompany’s equity investment, the Company re-performs its analysis to determinewhether it is still the primary beneficiary.

 

The following table listseach of the Company’s CDOs outstanding as of September 30, 2007 (dollars inmillions):

 
| ** **                       | ** ** | **Year**   | ** ** | ** **       | ** ** | ** **                        | ** ** | ** **                  | ** ** | ** **       | ** ** | **Original**             | ** ** | **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        |             | No         |                     | $          | 18.0              |       | 100                   |       | 8/2005       |       | 8/2037 |   |
| ACA ABS 2003-1                   |       | 2003       |       | Funded           |       | Investment Grade                  |       | 400                         |       | No               |       | 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                         |       | No               |       | 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      |       |
| Abacus 2007-AC1                  |       | 2007       |       | Unfunded         |       | Investment Grade                  |       | 192                         |       | No               |       | —                   |       | —            |       | 6/2010                |       | 3/2038       |       |
| ACA ABS 2007-2                   |       | 2007       |       | Partially funded |       | Investment Grade                  |       | 750                         |       | No               |       | —                   |       | —            |       | 7/2011                |       | 7/2045       |       |
| Lancer II                        |       | 2007       |       | Partially funded |       | High-Grade                        |       | 1,000                       |       | No               |       | —                   |       | —            |       | 7/2011                |       | 7/2047       |       |
| ACA ABS 2007-3                   |       | 2007       |       | Partially funded |       | Investment Grade                  |       | 350                         |       | No               |       | —                   |       | —            |       | 8/2013                |       | 5/2047       |       |
| **Total  Asset-Backed CDOs**     |       |       |       |             |       |                              |       | 15,496                      |       |             |       |                     |       | 133.8             |       |                  |       |         |       |
|                             |       |       |       |             |       |                              |       |                        |       |             |       |                     |       |              |       |                  |       |         |       |
| **Corporate  Credit CDOs:**      | ** ** | ** ** | ** ** | ** **       | ** ** | ** **                        | ** ** | ** **                  | ** ** | ** **       | ** ** | ** **               | ** ** | ** **        | ** ** | ** **            | ** ** | ** **   | ** ** |
| ACA CDS 2002-2                   |       | 2003       |       | Unfunded         |       | Investment Grade                  |       | 1,000                       |       | No               |       | 25.0                     |       | 100               |       | N/A                   |       | 3/2008       |       |
| Argon 49                         |       | 2005       |       | Funded           |       | Investment Grade                  |       | 71                          | (2)        | No               |       | —                   |       | —            |       | N/A                   |       | 6/2015       |       |
| Argon 57                         |       | 2006       |       | Funded           |       | Investment Grade                  |       | 71                          | (2)        | No               |       | —                   |       | —            |       | N/A                   |       | 6/2013       |       |
| Tribune                          |       | 2006       |       | Unfunded         |       | Investment Grade                  |       | 217                         | (5)        | No               |       | —                   |       | —            |       | N/A                   |       | 9/2016       |       |
| Dolomite                         |       | 2007       |       | Unfunded         |       | Investment Grade                  |       | 71                          | (2)        | No               |       | —                   |       | —            |       | N/A                   |       | 7/2014       |       |
| **Total  Corporate Credit CDOs** |       |       |       |             |       |                              |       | 1,430                       |       |             |       |                     |       | 25.0              |       |                  |       |         |       |
|                             |       |       |       |             |       |                              |       |                        |       |             |       |                     |       |              |       |                  |       |         |       |
| **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       |       |
| ACA CLO Euro  2007-1             |       | 2007       |       | Funded           |       | Non-Investment Grade              |       | 571                         | (2)        | No               |       | 5.5                      |       | 10                |       | 6/2010                |       | 6/2024       |       |
| ACA CLO 2007-1                   |       | 2007       |       | Funded           |       | Non-Investment Grade              |       | 350                         |       | No               |       | 2.7                      |       | 10                |       | 6/2011                |       | 6/2022       |       |
| **Total  Leveraged Loan CDOs**   |       |       |       |             |       |                              |       | 1,871                       |       |             |       | 15.4                     |       |              |       |                  |       |         |       |
|                             |       |       |       |             |       |                              |       |                        |       |             |       |                     |       |              |       |                  |       |         |       |
| **Total**                        | ** ** | ** ** | ** ** | ** **       | ** ** | ** **                        | ** ** | **$**                       | **18,797** | ** **       | ** ** | ** **               | **$**      | **174.2**         | ** ** | ** **            | ** ** | ** **   | ** ** | ** ** | ** ** |

 

11

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(1)            Based on original rating, 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 49 and Argon 57 were €50 millioneach, and that for Dolomite was €49 million and $1 million. The originaldeal size for ACA CLO Euro 2007-1 was €400 million.  For purposes of thischart, we have converted the amounts to U.S. dollars at the prevailingcurrency exchange rate on September 30, 2007.

 

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

 

(4)            Cash flow CDOs are generally callable once per quarter by a majority or greatervote of the equity holders on a specific date as negotiated, which is referredto as the First Optional Call Date.

 

(5)            Tribune is comprised of 11 distinct trades some of which are denominated inEuros or Yen.  For purposes of this chart, we have converted therespective amounts to U.S. dollars at the prevailing currency exchange rates onSeptember 30, 2007.

 

As of September 30, 2007and December 31, 2006, consolidated liabilities include non-recourse debtfrom consolidated CDOs of $3,258.0 million and $4,711.8 million,respectively.  Also, as of September 30, 2007 and December 31, 2006,consolidated assets include investments in CDO related fixed maturitysecurities and guaranteed investment contracts of $2,772.6 million and$4,656.0 million, respectively, and cash of $225.0 million and $265.0million, respectively.

 

During the third quarter of 2007, the Company sold aportion of its equity investment in three CDO deals, ACA ABS 2002-1, ACA ABS2003-1 and ACA ABS 2003-2, each for fair market value to an independent thirdparty. In conjunction with the equity sale, the Company determined that it wasno longer the primary beneficiary of these deals under FIN 46(R),*“Consolidation of Variable Interest Entities — an interpretation ofARB No. 51”*(“FIN 46(R)”) and, therefore, de-consolidated thesedeals in its financial statements, realizing a net gain of $39.6 million. Thegain was primarily related to the reversal of previously realized losses inexcess of the Company’s original equity investment. The de-consolidation alsoresulted in a decrease in both assets, primarily fixed-maturity securitiesavailable for sale, and liabilities, primarily long-term debt, of approximately$1.0 billion, as well as an increase to accumulated other comprehensive incomeof $66.4 million. The decreases in fixed-maturity securities available for saleand long-term debt will result in a reduction of related investment income andinterest expense in the Company’s statement of operations in future periods.

 

Beginning in 2005, theCompany has retained a lesser share of the equity position of newly issuedCDOs.  Based on analyses under FIN 46(R), the Company is not deemed to bethe primary beneficiary of these VIEs.  As a result, these CDOs are notconsolidated in the financial statements.  Rather, the non-majority investmentis recorded as an investment in a single fixed maturity security under theprovisions of FAS 115 and Emerging Issues Task Force (“EITF”) IssueNo. 99-20, *“Recognition of Interest Income and Impairment on Purchased and RetainedBeneficial Interests in Securitized Financial Assets”* (“EITF 99-20”). The deconsolidated CDOs described in the paragraph above are also accounted forunder this principle. During the first nine months of 2007, the Company closednine CDOs and purchased an equity interest in three.  During 2006, theCompany closed eight CDOs and purchased an equity interest in four. During 2005, the Company closed five CDOs and purchased an equity interest infour.  The Company was not determined to be the primary beneficiary in anyof these CDOs and therefore did not consolidate them.

 

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

 

Net insured credit swaprevenue includes insured credit swap premiums received for credit protectionthe Company 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.

 

The following tabledisaggregates net insured credit swap revenue into its component parts for thethree months and nine months ended September 30, 2007 and 2006:
| ** **                                         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                         | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                         | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                         | ** ** | **(in thousands)**          | ** ** |
| Net insured  credit swap revenue                   |       |                             |       |                            |       |   |   |   |   |
| Insured credit  swap premiums earned               |       | $                                | 28,147     |                            | $          | 13,742 |   | $ | 70,509 |   | $ | 35,023 |   |
| Unrealized gains  (losses) on insured credit swaps |       | (1,655,607                       | )          | 3,337                           |       | (1,738,453 | ) | 2,158 |   |
| Realized gains  on insured credit swaps            |       | —                           |       | —                          |       | — |   | 2,009 |   |
| Total net  insured credit swap revenue             |       | $                                | (1,627,460 | )                               | $          | 17,079 |   | $ | (1,667,944 | ) | $ | 39,190 |   |

 

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Of the $(1,655.6) millionunrealized loss recorded in the three months ended September 30, 2007,$(1,652.1) million was related to valuation changes in the Company’s StructuredCredit line of business transactions.  The residential mortgage-backedsecurities (“RMBS”) portion of the Structured Credit portfolio incurredvaluation losses of $(1,493.8) million for the three months ended September 30,2007.  However, no realized or actual losses were incurred on thisportfolio based on its very high credit quality, with over 99% of the portfolioconstructed of exposures attaching above the “AAA” rated level ofsubordination.  These valuation losses were precipitated by the severelevel of delinquencies and defaults that have occurred in the residentialmortgage market, particularly in the sub-prime and second lien segments, whichconstitute a significant portion of the assets underlying the RMBS included inthe pools of assets referenced by certain of our Structured Credittransactions.  Additionally, the Company recorded unrealized losses of$(158.3) million on its Structured Credit’s corporate credit portfolio for thethree months ended September 30, 2007. The valuation losses on the corporateportfolio resulted from wider spreads at September 30, 2007, than at June 30,2007. It is the Company’s intention to generally hold its insured credit swapsto term, absent credit losses, these unrealized amounts will revert to $0 atcontract expiration, if the Company so held the position.

 

Other net credit swaprevenue includes revenues received from a partially funded CDS CDO, which sellscredit protection under credit swaps for which it receives fixed quarterlyfees, the residual returns on two synthetic equity participations and the costof credit protection purchased in the form of a credit default swap.  Thiscredit protection was purchased to hedge against our exposure to RMBS in ourCDO Asset Management line of business. It also includes trading activity incredit default swaps by the Credit Fund. Other net credit swap revenue alsoincludes net realized and unrealized gains and losses associated with thesetransactions, if any.  As of June 30, 2007, the Company’s risk to thepartially funded CDS CDO and one of the synthetic equity participations hadexpired.  These revenues were included in the Company’s consolidatedstatement of operations for periods prior to that date. The following tabledisaggregates other net credit swap revenue into its component parts for thethree months and nine months ended September 30, 2007 and 2006:

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                      | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                      | ** ** | **(in thousands)**          | ** ** |
| Other net credit  swap revenue                  |       |                             |       |                            |       |   |   |   |   |
| Credit swap fees  earned                        |       | $                                | (2,395     | )                               | $          | 2,530 |   | $ | 3,415 |   | $ | 7,783 |   |
| Unrealized gain  on credit protection purchased |       | 3,242                            |       | —                          |       | 14,816 |   | — |   |
| Unrealized gains  on credit swaps - credit fund |       | 1,947                            |       | —                          |       | 1,667 |   | — |   |
| Unrealized  losses on credit swaps - CDOs       |       | —                           |       | (440                            | )          | (947 | ) | (149 | ) |
| Total other net  credit swap revenue            |       | $                                | 2,794      |                            | $          | 2,090 |   | $ | 18,951 |   | $ | 7,634 |   |

 

**6. INCOME TAXES**

 

Effective January 1, 2007, the Company adopted theprovisions of FIN 48. As a result, the Company recorded a $1.5 million reservefor uncertain tax positions and a corresponding decrease to the 2007 openingretained earnings. The Company’s effective tax rate would have increased ifthis amount was recognized as a tax expense. It is unlikely that theunrecognized tax expense will significantly change in the next 12 months.

 

The Company files income tax returns in the U.S,federal jurisdiction, and various states and foreign jurisdictions. With fewexceptions, the Company is no longer subject to U.S. federal, state and local,or non-U.S. income tax examinations by tax authorities for years before 2003.

 

The Company records interest and penalties related tounrecognized tax benefits in income taxes, $0.5 million in accrued interest andpenalties is included in the $1.5 million reserve for uncertain tax positionsrelated to our adoption of FIN 48. Additional accrued interest and penalties of $0.4million were recognized during the first nine months of 2007 increasing thereserve for uncertain tax positions to $1.9 million.

 

Our tax provision for interim periods is determinedusing an estimate of our annual effective tax rate. The 2007 effective tax rate is estimated to beequal to the 35% statutory rate.

 

TheCompany, as a financial guaranty insurance writer, is eligible for a taxdeduction, subject to certain limitations, under Section 832(e) of the InternalRevenue Code for amounts required by state law or regulation to be set-aside instatutory contingency reserves. The deduction is allowed only to the extentthat the Company purchases non-interest-bearing U. S. Mortgage Guaranty Tax andLoss Bonds (“T&L bonds”) issued by the Treasury Department in an amountequal to the tax benefit derived from deducting any portion of the Company’sstatutory contingency reserves. We record these bonds on our balance sheet incurrent federal income taxes. Purchases of T&L bonds are a prepayment offederal income taxes that becomes due in ten years, when the contingencyreserve is released and the T&L bonds mature. The proceeds from thematurity from the T&L bonds are used to fund the income tax 

 

13

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payments. Thetotal T&L bonds recorded in current federal income tax payable as ofSeptember 30, 2007 is $18.3 million.

 

AtSeptember 30, 2007, the Company had federal capital loss carryforwards ofapproximately $30.4 million that begin to expire in 2010 and are fullyexpired by 2012. Based on available evidence, it is more likely than not thatthe deferred tax assets relating to the capital loss will not be fully realized.Accordingly, a valuation allowance was established in September 30, 2007 in theamount of $4.0 million relating to the portion of the tax benefits attributableto certain capital losses.

 

**7.  LITIGATION**

 

In May 2006, theCompany paid a judgment in the amount of $3.7 million in satisfaction of adamages award in connection with an employment contract dispute with a formerexecutive of the Company plus accrued interest through the date ofpayment.  Also in May 2006, the Company settled the former executive’sattorney’s fees at an additional amount of $0.6 million.  The Companyhad recorded a reserve of $4.2 million to cover these costs inDecember 2005.  A judicial satisfaction of the judgment has beenfiled and the Company has no additional liability with respect to this matter.

 

The Company is not awareof any pending or threatened litigation that it believes could reasonably belikely to result in a material adverse effect on the Company’s financialposition, results of operations or cash flows.

 

**8. SEGMENT INFORMATION**

 

The Company’s reportablesegments are as follows:

 

(1)          Structured Credit, which structures and sells credit protection, principally inthe form of insured credit swaps, 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, primarilycorporate obligations or asset-backed securities, in funded, partially fundedor 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 first threereportable segments are strategic business units that offer different productsand services.  They are managed separately since each business requiresdifferent marketing strategies, personnel skill sets and technology.

 

Where determinable, theCompany specifically assigns assets to each segment, otherwise, the Companyallocates assets based on estimates.  In general, allocation percentagesfor assets are determined based on each line’s estimated capital utilizationfrom a rating agency perspective.

 

The accounting policiesof the segments are the same as those described in the summary of significantaccounting policies.  The Company evaluates segment performance based onits income (loss) before income taxes.  Reportable segment results arepresented net of material inter-segment transactions.  The followingtables summarize the Company’s operations and allocation of assets as of andfor the three months and nine months ended September 30, 2007 and 2006 (dollarsin thousands):

 

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| ** **                                                    | ** ** | **Three Months Ended September 30, 2007** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                    | ** ** | **Structured**                                                     | ** ** | **Public** | ** ** | **CDO Asset** | ** ** | ** ** | ** ** | **Consolidated** | ** ** |
| ** **                                                    | ** ** | **Credit**                                                         | ** ** | **Finance** | ** ** | **Management** | ** ** | **Other** | ** ** | **Totals** | ** ** |
| REVENUES:                                                     |       |                                                               |       |   |   |   |   |   |   |   |   |
| Gross premiums  written                                       |       | $                                                                  | 36         |   | $ | 6,997 |   | $ | — |   | $ | 80 |   | $ | 7,113 |   |
|                                                          |       |                                                               |       |   |   |   |   |   |   |   |   |
| Premiums earned                                               |       | $                                                                  | 36         |   | $ | 5,302 |   | $ | — |   | $ | 190 |   | $ | 5,528 |   |
| Net insured  credit swap revenue                              |       | (1,624,766                                                         | )          | (520 | ) | (2,174 | ) | — |   | (1,627,460 | ) |
| Net investment  income                                        |       | 4,722                                                              |       | 4,576 |   | 74,964 |   | 3,209 |   | 87,471 |   |
| Net realized and  unrealized gains (losses) on investments    |       | (7,142                                                             | )          | (209 | ) | 26,916 |   | (51 | ) | 19,514 |   |
| Net realized and  unrealized losses on derivative instruments |       | (33                                                                | )          | — |   | (2,364 | ) | — |   | (2,397 | ) |
| Other net credit  swap revenue                                |       | (496                                                               | )          | — |   | 3,290 |   | — |   | 2,794 |   |
| Fee and other  income                                         |       | 180                                                                |       | 58 |   | 9,381 |   | — |   | 9,619 |   |
| Total revenues                                                |       | (1,627,499                                                         | )          | 9,207 |   | 110,013 |   | 3,348 |   | (1,504,931 | ) |
|                                                          |       |                                                               |       |   |   |   |   |   |   |   |   |
| EXPENSES:                                                     |       |                                                               |       |   |   |   |   |   |   |   |   |
| Loss and loss  adjustment expenses                            |       | 3,500                                                              |       | 1,208 |   | — |   | 2,546 |   | 7,254 |   |
| Policy  acquisition costs                                     |       | —                                                             |       | 1,488 |   | — |   | 27 |   | 1,515 |   |
| Other operating  expenses                                     |       | 6,352                                                              |       | 2,474 |   | 5,719 |   | 8 |   | 14,553 |   |
| Interest expense                                              |       | 2,686                                                              |       | 397 |   | 67,766 |   | 94 |   | 70,943 |   |
| Depreciation and  amortization                                |       | 202                                                                |       | 154 |   | 1,747 |   | — |   | 2,103 |   |
| Total expenses                                                |       | 12,740                                                             |       | 5,721 |   | 75,232 |   | 2,675 |   | 96,368 |   |
| Income of  minority interest                                  |       | 1,839                                                              |       | — |   | (249 | ) | — |   | 1,590 |   |
| Income (loss)  before income taxes                            |       | (1,638,400                                                         | )          | 3,486 |   | 34,532 |   | 673 |   | (1,599,709 | ) |
| Provision for  income tax expense (benefit)                   |       | (571,229                                                           | )          | 1,337 |   | 10,955 |   | 252 |   | (558,685 | ) |
| Net income  (loss)                                            |       | $                                                                  | (1,067,171 | ) | $ | 2,149 |   | $ | 23,577 |   | $ | 421 |   | $ | (1,041,024 | ) |
|                                                          |       |                                                               |       |   |   |   |   |   |   |   |   |
| Segment Assets                                                |       | $                                                                  | 1,023,803  |   | $ | 525,882 |   | $ | 3,281,927 |   | $ | 121,052 |   | $ | 4,952,664 |   |

 
| ** **                                                   | ** ** | **Three Months Ended September 30, 2006** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **Structured**                                                     | ** ** | **Public** | ** ** | **CDO Asset** | ** ** | ** ** | ** ** | **Consolidated** | ** ** |
| ** **                                                   | ** ** | **Credit**                                                         | ** ** | **Finance** | ** ** | **Management** | ** ** | **Other** | ** ** | **Totals** | ** ** |
| REVENUES:                                                    |       |                                                               |       |   |   |   |   |   |   |   |   |
| Gross premiums  written                                      |       | $                                                                  | 153        |   | $ | 5,285 |   | $ | — |   | $ | 132 |   | $ | 5,570 |   |
|                                                         |       |                                                               |       |   |   |   |   |   |   |   |   |
| Premiums earned                                              |       | $                                                                  | 168        |   | $ | 8,128 |   | $ | — |   | $ | 298 |   | $ | 8,594 |   |
| Net insured  credit swap revenue                             |       | 14,524                                                             |       | 284 |   | 2,271 |   | — |   | 17,079 |   |
| Net investment  income                                       |       | 2,136                                                              |       | 3,852 |   | 81,008 |   | 892 |   | 87,888 |   |
| Net realized and  unrealized losses on investments           |       | (126                                                               | )          | (154 | ) | (436 | ) | (36 | ) | (752 | ) |
| Net realized and  unrealized gains on derivative instruments |       | —                                                             |       | — |   | 755 |   | — |   | 755 |   |
| Other net credit  swap revenue                               |       | 25                                                                 |       | — |   | 2,065 |   | — |   | 2,090 |   |
| Fee and other  income                                        |       | 593                                                                |       | 159 |   | 6,106 |   | — |   | 6,858 |   |
| Total revenues                                               |       | 17,320                                                             |       | 12,269 |   | 91,769 |   | 1,154 |   | 122,512 |   |
|                                                         |       |                                                               |       |   |   |   |   |   |   |   |   |
| EXPENSES:                                                    |       |                                                               |       |   |   |   |   |   |   |   |   |
| Loss and loss  adjustment expenses                           |       | —                                                             |       | 2,120 |   | — |   | 456 |   | 2,576 |   |
| Policy  acquisition costs                                    |       | —                                                             |       | 2,556 |   | — |   | 82 |   | 2,638 |   |
| Other operating  expenses                                    |       | 4,673                                                              |       | 2,115 |   | 5,150 |   | 61 |   | 11,999 |   |
| Interest expense                                             |       | 679                                                                |       | 450 |   | 74,872 |   | 94 |   | 76,095 |   |
| Depreciation and  amortization                               |       | 221                                                                |       | 201 |   | 2,034 |   | — |   | 2,456 |   |
| Total expenses                                               |       | 5,573                                                              |       | 7,442 |   | 82,056 |   | 693 |   | 95,764 |   |
| Income of minority  interest                                 |       | (32                                                                | )          | — |   | (865 | ) | — |   | (897 | ) |
| Income before income  taxes                                  |       | 11,715                                                             |       | 4,827 |   | 8,848 |   | 461 |   | 25,851 |   |
| Provision for income  tax expense                            |       | 4,372                                                              |       | 1,829 |   | 3,404 |   | 185 |   | 9,790 |   |
| Net income                                                   |       | $                                                                  | 7,343      |   | $ | 2,998 |   | $ | 5,444 |   | $ | 276 |   | $ | 16,061 |   |
|                                                         |       |                                                               |       |   |   |   |   |   |   |   |   |
| Segment Assets                                               |       | $                                                                  | 351,178    |   | $ | 483,516 |   | $ | 5,107,310 |   | $ | 104,163 |   | $ | 6,046,167 |   |

 

15

----

 
| ** **                                                   | ** ** | **Nine Months Ended September 30, 2007** | ** ** |
|--------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **Structured**                                                    | ** ** | **Public** | ** ** | **CDO Asset** | ** ** | ** ** | ** ** | **Consolidated** | ** ** |
| ** **                                                   | ** ** | **Credit**                                                        | ** ** | **Finance** | ** ** | **Management** | ** ** | **Other** | ** ** | **Totals** | ** ** |
| REVENUES:                                                    |       |                                                              |       |   |   |   |   |   |   |   |   |
| Gross premiums  written                                      |       | $                                                                 | 170        |   | $ | 27,040 |   | $ | — |   | $ | 422 |   | $ | 27,632 |   |
|                                                         |       |                                                              |       |   |   |   |   |   |   |   |   |
| Premiums earned                                              |       | $                                                                 | 170        |   | $ | 18,408 |   | $ | — |   | $ | 544 |   | $ | 19,122 |   |
| Net insured  credit swap revenue                             |       | (1,664,749                                                        | )          | 910 |   | (4,105 | ) | — |   | (1,667,944 | ) |
| Net investment  income                                       |       | 17,440                                                            |       | 13,119 |   | 232,147 |   | 5,312 |   | 268,018 |   |
| Net realized and  unrealized losses on investments           |       | (9,638                                                            | )          | (236 | ) | (84,674 | ) | (58 | ) | (94,336 | ) |
| Net realized and  unrealized gains on derivative instruments |       | 255                                                               |       | — |   | 2,684 |   | — |   | 2,939 |   |
| Other net credit  swap revenue                               |       | (770                                                              | )          | — |   | 19,721 |   | — |   | 18,951 |   |
| Fee and other  income                                        |       | 525                                                               |       | 402 |   | 22,975 |   | — |   | 23,902 |   |
| Total revenues                                               |       | (1,656,497                                                        | )          | 32,603 |   | 188,748 |   | 5,798 |   | (1,429,348 | ) |
|                                                         |       |                                                              |       |   |   |   |   |   |   |   |   |
| EXPENSES:                                                    |       |                                                              |       |   |   |   |   |   |   |   |   |
| Loss and loss  adjustment expenses                           |       | 3,500                                                             |       | 3,847 |   | — |   | 3,139 |   | 10,486 |   |
| Policy  acquisition costs                                    |       | —                                                            |       | 5,792 |   | — |   | 242 |   | 6,034 |   |
| Other operating  expenses                                    |       | 19,050                                                            |       | 8,213 |   | 18,986 |   | 21 |   | 46,270 |   |
| Interest expense                                             |       | 10,451                                                            |       | 1,174 |   | 211,784 |   | 279 |   | 223,688 |   |
| Depreciation and  amortization                               |       | 499                                                               |       | 400 |   | 5,741 |   | — |   | 6,640 |   |
| Total expenses                                               |       | 33,500                                                            |       | 19,426 |   | 236,511 |   | 3,681 |   | 293,118 |   |
| Income of minority  interest                                 |       | 1,781                                                             |       | — |   | (2,335 | ) | — |   | (554 | ) |
| Income (loss) before  income taxes                           |       | (1,688,216                                                        | )          | 13,177 |   | (50,098 |  ) | 2,117 |   | (1,723,020 | ) |
| Provision for income  tax expense (benefit)                  |       | (587,951                                                          | )          | 4,590 |   | (17,453 |  ) | 737 |   | (600,077 | ) |
| Net income (loss)                                            |       | $                                                                 | (1,100,265 | ) | $ | 8,587 |   | $ | (32,645 | )  | $ | 1,380 |   | $ | (1,122,943 | ) |
|                                                         |       |                                                              |       |   |   |   |   |   |   |   |   |
| Segment Assets                                               |       | $                                                                 | 1,023,803  |   | $ | 525,882 |   | $ | 3,281,927 |   | $ | 121,052 |   | $ | 4,952,664 |   |

 
| ** **                                                   | ** ** | **Nine Months Ended September 30, 2006** | ** ** |
|--------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **Structured**                                                    | ** ** | **Public** | ** ** | **CDO Asset** | ** ** | ** ** | ** ** | **Consolidated** | ** ** |
| ** **                                                   | ** ** | **Credit**                                                        | ** ** | **Finance** | ** ** | **Management** | ** ** | **Other** | ** ** | **Totals** | ** ** |
| REVENUES:                                                    |       |                                                              |       |   |   |   |   |   |   |   |   |
| Gross premiums  written                                      |       | $                                                                 | 623        |   | $ | 24,669 |   | $ | — |   | $ | 793 |   | $ | 26,085 |   |
|                                                         |       |                                                              |       |   |   |   |   |   |   |   |   |
| Premiums earned                                              |       | $                                                                 | 674        |   | $ | 19,880 |   | $ | — |   | $ | 1,397 |   | $ | 21,951 |   |
| Net insured  credit swap revenue                             |       | 34,963                                                            |       | 916 |   | 3,311 |   | — |   | 39,190 |   |
| Net investment  income                                       |       | 3,870                                                             |       | 11,856 |   | 229,585 |   | 2,741 |   | 248,052 |   |
| Net realized and  unrealized losses on investments           |       | (297                                                              | )          | (971 | ) | (2,482 | ) | (225 | ) | (3,975 | ) |
| Net realized and  unrealized gains on derivative instruments |       | —                                                            |       | — |   | 6,894 |   | — |   | 6,894 |   |
| Other net credit  swap revenue                               |       | —                                                            |       | — |   | 7,634 |   | — |   | 7,634 |   |
| Fee and other  income                                        |       | 876                                                               |       | 311 |   | 16,848 |   | — |   | 18,035 |   |
| Total revenues                                               |       | 40,086                                                            |       | 31,992 |   | 261,790 |   | 3,913 |   | 337,781 |   |
|                                                         |       |                                                              |       |   |   |   |   |   |   |   |   |
| EXPENSES:                                                    |       |                                                              |       |   |   |   |   |   |   |   |   |
| Loss and loss  adjustment expenses                           |       | —                                                            |       | 5,035 |   | — |   | 1,223 |   | 6,258 |   |
| Policy acquisition  costs                                    |       | —                                                            |       | 6,346 |   | — |   | 452 |   | 6,798 |   |
| Other operating  expenses                                    |       | 13,336                                                            |       | 6,519 |   | 15,377 |   | 61 |   | 35,293 |   |
| Interest expense                                             |       | 852                                                               |       | 1,280 |   | 211,079 |   | 267 |   | 213,478 |   |
| Depreciation and  amortization                               |       | 588                                                               |       | 510 |   | 6,075 |   | — |   | 7,173 |   |
| Total expenses                                               |       | 14,776                                                            |       | 19,690 |   | 232,531 |   | 2,003 |   | 269,000 |   |
| Income of minority  interest                                 |       | (39                                                               | )          | — |   | (3,087 | ) | — |   | (3,126 | ) |
| Income before income  taxes                                  |       | 25,271                                                            |       | 12,302 |   | 26,172 |   | 1,910 |   | 65,655 |   |
| Provision for income  tax expense                            |       | 9,009                                                             |       | 4,386 |   | 9,329 |   | 681 |   | 23,405 |   |
| Net income                                                   |       | $                                                                 | 16,262     |   | $ | 7,916 |   | $ | 16,843 |   | $ | 1,229 |   | $ | 42,250 |   |
|                                                         |       |                                                              |       |   |   |   |   |   |   |   |   |
| Segment Assets                                               |       | $                                                                 | 351,178    |   | $ | 483,516 |   | $ | 5,107,310 |   | $ | 104,163 |   | $ | 6,046,167 |   |

 

16

----

 

**9.  STOCK PLANS AND STOCK BASEDCOMPENSATION**

 

In 2001, the Companyadopted the American Capital Access Holdings, Incorporated Omnibus IncentiveCompensation Plan (the “Prior Plan”) under which 2,188,584 shares of theCompany’s common shares were reserved for issuance to employees, directors andconsultants.  In 2003, the Company’s Board of Directors approved theincrease of the number of shares reserved for issuance by 72,954.  In2004, the Board of Directors approved the ACA Capital Holdings, Inc.Amended and Restated 2004 Stock Incentive Plan effective September 30,2004 (as amended on October 4, 2004, the “2004 Plan”) amending andrestating the Prior Plan and increasing the total options available under the2004 Plan (including those previously distributed under the Prior Plan) to4,241,538.  In August 2006, the Board of Directors approved theAmended and Restated 2006 Stock Incentive Plan, to become effective uponcompletion of the IPO (the “2006 Plan”) which increased the total optionsavailable under the 2006 Plan, including all shares subject to existing awardsthereunder pursuant to the Prior Plan and the 2004 Plan, to 6,327,972. The 2006 Plan became effective November 9, 2006.  The 2006 Plan permitsthe grant of nonqualified and qualified stock options, incentive stock options,restricted stock, stock units, unrestricted stock, dividend equivalent andcash-based awards.  The objectives of the 2006 Plan are to optimize theprofitability and growth of the Company through annual long-term incentivesthat 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 3 and 1/2 years, beginning at the date of grant.

 

On September 30, 2004,the Company granted 335,214 restricted shares at a fair market value of $10.38per share, to the Company’s president and chief executive officer (the “Executive”). The total value at the grant date of the restricted stock totaled $3.5million.  The restricted stock vested one-third per year over a three-yearperiod provided the Executive was continuously employed by the Company or asubsidiary throughout the applicable vesting period. As of September 30, 2007,these shares were completely vested. In both the first nine months of 2007 and2006, the vested portion of the restricted stock totaled $0.9 million, whichwas recognized in the Company’s consolidated statement of operations.

 

In December 2004,the FASB issued FAS 123(R), “*SharedBased Payments*” (“FAS 123(R)”) that requires compensation costrelated to share-based payment transactions to be recognized in an issuer’sfinancial statements.  The compensation cost, with limited exceptions, ismeasured based on the grant-date fair value of the equity or liabilityinstrument issued.  FAS 123(R) replaces FAS 123, “*Accounting for Stock Based Compensation”* (“FAS123”) and supersedes Accounting Principles Board (“APB”) Opinion No. 25, “*Accounting for Stock Issue to Employees*” (“APB25”).

 

Effective January 1,2006, the Company adopted FAS 123(R) using the prospective application aspermitted by FAS 123(R).  Under this application, we are required torecord compensation expense for all awards granted after the date of adoption. Awards granted prior to the date of adoption of FAS 123(R) continue to beaccounted for under APB 25.  Compensation cost is recognized over theperiods that an employee provides service in exchange for the award.  TheCompany recorded stock-based compensation expense of $0.8 million and $0.2million for the three months ended September 30, 2007 and 2006, respectively,$0.1 million and $0 million of which, respectively, was deferred related topolicy acquisition costs.  The Company recorded a tax benefit of $0.2million and $0.1 million for the three months ended September 30, 2007 and2006, respectively.  The Company recorded stock-based compensation expenseof $2.6 million and $0.6 million for the nine months ended September 30, 2007and 2006, respectively, $0.4 million and $0 million of which, respectively, wasdeferred related to policy acquisition costs.  The Company recorded a taxbenefit of $0.8 million and $0.2 million for the nine months ended September30, 2007 and 2006, respectively.

 

The fair value of thestock options granted was estimated on the date of grant using a Black-Scholesoption valuation model that uses the assumptions noted in the followingtable.  The risk-free rate is based on the U.S. Treasury yield curve ineffect 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 term equals the average of the graded vestingterm and the contractual term.  Expected volatility was estimated based onthe historical volatility of comparable public companies for a period equal tothe stock option’s expected term, ending on the day of grant, and calculated ona monthly basis.

 
| ** **               | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
|--------------------------|------------|------------------------|------------|------------------------|------------|
| ** **               | ** ** | **2007**               | ** ** | **2006**               | ** ** |
| Expected life  (years)   |       | 6.00                   |       | 6.00                   |       |
| Risk free  interest rate |       | 4.71                   | %          | 4.55-4.91              | %          |
| Volatility               |       | 25.00                  | %          | 25.00                  | %          |
| Dividend yield           |       | 0.00                   | %          | 0.00                   | %          |

 

Utilizing theseassumptions, the weighted-average per-share fair value of stock options grantedin the first nine months of 2007 and 2006 was $5.19 and $4.47, respectively.

 

17

----

 

A summary of optionactivity for the nine months ended September 30, 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    |       | $                                                                | 11.52      |   | 3,043,650 |   | $ | 10.54 |   |
| Granted                           |       | 460,000      |       | $                                                                | 14.63      |   | 1,077,000 |   | $ | 12.70 |   |
| Exercised                         |       | (69,750      | )          | $                                                                | 10.44      |   | (663,540 | ) | $ | 10.23 |   |
| Forfeited                         |       | (119,088     | )          | $                                                                | 12.40      |   | (75,384 | ) | $ | 10.93 |   |
| Expired                           |       | —       |       | —                                                           |       | — |   | — |   |
| Outstanding, end  of period       |       | 4,168,210    |       | $                                                                | 11.86      |   | 3,381,726 |   | $ | 11.28 |   |
| Options vested,  end of period    |       | 2,523,769    |       | $                                                                | 11.26      |   | 1,689,567 |   | $ | 10.88 |   |

 

As of September 30, 2007,there was $7.7 million of total unrecognized compensation cost related tononvested share-based compensation awards granted under our stock optionplans.  This cost is expected to be recognized over a weighted averageperiod of 2.69 years.

 

During the first quarterof 2007, the Company granted 106,500 shares of restricted stock.  As ofSeptember 30, 2007, the Company had 346,654 shares of unvested restricted stockoutstanding under the 2006 Plan. With the exception of 6,154 shares ofrestricted stock granted to certain independent directors of the Company, whichvest pro rata, annually over three years, these shares vest pro-rata, annuallyover 4 years, as long as the grantee is still with the Company.

 

The table summarizesinformation regarding fully vested share options as of September 30, 2007(dollars in thousands, except per share amounts):

 
| Number of options  vested                                            |   | 2,523,769 |   |
|----------------------------------------------------------------------|--------|-----------|--------|
| Weighted average  exercise price per share                           |   | $         | 11.26  |   |
| Aggregate  intrinsic value (excess market price over exercise price) |   | $         | — |   |
| Weighted average  remaining contractual term of options (in years)   |   | 5.44      |   |

 

The following table summarizesinformation concerning outstanding and exercisable options at September 30,2007:

 
| ** **                                  | ** ** | **Options Outstanding**  | ** ** | **Options Exercisable**                                     | ** ** |
|---------------------------------------------|------------|-------------------------------|------------|------------------------------------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | **Number   Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|   $9.01-$10.51                    |       | 1,825,342                     |       | 5.00                                                             |       | $ | 10.32 |   | 1,522,639 |   | $ | 10.32 |   |
| $10.52-$12.01                               |       | 96,000                        |       | 7.37                                                             |       | $ | 11.63 |   | 66,167 |   | $ | 11.63 |   |
| $12.02-$13.51                               |       | 1,807,584                     |       | 7.66                                                             |       | $ | 12.75 |   | 872,855 |   | $ | 12.65 |   |
| $13.52-$15.01                               |       | 439,284                       |       | 9.36                                                             |       | $ | 14.63 |   | 62,108 |   | 14.63 |   |
|                                        |       | 4,168,210                     |       | 6.67                                                             |       | $ | 11.86 |   | 2,523,769 |   | $ | 11.26 |   |

 

Prior to the adoption ofFAS 123(R), the Company applied APB 25 to account for its stock-basedcompensation awards and provided the required pro forma disclosures ofFAS 123.  The following table illustrates the effect on net incomeand earnings per share had compensation expense for stock-based compensationawards been recorded in the nine months ended September 30, 2007 and 2006,based on the fair value method under FAS 123 (dollars in thousands, exceptper share amounts).

 
| ** **                                                                                                                                                        | ** ** | **Nine months ended**  | ** ** | **Nine Months Ended**  | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                                        | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** |
| Net income  (loss), as reported                                                                                                                                   |       | $                                | (1,122,943 | )                                | $          | 42,250 |   |
| 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 |       | (229                             | )          | (318                             | )          |
| Pro forma net  income (loss)                                                                                                                                      |       | $                                | (1,123,172 | )                                | $          | 41,932 |   |
|                                                                                                                                                              |       |                             |       |                             |       |
| Basic earnings  (loss) per share                                                                                                                                  |       |                             |       |                             |       |
| As reported                                                                                                                                                       |       | $                                | (31.05     | )                                | $          | 1.85 |   |
| Pro forma                                                                                                                                                         |       | $                                | (31.06     | )                                | $          | 1.83 |   |
| Diluted earnings  (loss) per share                                                                                                                                |       |                             |       |                             |       |
| As reported                                                                                                                                                       |       | $                                | (31.05     | )                                | $          | 1.40 |   |
| Pro forma                                                                                                                                                         |       | $                                | (31.06     | )                                | $          | 1.39 |   |

 

 

18

----

 

The computation of diluted earnings (loss) per share for the ninemonths ended September 30, 2007, did not include the effects of0.2 million options to purchase shares of common stock due to the net lossfor the period. The computation of diluted earnings (loss) per share for thethree months ended September 30, 2007 excluded 4.2 million options to purchaseshares of common stock because they would have an anti-dilutive effect on thecomputation. The computation of diluted earnings (loss) per share for the ninemonths ended September 30, 2007 and 2006 excluded 2.1 million and 0.1 millionoptions, respectively, to purchase shares of common stock because they wouldhave an anti-dilutive effect on the computation.

 

**10.  INVESTMENTS**

 

The Company accounts forits investments in fixed maturity securities in accordance with theFAS 115, “*Accounting for CertainInvestments in Debt and Equity Securities* “ (“FAS 115”) and EmergingIssues Task Force (“EITF”) Issue  99-20, “*Recognition of Interest Income and Impairment on Purchased and RetainedBeneficial Interests in Securitized Financial Assets.* “ Management determines the appropriate classification of securities at the timeof purchase.  As of September 30, 2007 and December 31, 2006, allinvestments in fixed maturity securities, with the exception of the Company’sinvestments in its Credit-Focused Absolute Return Fixed Income Fund (the “CreditFund”) (see Note 11), were designated as available-for-sale and werecarried at fair value.  Fixed maturity securities in the Company’s CreditFund are designated as trading securities and are also carried at fairvalue.  The difference between fair value and amortized cost ofavailable-for-sale securities is included in the accumulated othercomprehensive income component of stockholders’ equity, net of applicabledeferred income tax.  Changes in fair value of trading securities areincluded in net income.  The fair value of these securities is based onindependent market quotations or, when such quotations are not readilyavailable because the securities are infrequently traded in the public market,from internal valuation models.  These models include estimates, made bymanagement, which utilize current market information.  The valuationresults from these models could differ materially from amounts realizable in anopen 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 factorsinclude (i) the duration of a significant decline in value, (ii) theliquidity, business prospects and overall financial condition of the issuer,(iii) the magnitude of the decline, (iv) the collateral structure andother credit support, as applicable, (v) the Company’s intent and abilityto hold the investment until the values recover, and (vi) for asset-backedsecurities, the estimated cash flows. When the analysis of the above factorsresults in a conclusion that a decline in fair value is other than temporary,the cost of the security is written down to fair value as of the reporting dateand any previously unrealized loss is realized in the period such adetermination is made.

 

The following table showsthe gross unrealized losses and fair value of our fixed maturity securitiesavailable for sale with unrealized losses that are not deemed to beother-than-temporarily impaired, aggregated by investment category and lengthof time that individual securities have been in a continuous unrealized lossposition, at September 30, 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                            |       | $                                      | 19,662     |                                 | $          | (164      | )          | $ | 1,871 |   | $ | (24 | ) | $ | 21,533 |   | $ | (188 | ) |
| Federal-agency  securities                           |       | 23,451                                 |       | (133                                 | )          | 20,624    |       | (69 | ) | 44,075 |   | (202 | ) |
| Obligations of  states and political subdivisions    |       | 23,738                                 |       | (157                                 | )          | 52,211    |       | (676 | ) | 75,949 |   | (833 | ) |
| Corporate  securities                                |       | 31,964                                 |       | (1,337                               | )          | 46,669    |       | (2,161 | ) | 78,633 |   | (3,498 | ) |
| Asset-backed  securities                             |       | 1,976                                  |       | (23                                  | )          | 4,743     |       | (111 | ) | 6,719 |   | (134 | ) |
| Mortgage-backed  securities                          |       | 42,098                                 |       | (594                                 | )          | 90,379    |       | (2,898 | ) | 132,477 |   | (3,492 | ) |
| Total non-VIE  securities                            |       | 142,889                                |       | (2,408                               | )          | 216,497   |       | (5,939 | ) | 359,386 |   | (8,347 | ) |
| Available for  sale-VIE—asset-backed securities |       | 2,137,534                              |       | (368,322                             | )          | 439,906   |       | (63,485 | ) | 2,577,440 |   | (431,807 | ) |
| Total                                                |       | $                                      | 2,280,423  |                                 | $          | (370,730  | )          | $ | 656,403 |   | $ | (69,424 | ) | $ | 2,936,826 |   | $ | (440,154 | ) |

 

A substantial portion ofthe unrealized loss in CDO VIE asset-backed securities is related to RMBS,including both sub-prime and second lien mortgages. Beginning in late 2006 andcontinuing throughout  2007 there hasbeen significant disruption in the sub-prime and second lien mortgage markets,with some mortgage originators being purchased or exiting the business. This severe disruption continued into the third quarter of 2007 with othertypes of market participants (i.e., investment and commercial banks, hedgefunds, insurance companies and other financial institutions) announcingsignificant losses in connection with their sub-prime and second lien mortgageexposure.  This disruption further translated into decreased liquidity andwider spreads across the market, decreasing the market value of the portfolios. An additional factor weighing on the market valuations for the Company’spositions is the limited liquidity associated with the seasoned securitieswhich have already received or are about to receive a significant return of 

 

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principal.  During the three months and nine months endedSeptember 30, 2007, the Company determined that certain of its holdings inRMBS, primarily in its consolidated CDOs, were other than temporarilyimpaired.  As a result, write-offs relating primarily to those securities,aggregating $6.5 million and $118.5 million were recorded as a reduction of netincome during the three months and nine months ended September 30, 2007,respectively. In the third quarter of 2007, the Company recognized a $39.6million gain on the deconsolidation of three CDO deals, principally related torealized impairments taken in the second quarter of 2007 that were in excess ofthe Company’s equity position in these deals.

 

Regarding the unimpairedsecurities carried at an unrealized loss position as of September 30, 2007, theCompany believed that it would be able to realize the principal amounts due onthese RMBS positions and has the ability and intent to hold these investmentsuntil a recovery of fair value, which may be at their maturities.  TheCompany, therefore, did not consider these investments to beother-than-temporarily impaired at September 30, 2007.

 

Regarding the Company’sconsolidated CDOs, realized and unrealized losses could exceed the amount ofthe Company’s true economic exposure or equity investment in the CDO. This impairment in excess of the Company’s equity investment is a result of theconsolidation of CDO assets and liabilities on the Company’s balance sheet inaccordance with FIN 46(R). Unrealized losses recorded in other comprehensiveincome in excess of the Company’s investment at September 30, 2007 totaled$(220.5) million

 

The Company’s accumulatedother comprehensive loss of $(261.2) million at September 30, 2007, includes$(262.1) million related to unrealized losses on fixed maturity securitiesavailable for sale.

 

Included in the tableabove are 703 fixed maturity securities, 170 in the non-VIE portfolios, and 533in the VIE portfolios.  At September 30, 2007, there were 141 fixedmaturity securities, 140 of which are in the VIE portfolios, whose fair valuewas less than 80% of its amortized cost.  Over 97% of the securities inboth the non-VIE portfolio and the VIE portfolios are rated investment grade. Management has assessed these and other factors and concluded that there wereno other than temporarily impaired fixed maturity securities included in theabove table as of September 30, 2007.

 

**11.  CREDIT-FOCUSED ABSOLUTERETURN FIXED INCOME FUND**

 

In May 2006, the Companylaunched the Credit Fund to leverage its expertise in the capital and creditmarkets and as an asset manager.  The fund invests in fixed incomesecurities, particularly in the asset-backed sector.  Through September30, 2007, the Credit Fund had received capital contributions of $38.0 million,of which the Company had invested $26.4 million and third parties had invested$11.6 million.  In addition to receiving a return on its investment in theCredit Fund, the Company is paid a management fee to select and manage theassets of the fund for the Credit Fund’s third party investors.  Foraccounting purposes, the Credit Fund is consolidated in the Company’s financialstatements as of September 30, 2007 and its financial results are recorded inthe Structured Credit line of business. As of September 30, 2007, the CreditFund had total assets of $136.2 million, including investments infixed-maturity securities trading of $125.2 million, and total liabilities andminority interest of $114.4 million, including securities sold under agreementsto repurchase of $104.1 million, included in the Company’s unaudited condensedconsolidated balance sheet.

 

**12.  SENIOR CONVERTIBLEPREFERRED STOCK**

 

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

 

**13.  STOCK SPLIT**

 

On August 3, 2006,the Company’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 onAugust 3, 2006 received five additional shares of common stock for eachshare of common stock held by such stockholder on that date.  Funds werereclassified from the additional paid in capital account to the common stockaccount in an amount equal to the par value of the incremental shares issuedunder the stock split.  Upon the conversion of the various classes of theCompany’s preferred stock, each holder of convertible preferred stock, seniorconvertible preferred stock and series B senior convertible preferredstock was issued, in the case of convertible preferred stockholders and seniorconvertible preferred stockholders, 6,000 shares for each share of preferredstock held by such holder and, in the case of the series B seniorconvertible preferred stockholders, 6 shares of each share of preferred stock heldby such holder. All earnings per share and related stock option informationpresented in these financial statements and accompanying footnotes have beenretroactively adjusted to reflect the increased number of shares resulting fromthis action.

 

On November 9, 2006, ACACapital priced its initial public offering of common stock.  The Companysold 6,875,000 shares of common stock in the offering, at $13.00 per share,with net proceeds to ACA Capital of $79.2 million.  The transaction closedon November 15, 2006.  ACA Capital is listed on the New York StockExchange under the symbol “ACA”.  Upon the closing of its initial publicoffering of common stock, the Company converted 154 shares of seniorconvertible stock to 924,000 shares of common stock, 959 shares of convertiblepreferred stock converted to 5,754,000 shares of common stock and 2,785,769shares of series B 

 

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senior convertiblepreferred stock converted to 16,714,614 shares of common stock.

 

**14.  LIQUIDITY FACILITY**

 

The Company entered intoa $150 million credit agreement (“Credit Facility”) on April 26, 2007 with asyndicate of banks, replacing the previous $75 million credit facility that wasin place. On October 15, 2007, the Company entered into an amendment (the “FirstAmendment”) to the Credit Facility (as amended by the First Amendment, the “AmendedCredit Facility”) with the syndicate of banks. In addition to amending certainof the terms of the Credit Facility, the First Amendment (i) waived any defaultor event of default that may have been in effect under the Credit Facility atany time during the period from July 1, 2007 to October 15, 2007 and (ii)suspended the availability of the facility commitments from October 15, 2007though such date as the Company’s Net Worth (as defined in the credit agreementfor the Amended Credit Facility) is at least $500 million (the “First AmendmentSuspension Period”).

 

The Amended CreditFacility provides for borrowings by us on a revolving basis up to an aggregateof (x) $75 million at any one time outstanding after our Net Worth  is at least $500 million and (y) $150 millionat any one time outstanding after our Net Worth is greater than $600 million. TheAmended Credit Facility requires us to prepay any amounts outstanding under thefacility in excess of $75 million in the event our Net Worth is less than $600million after the end of the First Amendment Suspension Period. The Company hadno amounts outstanding nor made any borrowing under the Credit Facility as ofSeptember 30, 2007 and for the nine-month period then ended.

 

The Company may borrowcash under the Amended 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 facilityfee between 0.08% up to 0.15% per annum of the total commitments under theCredit Facility depending on our leverage ratio.  In addition, the Companyalso agreed to pay a utilization fee at a rate of 0.125% per annum on theaverage daily amount of the outstanding principal under the Amended CreditFacility, but only payable when such outstanding principal amount exceeds 50%of the commitments under the Amended Credit Facility.

 

The Amended CreditFacility contains certain financial covenants that require, among other things,the Company to maintain a minimum net worth and a maximum leverage ratio. The net worth covenant includes in its calculation all FAS 133 mark-to-marketvaluations recorded in our statement of operations. The Company is currentlynot able to borrow against the facility because of the magnitude of theunrealized FAS 133 loss on its Structured Credit insured credit swaps. TheCompany does not, however, currently have liquidity needs that wouldnecessitate a borrowing under the facility.

 

**15.  STOCK REPURCHASE PLAN**

 

On July 24, 2007, theCompany’s Board of Directors authorized a $20 million stock repurchase programof the Company’s outstanding common stock. As of November 9, 2007, the Companyhas repurchased 2,087,900 shares of common stock at a cost of $14.9 million inthe aggregate.

 

**16.  SUBSEQUENT EVENT**

 

On November 9, 2007,S&P placed its financial strength rating of ACA Financial Guaranty on “CreditWatchwith negative implications”. S&P based its rating action on its opinionthat the substantial unrealized mark to market loss recorded by the Company forthe three months ended September 30, 2007 may impair ACA Financial Guaranty’sability to generate a satisfactory level of new business. Amongst other things,S&P also cited the Company’s inability to access its liquidity facilityunder its recently revised terms as a relevant factor in its rating action. TheCompany is continuing to have discussions with S&P to better understand itsactions and any remedies available to the Company to remediate the issuesraised by S&P.

 

The placement of ACAFinancial Guaranty’s financial strength rating on CreditWatch with negativeimplications does not have a direct impact on the Company, although it doesincrease the uncertainty about ACA Financial Guaranty’s ability to write newbusiness at historic levels. However, should S&P ultimately downgrade ACAFinancial Guaranty’s financial strength rating below A-, under the existingterms of the Company’s insured credit swap transactions, the Company would berequired to post collateral based on the fair value of the insured credit swapsas of the date of posting. The failure to post collateral would be an event ofdefault, resulting in a termination payment in an amount approximately equal tothe collateral call. This termination payment would give rise to a claim underthe related ACA Financial Guaranty insurance policy. Based on current fairvalues, neither the Company nor ACA Financial Guaranty would have the abilityto post such collateral or make such termination payments. As of September 30,2007, the Company’s estimated fair value of its insured credit swaps was $(1.7)billion. Additionally, upon termination of these transactions, installmentpremiums payable to ACA Financial Guaranty would cease. The estimated aggregatepresent value of future installments under all insured credit swap transactionstotaled $468.8 million at September 30, 2007.

 

Management is currentlyinvestigating the possibility of restructuring its insured credit swaptransactions to eliminate the 

 

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collateral postingrequirement.

 

Absent a downgrade orother requirements to post collateral, ACA Financial Guaranty and the Companyare currently adequately capitalized to operate their businesses and meet theirfinancial obligations. While the Company recorded a substantial unrealized markto market loss in the third quarter resulting in a net loss, no defaults thatresulted in cash payments under the agreements have occurred and, in theCompany’s estimation, are not certain to occur or imminent.

 

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**Item2.    Management’s Discussion and Analysis of FinancialCondition and Results of Operations**

 

*Thefollowing discussion relates to our unaudited condensed consolidated financialstatements and should be read in conjunction with the financial statements andnotes thereto appearing 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-looking statements are not guarantees of futureperformance and are subject to risks, uncertainties and assumptions, including,among other things, information set forth under “Risk Factors” below and in ourperiodic reports filed with the SEC.  In making these statements, we arenot undertaking 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 holding companythat provides financial guaranty insurance products to participants in theglobal credit derivatives markets, structured finance capital markets andpublic 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. Approximately 78% of ourassets 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, in January 2007, we obtained alicense from the FSA to conduct a European asset management business throughour wholly-owned indirect subsidiary ACA Capital Management (U.K.) Pte.Limited.  As of September 30, 2007, we had credit exposure of $76.7billion and our assets under management for third parties were $18.0 billion.

 

Our financial resultsinclude three principal operating lines of business: Structured Credit andPublic Finance, which are both financial guaranty insurance lines of business,and our CDO Asset Management business. We have a fourth line of business,Other, which encompasses specified insurance transactions in areas in which weare no longer active, including industry loss warranty transactions, tradecredit reinsurance and insurance of certain asset-backed securitizations,principally, manufactured housing. Our lines of business constitute segmentsfor accounting purposes.

 

Through our StructuredCredit line of business, we select, structure and sell credit protection,principally in the form of insured credit swaps, against a variety of assetclasses in the institutional fixed income markets. Structured Credit alsoincludes the consolidated results of the Credit Fund.  The Credit Fund wascreated in 2006 to leverage our expertise in the capital and credit markets andas an asset manager. The fund primarily invests in fixed income securities,particularly in the asset-backed sector.

 

Within Structured Credit,our principal revenues are net insured credit swap revenue and net investmentincome, which includes amounts received from the Credit Fund and its allocatedportion of corporate-wide investment income. Generally, we receive insuredcredit swap premiums in quarterly installments over the life of the relatedswaps which is typically in the range of 5 to 7 years. The principal expensesof this line of business are its allocated portion of corporate-wide operatingexpenses, interest expense and depreciation and amortization. It also incursdirect interest expense related to the financing of our consolidated CreditFund’s purchased investments. We enter into our insured credit swaps with theintent that they remain outstanding for the entire term of the contract. These insured credit swaps are accounted for at fair value because they do notqualify for the financial guarantee scope exception under FAS No. 133, “*Accounting for Derivative Instruments and CertainHedging Activities*”, as amended (“FAS 133”).  Changes in thefair value of these contracts are required to be marked to market under the requirementsof FAS 133 and are recorded, together with the related fixed quarterly premiumpayments payable to us under the insured credit swaps, under the caption netinsured credit swap revenue.  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, which is our intent,the cumulative changes in fair value will net to zero at the end of the term,provided that we do not incur credit losses on the contract.  In certaincircumstances, we may agree with a counterparty to terminate an insured creditswap transaction prior to its maturity (such as on request of the counterpartyor for risk management purposes, such as in connection with a deterioration ofthe underlying portfolio) and may experience realized gains or losses inconnection with the early termination of such transactions.  See “—CriticalAccounting Policies and Estimates and—Net Insured Credit Swap Revenue”.

 

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In our Public Financeline of business, we primarily provide financial guaranty insurance policiesguaranteeing the timely payment of principal and interest on public finance andother debt obligations. Our principal revenues in this line of business arepremiums earned on our financial guaranty insurance policies and its allocatedportion of corporate-wide investment income. The principal expenses of thisline of business include its allocated portion of corporate-wide operatingexpenses, interest expense and depreciation and amortization. We also incurloss and loss adjustment expenses, related to the non-derivative exposure weinsure, and policy acquisition costs, which are expenses that vary with and aredirectly attributable to the generation of insurance premiums and are deferredand recognized over the period in which the related premiums are earned.Typically, public finance premiums are received by us on an up front basis.However, under current accounting standards, they are recognized into incomeover 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 syntheticCDOs.  Also included is an allocated portion of corporate-wide investmentincome. The principal direct expenses are interest expense related to the CDOdebt and the amortization of related capitalized debt issuance costs. This lineof business also receives an allocated portion of corporate-wide operatingexpenses, interest expense and depreciation and amortization. Several of ourCDOs are consolidated in our financial statements because we have beendetermined to be the primary beneficiary under FIN 46(R),*“Consolidation of Variable Interest Entities —aninterpretation of ARB No. 51 analyses*”.  See “—Results ofOperations—CDO Asset Management—Supplementary Information” for a discussion onthe 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 three and ninemonths ended September 30, 2007 and 2006.

 

We believe it is moremeaningful to analyze our financial performance on an annual, rather than aquarterly, 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 performance 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, managementreviews our performance using a measure known as net economic income.Management believes that analyzing net economic income supplements theunderstanding of our results of operations by highlighting income attributableto our ongoing operating performance.  See “—Net Economic Income”.

 

On November 9, 2007,S&P placed its financial strength rating of ACA Financial Guaranty on “CreditWatchwith negative implications”. S&P based its rating action on its opinionthat the substantial unrealized mark to market loss recorded by us for thethree months ended September 30, 2007 may impair ACA Financial Guaranty’sability to generate a satisfactory level of new business. Amongst other things,S&P also cited our inability to access our liquidity facility underrecently revised terms as a relevant factor in its rating action. We arecontinuing to have discussions with S&P to better understand its actionsand any remedies available to us to remediate the issues raised by S&P. See“—Part II, Item 1A – Risk Factors”.

 

The placement of ACAFinancial Guaranty’s financial strength rating on CreditWatch with negativeimplications does not have a direct impact on the Company, although it doesincrease the uncertainty about ACA Financial Guaranty’s ability to write newbusiness at historic levels. However, should S&P ultimately downgrade ACAFinancial Guaranty’s financial strength rating below A-, under the existingterms of our insured credit swap transactions, we would be required to postcollateral based on the fair value of the insured credit swaps as of the dateof posting. The failure to post collateral would be an event of default,resulting in a termination payment in an amount approximately equal to thecollateral call. This termination payment would give rise to a claim under therelated ACA Financial Guaranty insurance policy. Based on current fair values,we would not have the ability to post such collateral or make such terminationpayments. As of September 30, 2007, we estimated fair value of its insuredcredit swaps was $(1.7) billion. Additionally, upon termination of thesetransactions, installment premiums payable to ACA Financial Guaranty would cease.The estimated aggregate present value of future installments under all insuredcredit swap transactions totaled $468.8 million at September 30, 2007.

 

We are currentlyinvestigating the possibility of restructuring our insured credit swaptransactions to eliminate the collateral posting requirement.

 

Absent a downgrade orother requirements to post collateral, we are currently adequately capitalizedto operate our businesses and meet our financial obligations. While we recordeda substantial unrealized mark to market loss in the third quarter resulting ina net loss, no defaults that resulted in cash payments under the agreementshave occurred and, in our estimation, are not certain to occur or imminent.

 

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**CriticalAccounting Policies and Estimates**

 

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

 

*FinancialGuaranty Revenue Recognition*

 

*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 guarantycontracts are not subject to FAS 133, if they meet certain specifiedcriteria. Installment premiums are earned over each installment period, whichis generally one year or less. Up front premiums are earned in proportion tothe expiration of risk, which is par. Premium is allocated to each par maturity(*e.g.*, principal payment)included in an insured bond and earned on a straight-line basis for the periodthe related insured risk is outstanding.  Unearned premiums represent thatportion of premiums which is applicable to coverage of risk to be provided inthe future on policies in-force. When an insured issue is retired or defeasedprior to the end of the expected period of coverage, the remaining unearnedpremiums, less any amount credited to the refunding issue insured by us, arerecognized as earned premium. The amounts earned from refundings wereapproximately $0.9 million and $3.8 million for the three months endedSeptember 30, 2007 and 2006, respectively, and $5.9 million and $7.3 millionfor the comparable nine months then ended.

 

On April 18, 2007, the FASB released an exposure draft entitled “*Accounting for Financial Guarantee InsuranceContracts—An Interpretation of FASB Statement No. 60*” (the “ProposedStatement”).  While FASB Statement No. 60, “*Accounting and Reporting by Insurance Enterprises”,*  sets out accounting standards for property and casualty and life insuranceenterprises, it has historically not specifically considered financial guarantyinsurance.  This new interpretation is intended to address the specificattributes of this type of insurance. The principal items addressed in theexposure draft relate to revenue recognition, the establishment of claimreserves and disclosures around such reserves.  In response to exposuredraft comments the FASB received from financial guaranty insurance financialstatement preparers, reviewers and users, the FASB is expected to issue arevised exposure draft in the first quarter of 2008. The proposed scope andeffective date of this revised exposure draft are not known at this time. Whilecertain provisions of the Proposed Statement are still being analyzed,management believes that the cumulative effect of initially applying theProposed Statement could be material to the Company’s financialstatements. Until the final interpretation is issued and effective, wewill continue to apply the accounting policies as disclosed in our auditedfinancial statements as of December 31, 2006 and 2005 and for the years endedDecember 31, 2006, 2005 and 2004.

 

*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) forsuch instruments requires the use of management judgment. We do not believethat our insured credit swaps meet the scope exception of FAS 133, paragraph10(d), as amended by FAS 149, because there is no contractual requirement thatthe protection purchaser by exposed to the underlying risk.

 

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

 

We value our insuredcredit swap transactions either by obtaining market quotes from dealers orthrough the application of our valuation model.  During the quarter endedJune 30, 2007, we refined our valuation model to estimate fair value of ourinsured credit swap transactions.  The change was implemented to be moreconsistent with models that we understand other market participants utilize,including many of our insured credit swap counterparties.  The relativelyyoung market for credit swaps has continued to evolve over time and, whilethere is still substantial variance in valuation models among marketparticipants, the trend is toward increasing convergence in this area. Underour refined model, we fully use market spread data as a proxy for defaultprobabilities in the determination of fair value. For transactions in which theunderlying exposure is to corporate credits, we use individual market spreadsas proxies for defaults as they are readily available. For syntheticasset-backed transactions, historically, individual spread data has been notquite as readily available and the Company used current weighted averageportfolio spreads as a proxy for individual spreads where necessary. In thethird quarter of 2007, however, individual spreads were obtained and utilizedfor all synthetic ABS underlying exposures. The Company believes that its newmodel will inherently increase the volatility of these valuations, but providea better estimate of the cost or benefit of unwinding the related.

 

*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 structured financebusiness. Anticipated claims and claim adjustment expenses are considered indetermining the recoverability of acquisition costs. Net acquisition costs are 

 

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deferred and amortizedover the period in which the related premiums are earned. In connection withits review of certain accounting standards for financial guaranty insurancecontracts, the FASB is considering potential changes relating to deferredpolicy acquisition costs. See “—Critical Accounting Policies andEstimates—Financial Guaranty Revenue Recognition—Premiums Earned” for furtherexplanation of potential changes.

 

*Lossand Loss Adjustment Expenses.*  Financial guaranty lossand 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 theobligations ACA Financial Guaranty has incurred. In determining our accountingpolicy for loss reserves, we rely primarily on FAS 60,*“Accounting and Reporting by Insurance Enterprises”*(“FAS 60”).  However, FAS 60 was adopted when the financial guarantyindustry was just beginning. As a result, FAS 60 did not contemplate thespecific attributes of financial guaranty insurance as distinct from otherforms of insurance. In particular, financial guaranty insurance is considered ashort-duration insurance product; however, it has features that are more akinto long-duration contracts in that the term of some insured obligations can beas long as 30 years or more and the contracts are generally irrevocable.Under FAS 60, accounting for losses differs for short-duration andlong-duration contracts. Because of this inconsistency, we also apply FAS 5, “*Accounting for Contingencies*” (“FAS 5”) inthe determination of our loss reserves.  Specifically, FAS 5 requires theestablishment of reserves when it is probable that a liability has beenincurred at the reporting date, but only to the extent the loss can bereasonably estimated. The Proposed Statement includes guidance on theestablishment of claim reserves and disclosure around such reserves. Until the final interpretation is issued and effective, we will continue toapply the accounting policies as disclosed in our audited financial statementsas of December 31, 2006 and 2005 and for the years ended December 31, 2006,2005 and 2004. In response to exposure draft comments the FASB receivedfrom financial guaranty insurance financial statement preparers, reviewers andusers, the FASB is expected to issue a revised exposure draft in the firstquarter of 2008. The proposed scope and effective date of this revised exposuredraft are not known at this time but, could be material.  See “—CriticalAccounting Policies and Estimates—Financial Guaranty RevenueRecognition—Premiums Earned” for further explanation of potential changes.

 

The financial guarantyinsurance policies we issue insure scheduled payments of principal and interestdue on various types of financial obligations against a payment default on suchpayments by the issuers of the obligations. Active surveillance of our insuredportfolio tracks the performance of insured obligations from period to period.We establish loss and loss adjustment expenses, or LAE, reserves based onsurveillance group reports, the latest available industry data, and analysis ofhistorical default and recovery experience for the relevant sectors of thefixed-income market. Together the case reserves and non-specific reservesrepresent management’s estimate of incurred losses on our non-derivativeinsured portfolio exposures.

 

Case specific reservesare reserves created on those obligations identified as currently or likely tobe in default, and represent the present value, discounted at the U.S. TreasuryNote rate applicable to the term of the underlying insured obligations, of theexpected LAE payments, net of estimated recoveries (under salvage, subrogationor other recovery rights).  Gross case-specific reserves, net of estimatedrecoveries, were $17.3 million and $20.2 million as of September 30,2007 and December 31, 2006, respectively.  We take into account a numberof variables that depend primarily on the nature of the underlying insuredobligation when we establish case specific reserves for individualpolicies.  These variables include the nature and creditworthiness of theunderlying issuer of the insured obligation, whether the obligation is securedor unsecured and the expected recovery rates on the insured obligation, the projectedcash flow or market value of any assets that support the insured obligation andthe historical and projected loss rates on such assets.  The state of theeconomy, rates of inflation and the salvage values of specific collateral,among other factors, may affect the actual ultimate realized losses for anypolicy.  Currently, we do not believe that changes to these factors wouldmaterially change the amount of our case specific loss reserves, with theexception of significant changes in salvage values of specificcollateral.  However, case specific reserves are regularly reviewed inorder to incorporate relevant current facts and circumstances and changes tothese factors may in the future materially change the amount of our casespecific loss reserves.

 

Our non-specific reservewas derived from the calculation of expected loss, which we estimate using aMonte Carlo simulation.  A Monte Carlo simulation is a technique that iscommonly used to estimate the probability of certain mathematical outcomes. It randomly selects values to create scenarios of outcomes and this randomselection process is repeated many times to create multiple scenarios. Each time a value is randomly selected, it forms one possible scenario andoutcome.  Together, these scenarios give a range of possible outcomes,some of which are more probable and some less probable.  By definition,the average solution will give the most likely potential outcome.  Ourrisk management team typically runs at least 100,000 trials in order todetermine future expected losses.  The model uses the current ratings anddefault frequency (net of recovery) applied to each transaction withoutstanding exposure to determine the expected probability distribution ofloss.  Default frequency and recovery amounts are published periodicallyby each of the major rating agencies.  From the model output, we canestimate a range of expected loss.  The amount of non-specific reserverecorded in our financial statements is based on the loss ratio resulting fromthe calculation of total losses, including past incurred losses and expectedfuture losses divided by premium.  For this purpose, premium is defined asever-to-date written premium as of September 30, 2007 plus future installmentpremium on closed transactions.  This derived loss ratio is applied tototal ever-to-date earned premiums as of September 30, 2007.  Casespecific reserves are subtracted from this amount to arrive at net non-specificreserves.  The table below shows our case and non-specific reserves as ofSeptember 30, 2007 and December 31, 2006.

 

26

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| ** **              | ** ** | **As of September 30,** | ** ** | **As of December 31,** | ** ** |
|-------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **              | ** ** | **2007**                               | ** ** | **2006**                              | ** ** |
| ** **              | ** ** | **(in thousands)**                | ** ** |
| Case specific  reserves |       | $                                      | 17,315     |                                  | $          | 20,232 |   |
| Non specific  reserves  |       | 25,563                                 |       | 21,881                                |       |
| Total                   |       | $                                      | 42,878     |                                  | $          | 42,113 |   |

 

*InvestmentPortfolio.*  The primary components of our investmentportfolio are the fixed maturity securities of ACA Financial Guaranty, our CDOinvestments and the investments of the Credit Fund. As per FAS 115, “*Accounting for Certain Investments in Debt and EquitySecurities*” (“FAS 115”) management determines the appropriateclassification of these securities at the time of purchase.  As ofSeptember 30, 2007, all investments in fixed maturity securities except forthose related to the Credit Fund were designated as available for sale and werecarried at fair value. Unrealized gains and losses for available for salessecurities are the difference between fair value and amortized cost included inthe accumulated other comprehensive income component of stockholders’ equity,net of applicable deferred income tax. As of September 30, 2007, theinvestments of the Credit Fund were designated as trading securities and werealso carried at fair value. Unrealized gains and losses for trading securitiesare included in net income. The fair values of our securities are based onindependent market quotations or, when such quotations are not readilyavailable because the securities are infrequently traded in the public market,from internal valuation models. The valuation results from these models coulddiffer materially from amounts realizable in an open market sale or exchange.

 

*Consolidationof Variable Interest Entities (VIEs) and Other Restricted Investments.*  Fundedand partially funded CDOs are generally issued out of VIEs. As such, each timea CDO is formed that includes the issuance of debt instruments to third partiesand the purchase of investment assets, we perform an analysis to determinewhether we are the primary beneficiary and thus required to consolidate the CDOunder the provisions of Financial Interpretation 46(R), “*Consolidation of Variable Interest Entities**— an interpretation of ARB No. 51”* (“FIN 46(R)”). Prior to 2005, we retained all or most ofthe equity position in our CDOs, and these CDOs are therefore consolidated inour financial statements (a total of seven CDOs were consolidated). Althoughthe CDO is consolidated, we do not have the right to use the assets of the CDOfor general operations and the debt liabilities of the CDO are without recourseto any assets other than those of the CDO. Our investment exposure to our CDOsis therefore limited to our equity investment, which is a first loss positionof the CDO. In the instances that we own less than 100% of the CDO’s equity,but are the primary beneficiary and thus consolidate the CDO, we establishminority interests for the unowned portion.  Upon the occurrence of areconsideration event, such as the sale or disposal of all or part of theCompany’s equity investment, the Company re-performs its analysis to determinewhether it is still the primary beneficiary.

 

During the third quarter of 2007, the Company sold aportion of its equity investment in three asset-backed fully funded CDO deals,ACA ABS 2002-1, ACA ABS 2003-1 and ACA ABS 2003-2, to an unrelated third party eachfor fair market value, realizing a net gain of $39.6 million. These CDOs werepreviously consolidated in the Company’s financial statements, since atinception the Company was considered the primary beneficiary under FIN 46(R). Inconjunction with the equity sale, the Company determined that it was no longerthe primary beneficiary of these deals under FIN 46(R) and, therefore,de-consolidated these deals in its financial statements as of September 30,2007.

 

As of September 30, 2007and December 31, 2006, consolidated liabilities include non-recourse debtfrom consolidated CDOs of $3,258.0 million and $4,711.8 million,respectively.  Also, as of September 30, 2007 and December 31, 2006,consolidated assets include investments in CDO related fixed maturitysecurities and guaranteed investment contracts of $2,753.3 million and$4,632.2 million, respectively, and cash of $225.0 million and $265.0million, respectively. As of September 30, 2007 and December 31, 2006, we alsohad investments in non-consolidated CDO equity of $19.3 million and $23.8million, respectively. We have the right to use these investments innon-consolidated CDO equity for our general operations.

 

Beginning in 2005, wehave 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 theprimary beneficiary of these VIEs.  As a result, these CDOs are notconsolidated in our financial statements.  Rather, our non-majorityinvestment is recorded as an investment in a single fixed maturity securityunder the provisions of FAS 115 and Emerging Issues Task Force (“EITF”) IssueNo. 99-20, *“Recognition of Interest Income and Impairment on Purchased and RetainedBeneficial Interests in Securitized Financial Assets”* (“EITF 99-20”). The deconsolidated CDOs described in above are also accounted for under thisprinciple. During the first nine months of 2007, we closed nine CDOs andpurchased an equity interest in three.  During 2006, we closed eight CDOsand purchased an equity interest in four.  During 2005, we closed fiveCDOs and purchased an equity interest in four.  We determined we were notthe primary beneficiary in any of these CDOs and therefore do not consolidate them.

 

In May of 2006, webegan managing our Credit Fund.  The Credit Fund was created to leverageour expertise in the capital and credit markets and as an asset manager. The Credit Fund invests in fixed maturity securities, including the asset-backedsector.  Through September 30, 2007, the Credit Fund had received capitalcontributions of $38.0 million, of which the Company had invested $26.4 millionand third parties had invested $11.6 million.  In addition to receiving areturn on our investment in the Credit Fund, we are paid a management fee toselect and manage the assets for the Credit Fund’s third party investors. Although the Credit Fund is consolidated pursuant to the requirements of U.S.GAAP accounting, we do not have the right to use the assets for generaloperations.  See “—Results of Operations—Structured Credit.”

 

27

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**Resultsof Operations**

 

*Summaryof Consolidated Results*

 

The following describesour consolidated financial results for the three months and the nine monthsended September 30, 2007 and 2006 and our financial condition as of September30, 2007 and December 31, 2006. In order to understand our consolidatedfinancial results, we perform a detailed segment by segment analysis for ourlines of business and therefore, to augment the segments discussion, thefollowing consolidated discussion has been prepared to describe(1) revenue and expense items that are allocated to our four lines ofbusiness and (2) the results of our lines of business:  StructuredCredit, Public Finance, CDO Asset Management and Other.

 

The accounting policiesof our lines of business are the same as those described in the summary of “CriticalAccounting Policies and Estimates” above and in our Form 10-K. Our two financialguaranty insurance lines of business, Structured Credit and Public Finance, arepresented as separate lines of business. Items not directly attributable areallocated to each operating line of business. Allocated items consist ofinvestment income from the corporate-wide investment portfolio of cash andinvestments, primarily from ACA Financial Guaranty, realized gains and losseson those investment portfolios, interest expense on the corporate debt at theholding company level, all operating expenses, non-CDO related depreciation andamortization expenses and income taxes. Income and expense items that aredirectly attributable to a business line are recorded as such.

 

The Company’sconsolidated net income (loss) for the three months ended September 30, 2007was $(1,041.0) million, or $(29.42) per diluted share, as compared to $16.1million, or $0.53 per diluted share, for the three months ended September 30,2006, a decrease of $1,057.1 million.  The decrease in net income wasprincipally related to after-tax net unrealized mark-to-market valuation losseson our portfolio of Structured Credit transactions of $1,073.9 million.

 

The Company’sconsolidated net income (loss) for the nine months ended September 30, 2007 was$(1,122.9) million, or $(31.05) per diluted share, as compared to $42.3million, or $1.40 per diluted share, for the nine months ended September 30,2006, a decrease of $1,165.2 million, which was primarily the result ofunrealized mark-to-market valuation losses on our portfolio of StructuredCredit transactions discussed above and other than temporary impairments in ourCDOs of $50.9 million, net of tax.

 

The following tablesummarizes the contribution of each line of business to net consolidated income(loss) for the three and nine months ended September 30, 2007 and 2006:

 
| ** **                             | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                             | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                             | ** ** | **(in thousands)**                              | ** ** |
| Net income  (loss) by line of business |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| Structured  Credit                     |       | $                                                    | (1,067,171 | )                                                   | $          | 7,343 |   | $ | (1,100,265 | ) | $ | 16,262 |   |
| Public Finance                         |       | 2,149                                                |       | 2,998                                               |       | 8,587 |   | 7,916 |   |
| CDO Asset  Management                  |       | 23,577                                               |       | 5,444                                               |       | (32,645 | ) | 16,843 |   |
| Other                                  |       | 421                                                  |       | 276                                                 |       | 1,380 |   | 1,229 |   |
| Net income  (loss)                     |       | $                                                    | (1,041,024 | )                                                   | $          | 16,061 |   | $ | (1,122,943 | ) | $ | 42,250 |   |
|                                        |            |                                                      |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |  |

 

*  StructuredCredit*

 

For the three monthsended September 30, 2007, a net loss of $(1,067.2) million was recognizedcompared to net income of $7.3 million for the same period of 2006.  Thethird quarter of 2007 net loss includes a net unrealized mark to marketvaluation loss on insured credit swap transactions of $(1,652.1) million, on apre-tax basis.  This unrealized loss was primarily related to insuredcredit swap transactions for which the underlying exposure is pools ofsub-prime and second-lien residential mortgage-backed securities (“RMBS”) andthe associated significant widening of credit spreads on those assets thatoccurred during the quarter.  The significant spread widening was inresponse to the pronounced increase in homeowner delinquencies and defaults withrespect to sub-prime and second lien residential mortgages primarily originatedin late 2005 and 2006.  For the three months ended September 30, 2006, werecognized pre-tax net unrealized gains in the amount of $2.0 million relatedto these marks.  Insured credit swap premiums earned from credit swaptransactions increased to $27.3 million for the three months ended September30, 2007 from $12.5 million for the same period of 2006.

 

For the nine months endedSeptember 30, 2007, a net loss of $(1,100.3) million was recognized compared tonet income of $16.3 million for the same period in 2006.  For the ninemonths ended September 30, 2007 net loss includes a net unrealized mark tomarket valuation loss on insured credit swap transactions of $(1,732.4), on apre-tax basis, compared with a valuation gain of $1.6 million over the sameperiod in 2006.  Insured credit swap premiums earned from credit swaptransactions increased to $67.7 million for the nine months ended September 30,2007 from $31.3 million for the same period in 2006.  Other operatingexpenses increased in the three and nine months ended September 30, 2007compared to the same period in 2006.  This increase was in connection withthe additional expenses incurred due to our status as a public company as wellas additional expenses incurred, mainly personnel related, in direct support ofour three lines of business.

 

28

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*PublicFinance*

 

For the three monthsended September 30, 2007, net income decreased to $2.1 million from $3.0million for the same period in 2006. Premiums earned included $0.9 million ofrefunded premiums for the third quarter of 2007 compared to $3.8 million forthe same period in 2006. On a net basis (premiums earned less amortization ofdeferred expenses and taxes), this refunding activity added $0.4 million to netincome for the third quarter of 2007 compared to $1.9 million for the sameperiod in 2006. Gross premiums written was $7.0 million for the three monthsended September 30, 2007 compared to $5.3 million for the same period of 2006. Netinvestment income was $4.5 million for the third quarter of 2007 compared to$3.8 million for the same period in 2006. This increase was primarilyattributable to the growth in ACA FG’s investment portfolio as a result ofoperating cash flows.

 

For the nine months endedSeptember 30, 2007, net income increased to $8.6 million from $7.9 million forthe same period in 2006. Premiums earned included $5.9 million of refundedpremiums for the first nine months of 2007 compared to $7.3 million for thesame period in 2006. On a net basis (premiums earned less amortization ofdeferred expenses and taxes), this refunding activity added $2.9 million to netincome for the first nine months of 2007 compared to $3.6 million for the sameperiod in 2006. During the period, gross premiums written were $27.0 million,an increase from $24.7 million for the same period in 2006. Net investmentincome was $13.1 million for the nine months ended September 30, 2007 comparedto $11.9 million for the same period in 2006.

 

*CDOAsset Management*

 

For the three monthsended September 30, 2007, net income increased to $23.6 million from $5.4million for the same period in 2006.  During the third quarter of 2007,the Company sold a portion of its equity investment in three asset-backed CDOs,ACA ABS 2002-1, ACA ABS 2003-1 and ACA ABS 2003-2, to an unrelated third party eachfor fair market value, realizing a net gain of $39.6 million. This gainrepresents the reversal of non-recourse impairments recognized in the secondquarter of 2007, due to the third quarter deconsolidation of such CDOs. This gain was partially offset by $12.7million of realized losses recognized during the quarter, comprised of $6.5million of other than temporary impairments on CDO assets and $6.2 million of arealized loss on a debt investment in ACA ABS 2007-3, a CDO that closed in thethird quarter. We made this investment to mitigate a potential loss in the CDOasset accumulation, or warehouse, phase.

 

For the nine months endedSeptember 30, 2007, a net loss of $(32.6) million was recorded compared to netincome of $16.8 million for the same period in 2006.  The Companyrecognized pre-tax net realized losses during the nine months ended September 30,2007 of $78.9 million, or $51.3 million net of tax.  These impairmentlosses were largely due to the deterioration in the form of increased mortgagedelinquencies and rates of defaults on mortgages underlying RMBS originated,primarily, in late 2005 and 2006.

 

*Other*

 

Other represented animmaterial portion of our reported results for the three and nine months endedSeptember 30, 2007 and 2006 and reflects the continued run-off of insurancecontracts written in prior years in areas in which we are no longer active.

 

*ItemsAllocated to Business Lines*

 

Within our statement ofoperations, we have income and expense items that are directly attributable toour lines of business and items that are indirectly attributable. Examples ofitems that are directly attributable to lines of business are gross premiumswritten, premiums earned, insured credit swap revenue, net realized andunrealized gains and losses on derivatives, losses and loss adjustment expensesand depreciation and amortization related to the consolidation of ourCDOs.  Certain operating expenses, including those related to personneland other expenses dedicated to a line of business are allocated to that lineof business. Remaining expenses are allocated to lines of business based ontime and expense studies conducted annually. Due to its run-off statusbeginning in 2004, our Other line of business is not allocated other operatingexpenses.  Items allocated to lines of business include net investmentincome on the corporate-wide cash investment portfolios and other non-VIEentities within the consolidated group, net realized gains and losses on thoseportfolio, operating expenses, interest expense related to our corporate debt,depreciation and amortization and income taxes. The net investment income andnet realized gains and losses on investments related to our CDO AssetManagement business 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 and the nine months ended September 30, 2007 and 2006. Allother revenue and expense items included in the consolidated statement ofoperations are directly attributable to a specific line of business.

 

29

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| ** **                                         | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                                 | ** ** | **2006**                                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                         | ** ** | **(in thousands)**                                  | ** ** |
| Net investment  income                             |       |                                                     |       |                                                          |       |   |   |   |   |
| Allocated                                          |       | $                                                        | 8,017      |                                                          | $          | 5,927 |   | $ | 23,015 |   | $ | 18,242 |   |
| Direct to  Business Lines                          |       | 79,454                                                   |       | 81,961                                                        |       | 245,003 |   | 229,810 |   |
| Total                                              |       | $                                                        | 87,471     |                                                          | $          | 87,888 |   | $ | 268,018 |   | $ | 248,052 |   |
| Net realized and  unrealized losses on investments |       |                                                     |       |                                                          |       |   |   |   |   |
| Allocated                                          |       | $                                                        | (367       | )                                                             | $          | (238 | ) | $ | (415 | ) | $ | (1,495 | ) |
| Direct to Business  Lines                          |       | 19,881                                                   |       | (514                                                          | )          | (93,921 | ) | (2,480 | ) |
| Total                                              |       | $                                                        | 19,514     |                                                          | $          | (752 | ) | $ | (94,336 | ) | $ | (3,975 | ) |
| Other operating  expenses                          |       |                                                     |       |                                                          |       |   |   |   |   |
| Allocated                                          |       | $                                                        | 14,279     |                                                          | $          | 11,548 |   | $ | 45,027 |   | $ | 33,934 |   |
| Direct to  Business Lines                          |       | 274                                                      |       | 451                                                           |       | 1,243 |   | 1,359 |   |
| Total                                              |       | $                                                        | 14,553     |                                                          | $          | 11,999 |   | $ | 46,270 |   | $ | 35,293 |   |
| Interest expense                                   |       |                                                     |       |                                                          |       |   |   |   |   |
| Allocated                                          |       | $                                                        | 1,891      |                                                          | $          | 1,873 |   | $ | 5,589 |   | $ | 5,332 |   |
| Direct to  Business Lines                          |       | 69,052                                                   |       | 74,222                                                        |       | 218,099 |   | 208,146 |   |
| Total                                              |       | $                                                        | 70,943     |                                                          | $          | 76,095 |   | $ | 223,688 |   | $ | 213,478 |   |
| Depreciation and  amortization                     |       |                                                     |       |                                                          |       |   |   |   |   |
| Allocated                                          |       | $                                                        | 515        |                                                          | $          | 658 |   | $ | 1,334 |   | $ | 1,664 |   |
| Direct to  Business Lines                          |       | 1,588                                                    |       | 1,798                                                         |       | 5,306 |   | 5,509 |   |
| Total                                              |       | $                                                        | 2,103      |                                                          | $          | 2,456 |   | $ | 6,640 |   | $ | 7,173 |   |
| Provision for  income tax expense (benefit)        |       |                                                     |       |                                                          |       |   |   |   |   |
| Allocated                                          |       | $                                                        | (558,685   | )                                                             | $          | 9,790 |   | $ | (600,077 | ) | $ | 23,405 |   |
| Direct to  Business Lines                          |       | —                                                   |       | —                                                        |       | — |   | — |   |
| Total                                              |       | $                                                        | (558,685   | )                                                             | 9,790      |   | $ | (600,077 | ) | $ | 23,405 |   |

 

*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 monthsended September 30, 2007, allocated net investment income increased to $8.0million from $5.9 million for the three months ended September 30, 2006. Thisincrease was related to growth in the investment portfolio from $598.3 millionat September 30, 2006 to $706.8 million at September 30, 2007. The growth inthe investment portfolio between periods was primarily related to positive cashflows generated by our businesses and, from $79.2 million raised from theproceeds of our initial public offering in November 2006 (“IPO”).

 

For the nine months endedSeptember 30, 2007, allocated net investment income increased to $23.0 millionfrom $18.2 million for the nine months ended September 30, 2006 primarilyrelated to growth in the respective investment portfolio.

 

*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 and ninemonths ended September 30, 2007, the direct-to-business-line net realized gain(loss) was $19.9 million and $(93.9) million, respectively.

 

Thedirect-to-business-line net realized gain for the three months ended September30, 2007 included $39.6 million related to the sale of a portion of our equityinvestment in three CDOs. This gain represents the reversal of non-recourseimpairments recognized in the second quarter of 2007, due to the third quarterdeconsolidation of those CDOs. This gain was partially offset by $12.7 million of realized lossesrecognized during the quarter, comprised of $6.5 million of other thantemporary impairments on CDO assets and $6.2 million of a realized loss on adebt investment in ACA ABS 2007-3, a CDO that closed in the third quarter. Wemade this investment to mitigate a potential loss in the CDO assetaccumulation, or warehouse, phase. We recognized pre-tax net realizedimpairment losses during the nine months ended September 30, 2007 of $(78.9)million in our CDO line of business due to the deterioration in the form ofincreased mortgage delinquencies and rates of defaults on mortgages underlyingRMBS originated, primarily, in 2006.

 

Allocated net unrealizedand realized losses on investments for the nine months ended September 30, 2007and 2006 were $(0.4) million and $(1.5) million, respectively.  Theselosses were primarily attributable to the ACA Financial Guaranty portfolio.

 

*OtherOperating Expenses. * Allocated other operating expensesis comprised of all costs related to personnel, office leases and expenses,legal, accounting and rating agencies. Allocated other operating expenses doesnot include expenses related to the consolidation of our CDOs or the CreditFund. Those expenses are treated as direct expenses of the CDO Asset Managementline of business and the Structured Credit line of business, respectively. Forthe three months ended September 30, 2007, allocated other operating expensesincreased to $14.3 million from $11.5 million for the three months endedSeptember 30, 2006.  For the nine months ended September 30, 2007,allocated other operating expenses increased to $45.0 million from $33.9million for the nine months ended September 30, 2006.  The increase inexpenses was attributable to additional personnel hired to support thebusinesses, the increased costs attendant with being a public company andexpenses in connection with the opening of our United Kingdom and Singapore officesin 2006.

 

*InterestExpense. * Allocated interest expense is related to ourholding company floating rate debt.  It is allocated to our lines ofbusiness based on capitalization of the respective lines of business asdescribed above with respect to net investment income.  Allocated interestexpense for both the three months ended September 30, 2007 and 2006 remainedstable at $1.9 million.  Allocated 

 

30

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interest expense for thenine months ended September 30, 2007 and 2006 was also relatively stable at$5.6 million and $5.3 million, respectively.  No new debt was issued in2007 or 2006 and three month LIBOR, on which the floating interest rates arebased, was largely unchanged.

 

*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.

 

*Structured Credit*

 

The following tablesummarizes the operations of our Structured Credit line of business for thethree months and the nine months ended September 30, 2007 and 2006:

 
| ** **                                                            | ** ** | **Three Months Ended September 30,** | ** **     | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------------------|----------------|---------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2007**                                                 | ** **     | **2006**                                                | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                            | ** ** | **(in thousands)**                                  | ** **     |
| **REVENUES:**                                                         | ** ** | ** **                                               | ** **     | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Gross premiums  written                                               |       | $                                                        | 36             |                                                    | $          | 153 |   | $ | 170 |   | $ | 623 |   |
| Premiums earned                                                       |       | $                                                        | 36             |                                                    | $          | 168 |   | $ | 170 |   | $ | 674 |   |
| Net insured  credit swap revenue                                      |       | (1,624,766                                               | )              | 14,524                                                  |       | (1,664,749 | ) | 34,963 |   |
| Net investment  income                                                |       | 4,722                                                    |           | 2,136                                                   |       | 17,440 |   | 3,870 |   |
| Net realized and  unrealized losses on investments                    |       | (7,142                                                   | )              | (126                                                    | )          | (9,368 | ) | (297 | ) |
| Net realized and  unrealized gains (losses) on derivative instruments |       | (33                                                      | )              | —                                                  |       | 255 |   | — |   |
| Other net credit  swap revenue                                        |       | (496                                                     | )              | 25                                                      |       | (770 | ) | — |   |
| Fee income                                                            |       | 158                                                      |           | 478                                                     |       | 465 |   | 726 |   |
| Other income                                                          |       | 22                                                       |           | 115                                                     |       | 60 |   | 150 |   |
| **Total  revenues**                                                   | ** ** | **(1,627,499**                                           | **)**          | **17,320**                                              | ** ** | **(1,656,497** | **)** | **40,086** | ** ** |
| **EXPENSES:**                                                         |       |                                                     |           |                                                    |       |   |   |   |   |
| Loss and loss  adjustment expenses                                    |       | 3,500                                                    |           | —                                                  |       | 3,500 |   | — |   |
| Other operating  expenses                                             |       | 6,352                                                    |           | 4,673                                                   |       | 19,050 |   | 13,336 |   |
| Interest expense                                                      |       | 2,686                                                    |           | 679                                                     |       | 10,451 |   | 852 |   |
| Depreciation and  amortization                                        |       | 202                                                      |           | 221                                                     |       | 499 |   | 588 |   |
| **Total  Expenses**                                                   | ** ** | **12,740**                                               | ** **     | **5,573**                                               | ** ** | **33,500** | ** ** | **14,776** | ** ** |
| Income of  minority interest                                          |       | 1,839                                                    |           | (32                                                     | )          | 1,781 |   | (39 | ) |
| Income (loss)  before income taxes                                    |       | (1,638,400                                               | )              | 11,715                                                  |       | (1,688,216 | ) | 25,271 |   |
| Provision for  income tax expense (benefit)                           |       | (571,229                                                 | )              | 4,372                                                   |       | (587,951 | ) | 9,009 |   |
| **Net  Income (loss)**                                                | ** ** | **$**                                                    | **(1,067,171** | **)**                                                   | **$**      | **7,343** | ** ** | **$** | **(1,100,265** | **)** | **$** | **16,262** | ** ** |

 

*GrossPremiums Written.*   Gross premiums written withinthis line of business decreased to less than $0.1 million for the three monthsended September 30, 2007 from $0.2 million for the three months ended September30, 2006.  For the nine months ended September 30, 2007 and 2006, we wrotepremiums of $0.2 million and $0.6 million, respectively, in this businessline.  These declines occurred because the vast majority of transactionswith respect to this line of business have been conducted in the form ofinsured credit swaps.  No new traditional insurance contracts have beenwritten in 2007 for this line of business and the decline relates to thedecreased premium for contracts that were written in previous 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 $(1,624.8) million for the three months endedSeptember 30, 2007 from $14.5 million for the same period in 2006.  As setforth in the table below, insured credit swap revenue is the sum of premiumsearned on our insured credit swap transactions, unrealized gains (losses)resulting from the changes in fair value of these transactions and net realizedgains (losses) which may, from time to time, result from any termination orcredit events related to such transactions.  The third quarter 2007 overthird quarter 2006 decline in net insured credit swap revenue was directlyrelated to net unrealized mark to market losses recorded during 2007.  Valuationlosses in the third quarter 2007 were principally related to the wideningcredit spreads associated with insured credit swap transactions for which theunderlying exposure was to pools of sub-prime and second lien RMBS.  The$(1,652.1) million unrealized loss is comprised of an unrealized loss of$(1,493.8) million on our ABS/MBS portfolio and $(158.3) million on ourcorporate credit portfolio. The spread widening the occurred in the ABS sectoralso impacted spreads in other fixed income sectors, including corporatecredits

 

We value our insuredcredit swap transactions either by obtaining market quotes from dealers orthrough the application of our

 

31

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valuation model.  During the quarter ended June 30, 2007, werefined our valuation model to estimate fair value of our insured credit swaptransactions.  The change was implemented to be more consistent withmodels that we understand other market participants utilize, including many ofour insured credit swap counterparties.  The relatively young market forcredit swaps has continued to evolve over time and, while there is stillsubstantial variance in valuation models among market participants, the trend istoward increasing convergence in this area. Under our refined model, we fullyuse market spread data as a proxy for default probabilities in thedetermination of fair value. For transactions in which the underlying exposureis to corporate credits, we use individual market spreads as proxies fordefaults as they are readily available. For synthetic asset-backedtransactions, historically, individual spread data has been not quite asreadily available and the Company used current weighted average portfoliospreads as a proxy for individual spreads where necessary. In the third quarterof 2007, however, individual spreads were obtained and utilized for allsynthetic ABS underlying exposures. We believe our refined model willinherently increase the volatility of these valuations, but provide a betterestimate of the cost or benefit of unwinding the related.

 

Premiums earned from ourinsured credit swap transactions increased to $27.3 million for the threemonths ended September 30, 2007 from $12.5 million for the three months endedSeptember 30, 2006.  The primary reason for the increase was the highervolume of transactions completed.  As of September 30, 2007, the notionalcredit exposure in this line of business increased to $69.1 billion from $30.5billion at September 30, 2006.

 

For the nine months endedSeptember 30, 2007 and 2006, net insured credit swap revenue was$(1,664.7) million and $35.0 million, respectively.  As discussedabove, the decrease is primarily related to the net unrealized mark to marketlosses during the first nine months of 2007, partially offset by premiumsearned from our insured credit swap transactions of $67.7 million for the ninemonths ended September 30, 2007 compared to $31.3 million for the nine monthsended September 30, 2006.

 

The following table showsthe components of net insured credit swap revenue for the three months and thenine months ended September 30, 2007 and 2006:

 
| ** **                                 | ** ** | **Three MonthsEnded  September 30,** | ** ** | **Nine MonthsEnded  September 30,** | ** ** |
|--------------------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                 | ** ** | **2007**                                       | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                 | ** ** | **(in thousands)**                        | ** ** |
| Insured credit  swap premiums earned       |       | $                                              | 27,331     |                                          | $          | 12,506 |   | $ | 67,670 |   | $ | 31,337 |   |
| Unrealized  losses on insured credit swaps |       | (1,652,097                                     | )          | 2,018                                         |       | (1,732,419 | ) | 1,617 |   |
| Realized gains  on insured credit swaps    |       | —                                         |       | —                                        |       | — |   | 2,009 |   |
| Net insured  credit swap revenue           |       | $                                              | (1,624,766 | )                                             | $          | 14,524 |   | $ | (1,664,749 | ) | $ | 34,963 |   |

 

*NetInvestment Income.*   Net investment income was $4.7million for the three months ended September 30, 2007 compared to $2.1 millionfor the three months ended September 30, 2006.  Of the total netinvestment income of $4.7 million in 2007, $2.6 million related to the CreditFund and $2.1 million related to allocated investment income. In 2006,allocated investment income was $0.7 million.

 

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 and $62.4 millionduring the first nine months of 2007.  We also increased the allocation ofinvestment income to this business in 2007 based upon our expected utilizationof IPO proceeds across business lines.  For the nine months endedSeptember 30, 2007 and 2006, net investment income was $17.4 million and $3.9million, respectively.  Of the total net investment income of $17.4million in 2007, $12.9 million related to the Credit Fund and $4.5 millionrelated to allocated investment income.

 
| ** **                          | ** ** | **Three Months  Ended September 30,** | ** ** | **Nine Months  Ended September 30,** | ** ** |
|-------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                          | ** ** | **2007**                                        | ** ** | **2006**                                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                          | ** ** | **(in thousands)**                         | ** ** |
| Investment  income from Credit Fund |       | $                                               | 2,619      |                                           | $          | 1,424 |   | $ | 12,939 |   | $ | 1,680 |   |
| Allocated  investment income        |       | 2,103                                           |       | 712                                            |       | 4,501 |   | 2,190 |   |
| Total investment  income            |       | $                                               | 4,722      |                                           | $          | 2,136 |   | $ | 17,440 |   | $ | 3,870 |   |

 

The Credit Fund had totalassets of $136.2 million as of September 30, 2007, including investments infixed-maturity securities trading of $125.2 million and total liabilities andminority interest of $114.4 million, including securities sold under agreementsto repurchase of $104.1 million, all of which are included on our unauditedcondensed consolidated balance sheet.  Assets declined from $413.0 millionas of June 30, 2007 because we anticipated that the availability of financingwould decline given market conditions in the overall fixed income sector, as aresult of the sub-prime mortgage crisis, we decided to proactively de-leveragethrough the controlled sale of assets to avoid distressed sales of assets in adeclining market.

 

*NetRealized and Unrealized Losses on Investments.*  Netrealized losses are derived from our investment in the Credit Fund as well asallocated amounts related to our allocated investment portfolio. The followingtable shows the components of net realized losses for the three months and thenine months ended September 30, 2007 and 2006:

 

32

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| ** **                                           | ** ** | **Three Months  Ended September 30,** | ** ** | **Nine Months  Ended September 30,** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                           | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                           | ** ** | **(in thousands)**                              | ** ** |
| Net unrealized  and realized losses from Credit Fund |       | $                                                    | (7,084     | )                                                   | $          | (98 | ) | $ | (9,302 | ) | $ | (118 | ) |
| Allocated net  realized losses                       |       | (58                                                  | )          | (28                                                 | )          | (66 | ) | (179 | ) |
| Net realized and  unrealized losses on investments   |       | $                                                    | (7,142     | )                                                   | $          | (126 | ) | $ | (9,368 | ) | $ | (297 | ) |

 

Credit Fund losses wereprincipally unrealized and related to the fair valuation of fixed incomesecurities held in the portfolio.  Such securities are designated as heldfor trading, and as a result mark to market valuation losses are recorded onour statement of operations.

 

*Loss and Loss Adjustment Expenses*.During the third quarter we recorded a $3.5 million provision for lossesassumed under a reinsurance contract. We entered into two such facultativecontracts in 2006 and the underlying exposure relates to insuredmortgage-backed transactions. The $3.5 million represents a reserve for lossesincurred and is our maximum exposure under the contract.

 

*OtherOperating Expenses.*   Other operating expensesincreased to $6.4 million for the three months ended September 30, 2007 from$4.7 million for the same period in 2006.  Other operating expensesincreased to $19.1 million for the nine months ended September 30, 2007 from$13.3 million for the same period in 2006.  These increases are related tothe allocation of additional corporate and asset backed credit analystpersonnel in 2007 to this line of business in connection with its growth intransaction volume and the opening and staffing of our Singapore office, inlate 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 September30, 2007 was $2.6 million.  Allocated interest expense totaled $0.1million for both the three months ended September 30, 2007 and 2006,respectively.

 

For the nine months endedSeptember 30, 2007, total interest expense related to the Credit Fund was $10.1million.  Allocated interest expense totaled $0.4 million and $0.3 millionin the nine months ended September 30, 2007 and 2006, respectively.

 

*Incomeof Minority Interest.*  Income of minority interest isrelated to our investment in the Credit Fund. While we consolidate the fund, weare not the sole equity investor in the fund.  Income related to theportion of the Credit Fund not owned by us in both the three and nine monthsended September 30, 2007 was $1.8 million.

 

*Public Finance*

 

The following tablesummarizes the operations of our Public Finance line of business for the threemonths and the nine months ended September 30, 2007 and 2006:

 
| ** **                          | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                          | ** ** | **2007**                                                 | ** ** | **2006**                                                | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                          | ** ** | **(in thousands)**                                  | ** ** |
| **REVENUES:**                       | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Gross premiums  written             |       | $                                                        | 6,997      |                                                    | $          | 5,285 |   | $ | 27,040 |   | $ | 24,669 |   |
| Premiums earned                     |       | $                                                        | 5,302      |                                                    | $          | 8,128 |   | $ | 18,408 |   | $ | 19,880 |   |
| Net insured  credit swap revenue    |       | (520                                                     | )          | 284                                                     |       | 910 |   | 916 |   |
| Net investment  income              |       | 4,576                                                    |       | 3,852                                                   |       | 13,119 |   | 11,856 |   |
| Net realized  losses on investments |       | (209                                                     | )          | (154                                                    | )          | (236 | ) | (971 | ) |
| Fee income                          |       | 42                                                       |       | 55                                                      |       | 130 |   | 175 |   |
| Other income                        |       | 16                                                       |       | 104                                                     |       | 272 |   | 136 |   |
| **Total  revenues**                 | ** ** | **9,207**                                                | ** ** | **12,269**                                              | ** ** | **32,603** | ** ** | **31,992** | ** ** |
| **EXPENSES:**                       |       |                                                     |       |                                                    |       |   |   |   |   |
| Loss and loss  adjustment expenses  |       | 1,208                                                    |       | 2,120                                                   |       | 3,847 |   | 5,035 |   |
| Policy  acquisition costs           |       | 1,488                                                    |       | 2,556                                                   |       | 5,792 |   | 6,346 |   |
| Other operating  expenses           |       | 2,474                                                    |       | 2,115                                                   |       | 8,213 |   | 6,519 |   |
| Interest expense                    |       | 397                                                      |       | 450                                                     |       | 1,174 |   | 1,280 |   |
| Depreciation and  amortization      |       | 154                                                      |       | 201                                                     |       | 400 |   | 510 |   |
| **Total  Expenses**                 | ** ** | **5,721**                                                | ** ** | **7,442**                                               | ** ** | **19,426** | ** ** | **19,690** | ** ** |
| Income before  income taxes         |       | 3,486                                                    |       | 4,827                                                   |       | 13,177 |   | 12,302 |   |
| Provision for  income tax expense   |       | 1,337                                                    |       | 1,829                                                   |       | 4,590 |   | 4,386 |   |
| **Net  Income**                     | ** ** | **$**                                                    | **2,149**  | ** **                                              | **$**      | **2,998** | ** ** | **$** | **8,587** | ** ** | **$** | **7,916** | ** ** |

 

33

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*Gross Premiums Written.*  Public Finance gross premiums written totaled $7.0 million for the three monthsended September 30, 2007 compared to $5.3 million for the three months endedSeptember 30, 2006.  Public Finance gross premiums written totaled $27.0million for the nine months ended September 30, 2007 compared to $24.7 millionfor the nine months ended September 30, 2006.  The risk profile related topremiums written in the first nine months of 2007 improved materially whencompared to the full-year 2006, resulting in a 32% decrease in average capitalcharge in 2007 when compared to the 2006 rate. Since we are essentially a netretainer of the risks we underwrite, gross premiums written approximate netpremiums written.

 

*PremiumsEarned.*   Premiums earned were $5.3 million for thethree months ended September 30, 2007 compared to $8.1 million for the sameperiod in 2006.  Premiums earned from refundings were $0.9 million and$3.8 million for the three months ended September 30, 2007 and 2006,respectively.  Premiums earned were $18.4 million for the nine monthsended September 30, 2007 compared to $19.9 million for the same period in2006.  Premiums earned from refundings were $5.9 million and $7.3 millionfor the nine months ended September 30, 2007 and 2006, respectively. Essentially, premiums earned before refundings were flat when comparing thefirst quarter and first nine months of 2007 to the same period in 2006.

 

*NetInsured Credit Swap Revenue.*  Net insured credit swaprevenue was $(0.5) million for the three months ended September 30, 2007compared to $0.3 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. Since thesetransactions are in the form of insured credit swaps, they are marked to marketin the same manner as our credit swaps described above in “— Results ofOperations — Structured Credit”.  The unrealized gains or losses resultingfrom the changes in fair value of these transactions are included in netinsured credit swap revenue. An unrealized loss of $(0.7) million was includedin insured credit swap revenue for the three months ended September 30, 2007. Anunrealized gain of $0.2 million was included in insured credit swap revenue forthe three months ended September 30, 2006.

 

Net insured credit swaprevenue was $0.9 million for both the nine months ended September 30, 2007 and2006. An unrealized gain of $0.4 million and $0.5 million was included in netinsured credit swap revenue for the nine months ended September 30, 2007 and2006, respectively.

 

*NetInvestment Income.*   Net investment income totaled$4.6 million for the three months ended September 30, 2007 and $3.9 million forthe three months ended September 30, 2006.  The entire amount of netinvestment income for the Public Finance line of business is derived from theallocation of investment income. Allocated investment income increased due togrowth within the overall allocated investment portfolio because of netpositive cash flows from our businesses, which generated $46.3 million ofoperating cash flows during 2006 and $62.4 million during the first nine monthsof 2007.  This increase was partially offset by a lower overall capitalallocation in 2007 resulting from the additional IPO proceeds that wereprincipally allocated to the Structured Credit and CDO Asset Management linesof business.

 

Net investment incometotaled $13.1 million for the nine months ended September 30, 2007 and $11.9million for the nine months ended September 30, 2006.

 

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

 

*Lossand Loss Adjustment Expenses.*  Loss and loss adjustmentexpenses was $1.2 million for the three months ended September 30, 2007compared to $2.1 million for the three months ended September 30, 2006.

 

Loss and loss adjustmentexpenses was $3.8 million for the nine months ended September 30, 2007 comparedto $5.0 million for the nine months ended September 30, 2006. The followingtable shows the components of the loss and loss adjustment expenses for thethree months and the nine months ended September 30, 2007 and 2006:

 
| ** **                                | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                | ** ** | **2007**                                                 | ** ** | **2006**                                                | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                | ** ** | **(in thousands)**                                  | ** ** |
| Incurred Losses Related To |       |                                                     |       |                                                    |       |   |   |   |   |
| Case specific  and LAE reserves           |       | $                                                        | 147        |                                                    | $          | 472 |   | $ | 165 |   | $ | 984 |   |
| Non-specific  reserves                    |       | 1,061                                                    |       | 1,648                                                   |       | 3,682 |   | 4,051 |   |
| Total loss and  loss adjustment expenses  |       | $                                                        | 1,208      |                                                    | $          | 2,120 |   | $ | 3,847 |   | $ | 5,035 |   |

 

Loss adjustment expensesare costs associated with insured credits that are in varying stages ofwork-out or remediation. Non-specific reserves are based on the application ofour reserving model and take into account transactional characteristics such asrating, sector and assumed recoveries. The slight increase in non-specificreserves was a result of the increase in premiums earned and application of ournon-specific reserve model. Total loss and loss adjustment expenses remainrelatively unchanged from prior periods.

 

*NetPolicy Acquisition Costs*.   Net policy acquisitioncosts totaled $1.5 million for the three months ended September 30, 2007compared to $2.6 million for the same period in 2006.  Net policyacquisition costs totaled $5.8 million for the nine months ended September 30,2007 compared to $6.3 million for the same period in 2006.  Generally,such costs vary in accordance with the changes in premiums earned during eachperiod.

 

34

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*OtherOperating Expenses*.   Other operating expenses were$2.5 million for the three months ended September 30, 2007 compared to $2.1million for the three months ended September 30, 2006. These costs arenon-policy acquisition related costs and are allocated. The increase of $0.4million was primarily related to increased headcount to support thebusiness.  Similarly, increased headcount drove the increase in otheroperating expenses to $8.2 million for the nine months ended September 30, 2007compared to $6.5 million for the nine months ended September 30, 2006.

 

*InterestExpense*.   Interest expense was $0.4 million forthe three months ended September 30, 2007 compared to $0.5 million for thethree months ended September 30, 2006.  Interest expense was $1.2 millionfor the nine months ended September 30, 2007 compared to $1.3 million the ninemonths ended September 30, 2006.  Interest expense results from the allocatedinterest cost associated with corporate debt at our holding company.

 

*CDO Asset Management*

 

The following tablesummarizes the operations of our CDO Asset Management line of business for thethree months and the nine months ended September 30, 2007 and 2006:

 
| ** **                                                            | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2007**                                                 | ** ** | **2006**                                                | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                            | ** ** | **(in thousands)**                                  | ** ** |
| **REVENUES:**                                                         | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net insured  credit swap revenue                                      |       | $                                                        | (2,174     | )                                                       | $          | 2,271 |   | $ | (4,105 | ) | $ | 3,311 |   |
| Net investment  income                                                |       | 74,964                                                   |       | 81,008                                                  |       | 232,147 |   | 229,585 |   |
| Net realized and  unrealized losses on investments                    |       | 26,916                                                   |       | (436                                                    | )          | (84,674 | ) | (2,482 | ) |
| Net realized and  unrealized gains (losses) on derivative instruments |       | (2,364                                                   | )          | 755                                                     |       | 2,684 |   | 6,894 |   |
| Other net credit  swap revenue                                        |       | 3,290                                                    |       | 2,065                                                   |       | 19,721 |   | 7,634 |   |
| Fee income                                                            |       | 9,361                                                    |       | 5,983                                                   |       | 22,895 |   | 16,688 |   |
| Other income                                                          |       | 20                                                       |       | 123                                                     |       | 80 |   | 160 |   |
| **Total  revenues**                                                   | ** ** | **110,013**                                              | ** ** | **91,769**                                              | ** ** | **188,748** | ** ** | **261,790** | ** ** |
| **EXPENSES:**                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| Other operating  expenses                                             |       | 5,719                                                    |       | 5,150                                                   |       | 18,986 |   | 15,377 |   |
| Interest expense                                                      |       | 67,766                                                   |       | 74,872                                                  |       | 211,784 |   | 211,079 |   |
| Depreciation and  amortization                                        |       | 1,747                                                    |       | 2,034                                                   |       | 5,741 |   | 6,075 |   |
| **Total  Expenses**                                                   | ** ** | **75,232**                                               | ** ** | **82,056**                                              | ** ** | **236,511** | ** ** | **232,531** | ** ** |
| Income of  minority interest                                          |       | (249                                                     | )          | (865                                                    | )          | (2,335 | ) | (3,087 | ) |
| Income (loss)  before income taxes                                    |       | 34,532                                                   |       | 8,848                                                   |       | (50,098 | ) | 26,172 |   |
| Provision for  income tax expense (benefit)                           |       | 10,955                                                   |       | 3,404                                                   |       | (17,453 | ) | 9,329 |   |
| **Net  Income (loss)**                                                | ** ** | **$**                                                    | **23,577** | ** **                                              | **$**      | **5, 444** | ** ** | **$** | **(32,645** | **)** | **$** | **16,843** | ** ** |
| ** **                                                            | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| CDO assets under  management (end of period, in millions)             |       | $                                                        | 17,969     |                                                    | $          | 14,659 |   | $ | 17,969 |   | $ | 14,659 |   |

 

*NetInsured Credit Swap Revenue*.   Net insured creditswap revenue was $(2.2) million for the three months ended September 30, 2007compared to $2.3 million for the three months ended September 30, 2006. Netinsured credit swap revenue was $(4.1) million and $3.3 million for the ninemonths ended September 30, 2007 and September 30, 2006, respectively.

 

As set forth in the tablebelow, net insured credit swap revenue is the sum of insured credit swap premiumsearned, net realized gains (losses), which may result from time to time fromany termination or credit events related to such transactions and unrealizedgains (losses) resulting from the changes in fair value of these transactions.We receive insured credit swap premiums from two synthetic CDOs we closed in2003 and 2002 in which our insurance subsidiary, ACA Financial Guaranty,insured the equity tranche of each CDO. One of these credit swap transactionsexpired at the end of the first quarter 2007.  The following table showsthe components of net insured credit swap revenue for the three months and thenine months ended September 30, 2007 and 2006:

 

 
| ** **                                 | ** ** | **Three Months  Ended September 30,** | ** ** | **Nine Months  Ended September 30,** | ** ** |
|--------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                 | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                 | ** ** | **(in thousands)**                              | ** ** |
| Insured credit  swap premiums earned       |       | $                                                    | 653        |                                                | $          | 1,101 |   | $ | 2,359 |   | $ | 3,290 |   |
| Unrealized  losses on insured credit swaps |       | (2,827                                               | )          | 1,170                                               |       | (6,464 | ) | 21 |   |
| Net insured  credit swap revenue           |       | $                                                    | (2,174     | )                                                   | $          | 2,271 |   | $ | (4,105 | ) | $ | 3,311 |   |

 

Assuming no actuallosses, the valuation or unrealized loss on the second and last of the creditswap transactions included herein is expected to revert to $0 upon theexpiration of the transaction in mid-2008.

 

35

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*Net InvestmentIncome*.   Net investment income was $75.0 millionfor the three months ended September 30, 2007 compared to $81.0 million for thethree months ended September 30, 2006.  Net investment income includesincome from assets of our consolidated and unconsolidated CDO portfolios aswell as allocated amounts.  The portion of net investment income relatedto our consolidated and unconsolidated CDOs was $73.9 million for the threemonths ended September 30, 2007 compared to $80.5 million for the three monthsended September 30, 2006.  No new consolidated CDOs were added in 2007 or2006.  Unconsolidated CDO equity of $12.0 million was added since June2006, while a consolidated CDO deal matured in the third quarter of 2007, whichhas led to the decrease in direct net investment income for the third quarterof 2007 compared to the same period in 2006.  The portion of net non-CDOinvestment income allocated to the CDO Asset Management line of business was$1.0 million in the third quarter of 2007, compared to $0.5 million in thethird quarter of 2006.  Allocated investment income increased due tooverall growth within the allocated non-CDO investment portfolio, as a resultof net positive operating cash flows from our businesses, as well as anincrease in allocation percentage to this business line based on the expectedusage of the net proceeds from our IPO.

 

Net investment income was$232.1 million for the nine months ended September 30, 2007 compared to $229.6million for the nine months ended September 30, 2006. The portion of netinvestment income related to our consolidated and unconsolidated CDO portfoliowas $229.2 million for the nine months ended September 30, 2007 compared to$228.1 million for the nine months ended September 30, 2006. The portion of netnon-CDO investment income allocated to the CDO Asset Management line ofbusiness was $3.0 million in the nine months ended September 30, 2007, comparedto $1.5 million in the nine months ended September 30, 2006. The reason for theincrease allocated investment income is discussed above.

 
| ** **                       | ** ** | **Three Months  Ended September 30,** | ** ** | **Nine Months  Ended September 30,** | ** ** |
|----------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                       | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                       | ** ** | **(in thousands)**                              | ** ** |
| Investment  income from CDOs     |       | $                                                    | 73,921     |                                                | $          | 80,534 |   | $ | 229,155 |   | $ | 228,126 |   |
| Allocated net  investment income |       | 1,043                                                |       | 474                                                 |       | 2,992 |   | 1,459 |   |
| Total net  investment income     |       | $                                                    | 74,964     |                                                | $          | 81,008 |   | $ | 232,147 |   | $ | 229,585 |   |

 

*NetRealized and Unrealized Losses on Investments*.  Net realized losses are derived from our consolidated CDOs as well as allocatedamounts. There are no unrealized gains or losses on investments for this lineof business. The following table shows the components of net realized lossesfor the three months and the nine months ended September 30, 2007 and 2006.

 
| ** **                                         | ** ** | **Three MonthsEnded September 30,** | ** ** | **Nine MonthsEnded September 30,** | ** ** |
|----------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                           | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                         | ** ** | **(in thousands)**                            | ** ** |
| Net realized  losses from CDOs                     |       | $                                                  | 26,967     |                                              | $          | (418 | ) | $ | (84,616 | ) | $ | (2,363 | ) |
| Allocated net  realized losses                     |       | (51                                                | )          | (18                                               | )          | (58 | ) | (119 | ) |
| Net realized and  unrealized losses on investments |       | $                                                  | 26,916     |                                              | $          | (436 | ) | $ | (84,674 | ) | $ | (2,482 | ) |

 

During the third quarterof 2007, we sold a portion of our equity interests in three consolidatedasset-backed CDOs to an unrelated third party for fair market value. Because inthe second quarter of 2007 we recognized impairment losses in excess of ourinvestments relate to those CDOs, upon the sale of these investments and ourresulting ability to de-consolidate them, we recognized a $39.6 millionrealized gain in the third quarter. This gain was partially offset by netrealized losses of approximately $12.7 million. Such losses related to $6.5million of impairment losses in certain of our other asset-backed CDOs and $6.2million realized in connection with a purchase of an investment in ABS 2007-3at its closing in the third quarter. This $6.2 million realized loss was takento mitigate a potentially larger warehouse loss related to ABS 2007-3.

 

Net realized losses fromCDOs for the nine months ended September 30, 2007 includes losses from OTTI inthe amount of $(118.5) million, partially offset by a realized gain of $39.6million on the deconsolidation of three CDOs in the third quarter. OTTI for thenine months ended September 30, 2006 was $(2.4) million. Net realized lossesfrom CDOs including OTTI was $(12.7) million for the three months endedSeptember 30, 2007 compared to $(0.4) million for the three months endedSeptember 30, 2006.

 

OTTI is recognized whenthe fair value of investments in fixed maturity securities is determined to bebelow 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.  The last quarter of 2006 and first quarter of 2007saw significant disruption and consolidation in the sub-prime and second lienmortgage markets, with some mortgage originators being purchased or exiting thebusiness.  This severe disruption continued into the third quarter withmany other financial institutions, including investment banks, hedge funds andinsurance companies announcing significant losses in connection with theirsub-prime and second lien mortgage exposure.  This disruption furthertranslated into decreased liquidity and wider spreads across the market,decreasing the market value of the portfolios.  During 2007, the Companydetermined that certain of its holdings in RMBS through its consolidated CDOswere other than temporarily impaired related to these sub-prime and second lienRMBS market issues, resulting in the write-offs described above.

 

36

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*NetRealized and Unrealized Gains on Derivative Instruments.* The following table illustrates the type of derivative instruments reported inthis line item:

 
| ** **                                                                  | ** ** | **Three Months  Ended September 30,** | ** ** | **Nine Months  Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                                  | ** ** | **(in thousands)**                              | ** ** |
| Interest rate  swaps                                                        |       | $                                                    | 1,310      |                                                | $          | 1,350 |   | $ | 4,890 |   | $ | 7,020 |   |
| Interest rate  caps                                                         |       | (248                                                 | )          | (595                                                | )          | (136 | ) | (126 | ) |
| Realized  warehouse loss                                                    |       | (2,000                                               | )          | —                                              |       | (2,000 | ) | — |   |
| Trading  derivatives                                                        |       | (1,426                                               | )          | —                                              |       | (70 | ) | — |   |
| Total net  realized and unrealized gains (losses) on derivative instruments |       | $                                                    | (2,364     | )                                                   | $          | 755 |   | $ | 2,684 |   | $ | 6,894 |   |

 

As illustrated above, netrealized and unrealized gains (losses) on derivative instruments includeinterest rate swaps that are included in our consolidated CDOs. These CDOs havefour such swaps and they pay fixed amounts and receive floating amounts basedon three month LIBOR and pre-determined notional schedules. Unrealizedvaluation gains have been recognized on these four swaps as a result of asteady increase in short-term interest rates over the three year period. Interestrate caps are also used within consolidated CDOs to manage interest rate risk. Becausethree of the four CDOs were deconsolidated at September 30, 2007, we wouldexpect this item to become significantly less material in the future. In thethree months and nine months ended September 30, 2007 we recognized a loss of$(1.4) million and $(0.1) million, respectively, related to a leveraged loantrading program that began in December 2006 and is structured in the formof a total return swap.  Changes in the values of the underlying leveragedloans represent unrealized gains or losses to us until such time that the loansmay be sold. Income received under the total return swap is also included innet realized and unrealized gains on derivative instruments. Also included innet unrealized gains (losses) on derivatives is a loss of $2 million we paid inconnection with a warehouse arrangement for a planned CLO that was terminatedduring the quarter. This loss occurred because the environment for CDOs andCLOs deteriorated substantially in the quarter in response to the mortgagecrisis, making it very difficult to close CDO transactions**.**

 

*OtherNet Credit Swap Revenue*.   Other net credit swaprevenue was $3.3 million for the three months ended September 30, 2007 comparedto $2.1 million for the three months ended September 30, 2006.  As setforth in the table below, other net credit swap revenue is the sum of creditswap fees earned, net realized gains (losses) which may result from time totime result from any termination of such transactions, unrealized and realizedgains on credit protection we purchased to mitigate our exposure to 2006origination sub-prime and second lien RMBS and any credit events and unrealizedgains (losses) resulting from the changes in fair value of thesetransactions.  Credit swap fees result from a partially fundedconsolidated synthetic CDO, in which the underlying instruments are creditswaps sold by the CDO to third parties. Other net credit swap revenue includesrevenue in the third quarters of 2007 and 2006 of $0.2 million and $0.7million, respectively, that represents distributions to us as equity holder oftwo synthetic CDOs. Included as revenue in the first nine months of 2007 and2006 is $2.8 million and $2.3 million, of distributions to us as equity holderof those two synthetic CDOs. Finally, beginning in 2007, other net credit swaprevenue includes credit swaps entered in by our Credit Fund. Amounts related toour Credit Fund in the three and nine months ended September 30, 2007 were$(0.5) million and $(0.8) million, respectively.

 

The following table showsthe components of other net credit swap revenue for the three months and thenine months ended September 30, 2007 and 2006:

 
| ** **                                                   | ** ** | **Three Months  Ended September 30,** | ** ** | **Nine Months  Ended September 30,** | ** ** |
|--------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                   | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                   | ** ** | **(in thousands)**                              | ** ** |
| Credit swap fees                                             |       | $                                                    | 548        |                                                | $          | 2,505 |   | $ | 5,852 |   | $ | 7,783 |   |
| Realized and  unrealized gain on credit protection purchased |       | 3,242                                                |       | —                                              |       | 14,816 |   | — |   |
| Unrealized  losses on credit swaps                           |       | —                                               |       | (440                                                | )          | (947 | ) | (149 | ) |
| Total other net  credit swap revenue                         |       | $                                                    | 3,290      |                                                | $          | 2,065 |   | $ | 19,721 |   | $ | 7,634 |   |

 

Net unrealized gainsrelated to changes in value were recorded for each period.  The unrealizedgain recorded for the nine months ended September 30, 2007 was almost entirelyrelated to the change in the value of two credit swap transactions we enteredinto in late 2006 to hedge our exposure to certain classes of RMBS, whicharises from the equity we own in our CDOs.  These swaps referencerepresentative market indices to moderate the impact to us of impairmentsrelated to late 2005 and 2006 vintage subprime residential mortgageexposure.  We did this in light of the negative developments that we notedin this asset class at the time we entered into these swaps. Specifically, the relaxed underwriting standards of certain sub-prime originatorsin late 2005 and 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 negative developments in the market around thisvintage of 

 

37

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RMBS, we determined itprudent to purchase the credit swaps in late 2006. In July 2007 we closed outthese two positions and realized a gain of $3.2 million in the three monthsended September 30, 2007, and a cumulative gain of $14.8 million.

 

*FeeIncome*.  Fee income is principally related to quarterlymanagement fees, warehouse fees and structuring fees received in connectionwith our unconsolidated CDOs.  Total fee income for CDO Asset Managementwas $9.4 million for the three months ended September 30, 2007 compared to $6.0million for the three months ended September 30, 2006. Total fee income for CDOAsset Management was $22.9 million for the nine months ended September 30, 2007compared to $16.7 million for the nine months ended September 30, 2006. These increases were primarily the result of increased assets under managementwhich grew to $18.0 billion at September 30, 2007 from $14.7 billion at September30, 2006, partially offset by a decrease in warehouse and structuringfees.  In general, structuring fees and warehouse fees are highlynegotiated and vary from transaction to transaction.

 

The following table showsthe components of fee income for the three months and the nine months endedSeptember 30, 2007 and 2006:

 
| ** **                        | ** ** | **Three Months  Ended September 30,** | ** ** | **Nine Months  Ended September 30,** | ** ** |
|-----------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                        | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                        | ** ** | **(in thousands)**                              | ** ** |
| Asset management  fees            |       | $                                                    | 8,048      |                                                | $          | 4,908 |   | $ | 20,925 |   | $ | 11,027 |   |
| Warehousing and  structuring fees |       | 1,313                                                |       | 1,075                                               |       | 1,970 |   | 5,661 |   |
| Total fee income                  |       | $                                                    | 9,361      |                                                | $          | 5,983 |   | $ | 22,895 |   | $ | 16,688 |   |

 

*OtherOperating Expenses*.   Other operating expensestotaled $5.7 million for the three months ended September 30, 2007 compared to$5.2 million for the three months ended September 30, 2006.  Otheroperating expenses totaled $19.0 million for the nine months ended September30, 2007 compared to $15.4 million for the nine months ended September 30,2006.  Other operating expenses is made up of direct expenses ofconsolidated CDOs and includes items such as ongoing rating agency fees,trustee fees, accounting fees and other direct expenses related to themaintenance of the CDO. Also included in other operating expenses are allocatedexpenses.

 

The following table showsthe components of other operating expenses for the three months and the ninemonths ended September 30, 2007 and 2006:

 
| ** **                    | ** ** | **Three Months  Ended September 30,** | ** ** | **Nine Months  Ended September 30,** | ** ** |
|-------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                    | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                    | ** ** | **(in thousands)**                              | ** ** |
| Direct operating  expenses    |       | $                                                    | 411        |                                                | $          | 641 |   | $ | 1,339 |   | $ | 1,592 |   |
| Allocated  operating expenses |       | 5,308                                                |       | 4,509                                               |       | 17,647 |   | 13,785 |   |
| Total operating  expenses     |       | $                                                    | 5,719      |                                                | $          | 5,150 |   | $ | 18,986 |   | $ | 15,377 |   |

 

The nine months endedSeptember 30, 2007 increase compared to the same period in 2006 in allocatedexpenses was related to two principal items.  First, our status as apublicly traded company in November 2006 caused an increase in certaincorporate expenses. Additionally, we incurred expenses for our new office inthe United Kingdom, established in the second half of 2006.  This officewas established in connection with the expansion of our asset managementbusiness in Europe.

 

*InterestExpense*.  Interest expense totaled $67.8 million for thethree months ended September 30, 2007 compared to $74.9 million for the threemonths ended September 30, 2006. Interest expense totaled $211.8 million forthe nine months ended September 30, 2007 compared to $211.1 million for thenine months ended September 30, 2006.  Interest expense is made up of theallocated portion of interest expense on corporate debt issued by our holdingcompany, debt issued in connection with the purchase of certain of our CDOequity positions (CDO debt: operating) and debt issued by our consolidated CDOs(CDO debt: non-recourse).

 

The following table showsthe components of interest expense for the three months and the nine monthsended September 30, 2007 and 2006:

 
| ** **              | ** ** | **Three Months  Ended September 30,** | ** ** | **Nine Months  Ended September 30,** | ** ** |
|-------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **              | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **              | ** ** | **(in thousands)**                              | ** ** |
| Corporate debt          |       | $                                                    | 1,302      |                                                | $          | 1,441 |   | $ | 3,801 |   | $ | 3,724 |   |
| CDO debt:  operating    |       | 1,929                                                |       | 1,943                                               |       | 5,717 |   | 5,560 |   |
| CDO debt:  non-recourse |       | 64,535                                               |       | 71,488                                              |       | 202,266 |   | 201,795 |   |
| Total interest  expense |       | $                                                    | 67,766     |                                                | $          | 74,872 |   | $ | 211,784 |   | $ | 211,079 |   |

 

All outstanding debt paysinterest based on a floating rate above one or three month LIBOR.  No newlong term debt was issued in 2007 or 2006. The decrease in non-recourseinterest expense in the third quarter of 2007 compared to the same period in2006 is attributable to the maturity of two consolidated CDO deals whichmatured in the second and third quarter of 2007. Interest expense also includesinterest expense on debt incurred to finance our CDO equity investments. As ofSeptember 30, 2007, we had $109.5 million of debt related to the financing ofCDO equity and $79.9 million of corporate debt issued through trust-preferredvehicles.

 

38

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*Depreciationand Amortization*.   Depreciation and amortizationwas relatively flat over each of the three months ended September 30, 2007 and2006.  Depreciation and amortization is comprised of the recognition ofcosts deferred in connection with our consolidated CDOs as well as allocated amounts.Depreciation and amortization related to consolidated CDOs totaled $1.7 millionfor the three months ended September 30, 2007 and $2.0 million for the threemonths ended September 30, 2006.  Depreciation and amortization was $5.7million for the nine months ended September 30, 2007 and $6.1 million for thenine months ended September 2006.

 

*Incomefrom Minority Interest*.  Income from minority interesttotaled ($0.2) million and $(0.9) million for the three months ended September30, 2007 and 2006, respectively.  Income from minority interest totaled$(2.3) million and $(3.1) million for the nine months ended September 30, 2007and 2006, respectively.  Income from minority interest results from thefact that we consolidate two CDOs in which we own less than 100% of theequity.  Minority interest reflected in the statement of operationsrepresents the share of the income or loss of the CDO that represents the thirdparty equity ownership. In both three month periods, the two CDOs recognizednet income and as a result we recorded minority interest income to reduce ournet income.

 

*CDOAsset Management—Supplementary Information*

 

*Consolidationof VIEs.  * Funded and partially funded CDOs aregenerally issued out of Variable Interest Entities (VIEs). As such, each time aCDO is formed through the issuance of debt instruments to third parties and thepurchase of investment assets, we perform an analysis to determine whether weare the primary beneficiary and thus required to consolidate the CDO under theprovisions of FIN 46(R). Prior to 2005, we retained all or most of the equityposition in our CDOs, and these CDOs are therefore consolidated in ourfinancial statements (a total of seven CDOs are consolidated). Although theseCDOs are consolidated, we do not have the right to use the assets of the CDOsfor general operations and the debt liabilities of the CDOs are withoutrecourse to any assets other than those of the CDOs.  Our investmentexposure to our CDOs is therefore limited to our retained equity, which is thefirst loss position of the CDO. In the transactions in which we own less than100% of the CDO’s equity, but are deemed to be the primary beneficiary and thusconsolidate the CDO, we establish minority interests for the portion not owned.

 

Beginning in 2005, wehave retained a lesser share of the equity position of our newly issued CDOs. Basedon our analysis of FIN 46(R) we are not deemed to be the primarybeneficiary and, as a result, these CDOs are not consolidated in our financialstatements. Rather, our non-majority investment is recorded as an investment ina single fixed maturity security under the provisions of FAS 115 and EITF99-20. During the first nine months of 2007, we closed nine CDOs and retainedequity interest in three. During 2005 and 2006, we closed thirteen CDOs andpurchased equity interests in eight. The fair value of our total investment inunconsolidated CDOs at September 30, 2007 was $19.3 million, not includingsynthetic CDOs in which we take derivative exposure but make no investment. Wedo not anticipate consolidating new CDOs in the future given our intentionto buy minority portions.

 

During the third quarterof 2007, we sold a portion of our equity investment in three CDO deals, ACA ABS2002-1, ACA ABS 2003-1 and ACA ABS 2003-2, each for a nominal amount to anindependent third party. In conjunction with the equity sale, we determinedthat we are no longer the primary beneficiary of these deals under FIN 46(R),*“Consolidation of Variable Interest Entities — an interpretation ofARB No. 51”*(“FIN 46(R)”) and, therefore, de-consolidated thesedeals in our financial statements, realizing a net gain of $39.6 million. Thegain was primarily related to the reversal of previously realized losses inexcess of our original equity investment. The de-consolidation also resulted ina decrease in both assets, primarily fixed-maturity securities available forsale, and liabilities, primarily long-term debt, of approximately $1.0 billion,as well as an increase to accumulated other comprehensive income of $66.4million. The decreases in fixed-maturity securities available for sale andlong-term debt will result in a reduction of related investment income andinterest expense in the Company’s statement of operations in future periods. Totalnon-recourse debt of the CDOs included on our balance sheet at September 30,2007 and December 31, 2006 was $3.3 billion and $4.7 billion,respectively.  Fixed maturity securities, and cash related to consolidatedCDOs included on our balance sheet at September 30, 2007 and December 31,2006 were $3.0 billion and $4.9 billion, respectively. Our consolidatedassets at December 31, 2006 also included in investment in a guaranteedinvestment contract of $119.3 million, in connection with one of our CDOs.

 

CDOs can be issued infunded, unfunded or partially funded form. Funded CDOs issue debt instrumentsand purchase investment assets, while unfunded CDOs synthetically acquireassets and issue liabilities synthetically (i.e., assets and liabilities are inderivative form).  Partially funded CDOs are a combination of these twoforms. We have three CDOs, ACA ABS 2002-1, ACA ABS 2003-1 and ACA ABS 2003-2wherein on September 28, 2007, we sold a portion of our investment in each CDO.These CDOs were previously consolidated in our financial statements since weowned the entire equity position in each. Because the sale constitutes areconsideration event under the provisions of FIN 46(R), we reevaluated ourstatus as primary beneficiary and determined that we were no longer the primarybeneficiary. As a result, at September 30, 2007, these three CDOs weredeconsolidated in our financial statements.

 

39

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The following tablesummarizes our outstanding CDO transactions as of September 30, 2007:

 
| **CDO name**                | ** ** | **Year  Deal  Closed** | ** ** | **Transaction  Type** | ** ** | **Collateral Type(1)** | ** ** | **Current  AUM** | ** ** | **Consolidated** | ** ** | **Current  Investment  in  Retained  Equity(5)** | ** ** | **Original  Retained  Equity %** | ** ** | **First  Optioal  Call Date(2)** | ** ** | **Maturity  Date** | ** ** |
|----------------------------------|------------|------------------------|------------|-----------------------|------------|-----------------------------|------------|------------------|------------|------------------|------------|--------------------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|--------------------|------------|
| ** **                       | ** ** | **(in millions)** | ** ** |
| **Asset-Backed  CDOs:**          | ** ** | ** **             | ** ** | ** **            | ** ** | ** **                  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **                                       | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **         | ** ** |
| ACA ABS 2002-1                   |       | 2002                   |       | Funded                |       | Investment Grade            |       | $                | 188        |             | No         |                                             | $          | —                                |       | 100                                   |       | 8/2005             |       | 8/2037 |   |
| ACA ABS 2003-1                   |       | 2003                   |       | Funded                |       | Investment Grade            |       | 374              |       | No               |       | —                                           |       | 100                                   |       | 6/2007                                |       | 6/2038             |       |
| Grenadier Funding                |       | 2003                   |       | Funded                |       | High-Grade                  |       | 1,487            |       | Yes              |       | 9.9                                              |       | 100                                   |       | 8/2008                                |       | 8/2038             |       |
| ACA ABS 2003-2                   |       | 2003                   |       | Funded                |       | Investment Grade            |       | 575              |       | No               |       | —                                           |       | 100                                   |       | 12/2007                               |       | 12/2038            |       |
| ACA ABS 2004-1                   |       | 2004                   |       | Funded                |       | Investment Grade            |       | 312              |       | Yes              |       | 11.8                                             |       | 61                                    |       | 7/2007                                |       | 7/2039             |       |
| Zenith Funding                   |       | 2004                   |       | Funded                |       | High-Grade                  |       | 1,498            |       | Yes              |       | 13.9                                             |       | 52                                    |       | 12/2009                               |       | 12/2039            |       |
| ACA ABS 2005-1                   |       | 2005                   |       | Funded                |       | Investment Grade            |       | 416              |       | No               |       | 1.0                                              |       | 24                                    |       | 4/2008                                |       | 4/2040             |       |
| ACA ABS 2005-2                   |       | 2005                   |       | Funded                |       | Investment Grade            |       | 386              |       | No               |       | 0.9                                              |       | 10                                    |       | 9/2009                                |       | 12/2044            |       |
| Khaleej II                       |       | 2005                   |       | Partially funded      |       | Investment Grade            |       | 750              |       | No               |       | 2.8                                              |       | 14                                    |       | 9/2009                                |       | 9/2040             |       |
| Lancer Funding                   |       | 2006                   |       | Funded                |       | High-Grade                  |       | 1,428            |       | No               |       | 0.4                                              |       | 10                                    |       | 7/2010                                |       | 4/2046             |       |
| ACA Aquarius  2006-1             |       | 2006                   |       | Partially funded      |       | Investment Grade            |       | 1,987            |       | No               |       | —                                           |       | —                                |       | 9/2010                                |       | 9/2046             |       |
| ACA ABS 2006-1                   |       | 2006                   |       | Funded                |       | Investment Grade            |       | 735              |       | No               |       | —                                           |       | 5                                     |       | 12/2009                               |       | 6/2041             |       |
| ACA ABS 2006-2                   |       | 2006                   |       | Funded                |       | Investment Grade            |       | 739              |       | No               |       | —                                           |       | 11                                    |       | 1/2011                                |       | 1/2047             |       |
| ACA ABS 2007-1                   |       | 2007                   |       | Partially funded      |       | Investment Grade            |       | 1,500            |       | No               |       | 1.5                                              |       | 5                                     |       | 3/2010                                |       | 5/2047             |       |
| Millbrook                        |       | 2007                   |       | Unfunded              |       | Investment Grade            |       | 67               |       | No               |       | —                                           |       | —                                |       | 3/2010                                |       | 10/2052            |       |
| Abacus 2007-AC1                  |       | 2007                   |       | Unfunded              |       | Investment Grade            |       | 192              |       | No               |       | —                                           |       | —                                |       | 6/2010                                |       | 3/2038             |       |
| ACA ABS 2007-2                   |       | 2007                   |       | Partially funded      |       | Investment Grade            |       | 750              |       | No               |       | —                                           |       | —                                |       | 7/2011                                |       | 7/2045             |       |
| Lancer II                        |       | 2007                   |       | Partially funded      |       | High-Grade                  |       | 998              |       | No               |       | —                                           |       | —                                |       | 7/2011                                |       | 7/2047             |       |
| ACA ABS 2007-3                   |       | 2007                   |       | Partially funded      |       | Investment Grade            |       | 350              |       | No               |       | —                                           |       | —                                |       | 8/2013                                |       | 5/2047             |       |
| **Total  Asset-Backed CDOs**     |       |                   |       |                  |       |                        |       | 14,732           |       |             |       | 42.2                                             |       |                                  |       |                                  |       |               |       |
| ** **                       | ** ** | ** **             | ** ** | ** **            | ** ** | ** **                  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **                                       | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **         | ** ** |
| **Corporate  Credit CDOs:**      | ** ** | ** **             | ** ** | ** **            | ** ** | ** **                  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **                                       | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **         | ** ** |
| ACA CDS 2002-2                   |       | 2003                   |       | Unfunded              |       | Investment Grade            |       | 1,000            |       | No               |       | 25.0                                             |       | 100                                   |       | N/A                                   |       | 3/2008             |       |
| Argon 49                         |       | 2005                   |       | Funded                |       | Investment Grade            |       | 71               | (3)        | No               |       | —                                           |       | —                                |       | N/A                                   |       | 6/2015             |       |
| Argon 57                         |       | 2006                   |       | Funded                |       | Investment Grade            |       | 71               | (3)        | No               |       | —                                           |       | —                                |       | N/A                                   |       | 6/2013             |       |
| Tribune                          |       | 2006                   |       | Unfunded              |       | Investment Grade            |       | 217              | (4)        | No               |       | —                                           |       | —                                |       | N/A                                   |       | 9/2016             |       |
| Dolomite                         |       | 2007                   |       | Unfunded              |       | Investment Grade            |       | 71               | (3)        | No               |       | —                                           |       | —                                |       | N/A                                   |       | 7/2014             |       |
| **Total  Corporate Credit CDOs** |       |                   |       |                  |       |                        |       | 1,430            |       |             |       | 25.0                                             |       |                                  |       |                                  |       |               |       |
| ** **                       | ** ** | ** **             | ** ** | ** **            | ** ** | ** **                  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **                                       | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **         | ** ** |
| **Leveraged  Loan CDOs:**        | ** ** | ** **             | ** ** | ** **            | ** ** | ** **                  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **                                       | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** **         | ** ** |
| ACA CLO 2005-1                   |       | 2005                   |       | Funded                |       | Non-Investment Grade        |       | 300              |       | No               |       | 4.4                                              |       | 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        |       | 299              |       | No               |       | 2.2                                              |       | 10                                    |       | 1/2011                                |       | 1/2021             |       |
| ACA CLO Euro  2007-1             |       | 2007                   |       | Funded                |       | Non-Investment Grade        |       | 527              | (3)        | No               |       | 5.8                                              |       | 10                                    |       | 6/2010                                |       | 6/2024             |       |
| ACA CLO 2007-1                   |       | 2007                   |       | Funded                |       | Non-Investment Grade        |       | 340              |       | No               |       | 2.6                                              |       | 10                                    |       | 6/2011                                |       | 6/2022             |       |
| **Total  Leveraged Loan CDOs**   |       |                   |       |                  |       |                        |       | 1,807            |       |             |       | 15.0                                             |       |                                  |       |                                  |       |               |       |
| **Total**                        | ** ** | ** **             | ** ** | ** **            | ** ** | ** **                  | ** ** | **$**            | **17,969** | ** **       | ** ** | ** **                                       | **$**      | **82.2**                              | ** ** | ** **                            | ** ** | ** **         | ** ** | ** ** | ** ** |

 

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| (1)    | Based on original rating, investment grade  collateral is rated “BBB-” or better; however certain of our investment grade  CDOs include the ability to invest a minority portion (20% or less) in  non-investment grade assets. High-grade is “A-” or better. |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                              |
| (2)    | Cash flow CDOs are generally callable once per  quarter by a majority or greater vote of the equity holders on a specific  date as negotiated, which is referred to as the First Optional Call Date.                                                                              |
|   |                                                                                                                                                                                                                                                                              |
| (3)    | Argon 49, Argon 57, Dolomite and ACA CLO Euro 2007-1  are denominated in Euros. For purposes of this chart, we have converted the  amounts to U.S. dollars at the prevailing currency exchange rate on  September 30, 2007.                                                  |
|   |                                                                                                                                                                                                                                                                              |
| (4)    | Tribune is comprised of 11 distinct trades some of  which are denominated in Euros or Yen. For purposes of this chart, we have  converted the respective amounts to U.S. dollars at the prevailing currency  exchange rates on September 30, 2007.                                |
|   |                                                                                                                                                                                                                                                                              |
| (5)    | GAAP equity value, excluding accumulated other  comprehensive income, for consolidated deals or carrying value for  non-consolidated deals.                                                                                                                                       |

 

 

*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 issuesliabilities in the form of debt and equity and the assets are purchased out ofa warehouse facility with the proceeds from the issuance.  The followingshows the balance sheet impact of consolidating a hypothetical$400 million asset-backed CDO at the closing date, assuming we purchasethe entire equity position of $20 million for cash:

 
| ** **                    | ** ** | ** **              | ** ** | ** **           | ** ** | **At Closing** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------|------------|-------------------------|------------|----------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                    | ** ** | ** **              | ** ** | **ACA Funding** | ** ** | **ACA**             | ** ** | ** **       | ** ** | **ACA**          | ** ** |
| ** **                    | ** ** | **CDO VIE**        | ** ** | **Company(1)**       | ** ** | **Management(2)**   | ** ** | **Eliminations** | ** ** | **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 |   |

 

40

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(1) The purchaser of theequity.  For illustration purposes we assume the purchase of equity ismade with cash, although we sometimes finance our purchases of equity.

 

(2) The entity that earnsmanagement fees.

 

For purposes of thishypothetical CDO, we assume we do not earn warehouse or structuring fees, whichwe do on a number of our CDOs. This example also excludes the effects of anymark to market adjustments on derivatives contained within the CDO vehicle.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** | ** ** |
|-------------------------------|------------|------------------------------|------------|
| ** **                    | ** ** | ** **                   | ** ** | **ACA Funding** | ** ** | **ACA** | ** ** | ** ** | ** ** | **ACA** | ** ** |
| ** **                    | ** ** | **CDO VIE**             | ** ** | **Company** | ** ** | **Management** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                    | ** ** | **(in thousands)**      | ** ** |
| *Statement  of Operations*    | * *   | * *                     | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Investment  income            |       | $                            | 27,320     | (1) | $ | — |   | $ | — |   | $ | — |   | $ | 27,320 |   |
| Management fees               |       | (1,800                       | )          | — |   | 1,800 |   | — |   | — |   |
| Residual equity  return       |       | —                       |       | 2,000 |   | — |   | (2,000 | ) | — |   |
| Total revenues                |       | 25,520                       |       | 2,000 |   | 1,800 |   | (2,000 | ) | 27,320 |   |
| Interest expense              |       | 22,820                       | (2)        | — |   | — |   | — |   | 22,820 |   |
| Operating  expenses           |       | 700                          |       | — |   | — |   | — |   | 700 |   |
| Total expenses                |       | 23,520                       |       | — |   | — |   | — |   | 23,520 |   |
| Pre-tax income                |       | $                            | 2,000      |   | $ | 2,000 |   | $ | 1,800 |   | $ | (2,000 | ) | $ | 3,800 |   |
| *Balance  Sheet*              | * *   | * *                     | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Cash                          |       | $                            | 2,000      |   | $ | (20,000 | ) | $ | 1,800 |   | $ | — |   | $ | (16,200 | ) |
| Fixed maturity  securities    |       | 400,000                      |       | 22,000 |   | — |   | (22,000 | ) | 400,000 |   |
| Total assets                  |       | $                            | 402,000    |   | $ | 2,000 |   | $ | 1,800 |   | $ | (22,000 | ) | $ | 383,800 |   |
| Long term debt                |       | $                            | 380,000    |   | $ | — |   | $ | — |   | $ | — |   | $ | 380,000 |   |
| Total  liabilities            |       | 380,000                      |       | — |   | — |   | — |   | 380,000 |   |
| Equity                        |       | 22,000                       |       | 2,000 |   | 1,800 |   | (22,000 | ) | 3,800 |   |
| Total  liabilities and equity |       | $                            | 402,000    |   | $ | 2,000 |   | $ | 1,800 |   | $ | (22,000 | ) | $ | 383,800 |   |

 

----

| (1)    | Based on a hypothetical  investment rate of 6.83%. |
|--------|----------------------------------------------------|
|   |                                               |
| (2)    | Based on a hypothetical liability cost of 5.70%.   |

 

The presentation abovewould 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 we were toclose the same hypothetical CDO, but only purchase 10% of the equity, we wouldnot be deemed the primary beneficiary and therefore would not consolidate. Ourbalance sheet on the date of closing would then include the following:

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

 

41

----

 

After one year, assumingthe same return rates as in the consolidated example above but began havingonly purchased 10% of the equity, our statement of operations would include thefollowing from this CDO:

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

 

----

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

 

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      |   |

 

Management evaluates therevenue generation of our CDO Asset Management line of business on anunconsolidated basis as an alternative measure since management believes it isimportant to evaluate the revenue associated with each aspect of the businessthat relates to our investment or our contractual rights to payment and excludethose revenues that relate to other investors’ economic rights.

 

The table below setsforth the economic impact of our CDOs assuming all CDOs were unconsolidated forthe three and nine months ended September 30, 2007 and 2006.  Investorsshould neither place undue reliance on this presentation nor use it as asubstitute for our segment financial statements which are prepared inaccordance with U.S. GAAP. This presentation should be utilized only as asupplemental measure of financial performance in evaluating our CDO AssetManagement line of business.

 
| ** **                                                                | ** ** | **Three Months Ended September 30,**                  | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                | ** ** | **2007**                                                                  | ** ** | **2006**                                                | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                                | ** ** | **(in thousands, except where otherwise noted)** | ** ** |
| Assets under  management (in millions)                                    |       | $                                                                         | 17,969     |                                                    | $          | 14,659 |   | $ | 17,969 |   | $ | 14,659 |   |
|                                                                      |       |                                                                      |       |                                                    |       |   |   |   |   |
| Management and  other fees(1)                                             |       | $                                                                         | 9,958      |                                                    | $          | 7,895 |   | $ | 28,603 |   | $ | 20,073 |   |
| Warehouse and  structuring fees(2)                                        |       | (717                                                                      | )          | 1,075                                                   |       | (20 | ) | 5,661 |   |
| Equity  returns(3)                                                        |       | (9,974                                                                    | )          | 5,824                                                   |       | (49,915 | ) | 16,246 |   |
| CDO Asset  Management revenue, unconsolidated basis                       |       | $                                                                         | (733       | )                                                       | $          | 14,794 |   | $ | (21,332 | ) | $ | 41,980 |   |
| Reconciliation  to CDO Asset Management pre-tax income:                   |       |                                                                      |       |                                                    |       |   |   |   |   |
| CDO Asset  Management revenue, unconsolidated basis                       |       | $                                                                         | (733       | )                                                       | $          | 14,794 |   | $ | (21,332 | ) | $ | 41,980 |   |
| Impairments in  excess of equity investment                               |       | 46,936                                                                    |       | —                                                  |       | — |   | — |   |
| Net realized and  unrealized gains (losses) on CDO related derivatives(4) |       | (1,715                                                                    | )          | 1,485                                                   |       | (2,684 | ) | 6,765 |   |
| Allocated  investment income(5)                                           |       | 1,043                                                                     |       | 474                                                     |       | 2,992 |   | 1,459 |   |
| Allocated expenses(5)(5a)                                                 |       | (5,308                                                                    | )          | (4,509                                                  | )          | (17,647 | ) | (13,785 | ) |
| Allocated  interest expenses(5)(5b)                                       |       | (1,287                                                                    | )          | (1,237                                                  | )          | (3,801 | ) | (3,519 | ) |
| Allocated  depreciation(5)(5c)                                            |       | (311                                                                      | )          | (236                                                    | )          | (800 | ) | (595 | ) |
| Allocated  realized gains (losses)(5)(5d)                                 |       | (51                                                                       | )          | (18                                                     | )          | (58 | ) | (119 | ) |
| Interest  expense—operating(6)                                       |       | (1,929                                                                    | )          | (1,943                                                  | )          | (5,717 | ) | (5,560 | ) |
| Minority  interest (mark to market portion)(7)                            |       | (99                                                                       | )          | (84                                                     | )          | (464 | ) | (612 | ) |
| Loan Trading  Program(8)                                                  |       | (1,426                                                                    | )          | —                                                  |       | (70 | ) | — |   |
| Other                                                                     |       | (588                                                                      | )          | 122                                                     |       | (517 | ) | 158 |   |
| Total CDO Asset  Management pre-tax income (loss) -U.S. GAAP              |       | $                                                                         | 34,532     |                                                    | $          | 8,848 |   | $ | (50,098 | ) | $ | 26,172 |   |

 

42

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----

(1)        Represents the sum of management fees for all CDOs paid by CDO entities to ACAManagement, whether the CDO is consolidated or unconsolidated.  For CDOsthat we consolidate, management fees are eliminated from our consolidatedfinancial statements under U.S. GAAP.

 

(2)        Represents fees received during or at the end of the warehouse, or assetaccumulation, phase of the CDO.

 

(3)        Represents the return on our CDO equity investments.  For consolidatedCDOs, this is based on the investment income of the CDO less direct interestexpense, direct realized losses, operating expenses, amortization expense andmanagement fees.  For unconsolidated CDOs, equity return is the amount ofincome recorded on the related unconsolidated investment.

 

(4)        Represents the sum of net unrealized gains and losses included in net insuredcredit swap revenue, net realized and unrealized gains (losses) on derivativeinstruments and other net credit swap revenue.  This adjustment(subtracts) adds back mark to market gains (losses) on derivatives and realizedgains (losses) on warehouse facilities because they represent non-cash adjustmentsthat are expected to reverse themselves over time as the related contractsmature or expire.

 

(5)      Represents adjustments for the investment income and expenses which areallocated to the CDO Asset Management line of business but do not relate to thedirect economics of our managed 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 expenses equal total segment expense lessallocated amounts.  Direct CDO expenses were $0.4 million in the thirdquarter of 2007 and $0.6 million in the third quarter of 2006.  Whenwe consider the results related to our managed CDOs, allocated expenses areexcluded and must be added back in order to reconcile to segment based incomebefore taxes.  For the nine months ended September 30, 2007 and 2006,direct CDO expenses were $1.3million and $1.6 million, respectively.

 

(5b)  Represents a portion of our corporatedebt interest expense allocated to this line of business.  This allocatedinterest expense, combined with CDO debt operating and CDO debt-non-recourseinterest expense, equals total segment interest expense.

 

(5c)   Represents a portion ofcorporate depreciation and amortization expense allocated to this line ofbusiness.  Direct amortization of debt issuance costs of consolidated CDOsis included above as a reduction of equity returns (see note 3 above) andtotaled $1.4 million in the third quarter of 2007 and $1.8 million in thethird quarter of 2006.  These amounts totaled $4.8 million and $5.5million for the nine months ended September 30, 2007 and September 30, 2006,respectively.

 

(5d)  Represents a portion of ourcorporate realized (losses) gains allocated to this line of business. Direct net realized gains (losses) including impairments were $26.9million inthe third quarter of 2007 and $(0.4) million in the third quarter of2006.  These direct realized losses are included above as a reduction ofour equity return.  Direct net realized losses including impairments forthe nine months ended September 30, 2007 and 2006 were $(84.6) million and$(2.4) million, respectively.

 

(6)        Represents interest expense incurred in connection with the financing of ourequity purchases.  We view these costs as indirect costs of our CDO AssetManagement business and exclude them when we consider direct results of thisline of business.  Therefore, management subtracts them to arrive atsegment income before taxes.

 

(7)        Represents the minority interest portion of net unrealized gains (losses) onderivatives for two consolidated CDOs in which we own less than 100% of theequity.  We exclude this item when we examine the results related to ourmanaged CDOs.

 

(8)        Represents return and unrealized gains (losses) on a leveraged loan tradingprogram that is structured in the form of a total return swap.  We excludethis item when we examine the results related to our managed CDOs.

 

*CDOStructures and Related Revenue Recognition*

 

The impact of a CDO onour financial statements depends on the structure of the CDO (fully funded,partially funded or unfunded), whether or not the CDO is consolidated and thenature of the underlying assets and liabilities.

 

Fully funded CDOs containinvestments in interest bearing financial assets such as fixed maturitysecurities or guaranteed investment contracts. At September 30, 2007, we havethree fully funded consolidated CDOs. At December 31, 2006, we had 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

 

43

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issuing funded liability securities. The proceeds of the securitiesissued by the partially funded CDO are invested in a guaranteed investmentcontract, or GIC. Until July 2007, we consolidated one partially funded CDSCDO. From this consolidated CDO, we consolidated investment income, relating tothe return on the GIC, and interest expense in connection with the liabilitysecurities issued by the CDO. We also consolidated derivative income relatingto net revenues from the fixed fees payable to the CDO under the terms of thecredit swaps pursuant to which the CDS CDO sold credit protection on referencedassets and the fixed fees payable by the CDO on the credit protection that itpurchased. This income is reflected in the consolidated statements of operationsas other net credit swap revenue. This income was used to pay the interest onthe liabilities of the CDO and other expenses of the CDO, including themanagement fee. Similar to the fully funded and consolidated CDOs, allmanagement fees in this partially funded CDS CDO were paid to ACA Management,but eliminated in consolidation. Our return on our equity investment was thenet of the CDO’s revenues (interest income and other credit swap income) andthe CDO’s expenses, including the management fee paid to ACA Management.

 

For funded and partially funded unconsolidated CDOs,we reflect management fees and investment income in our consolidated statementsof operations.  As of September 30, 2007, we had 23 funded and partiallyfunded CDOs that are not consolidated. In these instances, the investmentincome recorded is only on the equity investment made by us as compared to allof the assets in a consolidated CDO. Partially funded, unconsolidated CDOs inwhich we invest in the funded equity securities are reflected in our financialstatements in the same way as funded unconsolidated CDOs.

 

We originated a fully synthetic, or unfunded, CDS CDOin each of 2002 and 2003. In these transactions, we act as asset manager, and,through ACA Financial Guaranty, insure the equity or first loss position of theCDO. No variable interest entities, or VIEs, exist in these structures; rather,the sponsoring investment bank acts as the counterparty to the various creditswaps that constitute the assets and liabilities of the synthetic CDO. CDOs that do not use VIEs are not subject to consolidation under FIN 46(R). Forour various roles in the unfunded CDS CDOs, we receive structuring fees,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 June 30, 2007, one of the transactions matured, therebyreducing our exposure to $25.0 million.

 

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

 

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

 

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

 

We may experience increased volatility in ourfinancial statements which is not related to the underlying economic value ofour investment in these CDOs because we consolidate VIEs where we are theprimary beneficiary. This may make the evaluation of our financial statementsmore difficult. Our investment exposure to our CDOs is limited to our equityinterest; however, we record fluctuations in the fair value of the assets andliabilities of our consolidated CDOs. These valuation fluctuations, in the formof unrealized mark to market adjustments that are recorded in Accumulated OtherComprehensive Income, have exceeded our economic exposure in the form of ourequity investment in the past and could exceed our economic exposure in thefuture. These valuation adjustments reverse themselves over time, to the extentthe gains or losses are not realized by sales or other than temporaryimpairments. We may have realized losses from the assets (from sales and OTTI)in our consolidated CDOs and those losses could exceed the amount of our equityexposure. This occurred in the third quarter of 2007.  These losses wererecorded in our consolidated statement of operations as realized losses. Excessimpairments when realized by actual defaults are absorbed by other CDOinvestors, since as an economic matter, excess impairments by the Companyindicate those parties will ultimately not receive repayment of all of theirprincipal investment.  For the Company, the financial statement impact ofthe realized losses is offset at CDO maturity when the associated non-recourseliabilities are written off or upon the deconsolidation of the CDO.  Forexample, during the second quarter of 2007, we incurred impairment lossesrelated to two consolidated CDOs in excess of our total remaining economicexposure.  The excess impairment amount was reversed in our statement ofoperations through a realized gain recognized at the end of third quarter of2007, when we sold a portion of each and deconsolidated these CDOs, afterdetermining that we were no longer the primary beneficiary under FIN 46(R).

 

44

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*Other*

 

Our fourth line of business, Other, encompassesinsurance products in which we are no longer active, including industry losswarranty transactions, trade credit reinsurance and insurance of certainclasses of assets in asset-backed securitizations, principally manufacturedhousing. At September 30, 2007, all of the exposure in this line of businesshad either expired or was in run-off. Run-off indicates that while we will notadd new exposure, we have some current exposure that has not yet expired. Thefollowing table summarizes the results of our Other line of business for thethree months and nine months ended September 30, 2007 and 2006:

 
| ** **                                         | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                                 | ** ** | **2006**                                                | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                         | ** ** | **(in thousands)**                                  | ** ** |
| **REVENUES:**                                      | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Gross premiums  written                            |       | $                                                        | 80         |                                                    | $          | 132 |   | $ | 422 |   | $ | 793 |   |
| Premiums earned                                    |       | $                                                        | 190        |                                                    | $          | 298 |   | $ | 544 |   | $ | 1,397 |   |
| Net investment  income                             |       | 3,209                                                    |       | 892                                                     |       | 5,312 |   | 2,741 |   |
| Net realized and  unrealized losses on investments |       | (51                                                      | )          | (36                                                     | )          | (58 | ) | (225 | ) |
| **Total  revenues**                                | ** ** | **3,348**                                                | ** ** | **1,154**                                               | ** ** | **5,798** | ** ** | **3,913** | ** ** |
| **EXPENSES:**                                      | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loss and loss  adjustment expenses                 |       | 2,546                                                    |       | 456                                                     |       | 3,139 |   | 1,223 |   |
| Policy  acquisition costs                          |       | 27                                                       |       | 82                                                      |       | 242 |   | 452 |   |
| Other operating  expenses                          |       | 8                                                        |       | 61                                                      |       | 21 |   | 61 |   |
| Interest expense                                   |       | 94                                                       |       | 94                                                      |       | 279 |   | 267 |   |
| **Total  Expenses**                                | ** ** | **2,675**                                                | ** ** | **693**                                                 | ** ** | **3,681** | ** ** | **2,003** | ** ** |
| Income before  income taxes                        |       | 673                                                      |       | 461                                                     |       | 2,117 |   | 1,910 |   |
| Provision for  income tax expense                  |       | 252                                                      |       | 185                                                     |       | 737 |   | 681 |   |
| **Net  Income**                                    | ** ** | **$**                                                    | **421**    | ** **                                              | **$**      | **276** | ** ** | **$** | **1,380** | ** ** | **$** | **1,229** | ** ** |

 

*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 third quarter of 2007 from $0.3million in the third quarter of 2006.  Premiums earned for the nine monthsended September 30, 2007 and 2006 were $0.5 million and $1.4 million,respectively.  Our exposure in the trade credit business, a component ofthis line of business, continues to rapidly decline.  Premiums earned forthe other insurance contracts accounted for in this line of business alsocontinue to decline.  We still continue to receive a small amount ofinstallment premium for in-force asset-backed securitizations, principallymanufactured housing, that were insured several years ago.

 

*NetInvestment Income.*  Net investment income was $3.2million and $0.9 million for the three months ended September 30, 2007 and2006, respectively.  Net investment income was $5.3 million and $2.7million for the nine months ended September 30, 2007 and 2006,respectively.  The three and nine month ended September 30, 2007 amountsinclude $2.1 million of accrued interest related to subrogation that we expectto receive on an insured transaction in which we have paid losses since 2002and expect to fully recover. In addition to receiving full recovery of paidclaims, we are entitled to receive interest on our ever to date payments. Inconnection with the cancellation of this insurance contract during the thirdquarter of 2007, we recognized the interest due to date. Allocated netinvestment income is derived from the allocation of income from ACA FinancialGuaranty’s investment portfolio.  A portion of our capital is allocated tothis line of business because we have outstanding exposure, principally relatedto our exposure to insured manufactured housing securitizations.Notwithstanding the run-off or expiration of our exposure overall in our Otherline of business, allocated investment income increased due to the increase inthe size of the ACA Financial Guaranty investment portfolio.

 

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

 

In 1999, we insured 12securitized manufactured housing bonds with a collective balance of $213.3million.  In response to an increase in the level of realized lossesobserved in the mortgages underlying four of these securitizations, weestablished a case specific reserve in 2004 in the amount of $20.3 million. Thisreserve represented the present value of expected losses, discounted at theapplicable treasury rate. Due to the very long tenor of these bonds, paymentsare projected 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. While the reserve represents our best estimate at the time ofestablishment of ultimate losses on a present value basis, facts andcircumstances may change such that the estimate is required to be revalued. Threeof the bonds in our securitized manufactured housing portfolio experiencedlosses beginning in 2004. A fourth bond incurred losses beginning in 2006.

 

During the third quarterof 2007, for purposes of optimizing our rating agency capital, we agreed withthe insured party on this 

 

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portfolio of transactions to terminate certain of our insurancecontracts. As part of the termination, we agreed to purchase at par a portionof the insured bond on one of the four policies for which we had established aloss reserve. At June 30, 2007, the case reserve for that bond was $12.2million and was based on the present value of the expected future claimpayments discounted at the risk-free rate in effect at the time the reserve wasestablished. We also agreed that we would continue to pay claims as they camedue on the other three policies. In connection with our purchase of the insuredbond at par, we recorded a paid loss equal to the difference between ourestimate of the fair value of the bond and the par amount paid. The fair valueof the bond was determined based on the future cash flows of the purchased bonddiscounted at a market yield, estimated at 13%. We also reduced our lossreserve on this bond by the percentage of the par amount we purchased. The netimpact, recorded to losses incurred was a loss in the amount of $1.8 millionfor the three months ended September 30, 2007. This same amount for the threemonths ended September 30, 2006 was $0.8 million, which related to accretion ofthe loss reserve. As of September 30, 2007, our case specific reserve on thesefour manufactured housing bond policies was $16.9 million.

 

**NetEconomic Income**

 

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

 

We define net economicincome as net income (loss) excluding the after-tax effects of:

 

1.       Unrealizedgains (losses) on derivatives included in:

 

•       Netinsured credit swap revenue;

 

•       Netrealized and unrealized gains (losses) on derivative instruments; and

 

•       Othernet credit swap revenue;

 

2.       Realizedgains (losses) on non-CDO investments;

 

3.       Theportion of interest expense related to the principal payments on borrowingsthat were financed with derivatives; and

 

4.       Netrealized losses related to the impairment of non-recourse CDO assets in excessof our equity investment, if any.

 

Also, included in neteconomic income (loss) are net recognized gains from credit protectionpurchased on the ABX indices.  This credit protection was purchased tomoderate impairments on our ABS CDO equity and is included in the net economicresults given the amount of impairments recorded in the third quarter of 2007.

 

Unrealized gains (losses)on derivatives are excluded because (i) they widely vary with changes inthe credit market and interest rate environment and are not necessarilyindicative of the performance of our underlying businesses and (ii) theCompany intends to hold the positions to the derivative contracts’ expiration,at which time the mark to market values would revert to zero, to the extent norealized derivative gains or losses had occurred. Realized gains (losses) onnon-CDO investments are excluded because our investment strategy is focused onthe preservation of capital and generation of current income as opposed to thegeneration of trading gains and losses. We include in net economic income theunrealized gains (losses) on derivatives and investments generated by ourwarehouse facilities and also related to trading activity, if any. Alsoexcluded is a portion of interest expense on borrowings that were financed withinterest rate swaps to pay the up front issuance costs of some of ourconsolidated CDOs. FAS 133 requires that all payments made under the interestrate swaps, representing both principal and interest, be recorded as interestexpense.  In order to approximate the economic expense on theseborrowings, the portion of interest expense that is excluded is related to whatwould be principal payments if these borrowings had been financed with debtobligations.  Net realized losses related to the impairment ofnon-recourse CDO assets in excess of the Company’s equity investment in theCDO, if any, are excluded because they do no represent economic losses to theCompany, rather result from the effects of consolidation.

 

We had after-taxunrealized losses of $(1,076.1) million in the third quarter of 2007, comparedwith after-tax unrealized gains of $2.2 million in the third quarter of 2006 onour insured credit swaps included in net insured credit swap revenue. We hadafter-tax unrealized gains of $0.6 million in the third quarter of 2007 and$0.4 million in 2006 on our derivatives included in net realized and unrealizedgains (losses) on derivative instruments. We had unrealized gains (losses) of$2.1 million in the third quarter of 2007 and $(0.3) million in the thirdquarter of 2006 on our credit swaps included in other net insured credit swaprevenue.  We had realized losses of $(0.2) million in the third quarter of2007 and 2006 on our non-CDO investments.  We had after-tax expenses of$0.8 million in the third quarter of 2007 and $0.9 million in the third quarterof 2006, which effectively constituted principal payments on our interest rateswaps.  We had after-tax realized gains in the third quarter of 2007related to the recovery of the impairment of non-recourse CDO assets of $30.5million.  Lastly, we had after-tax net recognized gains in the thirdquarter of 2007 related to credit protection purchased of $2.1 million.

 

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We had after-taxunrealized gains (losses) of $(1,130.0) million in the nine months endedSeptember 30, 2007 and $1.4 million in the nine months ended September 30, 2006on our insured credit swaps included in net insured credit swap revenue. We had after-tax unrealized gains of $2.8 million in the nine months endedSeptember 30, 2007 and $4.0 million in the nine months ended September 30, 2006on our derivatives included in net realized and unrealized gains (losses) onderivative instruments.  We had unrealized gains (losses) of $9.0 millionin the nine months ended September 30, 2007 and $(0.1) million in the ninemonths ended September 30, 2006 on our credit swaps included in other netinsured credit swap revenue.  We had realized losses of $(0.3) million inthe nine months ended September 30, 2007 and $(1.0) million in the nine monthsended September 30, 2006 on our non-CDO investments.  We had after-taxexpenses of $2.3 million in the nine months ended September 30, 2007 and $2.9million in the nine months ended September 30, 2006, which effectivelyconstituted principal payments on our interest rate swaps.  Lastly, we hadafter-tax net recognized gains in the nine months ended September 30, 2007related to credit protection purchased of $9.7 million

 

**Liquidity and Capital Resources**

 

We are a holding company,and as such, have no direct operations of our own. Our liquidity, both on ashort-term basis (for the next 12 months) and a long-term basis (beyond thenext 12 months) is dependent upon how much of our initial public offeringproceeds we retain at the holding company level, the ability of our operatingsubsidiaries, which excludes our consolidated CDO entities, to pay dividends ormake other payments to us, and our ability to incur indebtedness and otherwiseaccess the capital markets. As of September 30, 2007, we held at our holdingcompany approximately $5.2 million of the approximately $79.2 million in netproceeds from our IPO. For further discussion regarding the balance of proceedsafter September 30, 2007, see Part II, Item 2 of this report.  Ourliquidity is also a function of certain assets of our non-insurancesubsidiaries which can be readily converted to cash. When assessing ourliquidity, we generally exclude the resources of our insurance subsidiary, ACAFinancial Guaranty, except for amounts that have been approved as dividends,since those funds are required to be maintained in the insurance company to payclaims incurred and insurance company expenses only.  Including our othernon-insurance subsidiaries, as of November 9, 2007, we have approximately$106.1 million in assets that are in the form of cash or investments. Ourprincipal liquidity requirement is the payment of interest on our debt andoperating 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 liquidity to make periodic capitalinvestments in our operating subsidiaries. We do not currently intend to paydividends. In the ordinary course of our business, we evaluate our liquidityneeds and capital resources in light of holding company expenses anddebt-related expenses. Subject to the collateral posting requirements on ourinsured credit swaps not being triggered, based on the amount of dividends weexpect to receive from our subsidiaries, and existing cash, including theremaining proceeds from our initial public offering retained at our holdingcompany, management believes that we will have sufficient liquidity to satisfyour needs over the next 12 months. Beyond the next 12 months, theability of our operating subsidiaries to declare and pay dividends may beinfluenced by a variety of factors including market conditions, insurance andrating agencies actions and general economic conditions as well as other itemsdescribed in our risk factors herein and 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, debt service obligations orincreased capital requirements.

 

As discussed above, onesource of our liquidity, for the next 12 months and for the longer term,will be amounts paid by our operating subsidiaries as dividends to us. ACAFinancial Guaranty is our principal subsidiary through which we operate all ourlines of business. ACA Financial Guaranty is subject to restrictions understate insurance law on its ability to pay dividends. In December 2005, theMaryland Insurance Commissioner approved ACA Financial Guaranty’s request topay a dividend in an amount equal to the interest payments on $40 millionof the $80 million of our trust preferred issuance outstanding through theyear ended December 31, 2006.  The Maryland Insurance Commissioneralso approved interest payments by ACA Financial Guaranty on the $10 millionsurplus note due in the 2006 fiscal year.  Accordingly, during 2006 ACAFinancial Guaranty paid dividends of $2.7 million for the ultimate benefitof its parent, ACA Capital, and $0.8 million in interest on the surplusnote.  Approval of the Maryland Insurance Commissioner to make dividendand surplus note interest payments due in 2007 on the $40 million of trustpreferred securities and the $10 million surplus note, respectively, wasreceived by us in December 2006.  As of September 30, 2007, ACAFinancial Guaranty paid dividends of $2.9 million and $0.7 million in intereston the surplus note.  We have not received dividends from our operatingsubsidiaries other than ACA Financial Guaranty.

 

With the placement of ACAFinancial Guaranty on CreditWatch with negative implications, we are uncertainabout our current ability to continue to write new business in our PublicFinance and Structured Credit lines of business at historic levels. Inaddition, should S&P ultimately downgrade ACA Financial Guaranty’sfinancial strength rating below A-, under the existing terms of our insuredcredit swap transactions, we would be required to post collateral based on thefair value of the insured credit swaps as of the date of posting. The failureto post collateral would be an event of default, resulting in a terminationpayment in an amount approximately equal to the collateral call. Thistermination payment would give rise to a claim under the related ACA FinancialGuaranty insurance policy. Based on current fair values, we would not have theability to post such collateral or make such termination payments. As ofSeptember 30, 2007, we estimated fair value of our insured credit swaps was$(1.7) billion. As well, in the case of certain insured credit swaps, if theunderlying portfolio incurs losses to a pre-agreed point, we are generallyrequired to post collateral in an amount that is the lesser of the amount bywhich actual losses exceed this pre-agreed point and the amount of any negativemark to market value of the insured credit swap. Moreover, the losses on theseportfolios could result in downgrades on the 

 

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tranches that we insure, resulting in increased capital charges. If anyof these events occurred, it would materially hurt our financial performanceand liquidity and 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. Unrelated to the recent S&P ratingaction, we had $41.2 million of collateral posted related to certain syntheticequity transactions in our CDO Asset Management and Structured Creditbusinesses as of September 30, 2007.  On an ongoing basis, our sources offunds 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 differ substantially from net income.

 

In July 2007, our Boardof Directors approved a stock repurchase program of up to $20 million. Such purchases of stock will be funded from the holding company and othernon-insurance subsidiaries as necessary.  As of November 9, 2007, theCompany has repurchased 2,087,900 shares of common stock at a cost of $14.9million in the aggregate.

 

See “—Indebtedness.”

 

*CashFlows for the Nine months ended September 30, 2007*

 

For the nine months endedSeptember 30, 2007, we generated positive net operating cash flow of $62.4million, primarily related to income from operations, taking into account thenon-cash effects of other than temporary impairments and unrealized mark tomarket losses on net insured credit swap revenue, and investment income. This amount is net of our $10.0 million investment in our Credit Fund inthe first quarter of 2007.  In the first nine months of 2007, we had netproceeds from invested assets of $218.7 million principally from the sale andmaturity of fixed maturity securities available for sale, primarily in ourconsolidated CDOs.  We had net cash outflows of $377.8 million related tofinancing activities, which included the paydown of $364.1 million of long-termdebt, primarily in our consolidated CDOs.  As of September 30, 2007, wehad contributed $59.1 million of the proceeds from our initial public offeringto our subsidiaries.  As of September 30, 2007, we had a cash balance of$283.2 million, comprised of $225.0 million in our consolidated CDOs, $3.6million in our Credit Fund and $54.6 million of unrestricted cash in our otheroperating subsidiaries, principally at ACA Financial Guaranty and our holdingcompany.

 

*CashFlows for the Nine months ended September 30, 2006*

 

For the nine months endedSeptember 30, 2006, we generated positive net operating cash flow of $21.2million, primarily related to income from operations and investment income.During the same period, we had net cash provided by investing activities of$123.2 million principally from the sale and maturity of fixed maturitysecurities available for sale, primarily in our consolidated CDOs.  We hadnet cash outflows of $93.9 million through financing activities, which includedthe paydown of $107.0 million of long-term debt, primarily related to ourconsolidated CDOs.  As of September 30, 2006, we had a cash balance of$224.9 million, comprised of $173.6 million in our consolidated CDOs, $0.6million in our Credit Fund and $50.7 million of unrestricted cash in our otheroperating subsidiaries, principally at ACA Financial Guaranty and our holdingcompany.

 

**CapitalExpenditures**

 

We did not makesignificant capital expenditures for or during the three or nine months endedSeptember 30, 2007 and 2006. We do not anticipate significant capitalexpenditures for the remainder of 2007.

 

**Off-BalanceSheet Arrangements**

 

We do not have any “off-balancesheet arrangements” (as such term is defined in Item 303 of Regulation S-Kof the General Rules and Regulations under the Securities Act of 1933, asamended) that are reasonably likely to have a current or future effect on ourfinancial condition, changes in financial condition, revenues or expenses,results of operations, liquidity, capital expenditures or capital resources. Wedo, however, have off-balance sheet exposure in the form of our financialguaranty exposure or par in force. Par in force as of September 30, 2007 was$76.7 billion and includes exposure to Public Finance, Structured Credit andCDO Asset Management and other transactions in which ACA Financial Guaranty hasissued insurance policies. Par in force as of September 30, 2006, was$31.4 billion.

 

**ContractualObligations**

 

The following tablesummarized our contractual obligations as of September 30, 2007(1):

 

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| ** **                                         | ** ** | ** **              | ** ** | **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                           |       | 109,521                 |       | —             |       | 100,000            |       | —             |       | 9,521                       |       |
| CDO  debt—non-recourse, net of discounts(2)   |       | 3,258,028               |       | 2,675,308          |       | —             |       | —             |       | 582,720                     |       |
| Total debt                                         |       | 3,447,448               |       | 2,675,308          |       | 100,000            |       | —             |       | 672,140                     |       |
| Securities sold  under agreements to repurchase(3) |       | 104,124                 |       | 104,124            |       | —             |       | —             |       | —                      |       |
| Lease  obligations                                 |       | 36,902                  |       | 3,052              |       | 7,064              |       | 5,310              |       | 21,476                      |       |
| Loss reserves(4)                                   |       | 42,878                  |       | 8,718              |       | 1,877              |       | 2,335              |       | 29,948                      |       |
| Total                                              |       | $                       | 3,631,352  |               | $          | 2,791,202          |       | $                  | 108,941    |                        | $          | 7,645 |   | $ | 723,564 |   |

 

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(1)    Does not include any potential borrowings under our credit facility, for whichthere were no outstanding borrowings as of September 30, 2007, described belowunder “—Indebtedness.”

 

(2)    Represents debt incurred by our CDOs that are consolidated under U.S. GAAPand that are without recourse to any assets other than those of the applicableCDO.

 

(3)    Represents debt incurred by our Credit Fund that are consolidated underU.S. GAAP and that are without recourse to any assets other than those ofthe Credit Fund.

 

(4)    The loss and loss adjustment expenses payments due by period in the table aboveare based upon the present value of loss and loss adjustment expenses estimatesas of September 30, 2007 and are not contractual liabilities with specifiedtimes of payment. Our contractual liability is to provide benefits under ourpolicies. As a result, our calculation of loss and loss adjustment expensespayments due by period is subject to the same uncertainties associated withdetermining the level of unpaid loss and loss adjustment expenses reservesgenerally and to the additional uncertainties arising from the difficulty ofpredicting when claims (including claims that have not yet been reported to us)will be paid. Actual payments of losses and loss adjustment expenses by periodwill vary, perhaps materially, from the above table to the extent that currentestimates of loss and loss adjustment expenses vary from actual ultimate claimsand amounts and as a result of variations between expected and actual payoutpatterns. Our failure to accurately set our loss reserves may result in havingto increase our loss reserves or make payments in excess of our loss reserves,which could materially and adversely impact our financial condition.

 

**RestrictedBalances**

 

Our insurance subsidiary,ACA Financial Guaranty, has assets on deposits with various regulatoryauthorities. At September 30, 2007, such assets on deposit were in the amountof $4.9 million. In connection with our CDO Asset Management and StructuredCredit businesses, we had on deposit $51.5 million for the benefit of variouscounterparties.

 

**Indebtedness**

 

*CreditFacilities*

 

*$75million Credit Facility*

 

We had a $75 million364-day senior unsecured revolving credit facility (the “Prior Credit Facility”)with a syndicate of banks, which was replaced with the New Credit Facility(defined below) in April 2007. The Prior Credit Facility required us tomaintain a net worth not less than the sum of (i) $298,500,000, (ii) 60% of ourcumulative Consolidated Net Income (as defined in the credit agreement for thePrior Credit Facility) for each fiscal quarter (beginning with the fiscalquarter ending September 30, 2006), and (iii) 60% of the net cash proceeds ofany offering of common equity consummated after the facility’s closingdate.  We were further required to not permit our debt to capital ratio tobe greater than 35% at any time and to maintain a minimum financial strengthrating from S&P of “A-” for ACA Financial Guaranty.  We had met all ofthese requirements as of the date of termination of the prior credit facility.

 

*$150million Credit Facility*

 

On April 26, 2007, weentered into a $150 million three-year senior unsecured revolving creditfacility (the “New Credit Facility”) with a syndicate of banks.  The NewCredit Facility replaced the Prior Credit Facility discussed above. On October15, 2007, we entered into an amendment (the “First Amendment”) to the NewCredit Facility (as amended by the First Amendment, the “Amended CreditFacility”) with the syndicate of banks. In addition to amending certain of theterms of the New Credit Facility described below, the First Amendment (i)waived any default or event of default that may have been in 

 

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effect under the New Credit Facility at any time during the period fromJuly 1, 2007 to October 15, 2007 and (ii) suspended the availability of thefacility commitments from October 15, 2007 though such date as our Net Worth(as defined in the credit agreement for the Amended Credit Facility) is atleast $500 million (the “First Amendment Suspension Period”).

 

The Amended CreditFacility provides for borrowings by us on a revolving basis up to an aggregateof (x) $75 million at any one time outstanding after our Net Worth  is at least $500 million and (y) $150 millionat any one time outstanding after our Net Worth is greater than $600 million. TheAmended Credit Facility requires us to prepay any amounts outstanding under thefacility in excess of $75 million in the event our Net Worth is less than $600million after the end of the First Amendment Suspension Period. The AmendedCredit Facility also includes a $25 million sub-commitment for the issuance ofletters of credit.  At our request and subject to the terms and conditionsof the credit agreement for the Amended Credit Facility, the maximum amount offacility commitments may be increased up to $250 million at the lenders’discretion. As of September 30, 2007, no amounts were outstanding under theAmended Credit Facility nor had there been any borrowings under the facility.

 

We may elect from time totime an interest rate per annum for the borrowings under the Amended 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 Amended CreditFacility) corresponding to our leverage ratio (the ratio of debt to capitalreflected in our then most current consolidated financial statements). In thecase of competitive bid loans, interest per annum is fixed and specified by thelender making such competitive loan.

 

We will also pay anApplicable Facility Fee (as defined in the credit agreement for the AmendedCredit Facility) on the commitments in effect under the Amended 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 Amended Credit Facility when such amount outstandingexceeds 50% of the commitments under the facility, a fronting fee on theaverage daily amount of the undrawn amount under all letters of credit andother fees for each letter of credit issued under the facility.  Thesefees are payable quarterly in arrears.

 

The terms of the AmendedCredit Facility include various restrictive covenants.  These covenantsinclude restrictions on indebtedness, liens, fundamental changes, sales ofassets, certain payments and transactions with affiliates.  The AmendedCredit Facility also includes a covenant requiring us to maintain at any timeafter the First Amendment Suspension Period a Net Worth of not less than thesum of (i) $500,000,000, (ii) 50% of our cumulative Consolidated NetIncome (as defined in the credit agreement for the Amended Credit Facility) foreach fiscal quarter (beginning with the first full fiscal quarter commencing onor after the First Amendment Suspension Period) for which Consolidated NetWorth is positive, and (iii) 50% of the net cash proceeds of any offering ofcommon equity consummated after the end of the First Amendment SuspensionPeriod.  The Net Worth definition includes in its calculation all FAS 133mark-to-market valuations recorded in our statement of operations. We arecurrently not able to borrow against the Amended Credit Facility because of themagnitude of the unrealized FAS 133 loss on our Structured Credit insuredcredit swaps. We do not, however, currently have liquidity needs that wouldnecessitate a borrowing under the Amended Credit Facility. We must further notpermit our debt to capital ratio to be greater than 35% at any time and mustmaintain a minimum financial strength rating from S&P of “A” for ACAFinancial Guaranty.

 

The Amended 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 natureof these events of default is similar to or more favorable than those containedin the Prior Credit Facility.  If an event of default occurs, all of ourobligations under the Amended Credit Facility could be accelerated by therequired lenders.  In the case of bankruptcy or insolvency, accelerationof our obligations under the Amended Credit Facility is automatic.

 

*TrustPreferred Securities*

 

We issued floating ratejunior 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 termof 30 years with a call provision at five years from the date of eachissuance. The current interest rates on the $79.9 million of outstanding trustpreferred debt securities range from 9.044% to 9.621% at September 30, 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 indentures governingthe debentures limit our ability to pay dividends and incur other indebtedness.Events of default under the indentures include failure to make timely principalor interest payments, continuation of a breach of the indentures 60 daysafter proper notice, bankruptcy, liquidation and dissolution.

 

50

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*OtherFinancings*

 

To the extent we purchaseequity in our CDOs, we may issue notes to finance such purchases. These notesare debt obligations secured by our equity interest in the CDO and insured asto the repayment of principal and interest by ACA Financial Guaranty. The notesgenerally may be redeemed prior to the scheduled maturity date at ouroption.  For the nine months ended September 30, 2007, no amounts ofequity purchased were financed.  Rather, these investments, totaling $8.2 millionwere purchased with cash from our subsidiary, ACA Financial Products.

 

In March 2005, oneof our subsidiaries, ACA Parliament, L.L.C. (“ACA Parliament”) entered into anagreement with an investment trust, pursuant to which $99 million wasdeposited in a fund that is maintained and invested by ACA Parliament inexchange for a medium term note. ACA Parliament is required to make quarterlyinterest payments at a rate equal to the three-month LIBOR plus 125 basispoints and the maturity date of the medium term note is 2010. We are likely tohave to refinance this medium term note program upon maturity in 2010 since thematurity date is in advance of the maturity date of many of the assets acquiredwith the proceeds of such issuance. Notes outstanding in connection with thefinancing of our equity purchases, including the aforementioned term note,totaled $109.5 million and $112.0 million as of September 30, 2007and December 31, 2006, respectively.

 

**InvestmentPortfolio**

 

As of September 30, 2007,our investment portfolio consisted of $3.5 billion of fixed maturitysecurities, of which $2.8 billion were from VIEs that we consolidate under FIN46(R), $19.3 million from our unconsolidated CDOs, $600.6 million were held inour insurance company investment portfolio and $125.2 million were from ourCredit Fund.  The vast majority of our fixed maturity securities aredesignated as available for sale in accordance with FAS 115. The remainingfixed maturity securities are designated as part of a trading portfolio. Thesesecurities were purchased by our Credit Fund.  Fixed maturity securitiesavailable for sale are reported at fair value in accordance with FAS 115,and the change in fair value is reported as part of accumulated othercomprehensive income in stockholders’ equity while changes in the fair value oftrading securities are recorded in the income statement. Other than temporaryimpairments on our VIE and non-VIE investments are recorded in net income asrealized losses.

 

The following tablesummarizes our investment portfolio as of September 30, 2007:

 
| ** **                                       | ** ** | **Amortized  Cost**     | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated Fair  Value** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| ** **                                       | ** ** | **(in thousands)** | ** ** |
| Available for  sale-non-VIE:                     |       |                    |       |                         |       |                          |       |                           |       |
| U.S. treasury  securities                        |       | $                       | 41,348     |                         | $          | 270                           |       | $                              | (188       | ) | $ | 41,430 |   |
| Federal-agency  securities                       |       | 68,595                  |       | 128                          |       | (202                          | )          | 68,521                         |       |
| Obligations of  sales and political subdivisions |       | 188,472                 |       | 1,188                        |       | (833                          | )          | 188,827                        |       |
| Corporate  securities                            |       | 103,449                 |       | 323                          |       | (3,498                        | )          | 100,274                        |       |
| Asset-backed  securities                         |       | 42,014                  |       | 357                          |       | (134                          | )          | 42,237                         |       |
| Mortgage-backed  securities                      |       | 162,554                 |       | 281                          |       | (3,492                        | )          | 159,343                        |       |
| Total non-VIE  securities                        |       | 606,432                 |       | 2,547                        |       | (8,347                        | )          | 600,632                        |       |
| Available for  sale VIE asset-backed securities  |       | 3,202,345               |       | 2,058                        |       | (431,807                      | )          | 2,772,596                      |       |
| Total available  for sale                        |       | 3,808,777               |       | 4,605                        |       | (440,154                      | )          | 3,373,228                      |       |
| Held for  trading- Credit Fund:                  |       |                    |       |                         |       |                          |       |                           |       |
| Securities held  for trading- assets             |       | 133,333                 |       | —                       |       | (8,157                        | )          | 125,176                        |       |
| Securities held  for trading- liabilities        |       | —                  |       | —                       |       | —                        |       | —                         |       |
| Total held for  trading- Credit fund             |       | 133,333                 |       | —                       |       | (8,157                        | )          | 125,176                        |       |
| Total                                            |       | $                       | 3,942,110  |                         | $          | 4,605                         |       | $                              | (448,311   | ) | $ | 3,498,404 |   |

 

The amortized cost andestimated fair value of fixed maturity securities available for sale and heldfor trading as of September 30, 2007, by contractual maturity, are shownbelow.  Expected maturities will differ from contractual maturitiesbecause borrowers may have the right to call or prepay obligations with orwithout penalties.

 

51

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| ** **                              | ** ** | **Non- VIE Securities** | ** ** | **VIE Securities** | ** ** | ** **    | ** ** | **Total**           | ** ** |
|-----------------------------------------|------------|-----------------------------------|------------|-------------------------|------------|---------------|------------|---------------------|------------|
| ** **                              | ** ** | **Amortized**                     | ** ** | **Estimated**           | ** ** | **Amortized** | ** ** | **Estimated**       | ** ** | **Amortized** | ** ** | **Estimated** | ** ** |
| ** **                              | ** ** | **Cost**                          | ** ** | **Fair Value**     | ** ** | **Cost**      | ** ** | **Fair Value** | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
| ** **                              | ** ** | **(in thousands)**           | ** ** |
| ** **                              | ** ** | ** **                        | ** ** | ** **              | ** ** | ** **    | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Available for  sale(1):                 |       |                              |       |                    |       |          |       |                |       |   |   |   |   |
| Due in one year  or less                |       | $                                 | 21,926     |                    | $          | 21,603        |       | $                   | 15,000     |   | $ | 15,029 |   | $ | 36,926 |   | 36,632 |   |
| Due after one  year through five years  |       | 103,446                           |       | 102,209                 |       | 87,018        |       | 86,563              |       | 190,464 |   | 188,772 |   |
| Due after five  years through ten years |       | 171,342                           |       | 168,900                 |       | 246,744       |       | 242,795             |       | 418,086 |   | 411,695 |   |
| Due after ten  years                    |       | 309,718                           |       | 307,920                 |       | 2,853,583     |       | 2,428,209           |       | 3,163,301 |   | 2,736,129 |   |
| Total available  for sale               |       | 606,432                           |       | 600,632                 |       | 3,202,345     |       | 2,772,596           |       | 3,808,777 |   | 3,373,228 |   |
| Held for  trading- Credit Fund(1):      |       |                              |       |                    |       |          |       |                |       |   |   |   |   |
| Due after ten  years                    |       | —                            |       | —                  |       | 133,333       |       | 125,176             |       | 133,333 |   | 125,176 |   |
| Total held for  trading                 |       | —                            |       | —                  |       |          |       |                |       |   |   |   |   |
| Total                                   |       | $                                 | 606,432    |                    | $          | 600,632       |       | $                   | 3,335,678  |   | $ | 2,897,772 |   | $ | 3,942,110 |   | $ | 3,498,404 |   |
|                                         |            |                                   |            |                         |            |               |            |                     |            |  |  |  |  |  |  |  |  |  |  |

 

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(1)         Actual maturities could differ from contractual maturities because borrowershave the right to call or prepay certain obligations which may or may notinclude call or prepayment penalties.

 

Fair value of the fixedmaturity 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.

 

We review our investmentportfolio on at least a quarterly basis for possible impairment losses.

 

The following tablesummarizes the ratings distributions of the fixed maturity securities in ourinvestment portfolio and the investment portfolio of our consolidated VIEs asof September 30, 2007 and December 31, 2006: 

 
| ** **                            | ** ** | **Estimated Fair Value** | ** ** |
|---------------------------------------|------------|------------------------------------|------------|
| ** **                            | ** ** | **As of**                     | ** ** | **As of** | ** ** |
| **Rating(1)**                         | ** ** | **September 30, 2007**   | ** ** | **December 31, 2006** | ** ** |
| ** **                            | ** ** | **(in thousands)**            | ** ** |
| AAA or  equivalent                    |       | $                                  | 425,103    |   | $ | 346,352 |   |
| AA                                    |       | 95,168                             |       | 55,687 |   |
| A                                     |       | 46,810                             |       | 52,125 |   |
| BBB                                   |       | 22,740                             |       | 24,213 |   |
| Below investment  grade and non-rated |       | 10,811                             |       | 11,205 |   |
| Total non-VIE  securities             |       | 600,632                            |       | 489,582 |   |
| VIE securities                        |       | 2,772,596                          |       | 4,536,694 |   |
| Held for  trading- Credit Fund        |       | 125,176                            |       | 251,825 |   |
| Total                                 |       | $                                  | 3,498,404  |   | $ | 5,278,101 |   |

 

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(1) Ratings arerepresented by the lower of the S&P and Moody’s Investors Serviceclassifications.

 

The following tablesummarizes 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 September 30, 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                            |       | $                                      | 19,662     |                                 | $          | (164      | )          | $ | 1,871 |   | $ | (24 | ) | $ | 21,533 |   | $ | (188 | ) |
| Federal-agency  securities                           |       | 23,451                                 |       | (133                                 | )          | 20,624    |       | (69 | ) | 44,075 |   | (202 | ) |
| Obligations of  states and political subdivisions    |       | 23,738                                 |       | (157                                 | )          | 52,211    |       | (676 | ) | 75,949 |   | (833 | ) |
| Corporate  securities                                |       | 31,964                                 |       | (1,337                               | )          | 46,669    |       | (2,161 | ) | 78,633 |   | (3,498 | ) |
| Asset-backed  securities                             |       | 1,976                                  |       | (23                                  | )          | 4,743     |       | (111 | ) | 6,719 |   | (134 | ) |
| Mortgage-backed  securities                          |       | 42,098                                 |       | (594                                 | )          | 90,379    |       | (2,898 | ) | 132,477 |   | (3,492 | ) |
| Total non-VIE  securities                            |       | 142,889                                |       | (2,408                               | )          | 216,497   |       | (5,939 | ) | 359,386 |   | (8,347 | ) |
| Available for  sale-VIE—asset-backed securities |       | 2,137,534                              |       | (368,322                             | )          | 439,906   |       | (63,485 | ) | 2,577,440 |   | (431,807 | ) |
| Total                                                |       | $                                      | 2,280,423  |                                 | $          | (370,730  | )          | $ | 656,403 |   | $ | (69,424 | ) | $ | 2,936,826 |   | $ | (440,154 | ) |

 

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A substantial portion ofthe unrealized loss in CDO VIE asset-backed securities is related to RMBS,including both sub-prime and mid-prime quality mortgages.  Late 2006 into2007 saw significant disruption in the sub-prime and second lien mortgagemarkets, with some mortgage originators being purchased or exiting the business. This severe disruption continued into the third quarter of 2007 with othertypes of market participants (i.e., investment banks, hedge funds, insurancecompanies) announcing significant losses in connection with their sub-prime andsecond lien mortgage exposure.  This disruption further translated intodecreased liquidity and wider spreads across the market, decreasing the marketvalue of the portfolios.  An additional factor weighing on the marketvaluations for the Company’s positions is the limited liquidity associated withthe seasoned securities which have already received or are about to receive asignificant return of principal.  During the first nine months of 2007,the Company determined that certain of its holdings in RMBS, primarily in itsconsolidated CDOs, were other than temporarily impaired.  As a result,write-offs relating primarily to those securities, aggregating $118.5 millionwere recorded as a reduction of net income during this period, $39.6 million ofwhich were non-recourse to the Company and were recaptured in the third quarterof 2007 upon the deconsolidation of the related CDOs in the third quarter of2007. The amount of unrealized losses in excess of the Company’s equityinvestment recorded in other comprehensive income is $(220.5) million as ofSeptember 30, 2007.

 

Regarding the unimpairedsecurities carried at an unrealized loss position as of September 30, 2007, theCompany believed that it would be able to collect amounts due on these RMBSpositions and has the ability and intent to hold these investments until arecovery of fair value, which may be at their maturities.  The Company,therefore, did not consider these investments to be other-than-temporarilyimpaired at September 30, 2007.

 

The Company’s accumulatedother comprehensive loss of $(261.2) million at September 30, 2007, includes$(262.1) million related to unrealized losses on fixed maturity securitiesavailable for sale.

 

Included in the tableabove are 703 fixed maturity securities, 170 in the non-VIE portfolios, and 533in the VIE portfolios.  At September 30, 2007, there were 141 fixedmaturity securities, 140 of which are in the VIE portfolios, whose fair valuewas less than 80% of its amortized cost.  Over 97% of the securities inboth the non-VIE portfolio and the VIE portfolios are rated investmentgrade.  Management has assessed these and other factors and concluded thatthere were no other than temporarily impaired fixed maturity securitiesincluded in the above table as of September 30, 2007.

 

**Item 3. Quantitative and Qualitative Disclosures AboutMarket Risk**

 

**MarketRisk**

 

Market risk representsthe potential for losses that may result from changes in the value of afinancial 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 risksand the specific types of financial instruments which they impact are describedbelow.  Senior managers in our risk management department are responsiblefor monitoring risk limits and applying risk measurement methodologies. The estimation of potential losses arising from adverse changes in marketconditions is a key element in managing market risk.  We use varioussystems, models and stress test scenarios to monitor and manage marketrisk.  These models include estimates made by management that use currentand historic market information.  The valuation results from these modelscould differ materially from amounts that actually are realized in themarket.  See “—Critical Accounting Policies and Estimates—InvestmentPortfolio” and “—Critical Accounting Policies and Estimates—DerivativeContracts” in Part I, Item 2.

 

During the nine monthsended September 30, 2007, we have witnessed severe disruption in theresidential mortgage market, which in turn has caused disruption in the sectorof the fixed income securities market backed by residential mortgages, andderivatives thereon.  This disruption is caused by the stark increase inmortgage payment delinquencies and defaults particularly in connection withsub-prime and second lien mortgage exposure which has materially adverselyaffected the valuation of fixed income securities backed by such mortgages, andderivatives thereon.  Many securities are projected to suffer the loss ofprincipal or are being priced at very depressed levels, or both.  TheCompany is subject to added risk in this market through its CDO AssetManagement and Structured Credit lines of business.

 

*InterestRate Risk*

 

Interest rate risk is therisk that the fair value of our interest rate sensitive assets or liabilitieswill change with changes in market interest rates.  We own both fixed rateand floating rate bonds in our non-CDO corporate-wide investment portfolios andconsolidated CDO portfolios.  Also, our unconsolidated CDO equityinvestments have fair values that are sensitive to yield curve movements.

 

We use interest rate swapsand caps to hedge differences in the cash flow of assets and liabilities withinmany of our CDOs.  These hedges also act to reduce the net sensitivity tofair value changes.  We do not hedge the interest rate risk of our non-CDOcorporate-wide investment portfolios since we prefer the income from thisportfolio be predominantly fixed coupon.  As interest rates go up or down,the yield of that investment portfolio will be fairly stable, however, the fairvalue 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 securitiesare generally not sensitive 

 

53

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to interest rate movements, the associated yields are sensitive tochanges in interest rates.

 

The following table showsthe change in fair value for all business activities with significant interestrate risk.  We employ proprietary cash flow models to derive these values.

 
| **Business Activity**    |   | **Fair Value at  September 30, 2007** |    | **+100 bps  per annum  Shift** |   | **-100 bps  per annum  Shift** |   |
|-------------------------------|--------|-----------------------------------------------------------|---------|------------------------------------------|--------|------------------------------------------|--------|
|                          |   | **(in millions)**                                    |    |
|                          |   |                                                      |    |                                     |   |                                     |   |
| Non-CDO  investment portfolio |   | $                                                         | 600.6   |                                     | $      | (30.7                                    | )      | $ | 34.0 |   |
| CDOs                          |   | 2,772.6                                                   |    | (4.1                                     | )      | 5.4                                      |   |
| Interest rate  swaps          |   | (4.8                                                      | )       | 2.7                                      |   | (2.8                                     | )      |
|                          |   | $                                                         | 3,368.4 |                                     | $      | (32.1                                    | )      | $ | 36.6 |   |

 

*CreditSpread Risk*

 

Credit spread risk is therisk that the fair value of our credit sensitive assets or other risk exposurewill change with changes in the credit spreads of the referencedentities.  Generally speaking, the term “credit spread” refers to theadditional yield above the risk-free benchmark yield that a borrower must payto its lenders.  The credit spread increases as investor perception of therisk of default of the borrower increases.  Fluctuations of credit spreadsbehave like movements in the market yield curve (interest rate risk) for simplefixed-income investments and impact fixed- and floating-rate debt equally. Our credit swap exposure in our Structured Credit and CDO Asset Managementtransactions is generally more sensitive to movements in credit spreads than tomovements in interest rates since the mathematical models that determine fairvalue use changing spreads as a proxy for changing likelihood of default in thefuture.

 

We value our insuredcredit swap transactions either by obtaining market quotes from dealers orthrough the application of our valuation model.  During the quarter endedJune 30, 2007, we refined our valuation model to estimate fair value of ourinsured credit swap transactions.  The change was implemented to be moreconsistent with models that we understand other market participants utilize,including many of our insured credit swap counterparties.  The relativelyyoung market for credit swaps has continued to evolve over time and, whilethere is still substantial variance in valuation models among marketparticipants, the trend is toward increasing convergence in this area. Under ourrefined model, we fully use market spread data as a proxy for defaultprobabilities in the determination of fair value. We believe that our new modelwill inherently increase the volatility of these valuations, but provide abetter estimate of the cost or benefit of unwinding the related transaction.

 

The following table showsthe change in fair value for all business activities with significant creditspread risk.  We employ proprietary cash flow and stochastic defaultmodels to derive these values.

 
| **Business Activity**    | ** ** | **Fair Value at  September 30, 2007** | ** ** | **+25 bps  per annum  Credit Spread Shift** | ** ** | **-25 bps  per annum  Credit Spread Shift** | ** ** |
|-------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                    | ** ** | **(in millions)**                                    | ** ** |
| Non-CDO  investment portfolio |       | $                                                         | 600.6      |                                                            | $          | (8.9                                                            | )          | $ | 8.9 |   |
| CDOs                          |       | 2,772.6                                                   |       | (24.0                                                           | )          | 22.1                                                            |       |
| Structured  Credit            |       | (1,772.6                                                  | )          | (588.0                                                          | )          | 321.5                                                           |       |
|                          |       | $                                                         | 1,600.6    |                                                            | $          | (620.9                                                          | )          | $ | 352.5 |   |

 

*AssetCorrelation 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 riskexists primarily in our CDO Asset Management and Structured Credit businesses.The industry participants generally measure this correlation as “assetcorrelation”, which is defined as the correlation of the enterprise value ofone firm to another. We perform proprietary mathematical calculations andassign asset correlation values to all corporate, asset-backed,mortgage-backed, and municipal risk positions in order to generate fair valueand risk-related results.

 

The following table showsthe change in fair value for these two business activities with significantasset correlation risk.  We employ proprietary cash flow, assetcorrelation, and stochastic default models to derive these values.

 

54

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| **Business Activity** |   | **Fair Value at  September 30, 2007** |    | **+5% Shift in Asset  Correlation** |   | **-5% Shift in Asset  Correlation** |   |
|----------------------------|--------|-----------------------------------------------------------|---------|----------------------------------------------------|--------|----------------------------------------------------|--------|
|                       |   | **(in millions)**                                    |    |
| CDOs                       |   | $                                                         | 2,772.6 |                                               | $      | 0.5                                                |   | $ | (0.2 | ) |
| Structured  Credit         |   | (1,772.6                                                  | )       | (304.4                                             | )      | 245.6                                              |   |
|                       |   | $                                                         | 1,000.0 |                                               | $      | (303.9                                             | )      | $ | 245.4 |   |

 

*OtherMarket 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 areABS prepayment risk, reinvestment risk and commercial paper refunding risk. ABSCDO equity returns depend on the leverage of a transaction (total portfoliosize divided by the equity tranche size).  Early prepayments on the ABSunderlying the CDO would quickly de-lever the transaction and, thus, diminishthe returns to the equity holders.  Since the majority of the underlyingCDO ABS pay interest based on a floating rate, the fair value of these assetsare not overly sensitive to prepayments.  Our non-CDO corporate-wideinvestment portfolios could also be impacted by prepayments. We limit thisexposure by imposing limits on the amount of such securities held in theseportfolios.

 

Some of our CDOtransactions are currently in the “reinvestment period”.  This means thatas the asset-backed securities or the leveraged loans return principal to theCDO portfolios, we re-invest the principal proceeds rather than repay CDO debt.Since the CDO liability cost is established at inception (either as a fixedcoupon, or, more typically, as a fixed spread to LIBOR), we, as equity investorbear the risk that reinvestment spreads will decrease.  Conversely,increasing reinvestment spreads benefit our equity investment.

 

In two of ourconsolidated CDO transactions, the senior liability (of approximately $1.3billion in each as at September 30, 2007) is comprised of commercial paper (“CP”). Hence, our balance sheet carries approximately $2.7 billion of short-term debtor commercial paper as at September 30, 2007 that we refund, on average,monthly.  The typical yield cost of this CP (including dealer cost) isLIBOR-flat.  More recently the CP yield has exceeded LIBOR.  Wemanage this refunding risk by negotiating into the CDO transaction, caps on thespread to LIBOR. As a result, the CP yield cannot exceed LIBOR +40 basis pointsper annum due to the presence of put option contracts.  An increase in thespread above LIBOR negatively impacts our equity investment. When the CP spreadwidens, we receive less cash distributions.

 

*CreditFund*

 

While the Credit Fund isconsolidated for financial reporting purposes, our net investment in the fundat September 30, 2007 is $26.4 million.  Total invested assets of the fundwere approximately $136.2 million at September 30, 2007.  The fund hedgesinterest rate risk on its fixed rate assets to remain close to market neutralwith respect to interest rate risk.  At September 30, 2007, theweighted average effective duration of the portfolio was less than oneyear. Additionally, at September 30, 2007, the vast majority of the bondsheld in the fund were floating interest rate payers which have minimal interestrate risk.  Regarding credit spread risk, the Fund’s assets are mostlycomprised of “AAA” rated assets, but include a material amount of assets withlower investment grade and non-investment grade ratings.  All of the Fund’sassets have experienced negative price changes given the recent re-pricingof mortgage and other credit-sensitive assets, and the non-”AAA” rated assetshave experienced very significant negative price changes.  In thecurrent market environment, we view the Fund as having a material amountof credit spread risk.

 

**Item 4.Controls and Procedures**

 

Asof the end of the period covered by this report, an evaluation was carried outby our management, with the participation of the Chief Executive Officer andChief Financial Officer, of the effectiveness of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934, as amended). Our Chief Executive Officer and Chief FinancialOfficer concluded that these disclosure controls and procedures were effectiveas of the end of the period covered by this report, except as described below.

 

Inpreparation for the Company’s first management report on internal control overfinancial reporting, the Company continues to make periodic improvements tointernal controls. An error was identified and corrected in the Company’sinterim financial statements, and the related earnings release, as of and forthe three and nine months ended September 30, 2007. The Company determined thata control related to the validation of certain inputs to the valuation modelfor its insured credit swaps did not operate effectively as of September 30,2007. The Company took immediate action and believes it has remedied thisdeficiency prior to the filing of its interim financial statements.Specifically, additional control activities are now in place to assist in thereview process of the quarterly valuation. This deficiency has been classifiedas a material weakness in internal controls. Management believes that thematerial weakness has been remedied.

 

Nochange in our internal control over financial reporting (as defined in Rules13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended)occurred during the period covered by this report that has materially affected,or its reasonably likely to materially affect, our internal control overfinancial reporting other than that described above.

* *

**PART II- OTHER INFORMATION**

 

**Item 1.Legal Proceedings**

 

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

 

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**Item 1A.Risk Factors**

 

In addition to the otherinformation in this report, the following factors and those discussed in “RiskFactors” in our Form 10-K, should be carefully considered in evaluating theCompany and its businesses.  These risks and uncertainties are not theonly ones facing the Company and its subsidiaries.  Additional risks anduncertainties, not presently known to us or otherwise, may also impair ourbusiness operations. If any of the risks described below and in our Form 10-Kor such other risks actually occur, our business, financial condition orresults of operations could be materially and adversely affected.

 

**We face risks associated with the recent ratingaction of S&P placing our insurance subsidiary, ACA Financial Guaranty’s,financial strength rating on CreditWatch with negative implications.**

 

On November 9, 2007, S&P placed ACA FinancialGuaranty’s financial strength rating on CreditWatch with negative implications.S&P based its rating action on its opinion that the substantial unrealizedmark to market loss recorded by the Company for the three months ended September30, 2007 may impair ACA Financial Guaranty’s ability to generate a satisfactorylevel of new business. Amongst other things, S&P also cited the Company’sinability to access its liquidity facility under its recently revised terms asa relevant factor in its rating action. The placement of ACA Financial Guaranty’srating on CreditWatch with negative implications could materially and adverselyimpact our reputation with the purchasers of our insured bonds and insuredcredit swap counterparties and therefore increase the uncertainty about ACAFinancial Guaranty’s ability to write new business in its Public Finance andStructured Credit lines of business, and as such could have a materiallyadverse impact our financial prospects even if such negative rating watch islifted.

 

CreditWatch highlights the potential direction of arating, focusing on identifiable events and short-term trends that cause arating to be placed under special surveillance by S&P. Ratings appear onCredit Watch negative when such an event or a deviation from an expected trendoccurs and S&P needs additional information to evaluate the rating. ShouldS&P ultimately elect to downgrade ACA Financial Guaranty’s financialstrength rating to below A- , under the existing terms of our insured creditswaps, we would be required to post collateral based on the fair value of theinsured credit swaps as of the date of posting. The failure to post collateralwould constitute an event of default under the swaps resulting in a claim onACA Financial Guaranty for a termination payment in an amount approximatelyequal to the collateral call. Based on current fair values of our insuredcredit swaps we would not have sufficient resources to post such collateral norwould ACA Financial Guaranty, in particular, have sufficient resources to makesuch termination payments. In view of the size of this obligation and thecurrent market conditions, the Company does not believe, should the need occur,that it would be able raise sufficient capital to address this deficiency inits resources.

 

Additionally, upon termination of our insured creditswap transactions, installment premiums payable to ACA Financial Guaranty, withan estimated aggregate present value of $468.8 million for all futureinstallments, would cease. The loss of this revenue would have an addedmaterial and adverse impact on the claims-paying resources of ACA FinancialGuaranty.

 

**We face risks from concentration tosub-prime and second lien mortgage-backed RMBS in our CDO Asset Management andStructured Credit lines of business.**

 

In our Structured Creditline of business, as of September 30, 2007, we had written $25.7 billion ofnotional insured credit swaps providing credit protection on tranches ofABS/MBS portfolios, materially comprised of late 2005 and 2006 vintagesub-prime RMBS.  Virtually all of these transactions have subordinationavailable to us at levels in excess of the AAA rated category, which must beused to absorb losses prior to any payment being made by us.  Publishedcommentary from research analysts and rating agencies on the likely levels ofcumulative default rates varies significantly. If default and delinquency ratesin the mortgages underlying these RMBS continue to increase to the more severescenarios, which assume historically unprecedented losses, we could be requiredto pay material claims on one or more transactions.  Payment of suchclaims could materially and adversely impact our financial condition andcapital adequacy and that of our insurance subsidiary.

 

A large portion of thefinancial assets included in our ABS CDOs is RMBS.  As of September 30,2007, we had RMBS assets under management of $14.7 billion in our CDOs, withremaining related equity exposure of $42.2 million.  Current market trendsindicate continued higher delinquency and foreclosure rates in the late 2005and 2006 vintage of sub-prime and second lien mortgages.  As a result, asof September 30, 2007, we impaired a portion of the underlying assets on ourfinancial statements in several of the CDOs which we assumed exposure to RMBSbelow the A-/A3 level reducing our aggregate equity exposure in our mezzanineABS transactions to approximately $18.0 million.  Additionally, weimpaired a portion of the underlying assets on our financial statements on oneof our four high-grade ABS CDOs that are backed by RMBS rated higher thanA-/A3, and currently have an aggregate of approximately $24.2 million of equityexposure remaining in these transactions.  If the current market trendcontinues, each of these transactions may experience reduced returns oradditional impairments of the underlying assets and corresponding write downsof our equity positions in the future.  Reduced returns and/or additionalimpairments in future may materially and adversely impact our financialcondition or results of operations.  See “Management’s Discussion andAnalysis of Financial Condition and Results of Operations — Results ofOperations – CDO Asset Management.”

 

**We have experienced and may continue to experiencea decline in our CDO asset management fees (“Fees”) paid to ACA Management dueto worsening performance, downgrades and defaults in the assets underlying ourABS CDOs and in some cases due to the occurrence of events of default or therelated triggering of the senior overcollaterization tests.**

 

In our CDO AssetManagement business, we are paid a senior management fee and a subordinatedmanagement fee on a quarterly basis for managing the selection, acquisition anddisposition of the underlying assets and for monitoring the underlying assets.The senior fee is payable after certain expenses of the CDO but prior topayment on the CDO liabilities, whereas the subordinated fee is payable afterpayment of debt service on the CDO liabilities. The calculation of such Fees isbased on the par value of the underlying assets, but generally excludes anydefaulted securities. Defaulted securities may, in some ABS CDOs, includeassets downgraded to “CCC” or below. Due to the continued severe levels ofdefaults and delinquencies on the assets underlying our ABS CDOs specificallyon the RMBS assets, we have experienced a decline in our Fees. If such defaultsand delinquencies on such assets continue to increase to more severe levels, wewill experience a continued decline in our ongoing Fees.

 

Additionally, such worsenperformance has in some cases, and will likely in other cases, createilliquidity with respect to downgraded and defaulted assets negativelyimpacting the aggregate value of the assets underlying our ABS CDOs and leadingto the failure to meet the senior overcollateralization tests (which is theexcess of the total current value assets over total value of currentliabilities). In such event, cash flows in these ABS CDOs will be diverted topay securities holders prior to any subordinated fee payment to us. Therefore,we are likely to experience a temporary or permanent loss of our subordinatedfees in such ABS CDOs.

 

Furthermore, in some ofour ABS CDOs, the failure to meet the senior overcollateralization test alsoconstitutes an event permitting the removal of ACA Management as collateral

 

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manager “for cause” generally by an affirmative vote of a majority ofthe holders of the senior CDO liabilities or a majority vote of the holders ofthe equity. If ACA Management is so removed as collateral manager, we willexperience a termination of our Fees on the day of removal as well aspotentially hurt our reputation as an asset manager.

 

**Continued severe levels of defaultsand delinquencies on mortgages underlying RMBS assets referenced by our insuredcredit  swaps in our Structured Creditline of business could result in downgrades of our insured tranches, resultingin increases in the related S&P capital charges and a need for additionalcapital in our insurance subsidiary.  This could have a material and**

 

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**adverse impact on our liquidityresources.**

 

In our Structured Creditline of business, we wrote $25.7 billion of notional insured credit swapsproviding credit protection on tranches of ABS/MBS portfolios at greater thanAAA rated levels of attachment.  Based on current ratings action taken todate by S&P with respect to the RMBS referenced in our ABS portfolios, webelieve that all but approximately $33 million of our aggregate exposure acrossall of these transactions remains AAA. We believe the $33 million of exposurewould carry a current rating of AA. Continued delinquencies and defaults on theRMBS underlying these portfolios could result in downgrades on the tranchesthat we insure, resulting in significantly increased capital charges whichcould materially and adversely impact the capital adequacy of our insurancesubsidiary and require additional contributions of capital from us.  Theneed to use our current liquid resources to add to the capital of our insurancecompany could have a material negative impact on our liquidity position as awhole.  Further, should our current liquid resources prove insufficient,we could be required to raise additional capital in order to meet the capitalrequirements of our insurance subsidiary and our ability to do this underprevailing market conditions may be possible.

 

**We face risks associated with thepotential negative perception by investors, insured bondholders andcounterparties of our financial condition based on our FAS 133/149 mark tomarket unrealized valuations on our Structured Credit transactions.**

 

In accordance with GAAPaccounting, we are required to mark to market its insured credit swaps. While we expect periodic volatility on our financial statements in connectionwith these unrealized valuations, because we intend to hold the insured creditswaps to maturity when, absent credit losses, the mark to market will revert tozero, our strategy is to continue to grow our Structured Credit businesswithout consideration of the related valuations.  Currently, creditspreads in the ABS market, in particular, have widened and, as of September 30,2007, we posted an aggregate net negative mark to market unrealized loss of$(1.1) billion, after tax.  Continued large negative marks have and couldcontinue to negatively impact the perception of our financial condition by theequity market, our insured bondholders and counterparties and affect theirwillingness to purchase our insured bonds or continue to enter intotransactions with us.  The failure of bondholders to continue to purchaseour insured bonds or our counterparties to purchase credit protection in theform of insured credit swaps could materially and adversely impact the rate ofgrowth of our Public Finance and Structured Credit lines of business, whichcould, in turn, materially and adversely impact our financial results.

 

**We face risks from prolongeddislocations in the markets in which we participate.**

 

Recently, the creditmarkets have generally experienced a significant correction associated with thesub-prime and second lien mortgage issues which has stalled ABS CDOorigination.  We expect that this disruption will continue through theforeseeable future.  This dislocation in the credit markets, in additionto impacting our CDO Asset Management business, has and may continue tonegatively impact the demand for the credit protection that we havehistorically provided through insured credit swaps in our Structured Creditline of business on “super AAA” tranches of fully distributed ABS CDOs,commonly referred to as negative basis trades.  Additionally, the CLOmarket has also experienced a slow down that could continue to materially andadversely impact the rate at which we are able to add assets under managementin this sector.  Prolonged dislocation of these markets could materiallyand adversely impact our results of operations or financial condition.

 

**We face risks associated with apotential negative perception by investors and counterparties of our financialcondition based on our stock price.**

 

The price of our commonstock has fluctuated widely since our initial public offering and currently, inthe face of the disruption in the credit markets and the recent placement ofACA Financial Guaranty’s financial strength rating on CreditWatch with negativeimplications, experienced a significant decline.  These fluctuations andthe recent decline has and will likely continue to  impact the perception of our financialcondition by our insured bond holders and counterparties and affect theirwillingness to purchase our insured bonds or continue to enter intotransactions with us.  The failure of bond holders to continue to purchaseour insured bonds or our counterparties to purchase credit protection in theform of insured credit swaps could materially and adversely impact the rate ofgrowth of our Public Finance and Structured Credit lines of business, whichcould, in turn, materially and adversely impact our financial results.

 

Additionally, over thepast few months credit spreads on our insured bonds have widened, which limitsour ability to obtain sufficient pricing for assumed risk in our Public Financeline of business.  Should our insured bonds continue to trade at thesewidened spreads the rate of growth of our Public Finance line of business couldbe materially and adversely impacted which could, in turn, also materially andadversely impact our financial results.

 

**We face risks associated with thepotential negative perception by investors, insured bondholders andcounterparties of our financial condition based on consolidation accounting forcertain of our CDOs.**

 

In accordance with GAAPaccounting, we are required to consolidate CDO transactions in which we weredetermined to be the primary beneficiary.  For certain of our consolidatedCDOs, realized and unrealized losses could exceed the amount of our trueeconomic exposure or equity investment in the CDO.  Under current rules governingconsolidation accounting, our consolidated income statement would reflect allof the CDOs realized losses and its balance sheet would reflect all of the CDOsunrealized losses despite the fact that our economic loss exposure is limitedto our equity investment in the CDOs.  Upon maturity, or the occurrence ofa deconsolidation event, we recognize a gain equal to all previous lossesrecognized in excess of our equity positions. Continued 

 

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adverse trends in delinquency and foreclosure rates for 2005 and 2006vintage RMBS could mean that we continue to reflect significant realized andunrealized losses on our income statement and balance sheet in excess of oureconomic exposure.  Though these additional losses are not economic lossesto us, as a result of consolidation, the recorded losses could materially andadversely impact the perception of our financial condition by the equitymarket, our insured bondholders and counterparties.  This could negativelyimpact the value of our stock and could affect bondholders and counterpartieswillingness to purchase our insured bonds or continue to enter intotransactions with us.  The failure of bondholders to continue to purchaseour insured bonds or our counterparties to purchase credit protection in theform of insured credit swaps could materially and adversely impact the rate ofgrowth of our Public Finance and Structured Credit lines of business, whichcould, in turn, materially and adversely impact our financial results.

 

**We have risks associated withaccelerated prepayment speeds on the mortgages underlying the RMBS in our ABSCDOs.**

 

Certain of our RMBSbacked ABS CDOs have experienced greater than expected prepayment speeds on theunderlying mortgages which caused us to impair a portion of these RMBS and totake associated equity write-downs in the second quarter of 2007.  Shouldprepayment speeds in these ABS CDO transactions continue at the current levelor increase, additional equity write-downs may occur in the future, which couldmaterially adversely impact our results of operations.  See “Management’sDiscussion and Analysis of Financial Condition and Results of Operations -Results of Operations - CDO Asset Management”.

 

**The stock repurchase program commencedby us on August 1, 2007 will decrease liquidity in our shares of common stockwhich could negatively impact the price of our common stock.**

 

Our Board of Directorsrecently approved a stock repurchase program of our outstanding common stock inan amount of up to $20 million and we commenced buying shares as a part of thisprogram on August 1, 2007.  As of November 9, 2007, we had repurchased2,087,900 shares of common stock at a cost of $14.9 million in the aggregate. Ifwe repurchase a substantial portion of our common stock under this program, theliquidity of the remaining outstanding shares of our common stock may besubstantially decreased which could materially and adversely impact the stockprice of those shares.

 

**If we fail to continue to meet allapplicable New York Stock Exchange (“NYSE”) continued listing standards, ourstock could be delisted by the NYSE. If delisting occurs, it would materiallyadversely affect the market liquidity of our common stock and harm ourbusiness.**

 

Inorder to maintain the listing of our common stock on the NYSE, we must satisfycertain continued listing standards. The quantitative continued listingstandards applicable to us include:

 
| • |   | Average market  capitalization of not less than $75 million over a 30-trading-day period and  stockholders’ equity of not less than $75 million, |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                  |
| • |   | Average market  capitalization of not less than $25 million over a 30-trading-day period, or                                                          |
|   |   |                                                                                                                                                  |
| • |   | Average closing share  price of $1.00 over a 30-trading-day period.                                                                                   |

 

If weare unable to meet these or any of the other NYSE continued listing standardsin the future, the NYSE staff could determine to delist our common stock, whichcould materially adversely affect the market liquidity of our common stock andthe market price of our common stock could decrease. Such delisting could alsomaterially adversely affect our ability to obtain financing for thecontinuation of our operations and could result in the loss of confidence byour investors, our insured bondholders and counterparties and our employees.

 

**Item 2.Unregistered Sales of Equity Securities and Use of Proceeds**

 

On November 9, 2006,the SEC declared effective our Registration Statement in connection with ourIPO. The underwriters were Credit Suisse Securities (USA) LLC, J.P. MorganSecurities Inc., Bear Stearns & Co. Inc., Stephens Inc. and Keefe,Bruyette & Woods, Inc. Our offering did not terminate before anysecurities were sold, but as of the date of the filing of this report, ouroffering had terminated and 6,875,000 shares of our common stock were sold byus.

 

All 6,875,000 shares ofour common stock registered in our offering were sold by us at a price pershare of $13.00. The aggregate purchase price of the offering was $89.4 millionand we incurred total estimated expenses, including the underwriters’ discountand commissions and transaction expenses paid to unaffiliated third parties inconnection with the offering, of approximately $10.2 million. The net offeringproceeds to us after deducting these expenses was approximately $79.2 million.

 

Of the $79.2 millionraised for the account of the Company, as of December 31, 2006, $10.0million and approximately $4.9 million were contributed to ACA FinancialGuaranty and ACA Capital Management (U.K.), respectively, to support thecontinuing growth of ACA Financial Guaranty and the start-up costs of ACACapital Management (U.K.), an additional $21.8 million was invested in certainCompany-managed investment vehicles, including the Credit Fund andapproximately $5.7 million was used to purchase equity in certain of theCompany’s recent CDOs. In the nine months ended September 30, 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, refinanced an intercompany note in the amount of $4.3 million andpurchased $14.9 million worth of our common stock as part of our stockrepurchase program. The balance of approximately $5.2 million has been retainedat the holding company. We continue to expect that the remainder of theproceeds from the IPO will be used for investments, as working capital and forgeneral corporate 

 

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purposes.  Pending such uses, the balance of the approximately $5.2million is currently invested by us in short-term investments.

 

**Item 3.Defaults Upon Senior Securities**

 

None.

 

**Item 4.Submission of Matters to a Vote of Security Holders**

 

None.

 

**Item 5.Other Information**

 

None.

 

**Item 6.Exhibits**

** **
| 31.1   |   | Chief Executive Officer  — Certification 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**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                    | ** ** | **ACA CAPITAL HOLDINGS, INC.**                  |
|-------------------------|------------|-------------------------------------------------|
|                    |       | (Registrant)                                    |
|                    |       |                                            |
|                    |       |                                            |
| Date: November 19, 2007 |       | /s/ Alan S. Roseman                             |
|                    |       | Alan S. Roseman                                 |
|                    |       | President and Chief Executive Officer |
|                    |       | (Principal Executive Officer)                   |
|                    |       |                                            |
|                    |       |                                            |
| Date: November 19, 2007 |       | /s/ Edward U. Gilpin                            |
|                    |       | Edward U. Gilpin                                |
|                    |       | Executive Vice President and Chief Financial    |
|                    |       | Officer                                         |
|                    |       | (Principal Financial Officer)                   |

 

 

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