**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 June 30, 2007**                                                      |
| ** ** | ** ** | ** **                                                                                    |
| ** ** | ** ** | **or**                                                                                        |
| ** ** | ** ** | ** **                                                                                    |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**Forthe transition period from                to         **

**Commissionfile number 1-33111**

**ACACapital Holdings, Inc.**

 (Exact name of registrant as specified in itscharter)
| **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, ofregistrant’s principal executive offices)

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.    Yes  x    No  o

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

| Large accelerated  filer  o | Accelerated  filer  o | Non-accelerated  filer  x |
|---------------------------------------|---------------------------------|-------------------------------------|

 

Indicate by check markwhether the Registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).    Yes  o     No  x

As of August 10, 2007, 35,749,818shares of Common Stock, par value $0.10 per share, were outstanding.

 

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**INDEX**
|                                     | ** ** | ** **                                                                                                                  | ** ** | **PAGE** |
|-------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------|------------|----------|
| **PART  I - FINANCIAL INFORMATION** |       |                                                                                                                        |
|                                |       |                                                                                                                        |
| Item 1.                             |       | Financial Statements  of ACA Capital Holdings, Inc. and Subsidiaries (Unaudited)                                            |       |     |
|                                |       |                                                                                                                        |       |     |
|                                |       | Condensed Consolidated  Balance Sheets (Unaudited) — June 30, 2007 and December 31, 2006                               |       | 3        |
|                                |       |                                                                                                                        |       |     |
|                                |       | Condensed Consolidated  Statements of Operations (Unaudited) — Three and six months ended June 30,  2007 and 2006      |       | 4        |
|                                |       |                                                                                                                        |       |     |
|                                |       | Condensed Consolidated  Statements of Stockholders’ Equity (Unaudited) — Six months ended June 30,  2007 and 2006 |       | 5        |
|                                |       |                                                                                                                        |       |     |
|                                |       | Condensed  Consolidated Statements of Cash Flows (Unaudited) — Six months ended June 30,  2007 and 2006                |       | 6        |
|                                |       |                                                                                                                        |       |     |
|                                |       | Notes to  Unaudited Condensed Consolidated Financial Statements                                                             |       | 7-18     |
|                                |       |                                                                                                                        |       |     |
| Item 2.                             |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                 |       | 19-48    |
|                                |       |                                                                                                                        |       |     |
| Item 3.                             |       | Quantitative  and Qualitative Disclosures About Market Risk                                                                 |       | 48-50    |
|                                |       |                                                                                                                        |       |     |
| Item 4.                             |       | Controls and  Procedures                                                                                                    |       | 50       |
|                                |       |                                                                                                                        |       |     |
| **PART  II - OTHER INFORMATION**    |       |                                                                                                                        |
|                                |       |                                                                                                                        |       |     |
| Item 1.                             |       | Legal Proceedings                                                                                                           |       | 51       |
|                                |       |                                                                                                                        |       |     |
| Item 1A.                       |       | Risk  Factors                                                                                                               |       | 51-53    |
|                                |       |                                                                                                                        |       |     |
| Item 2.                             |       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                |       | 53       |
|                                |       |                                                                                                                        |       |     |
| Item 3.                             |       | Defaults Upon  Senior Securities                                                                                            |       | 53       |
|                                |       |                                                                                                                        |       |     |
| Item 4.                             |       | Submission of  Matters to a Vote of Security Holders                                                                        |       | 53       |
|                                |       |                                                                                                                        |       |     |
| Item 5.                             |       | Other Information                                                                                                           |       | 53       |
|                                |       |                                                                                                                        |       |     |
| Item  6.                            |       | Exhibits                                                                                                                    |       | 53       |
|                                |       |                                                                                                                        |       |     |
| **SIGNATURES**                      |       | 54                                                                                                                          |

 

2

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**PARTI — FINANCIAL INFORMATION**

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

**ACACAPITAL HOLDINGS, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)**

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

**(Dollarsin thousands)**
| ** **                                                                                                                                                                                                                | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                | ** ** | **2007**          | ** ** | **2006**              | ** ** |
| **ASSETS**                                                                                                                                                                                                                | ** ** | ** **        | ** ** | ** **            | ** ** |
| Investments:                                                                                                                                                                                                              |       |              |       |                  |       |
| Fixed-maturity  securities available for sale at fair value, amortized cost of $4,843,922 and  $5,043,239, respectively                                                                                                   |       | $                 | 4,636,105  |                  | $          | 5,026,276 |   |
| Fixed-maturity  securities trading at fair value, amortized cost of $408,627 and $251,884,  respectively                                                                                                                  |       | 406,432           |       | 251,825               |       |
| Securities  purchased under agreements to resell                                                                                                                                                                          |       | 3,408             |       | 10,248                |       |
| Guaranteed  investment contract                                                                                                                                                                                           |       | 119,340           |       | 119,340               |       |
| Total  investments                                                                                                                                                                                                        |       | 5,165,285         |       | 5,407,689             |       |
| Cash:                                                                                                                                                                                                                     |       |              |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                                |       | 328,824           |       | 379,905               |       |
| Restricted cash                                                                                                                                                                                                           |       | 46,155            |       | 67,061                |       |
| Total cash                                                                                                                                                                                                                |       | 374,979           |       | 446,966               |       |
| Accrued investment  income                                                                                                                                                                                                |       | 22,439            |       | 21,222                |       |
| Derivative assets                                                                                                                                                                                                         |       | 232,267           |       | 19,730                |       |
| Deferred policy  acquisition costs, net                                                                                                                                                                                   |       | 48,498            |       | 48,810                |       |
| Deferred debt issuance  costs, net                                                                                                                                                                                        |       | 30,776            |       | 34,104                |       |
| Receivable for  securities sold                                                                                                                                                                                           |       | 8,145             |       | 824                   |       |
| Prepaid reinsurance  premiums                                                                                                                                                                                             |       | 494               |       | 528                   |       |
| Deferred income taxes                                                                                                                                                                                                     |       | 126,363           |       | —                |       |
| Other assets                                                                                                                                                                                                              |       | 82,996            |       | 58,321                |       |
| **Total  assets**                                                                                                                                                                                                         |       | $                 | 6,092,242  |                  | $          | 6,038,194 |   |
|                                                                                                                                                                                                                      |       |              |       |                  |       |
| **LIABILITIES, MINORITY INTEREST  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                         | ** ** | ** **        | ** ** | ** **            | ** ** |
| LIABILITIES                                                                                                                                                                                                               |       |              |       |                  |       |
| Unearned premiums                                                                                                                                                                                                         |       | $                 | 195,667    |                  | $          | 189,537 |   |
| Reserve for losses and  loss adjustment expenses                                                                                                                                                                          |       | 45,923            |       | 42,113                |       |
| Short-term debt                                                                                                                                                                                                           |       | 2,779,513         |       | 2,677,828             |       |
| Long-term debt                                                                                                                                                                                                            |       | 1,836,461         |       | 2,125,914             |       |
| Related party debt                                                                                                                                                                                                        |       | 100,000           |       | 100,000               |       |
| Securities sold under  agreements to repurchase                                                                                                                                                                           |       | 372,936           |       | 232,227               |       |
| Derivative liabilities                                                                                                                                                                                                    |       | 311,061           |       | 33,874                |       |
| Accrued interest  payable                                                                                                                                                                                                 |       | 15,797            |       | 17,900                |       |
| Accrued expenses and  other liabilities                                                                                                                                                                                   |       | 76,058            |       | 61,855                |       |
| Payable for securities  purchased                                                                                                                                                                                         |       | 2,110             |       | 9,628                 |       |
| Current income tax  payable                                                                                                                                                                                               |       | 15,765            |       | 7,056                 |       |
| Deferred income taxes                                                                                                                                                                                                     |       | —            |       | 258                   |       |
| Total  liabilities                                                                                                                                                                                                        |       | 5,751,291         |       | 5,498,190             |       |
| MINORITY INTEREST                                                                                                                                                                                                         |       | 14,645            |       | 30,190                |       |
|                                                                                                                                                                                                                      |       |              |       |                  |       |
| COMMITMENTS AND CONTINGENCIES                                                                                                                                                                                             |       |              |       |                  |       |
|                                                                                                                                                                                                                      |       |              |       |                  |       |
| STOCKHOLDERS’ EQUITY                                                                                                                                                                                                 |       |              |       |                  |       |
| Common stock of  100,000,000 shares authorized at June 30, 2007 and December 31, 2006;  37,444,873 and 37,375,123 shares issued and outstanding at June 30, 2007 and  December 31, 2006, respectively; par value of $0.10 |       | 3,744             |       | 3,737                 |       |
| Gross paid-in and  contributed capital                                                                                                                                                                                    |       | 441,545           |       | 438,935               |       |
| Treasury stock at cost  — 851,847 shares at June 30, 2007 and December 31, 2006                                                                                                                                      |       | (12,088           | )          | (12,088               | )          |
| Notes receivable from  stockholders                                                                                                                                                                                       |       | (3,121            | )          | (3,121                | )          |
| Deferred compensation                                                                                                                                                                                                     |       | (290              | )          | (870                  | )          |
| Accumulated other  comprehensive loss — net of deferred income tax of $(57,420) and $(1,760) at  June 30, 2007 and December 31, 2006, respectively                                                                   |       | (106,594          | )          | (3,308                | )          |
| Retained earnings                                                                                                                                                                                                         |       | 3,110             |       | 86,529                |       |
| Total  stockholders’ equity                                                                                                                                                                                          |       | 326,306           |       | 509,814               |       |
| **Total liabilities, minority  interest and stockholders’ equity**                                                                                                                                                   |       | $                 | 6,092,242  |                  | $          | 6,038,194 |   |

 

See notes tounaudited condensed consolidated financial statements.

3

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**ACACAPITAL HOLDINGS, INC. AND SUBSIDIARIES**

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

**FOR THETHREE AND SIX MONTHS ENDED JUNE 30, 2007 AND 2006**

**(Dollarsand shares in thousands, except per share amounts)**
| ** **                                                   | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                   | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                   | ** ** | **2007**                         | ** ** | **2006**                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| REVENUES:                                                    |       |                             |       |                           |       |   |   |   |   |
| Gross premiums written                                       |       | $                                | 15,478     |                           | $          | 15,727 |   | $ | 20,519 |   | $ | 20,515 |   |
| Less premiums ceded                                          |       | (630                             | )          | (61                            | )          | (761 | ) | (186 | ) |
| Net premiums written                                         |       | 14,848                           |       | 15,666                         |       | 19,758 |   | 20,329 |   |
| Increase in unearned premium reserve - net                   |       | (6,403                           | )          | (7,191                         | )          | (6,164 | ) | (6,972 | ) |
| Premiums earned                                              |       | 8,445                            |       | 8,475                          |       | 13,594 |   | 13,357 |   |
| Net insured credit swap revenue                              |       | (44,183                          | )          | 7,931                          |       | (40,484 | ) | 22,111 |   |
| Net investment income                                        |       | 90,627                           |       | 82,452                         |       | 180,547 |   | 160,164 |   |
| Net realized and unrealized losses on investments            |       | (110,142                         | )          | (1,256                         | )          | (113,850 | ) | (3,223 | ) |
| Net realized and unrealized gains on derivative  instruments |       | 3,256                            |       | 2,497                          |       | 5,336 |   | 6,139 |   |
| Other net credit swap revenue                                |       | 3,851                            |       | 2,631                          |       | 16,157 |   | 5,544 |   |
| Fee income                                                   |       | 7,596                            |       | 6,955                          |       | 13,928 |   | 11,073 |   |
| Other income                                                 |       | 299                              |       | 53                             |       | 355 |   | 104 |   |
| Total revenues                                               |       | (40,251                          | )          | 109,738                        |       | 75,583 |   | 215,269 |   |
|                                                         |       |                             |       |                           |       |   |   |   |   |
| EXPENSES:                                                    |       |                             |       |                           |       |   |   |   |   |
| Loss and loss adjustment expenses                            |       | 1,859                            |       | 1,661                          |       | 3,232 |   | 3,682 |   |
| Policy acquisition costs                                     |       | 3,042                            |       | 2,768                          |       | 4,519 |   | 4,160 |   |
| Other operating expenses                                     |       | 15,564                           |       | 12,681                         |       | 31,717 |   | 23,294 |   |
| Interest expense                                             |       | 76,337                           |       | 70,964                         |       | 152,745 |   | 137,383 |   |
| Depreciation and amortization                                |       | 2,278                            |       | 2,225                          |       | 4,537 |   | 4,717 |   |
| Total expenses                                               |       | 99,080                           |       | 90,299                         |       | 196,750 |   | 173,236 |   |
| Income of minority interest                                  |       | (1,265                           | )          | (1,074                         | )          | (2,144 | ) | (2,229 | ) |
| Income (loss) before income taxes                            |       | (140,596                         | )          | 18,365                         |       | (123,311 | ) | 39,804 |   |
| Provision for income tax expense (benefit)                   |       | (47,260                          | )          | 6,323                          |       | (41,392 | ) | 13,615 |   |
| Net income (loss)                                            |       | $                                | (93,336    | )                              | $          | 12,042 |   | $ | (81,919 | ) | $ | 26,189 |   |
| ** **                                                   | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Share and Per Share Data**                                 | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Earnings (loss) per share                                    |       |                             |       |                           |       |   |   |   |   |
| Basic                                                        |       | $                                | (2.55      | )                              | $          | 0.53 |   | $ | (2.24 | ) | $ | 1.15 |   |
| Diluted                                                      |       | $                                | (2.55      | )                              | $          | 0.40 |   | $ | (2.24 | ) | $ | 0.87 |   |
|                                                         |       |                             |       |                           |       |   |   |   |   |
| Weighted average shares outstanding                          |       |                             |       |                           |       |   |   |   |   |
| Basic                                                        |       | 36,577                           |       | 22,858                         |       | 36,558 |   | 22,830 |   |
| Diluted                                                      |       | 36,577                           |       | 30,085                         |       | 36,558 |   | 29,846 |   |

 

See notes tounaudited condensed consolidated financial statements.

4

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**ACACAPITAL HOLDINGS, INC. AND SUBSIDIARIES**

** CONDENSED CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY (UNAUDITED)**

** FOR THE SIX MONTHS ENDED JUNE 30, 2007AND 2006**

** (Dollars in thousands, except for shareamounts)**
| ** **                                                                                    | ** ** | ** **               | ** ** | ** **            | ** ** | ** **                | ** ** | ** **      | ** ** | **Gross**      | ** ** | ** ** | ** ** | **Notes**        | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** **             | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|---------------------------|------------|-----------------|------------|----------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                    | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Paid in and** | ** ** | ** **      | ** ** | **Receivable** | ** ** | ** ** | ** ** | **Other**        | ** ** | ** **        | ** ** | **Total**              | ** ** |
| ** **                                                                                    | ** ** | ** **               | ** ** | ** **            | ** ** | **Par**                   | ** ** | **Contributed** | ** ** | **Treasury**   | ** ** | **from**   | ** ** | **Deferred**     | ** ** | **Comprehensive** | ** ** | **Retained**           | ** ** | **Stockholders’** | ** ** |
| ** **                                                                                    | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**                | ** ** | **Value**       | ** ** | **Capital**    | ** ** | **Stock**  | ** ** | **Stockholders** | ** ** | **Compensation**  | ** ** | **Income (Loss)** | ** ** | **Earnings**           | ** ** | **Equity** | ** ** |
| BALANCE—January 1,  2006                                                            |       | 2,786,857                |       | $                     | 226,460    |                      | 6,442,950  |            | $          | 644            |       | $          | 125,184    |             | $          | (5,500            | )          | $                      | (1,355     | )                      | $          | (2,030     | )          | $ | 11,132 |   | $ | 29,778 |   | $384,313 |   |
| Comprehensive  income:                                                                        |       |                     |       |                  |       |                      |       |            |       |           |       |       |       |             |       |              |       |                   |       |                   |       |       |       |
| Net income                                                                                    |       | —                   |       | —                |       | —                    |       | —          |       | —         |       | —     |       | —           |       | —            |       | —                 |       | 26,189                 |       | 26,189     |       |
| Change in unrealized gain on investments, net of  change in deferred income tax of $(1,528)   |       | —                   |       | —                |       | —                    |       | —          |       | —         |       | —     |       | —           |       | —            |       | (3,999                 | )          | —                 |       | (3,999     | )          |
| Change in derivative hedges, net of change in deferred  income tax of $2,987                  |       | —                   |       | —                |       | —                    |       | —          |       | —         |       | —     |       | —           |       | —            |       | 5,547                  |       | —                 |       | 5,547      |       |
| Total  comprehensive income                                                                   |       | —                   |       | —                |       | —                    |       | —          |       | —         |       | —     |       | —           |       | —            |       | —                 |       | —                 |       | 27,737     |       |
| Vesting of Series B senior conv. prf stock to  CEO                                       |       | —                   |       | —                |       | —                    |       | —          |       | —         |       | —     |       | —           |       | 580               |       | —                 |       | —                 |       | 580        |       |
| 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                                                        |       | —                   |       | —                |       | —                    |       | —          |       | 350            |       | —     |       | —           |       | —            |       | —                 |       | —                 |       | 350        |       |
| 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—June 30,  2006                                                                   |       | 2,786,882                |       | $                     | 228,417    |                      | 7,106,490  |            | $          | 710            |       | $          | 133,558    |             | $          | (12,088           | )          | $                      | (3,121     | )                      | $          | (1,450     | )          | $ | 12,680 |   | $ | 54,010 |   | $ | 412,716 |   |
|                                                                                          |       |                     |       |                  |       |                      |       |            |       |           |       |       |       |             |       |              |       |                   |       |                   |       |       |       |
| 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                                                                                      |       | —                   |       | —                |       | —                    |       | —          |       | —         |       | —     |       | —           |       | —            |       | —                 |       | (81,919                | )          | (81,919    | )          |
| Change in  unrealized loss on investments, net of change in deferred income tax of  $(56,453) |       | —                   |       | —                |       | —                    |       | —          |       | —         |       | —     |       | —           |       | —            |       | (104,841               | )          | —                 |       | (104,841   | )          |
| Change in  derivative hedges, net of change in deferred income tax of $792                    |       | —                   |       | —                |       | —                    |       | —          |       | —         |       | —     |       | —           |       | —            |       | 1,472                  |       | —                 |       | 1,472      |       |
| Foreign exchange  unrealized gain                                                             |       | —                   |       | —                |       | —                    |       | —          |       | —         |       | —     |       | —           |       | —            |       | 83                     |       | —                 |       | 83         |       |
| Total  comprehensive loss                                                                     |       | —                   |       | —                |       | —                    |       | —          |       | —         |       | —     |       | —           |       | —            |       | —                 |       |                   |       | (185,205   | )          |
| Vesting of CEO restricted common stock                                                        |       | —                   |       | —                |       | —                    |       | —          |       | —         |       | —     |       | —           |       | 580               |       | —                 |       | —                 |       | 580        |       |
| Offering costs                                                                                |       | —                   |       | —                |       | —                    |       | —          |       | 63             |       | —     |       | —           |       | —            |       | —                 |       | —                 |       | 63         |       |
| Stock based compensation—restricted stock                                                |       | —                   |       | —                |       | —                    |       | —          |       | 476            |       | —     |       | —           |       | —            |       | —                 |       | —                 |       | 476        |       |
| Stock based compensation—stock options                                                   |       | —                   |       | —                |       | —                    |       | —          |       | 1,349          |       | —     |       | —           |       | —            |       | —                 |       | —                 |       | 1,349      |       |
| Exercise of common stock options                                                              |       | —                   |       | —                |       | 69,750                    |       | 7               |       | 722            |       | —     |       | —           |       | —            |       | —                 |       | —                 |       | 729        |       |
| BALANCE—June 30,  2007                                                              |       | —                   |       | $                     | —     |                      | 37,444,873 |            | $          | 3,744          |       | $          | 441,545    |             | $          | (12,088           | )          | $                      | (3,121     | )                      | $          | (290       | )          | $ | (106,594 | ) | $ | 3,110 |   | $ | 326,306 |   |

 

See notes tounaudited condensed consolidated financial statements.

5

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**ACACAPITAL HOLDINGS, INC. AND SUBSIDIARIES**

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

**FOR THESIX MONTHS ENDED JUNE 30, 2007 AND 2006**

**(Dollarsin thousands)**
| ** **                                                                                | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss)                                                                         |       | $          | (81,919    | )          | $          | 26,189 |   |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |       |       |       |       |       |
| Depreciation and amortization                                                             |       | 4,537      |       | 4,717      |       |
| Accrual of discount and amortization of premium on  investment—net                   |       | 194        |       | (208       | )          |
| Income of minority interest                                                               |       | 2,144      |       | 2,229      |       |
| Net realized losses on fixed-maturity  securities-available-for-sale                      |       | 111,632    |       | 3,203      |       |
| Net realized and unrealized losses on fixed-maturity  securities- trading                 |       | 2,219      |       | 20         |       |
| Net realized and unrealized gains on derivative  instruments                              |       | (5,336     | )          | (6,139     | )          |
| Net realized and unrealized (gains) losses on net  insured credit swap revenue            |       | 82,846     |       | (829       | )          |
| Net realized and unrealized gains on other net  credit swap revenue                       |       | (10,627    | )          | (291       | )          |
| Net foreign exchange loss                                                                 |       | 43         |       | —     |       |
| Share based compensation expense                                                          |       | 1,825      |       | 350        |       |
| Discharge of note receivable from shareholders                                            |       | —     |       | 496        |       |
| Deferred compensation                                                                     |       | 580        |       | 580        |       |
| Purchase of securities under agreement to resell                                          |       | 6,840      |       | —     |       |
| Purchases of fixed-maturity securities-trading                                            |       | (222,150   | )          | —     |       |
| Proceeds from sales of fixed-maturity securities-  trading                                |       | 64,183     |       | —     |       |
| Securities sold under agreement to repurchase                                             |       | 140,709    |       | —     |       |
|                                                                                      |       |       |       |       |       |
| Changes in assets and liabilities:                                                        |       |       |       |       |       |
| Income taxes payable                                                                      |       | 8,709      |       | 343        |       |
| Deferred income tax expense                                                               |       | (70,921    | )          | 2,967      |       |
| Prepaid reinsurance premiums                                                              |       | 34         |       | 228        |       |
| Derivative liabilities                                                                    |       | 307        |       | (1,905     | )          |
| Accrued expenses and other liabilities                                                    |       | (7,298     | )          | (2,591     | )          |
| Deferred policy acquisition costs                                                         |       | 312        |       | (661       | )          |
| Unearned premium reserve                                                                  |       | 6,130      |       | 6,743      |       |
| Loss and loss adjustment expenses                                                         |       | 3,810      |       | 2,938      |       |
| Interest payable                                                                          |       | (2,103     | )          | 632        |       |
| Interest receivable                                                                       |       | (1,217     | )          | (2,052     | )          |
| Other                                                                                     |       | 5,472      |       | 1,272      |       |
| Net cash provided by operating activities                                                 |       | 40,955     |       | 38,231     |       |
|                                                                                      |       |       |       |       |       |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                    |       |       |       |       |       |
| Net deposit of restricted cash                                                            |       | 20,906     |       | (3,881     | )          |
| Purchases of fixed maturity securities available for  sale                                |       | (538,170   | )          | (519,582   | )          |
| Proceeds from sales of fixed maturity securities  available for sale                      |       | 78,568     |       | 83,662     |       |
| Proceeds from maturities of fixed maturity  securities available for sale                 |       | 533,395    |       | 524,052    |       |
| Net purchase of property and equipment                                                    |       | (2,759     | )          | (230       | )          |
| Net cash provided by investing activities                                                 |       | 91,940     |       | 84,021     |       |
|                                                                                      |       |       |       |       |       |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                    |       |       |       |       |       |
| Paydown of commercial paper—net                                                      |       | (361       | )          | (393       | )          |
| Paydown on long-term debt                                                                 |       | (187,407   | )          | (72,507    | )          |
| Payment of issuance costs for debt                                                        |       | —     |       | (308       | )          |
| Proceeds from issuance of equity in Credit Fund                                           |       | 3,000      |       | —     |       |
| Proceeds from exercise of common stock options                                            |       | 729        |       | —     |       |
| Purchase of treasury stock                                                                |       | —     |       | (759       | )          |
| Offering costs                                                                            |       | 63         |       | —     |       |
| Net cash used in financing activities                                                     |       | (183,976   | )          | (73,967    | )          |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS                                     |       | (51,081    | )          | 48,285     |       |
|                                                                                      |       |       |       |       |       |
| CASH AND CASH  EQUIVALENTS—beginning of period                                       |       | 379,905    |       | 174,420    |       |
| CASH AND CASH  EQUIVALENTS—end of period                                             |       | $          | 328,824    |       | $          | 222,705 |   |
|                                                                                      |       |       |       |       |       |
| SUPPLEMENTAL  CASH FLOW DISCLOSURES:                                                      |       |       |       |       |       |
| Federal and local income taxes paid                                                       |       | $          | 10,356     |       | $          | 11,049 |   |
|                                                                                      |       |       |       |       |       |
| Interest paid                                                                             |       | $          | 154,848    |       | $          | 136,752 |   |
|                                                                                      |       |       |       |       |       |
| SUPPLEMENTAL  DISCLOSURES OF NON-CASH FINANCING ACTIVITIES:                               |       |       |       |       |       |
| Common stock  acquired in exchange for note receivable                                    |       | $          | —     |       | $          | 2,262 |   |

 

See notes tounaudited condensed consolidated financial statements.

6

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**ACACAPITAL HOLDINGS, INC. AND SUBSIDIARIES**

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**JUNE30, 2007**

**1.  BUSINESS, ORGANIZATION ANDOPERATIONS**

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 providing asset managementservices.  The Company’s principal activities include financial guarantyinsurance of public finance obligations, structured credit risk assumptionthrough insured credit derivatives and collateralized debt obligation assetmanagement.  ACA conducts its business through three principal wholly-ownedindirect subsidiaries.  Its financial guaranty insurance business isconducted through ACA Financial Guaranty Corporation (“ACA Financial Guaranty”),a Maryland domiciled insurance company.  ACA Financial Guaranty islicensed to conduct financial guaranty insurance business, which providescredit enhancement on public finance and other debt obligations, in all 50states, the District of Columbia, Guam, the U.S. Virgin Islands and PuertoRico.  Standard & Poor’s Rating Services (“S&P”) has assigneda financial strength rating of “A” to ACA Financial Guaranty.  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’sbusiness is composed of three distinct continuing lines of business orsegments.  They are Public Finance, Structured Credit and CDO AssetManagement.  A fourth line of business, Other, includes business in areasand markets in which the Company is no longer active.  Although the PublicFinance and Structured Credit businesses are reported in separate segments,together they form the Company’s financial guaranty insurance business. Public Finance primarily provides financial guaranty insurance policiesguaranteeing the timely payment of scheduled principal and interest on publicfinance and other debt obligations.  Structured Credit structures andsells credit protection, principally in the form of insured credit defaultswaps (“CDS” or “credit swaps”), against a variety of asset classes in theinstitutional fixed income markets.  CDO Asset Management focuses on CDOorigination, structuring and management.  The Company will at times assumerisk in the CDOs it manages through investment in some portion of the capitalstructure.

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.

OnNovember 9, 2006, the Company priced its initial public offering of6,875,000 shares of newly issued common stock and 23,541 shares of existingcommon stock.  The Company realized gross proceeds of $13 per share on thenewly issued common stock, or $89.4 million.  Net proceeds to the Companywere $79.2 million, after issuance costs.  On November 10, 2006, theCompany’s common stock commenced trading on the New York Stock Exchange underthe symbol “ACA.”  In conjunction with the initial public offering, theCompany’s senior convertible preferred stock, convertible preferred stock andseries B senior convertible preferred stock all converted to common stockconcurrently with the closing of our offering on November 15, 2006 attheir conversion ratios of 6,000:1 shares, 6,000:1 shares and 6:1 shares, respectively.

**2.  SUMMARY OF SIGNIFICANTACCOUNTING POLICIES**

These unauditedcondensed consolidated financial statements have been prepared pursuant to therules and regulations of the Securities and Exchange Commission (“SEC”)regarding interim financial reporting.  Accordingly, they do not includeall of the information and footnotes required by accounting principlesgenerally accepted in the United States of America (“GAAP”) for completefinancial statements and should be read in conjunction with the Company’s AnnualReport on Form 10-K for the year ended December 31, 2006 (“Form 10-K”),filed with the SEC on April 2, 2007.  These unaudited condensedconsolidated financial statements include all adjustments, consisting only ofnormal recurring adjustments, that we consider necessary for the fairpresentation of our financial position and results of operations for theseperiods.  The preparation of financial statements in conformity with GAAPrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting periods.  Actual results coulddiffer from those estimates.  Operating results for the three and sixmonths ended 

7

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June 30, 2007 are notnecessarily indicative of the results that may be expected for the year endedDecember 31, 2007.

In August 2006,the Company’s Board of Directors authorized a dividend of stock in order toeffect a six-for-one stock split.  All prior share and per share amountshave been 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 the quarter ended June 30, 2007, theCompany refined its valuation model to estimate fair value of its insuredcredit swap transactions.  The change wasimplemented to be more consistent with models that the Company understandsother market participants utilize, including many of ACA’s insured credit swapcounterparties.  The relatively youngmarket for credit swaps has continued to evolve over time and, while there isstill substantial variance in valuation models among market participants, thetrend is toward increasing convergence in this area.  Under its refined model, the Company fullyuses market spread data as a proxy for default probabilities in thedetermination of fair value.  Fortransactions in which the underlying exposure is to corporate credits, theCompany uses individual market spreads as proxies for defaults as they are readilyavailable. For synthetic asset-backed transactions, the Company uses a currentweighted average portfolio spread because individual spread information historicallyhas not been consistently reliable and often has been unavailable. As theavailability and quality of individual asset-backed spread data improves, theCompany may make further refinements to its valuation model. The Companybelieves that its new model will inherently increase the volatility of thesevaluations, but provide a better estimate of the cost or benefit of unwindingthe related transaction.

**3.  RELEVANT RECENT ACCOUNTINGPRONOUNCEMENTS**

On April 18, 2007,the Financial 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.  The Proposed Statementwould be effective for financial statements issued for fiscal years beginningafter December 15, 2007.  While certainprovisions of the Proposed Statement are still being analyzed, managementbelieves that the cumulative effect of initially applying the ProposedStatement could be material to the Company’s financial statements.  Until the final interpretation is issued bythe FASB, the Company continues to apply the accounting policies as disclosedin its Form 10-K.

InFebruary 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 choose differentmeasurement attributes for similar types of assets and liabilities. FAS 159 iseffective for fiscal years that begin after November 15, 2007.  TheCompany did not elect to early adopt FAS 159.  Management is currentlyevaluating the potential impact, if any, which the adoption of FAS 159 willhave on the Company’s financial statements.

On January 1,2007, the Company 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, the Company adopted FASB Interpretation No.  (“FIN”) 48, “*Accounting for Uncertainty in Income Taxes—anInterpretation of FASB Statement No. 109*” (“FIN 48”).  The adoption of FIN 48 resulted in a decreaseto stockholders’ equity as of January 1, 2007 of $1.5 million (see Note6).

InSeptember 2006, the FASB issued FAS 157, “*FairValue Measurements*” (“FAS 157”).  FAS 157 enhancesexisting guidance for measuring assets and liabilities using fair value, suchas emphasizing 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 is currently evaluating the potential impact, if any, which theadoption of FAS 157 will have on the Company’s financial statements.

InSeptember 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB108”), “*Considering the Effects of PriorYear Misstatements when Quantifying Misstatements in Current Year FinancialStatements*”, which provides interpretive guidance on how the effectsof the carryover or reversal of prior year misstatements should be consideredin quantifying a current year misstatement.  The provisions of SAB 108were put in effect at December 31, 2006.  The adoption of thisstatement did not have a material impact on the Company’s financial statements.

InApril 2006, the FASB issued Staff Position (“FSP”) FIN 46(R)-6, “*Determining the Variability to Be Considered inApplying FASB Interpretation No. 46(R)*” (“FSP FIN 46(R)-6”).  FSP FIN 46(R)-6 addresses whether certainarrangements associated with variable interest entities (VIEs) should betreated as variable interests or considered as creators of variability, andindicates that the variability to be considered shall be on based on ananalysis of the design of the entity. FSP FIN 46(R)-6 was adopted on June 15, 

8

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2006.  The adoptionof this statement did not have a material impact on the Company’s financialstatements.

InMarch 2006, the FASB issued FAS 156, “*Accounting for Servicing of Financial Assets*” (“FAS 156”),an amendment of FAS 140.  FAS 156 requires that all separatelyrecognized servicing assets and servicing liabilities be initially measured atfair value, if practicable, and permits for subsequent measurement using eitherfair value measurement with changes in fair value reflected in earnings or theamortization and impairment requirements of FAS 140.  The subsequentmeasurement of separately recognized servicing assets and servicing liabilitiesat fair value eliminates the necessity for entities that manage the risksinherent in servicing assets and servicing liabilities with derivatives toqualify for hedge accounting treatment and eliminates the characterization ofdeclines in fair value as impairments or direct write-downs.  FAS 156is effective for an entity’s first fiscal year beginning afterSeptember 15, 2006.  The implementation of this statement did nothave a 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 MANAGEMENTBUSINESS**

One of the waysthe Company participates in the structured finance market is throughstructuring and managing CDOs originated in collaboration with investmentbanks.  CDOs can be issued in funded, unfunded or partially fundedform.  Funded CDOs issue debt instruments and purchase investment assets, whileunfunded CDOs synthetically acquire assets and issue liabilities (i.e., assetsand liabilities are in derivative form). Partially funded CDOs are acombination of these two forms.  From an accounting perspective, fundedand partially funded CDOs are determined to be VIEs.  Each time such CDOsare formed, the Company performs an analysis to determine whether it is theprimary beneficiary and thus required to consolidate the CDO under theprovisions of FSP FIN 46(R)-6.

The followingtable lists each of the Company’s CDOs outstanding as of June 30, 2007(dollars in millions):
| ** **                      | ** ** | **Year**   | ** ** | ** **        | ** ** | ** **                        | ** ** | ** **                  | ** ** | ** **       | ** ** | **Original**             | ** ** | ** **        | ** ** | **First**             | ** ** | ** **   | ** ** |
|---------------------------------|------------|------------|------------|-------------------|------------|-----------------------------------|------------|-----------------------------|------------|------------------|------------|--------------------------|------------|-------------------|------------|-----------------------|------------|--------------|------------|
| ** **                      | ** ** | **Deal**   | ** ** | **Transaction**   | ** ** | ** **                        | ** ** | **Notional**                | ** ** | ** **       | ** ** | **Investment in**   | ** ** | **Retained**      | ** ** | **Optional**          | ** ** | **Maturity** | ** ** |
| **CDO name**               | ** ** | **Closed** | ** ** | **Type**          | ** ** | **Collateral Type (1)** | ** ** | **Deal Size (3)** | ** ** | **Consolidated** | ** ** | **Retained Equity** | ** ** | **Equity %** | ** ** | **Call Date(4)** | ** ** | **Date**     | ** ** |
| **Asset-Backed  CDOs:**         | ** ** | ** ** | ** ** | ** **        | ** ** | ** **                        | ** ** | ** **                  | ** ** | ** **       | ** ** | ** **               | ** ** | ** **        | ** ** | ** **            | ** ** | ** **   | ** ** |
| ACA ABS 2002-1                  |       | 2002       |       | Funded            |       | Investment  Grade                 |       | $                           | 404        |             | Yes        |                     | $          | 18.0              |       | 100                   |       | 8/2005       |       | 8/2037 |   |
| ACA ABS 2003-1                  |       | 2003       |       | Funded            |       | Investment  Grade                 |       | 400                         |       | Yes              |       | 18.0                     |       | 100               |       | 6/2007                |       | 6/2038       |       |
| Grenadier Funding               |       | 2003       |       | Funded            |       | High-Grade                        |       | 1,500                       |       | Yes              |       | 22.5                     |       | 100               |       | 8/2008                |       | 8/2038       |       |
| ACA ABS 2003-2                  |       | 2003       |       | Funded            |       | Investment  Grade                 |       | 725                         |       | Yes              |       | 33.5                     |       | 100               |       | 12/2007               |       | 12/2038      |       |
| ACA ABS 2004-1                  |       | 2004       |       | Funded            |       | Investment  Grade                 |       | 450                         |       | Yes              |       | 10.0                     |       | 61                |       | 7/2007                |       | 7/2039       |       |
| Zenith Funding                  |       | 2004       |       | Funded            |       | High-Grade                        |       | 1,511                       |       | Yes              |       | 13.0                     |       | 52                |       | 12/2009               |       | 12/2039      |       |
| ACA ABS 2005-1                  |       | 2005       |       | Funded            |       | Investment  Grade                 |       | 452                         |       | No               |       | 4.4                      |       | 24                |       | 4/2008                |       | 4/2040       |       |
| ACA ABS 2005-2                  |       | 2005       |       | Funded            |       | Investment  Grade                 |       | 450                         |       | No               |       | 2.1                      |       | 10                |       | 9/2009                |       | 12/2044      |       |
| Khaleej II                      |       | 2005       |       | Partially  funded |       | Investment  Grade                 |       | 750                         |       | No               |       | 4.5                      |       | 14                |       | 9/2009                |       | 9/2040       |       |
| Lancer Funding                  |       | 2006       |       | Funded            |       | High-Grade                        |       | 1,500                       |       | No               |       | 1.5                      |       | 10                |       | 7/2010                |       | 4/2046       |       |
| ACA Aquarius  2006-1            |       | 2006       |       | Partially  funded |       | Investment  Grade                 |       | 2,000                       |       | No               |       | —                   |       | —            |       | 9/2010                |       | 9/2046       |       |
| ACA ABS 2006-1                  |       | 2006       |       | Funded            |       | Investment  Grade                 |       | 750                         |       | No               |       | 1.4                      |       | 5                 |       | 12/2009               |       | 6/2041       |       |
| ACA ABS 2006-2                  |       | 2006       |       | Funded            |       | Investment  Grade                 |       | 750                         |       | No               |       | 3.5                      |       | 11                |       | 1/2011                |       | 1/2047       |       |
| ACA ABS 2007-1                  |       | 2007       |       | Partially  funded |       | Investment  Grade                 |       | 1,500                       |       | No               |       | 1.4                      |       | 5                 |       | 3/2010                |       | 5/2047       |       |
| Millbrook                       |       | 2007       |       | Unfunded          |       | Investment  Grade                 |       | 62                          |       | No               |       | —                   |       | —            |       | 3/2010                |       | 10/2052      |       |
| Abacus                          |       | 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       |       |
| **Total Asset-Backed CDOs**     |       |       |       |              |       |                              |       | 15,146                      |       |             |       | 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                 |       | 67                          | (2)        | No               |       | —                   |       | —            |       | N/A                   |       | 6/2015       |       |
| Argon 57                        |       | 2006       |       | Funded            |       | Investment  Grade                 |       | 67                          | (2)        | No               |       | —                   |       | —            |       | N/A                   |       | 6/2013       |       |
| Tribune                         |       | 2006       |       | Unfunded          |       | Investment  Grade                 |       | 356                         | (5)        | No               |       | —                   |       | —            |       | N/A                   |       | 9/2016       |       |
| Dolomite                        |       | 2007       |       | Unfunded          |       | Investment  Grade                 |       | 66                          | (2)        | No               |       | —                   |       | —            |       | N/A                   |       | 7/2014       |       |
| **Total Corporate Credit CDOs** |       |       |       |              |       |                              |       | 1,556                       |       |             |       | 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             |       | 555                         | (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**   |       |       |       |              |       |                              |       | 1,855                       |       |             |       | 15.4                     |       |              |       |                  |       |         |       |
|                            |       |       |       |              |       |                              |       |                        |       |             |       |                     |       |              |       |                  |       |         |       |
| **Total**                       | ** ** | ** ** | ** ** | ** **        | ** ** | ** **                        | ** ** | **$**                       | **18,557** | ** **       | ** ** | ** **               | **$**      | **174.2**         | ** ** | ** **            | ** ** | ** **   | ** ** | ** ** | ** ** |

 

*Note: Asof June 30, 2007, the Company’s risk under corporate credit CDO ACA CDS 2002-1expired.*

----

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

9

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(2)            The original notional deal sizes for Argon 49 and Argon 57 were€50 million each, and that for Dolomite was €49 million and $1million. The original deal size for ACA CLO Euro 2007-1 was €400 million.  For purposes of this chart, we have convertedthe amounts to U.S. dollars at the prevailing currency exchange rate onJune 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 13 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 onJune 30, 2007.

As of June 30,2007 and December 31, 2006, consolidated liabilities include non-recoursedebt from consolidated CDOs of $4,525.9 million and $4,711.8 million,respectively.  Also, as of June 30, 2007 and December 31, 2006,consolidated assets include investments in CDO related fixed maturitysecurities and guaranteed investment contracts of $4,193.3 million and$4,656.0 million, respectively, and cash of $238.0 million and $265.0million, respectively.

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

Net insured creditswap revenue includes insured credit swap premiums received for creditprotection the Company has sold under its insured credit swaps as well asrealized and unrealized gains and losses related to those transactions. Realized losses arise upon the occurrence of credit events requiring payment bythe Company 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 followingtable disaggregates net insured credit swap revenue into its component partsfor the three months and six months ended June 30, 2007 and 2006:
| ** **                                | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                | ** ** | **2007**                         | ** ** | **2006**                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                | ** ** | **(in thousands)**          | ** ** |
| Net insured  credit swap revenue          |       |                             |       |                           |       |   |   |   |   |
| Insured credit swap premiums earned       |       | $                                | 23,600     |                           | $          | 11,218 |   | $ | 42,362 |   | $ | 21,282 |   |
| Unrealized losses on insured credit swaps |       | (67,783                          | )          | (5,075                         | )          | (82,846 | ) | (1,180 | ) |
| Realized gains on insured credit swaps    |       | —                           |       | 1,788                          |       | — |   | 2,009 |   |
| Total net insured  credit swap revenue    |       | $                                | (44,183    | )                              | $          | 7,931 |   | $ | (40,484 | ) | $ | 22,111 |   |

 

Of the $(67.8)million unrealized loss recorded in the three months ended June 30, 2007,$(67.5) million was related to valuation changes in the Company’s StructuredCredit transactions.  The residentialmortgage-backed securities (“RMBS”) portion of the Structured Credit portfolioincurred valuation losses of $253.0 million for the three months ended June 30,2007.  However, no realized or actuallosses were incurred on this portfolio based on its very high credit quality,with over 99.8% of the portfolio constructed of exposures attaching above the “AAA”rated level of subordination.  Thesevaluation losses were precipitated by the severe level of delinquencies anddefaults that have occurred in the residential mortgage market, particularly inthe sub-prime and second lien segments, which constitute a significant portionof the assets underlying the RMBS included in the pools of assets referenced bycertain of our Structured Credit transactions. Partially offsetting the valuation losses on the Structured Credit RMBSportfolio was an unrealized gain in the amount of $185.5 million on StructuredCredit’s corporate credit portfolio. The valuation gains on the corporateportfolio resulted from tighter spreads at June 30, 2007, on a portion ofthe portfolio, compared to spreads when the transactions were originated, andthe refinement in the Company’s valuation model to fully use market spread dataas a proxy for default probabilities (see Note 2). In addition, pricingdeclined as more seasoned transactions reached maturity without experiencinglosses, resulting in unrealized gains. As a result of the Company’s intentionto generally hold its insured credit swaps to term, absent credit losses, theseunrealized amounts will revert to $0 at contract expiration.

Other net creditswap revenue includes revenues received from a partially funded CDS CDO, whichsells credit protection under credit swaps for which it receives fixedquarterly fees as well as the residual returns on two synthetic equityparticipations.  Other net credit swap revenue also includes net realizedand unrealized gains and losses associated with these transactions, ifany.  As of June 30, 2007, the Company’srisk to the partially funded CDS CDO and one of the synthetic equityparticipation had expired.  Theserevenues are included in the Company’s consolidated statement of operations.

The followingtable disaggregates other net credit swap revenue into its component parts forthe three months and six months ended June 30, 2007 and 2006:

10

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| ** **                                     | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                     | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                     | ** ** | **2007**                         | ** ** | **2006**                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                     | ** ** | **(in thousands)**          | ** ** |
| Other net credit  swap revenue                 |       |                             |       |                           |       |   |   |   |   |
| Credit swap fees earned                        |       | $                                | 1,643      |                           | $          | 2,534 |   | $ | 5,811 |   | $ | 5,253 |   |
| Unrealized gain on credit protection purchased |       | 3,110                            |       | —                         |       | 11,565 |   | — |   |
| Unrealized gains (losses) on credit swaps      |       | (902                             | )          | 97                             |       | (1,219 | ) | 291 |   |
| Total other net credit  swap revenue           |       | $                                | 3,851      |                           | $          | 2,631 |   | $ | 16,157 |   | $ | 5,544 |   |

 

**6.  INCOME TAXES**

Effective January1, 2007, the Company adopted the provisions of FIN 48.  As a result of theimplementation of FIN 48, the Company recorded a $1.5 million reserve foruncertain tax positions and a corresponding decrease to the 2007 openingretained earnings.  The Company’s effective tax rate would be increased if$1.5 million of unrecognized tax expense were recognized.  It is unlikelythat the unrecognized tax expense will significantly change in the next 12months.

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

The Companyrecords interest and penalties related to unrecognized tax benefits in incometaxes.  $470,000 in accrued interest and penalties is included in the $1.5million reserve for uncertain tax positions related to our adoption of FIN 48.

Our tax provisionfor interim periods is determined using an estimate of our annual effective taxrate.  The 2007 effective tax rate is estimated to be lower than the 35%statutory rate primarily due to the Company’s investment in securities forwhich the interest payable is exempt from federal income tax.

**7. LITIGATION**

In May 2006,the Company paid a judgment in the amount of $3.7 million in satisfactionof a damages award in connection with an employment contract dispute with aformer executive of the Company plus accrued interest through the date of payment. Also in May 2006, the Company settled the former executive’s attorney’sfees at an additional amount of $0.6 million.  The Company hadrecorded 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 notaware of any pending or threatened litigation that it believes could reasonablybe likely to result in a material adverse effect on the Company’s financialposition, results of operations or cash flows.

**8.  SEGMENT INFORMATION**

The Company’sreportable segments 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,primarily corporate obligations or asset-backed securities, in funded,partially funded or synthetic CDOs; and

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

The Company’sreportable 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.

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

The accountingpolicies of the segments are the same as those described in the summary ofsignificant accounting policies.  The Company evaluates segmentperformance based on its income (loss) before income taxes.  Reportablesegment results are presented net of material inter-segment transactions. The following tables summarize the Company’s operations and allocation ofassets as of and for the three months and six months ended June 30, 2007 and2006 (dollars in thousands):

11

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| ** **                                                   | ** ** | **Three Months Ended June 30, 2007** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **Structured**                                                | ** ** | **Public** | ** ** | **CDO Asset** | ** ** | ** ** | ** ** | **Consolidated** | ** ** |
| ** **                                                   | ** ** | **Credit**                                                    | ** ** | **Finance** | ** ** | **Management** | ** ** | **Other** | ** ** | **Totals** | ** ** |
| REVENUES:                                                    |       |                                                          |       |   |   |   |   |   |   |   |   |
| Gross premiums written                                       |       | $                                                             | 47         |   | $ | 15,371 |   | $ | — |   | $ | 60 |   | $ | 15,478 |   |
|                                                         |       |                                                          |       |   |   |   |   |   |   |   |   |
| Premiums earned                                              |       | $                                                             | 47         |   | $ | 8,228 |   | $ | — |   | $ | 170 |   | $ | 8,445 |   |
| Net insured credit swap revenue                              |       | (44,628                                                       | )          | 284 |   | 161 |   | — |   | (44,183 | ) |
| Net investment income                                        |       | 6,973                                                         |       | 4,266 |   | 78,337 |   | 1,051 |   | 90,627 |   |
| Net realized and unrealized gains (losses) on  investments   |       | (714                                                          | )          | 2 |   | (109,430 | ) | — |   | (110,142 | ) |
| Net realized and unrealized gains on derivative  instruments |       | 292                                                           |       | — |   | 2,964 |   | — |   | 3,256 |   |
| Other net credit swap revenue                                |       | (237                                                          | )          | — |   | 4,088 |   | — |   | 3,851 |   |
| Fee and other income                                         |       | 230                                                           |       | 253 |   | 7,412 |   | — |   | 7,895 |   |
| Total revenues                                               |       | (38,037                                                       | )          | 13,033 |   | (16,468 | ) | 1,221 |   | (40,251 | ) |
|                                                         |       |                                                          |       |   |   |   |   |   |   |   |   |
| EXPENSES:                                                    |       |                                                          |       |   |   |   |   |   |   |   |   |
| Loss and loss adjustment expenses                            |       | —                                                        |       | 1,614 |   | — |   | 245 |   | 1,859 |   |
| Policy acquisition costs                                     |       | —                                                        |       | 2,841 |   | — |   | 201 |   | 3,042 |   |
| Other operating expenses                                     |       | 6,408                                                         |       | 2,832 |   | 6,322 |   | 2 |   | 15,564 |   |
| Interest expense                                             |       | 4,475                                                         |       | 391 |   | 71,378 |   | 93 |   | 76,337 |   |
| Depreciation and amortization                                |       | 159                                                           |       | 132 |   | 1,987 |   | — |   | 2,278 |   |
| Total expenses                                               |       | 11,042                                                        |       | 7,810 |   | 79,687 |   | 541 |   | 99,080 |   |
| Income of  minority interest                                 |       | (141                                                          | )          | — |   | (1,124 | ) | — |   | (1,265 | ) |
| Income (loss)  before income taxes                           |       | (49,220                                                       | )          | 5,223 |   | (97,279 | ) | 680 |   | (140,596 | ) |
| Provision for  income tax expense (benefit)                  |       | (16,520                                                       | )          | 1,736 |   | (32,702 | ) | 226 |   | (47,260 | ) |
| Net income  (loss)                                           |       | $                                                             | (32,700    | ) | $ | 3,487 |   | $ | (64,577 | ) | $ | 454 |   | $ | (93,336 | ) |
|                                                         |       |                                                          |       |   |   |   |   |   |   |   |   |
| Segment Assets                                               |       | $                                                             | 661,100    |   | $ | 598,761 |   | $ | 4,701,093 |   | $ | 131,288 |   | $ | 6,092,242 |   |

 
| ** **                                                   | ** ** | **Three Months Ended June 30, 2006** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **Structured**                                                | ** ** | **Public** | ** ** | **CDO Asset** | ** ** | ** ** | ** ** | **Consolidated** | ** ** |
| ** **                                                   | ** ** | **Credit**                                                    | ** ** | **Finance** | ** ** | **Management** | ** ** | **Other** | ** ** | **Totals** | ** ** |
| REVENUES:                                                    |       |                                                          |       |   |   |   |   |   |   |   |   |
| Gross premiums written                                       |       | $                                                             | 192        |   | $ | 15,301 |   | $ | — |   | $ | 234 |   | $ | 15,727 |   |
|                                                         |       |                                                          |       |   |   |   |   |   |   |   |   |
| Premiums earned                                              |       | $                                                             | 210        |   | $ | 7,575 |   | $ | — |   | $ | 690 |   | $ | 8,475 |   |
| Net insured credit swap revenue                              |       | 7,699                                                         |       | (30 | ) | 262 |   | — |   | 7,931 |   |
| Net investment income                                        |       | 882                                                           |       | 4,133 |   | 76,482 |   | 955 |   | 82,452 |   |
| Net realized and unrealized losses on investments            |       | (35                                                           | )          | (81 | ) | (1,120 | ) | (20 | ) | (1,256 | ) |
| Net realized and unrealized gains on derivative  instruments |       | —                                                        |       | — |   | 2,497 |   | — |   | 2,497 |   |
| Other net credit swap revenue                                |       | (11                                                           | )          | — |   | 2,642 |   | — |   | 2,631 |   |
| Fee and other income                                         |       | 153                                                           |       | 54 |   | 6,801 |   | — |   | 7,008 |   |
| Total revenues                                               |       | 8,898                                                         |       | 11,651 |   | 87,564 |   | 1,625 |   | 109,738 |   |
|                                                         |       |                                                          |       |   |   |   |   |   |   |   |   |
| EXPENSES:                                                    |       |                                                          |       |   |   |   |   |   |   |   |   |
| Loss and loss adjustment expenses                            |       | —                                                        |       | 1,539 |   | — |   | 122 |   | 1,661 |   |
| Policy acquisition costs                                     |       | —                                                        |       | 2,518 |   | — |   | 250 |   | 2,768 |   |
| Other operating expenses                                     |       | 4,746                                                         |       | 2,292 |   | 5,643 |   | — |   | 12,681 |   |
| Interest expense                                             |       | 90                                                            |       | 427 |   | 70,359 |   | 88 |   | 70,964 |   |
| Depreciation and amortization                                |       | 161                                                           |       | 121 |   | 1,943 |   | — |   | 2,225 |   |
| Total expenses                                               |       | 4,997                                                         |       | 6,897 |   | 77,945 |   | 460 |   | 90,299 |   |
| Income of  minority interest                                 |       | (7                                                            | )          | — |   | (1,067 | ) | — |   | (1,074 | ) |
| Income before  income taxes                                  |       | 3,894                                                         |       | 4,754 |   | 8,552 |   | 1,165 |   | 18,365 |   |
| Provision for  income tax expense                            |       | 1,351                                                         |       | 1,633 |   | 2,941 |   | 398 |   | 6,323 |   |
| Net income                                                   |       | $                                                             | 2,543      |   | $ | 3,121 |   | $ | 5,611 |   | $ | 767 |   | $ | 12,042 |   |
|                                                         |       |                                                          |       |   |   |   |   |   |   |   |   |
| Segment Assets                                               |       | $                                                             | 56,390     |   | $ | 452,947 |   | $ | 5,139,289 |   | $ | 96,877 |   | $ | 5,745,503 |   |

 

12

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| ** **                                                   | ** ** | **Six Months Ended June 30, 2007** | ** ** |
|--------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **Structured**                                              | ** ** | **Public** | ** ** | **CDO Asset** | ** ** | ** ** | ** ** | **Consolidated** | ** ** |
| ** **                                                   | ** ** | **Credit**                                                  | ** ** | **Finance** | ** ** | **Management** | ** ** | **Other** | ** ** | **Totals** | ** ** |
| REVENUES:                                                    |       |                                                        |       |   |   |   |   |   |   |   |   |
| Gross premiums written                                       |       | $                                                           | 134        |   | $ | 20,043 |   | $ | — |   | $ | 342 |   | $ | 20,519 |   |
|                                                         |       |                                                        |       |   |   |   |   |   |   |   |   |
| Premiums earned                                              |       | $                                                           | 134        |   | $ | 13,106 |   | $ | — |   | $ | 354 |   | $ | 13,594 |   |
| Net insured credit swap revenue                              |       | (39,983                                                     | )          | 1,430 |   | (1,931 | ) | — |   | (40,484 | ) |
| Net investment income                                        |       | 12,718                                                      |       | 8,543 |   | 157,183 |   | 2,103 |   | 180,547 |   |
| Net realized and unrealized losses on investments            |       | (2,226                                                      | )          | (27 | ) | (111,590 | ) | (7 | ) | (113,850 | ) |
| Net realized and unrealized gains on derivative  instruments |       | 288                                                         |       | — |   | 5,048 |   | — |   | 5,336 |   |
| Other net credit swap revenue                                |       | (274                                                        | )          | — |   | 16,431 |   | — |   | 16,157 |   |
| Fee and other income                                         |       | 345                                                         |       | 344 |   | 13,594 |   | — |   | 14,283 |   |
| Total revenues                                               |       | (28,998                                                     | )          | 23,396 |   | 78,735 |   | 2,450 |   | 75,583 |   |
|                                                         |       |                                                        |       |   |   |   |   |   |   |   |   |
| EXPENSES:                                                    |       |                                                        |       |   |   |   |   |   |   |   |   |
| Loss and loss adjustment expenses                            |       | —                                                      |       | 2,639 |   | — |   | 593 |   | 3,232 |   |
| Policy acquisition costs                                     |       | —                                                      |       | 4,304 |   | — |   | 215 |   | 4,519 |   |
| Other operating expenses                                     |       | 12,698                                                      |       | 5,739 |   | 13,267 |   | 13 |   | 31,717 |   |
| Interest expense                                             |       | 7,765                                                       |       | 777 |   | 144,018 |   | 185 |   | 152,745 |   |
| Depreciation and amortization                                |       | 297                                                         |       | 246 |   | 3,994 |   | — |   | 4,537 |   |
| Total expenses                                               |       | 20,760                                                      |       | 13,705 |   | 161,279 |   | 1,006 |   | 196,750 |   |
| Income of  minority interest                                 |       | (58                                                         | )          | — |   | (2,086 | ) | — |   | (2,144 | ) |
| Income (loss)  before income taxes                           |       | (49,816                                                     | )          | 9,691 |   | (84,630 | ) | 1,444 |   | (123,311 | ) |
| Provision for  income tax expense (benefit)                  |       | (16,722                                                     | )          | 3,253 |   | (28,408 | ) | 485 |   | (41,392 | ) |
| Net income  (loss)                                           |       | $                                                           | (33,094    | ) | $ | 6,438 |   | $ | (56,222 | ) | $ | 959 |   | $ | (81,919 | ) |
|                                                         |       |                                                        |       |   |   |   |   |   |   |   |   |
| Segment Assets                                               |       | $                                                           | 661,100    |   | $ | 598,761 |   | $ | 4,701,093 |   | $ | 131,288 |   | $ | 6,092,242 |   |

 
| ** **                                                   | ** ** | **Six Months Ended June 30, 2006** | ** ** |
|--------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **Structured**                                              | ** ** | **Public** | ** ** | **CDO Asset** | ** ** | ** ** | ** ** | **Consolidated** | ** ** |
| ** **                                                   | ** ** | **Credit**                                                  | ** ** | **Finance** | ** ** | **Management** | ** ** | **Other** | ** ** | **Totals** | ** ** |
| REVENUES:                                                    |       |                                                        |       |   |   |   |   |   |   |   |   |
| Gross premiums written                                       |       | $                                                           | 470        |   | $ | 19,383 |   | $ | — |   | $ | 662 |   | $ | 20,515 |   |
|                                                         |       |                                                        |       |   |   |   |   |   |   |   |   |
| Premiums earned                                              |       | $                                                           | 506        |   | $ | 11,752 |   | $ | — |   | $ | 1,099 |   | $ | 13,357 |   |
| Net insured credit swap revenue                              |       | 20,439                                                      |       | 632 |   | 1,040 |   | — |   | 22,111 |   |
| Net investment income                                        |       | 1,734                                                       |       | 8,004 |   | 148,577 |   | 1,849 |   | 160,164 |   |
| Net realized and unrealized losses on investments            |       | (171                                                        | )          | (817 | ) | (2,046 | ) | (189 | ) | (3,223 | ) |
| Net realized and unrealized gains on derivative  instruments |       | —                                                      |       | — |   | 6,139 |   | — |   | 6,139 |   |
| Other net credit swap revenue                                |       | (25                                                         | )          | — |   | 5,569 |   | — |   | 5,544 |   |
| Fee and other income                                         |       | 283                                                         |       | 152 |   | 10,742 |   | — |   | 11,177 |   |
| Total revenues                                               |       | 22,766                                                      |       | 19,723 |   | 170,021 |   | 2,759 |   | 215,269 |   |
|                                                         |       |                                                        |       |   |   |   |   |   |   |   |   |
| EXPENSES:                                                    |       |                                                        |       |   |   |   |   |   |   |   |   |
| Loss and loss adjustment expenses                            |       | —                                                      |       | 2,915 |   | — |   | 767 |   | 3,682 |   |
| Policy acquisition costs                                     |       | —                                                      |       | 3,790 |   | — |   | 370 |   | 4,160 |   |
| Other operating expenses                                     |       | 8,663                                                       |       | 4,404 |   | 10,227 |   | — |   | 23,294 |   |
| Interest expense                                             |       | 173                                                         |       | 830 |   | 136,207 |   | 173 |   | 137,383 |   |
| Depreciation and amortization                                |       | 367                                                         |       | 309 |   | 4,041 |   | — |   | 4,717 |   |
| Total expenses                                               |       | 9,203                                                       |       | 12,248 |   | 150,475 |   | 1,310 |   | 173,236 |   |
| Income of  minority interest                                 |       | (7                                                          | )          | — |   | (2,222 | ) | — |   | (2,229 | ) |
| Income before  income taxes                                  |       | 13,556                                                      |       | 7,475 |   | 17,324 |   | 1,449 |   | 39,804 |   |
| Provision for  income tax expense                            |       | 4,637                                                       |       | 2,558 |   | 5,925 |   | 495 |   | 13,615 |   |
| Net income                                                   |       | $                                                           | 8,919      |   | $ | 4,917 |   | $ | 11,399 |   | $ | 954 |   | $ | 26,189 |   |
|                                                         |       |                                                        |       |   |   |   |   |   |   |   |   |
| Segment Assets                                               |       | $                                                           | 56,390     |   | $ | 452,947 |   | $ | 5,139,289 |   | $ | 96,877 |   | $ | 5,745,503 |   |

 

13

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**9. STOCK PLANS AND STOCK BASED COMPENSATION**

In 2001, theCompany adopted the American Capital Access Holdings, Incorporated OmnibusIncentive Compensation Plan (the “Prior Plan”) under which 2,188,584 shares ofthe Company’s common shares were reserved for issuance to employees, directorsand consultants.  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 otherwiseprovided by the Company, depending upon which version of plan the options weregranted under, each option vests ratably either annually over 3 years or every6 months over 3 and 1/2  years, beginningat 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 vests one-third per year over a three-yearperiod provided the Executive has been continuously employed by the Company ora subsidiary throughout the applicable vesting period.  In both the firstsix months of 2007 and 2006, the vested portion of the restricted stock totaled$0.6 million, which was recognized in the Company’s consolidated statement ofoperations.

InDecember 2004, the FASB issued FAS 123(R), “*Shared Based Payments*” (“FAS 123(R)”) thatrequires compensation cost related to share-based payment transactions to berecognized in an issuer’s financial statements.  The compensation cost,with limited exceptions, is measured based on the grant-date fair value of theequity or liability instrument 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”).

EffectiveJanuary 1, 2006, the Company adopted FAS 123(R) using the prospectiveapplication as permitted by FAS 123(R).  Under this application, weare required to record compensation expense for all awards granted after thedate of adoption.  Awards granted prior to the date of adoption ofFAS 123(R) continue to be accounted for under APB 25.  Compensationcost is recognized over the periods that an employee provides service inexchange for the award.  The Companyrecorded stock-based compensation expense of $0.7 million and $0.2 million forthe three months ended June 30, 2007 and 2006, respectively, $0.1 million and$0 million of which, respectively, was deferred related to policy acquisitioncosts.  The Company recorded a taxbenefit of $0.2 million and $0.1 million for the three months endedJune 30, 2007 and 2006, respectively.  TheCompany recorded stock-based compensation expense of $1.8 million and $0.4million for the six months ended June 30, 2007 and 2006, respectively, $0.3million and $0 million of which, respectively, was deferred related to policyacquisition costs.  The Company recordeda tax benefit of $0.6 million and $0.1 million for the six monthsended June 30, 2007 and 2006, respectively.

The fair value ofthe stock options granted was estimated on the date of grant using aBlack-Scholes option valuation model that uses the assumptions noted in thefollowing table.  The risk-free rate is based on the U.S. Treasury yieldcurve in effect at the time of grant.  The expected term (estimated periodof time outstanding) of the stock options granted was estimated using thesimplified method, in which the expected term equals the average of the gradedvesting term and the contractual term.  Expected volatility was estimatedbased on the historical volatility of comparable public companies for a periodequal to the stock option’s expected term, ending on the day of grant, andcalculated on a monthly basis.

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

 

Utilizing theseassumptions, the weighted-average per-share fair value of stock options grantedin the first six months of 2007 and 2006 was $5.19 and $4.45, respectively.

A summary ofoption activity for the six months ended June 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    |       | $                                                          | 11.50      |   | 3,043,650 |   | $ | 10.54 |   |
| Granted                           |       | 448,000      |       | $                                                          | 14.63      |   | 1,017,000 |   | $ | 12.66 |   |
| Exercised                         |       | (69,750      | )          | $                                                          | 10.44      |   | (663,540 | ) | $ | 10.23 |   |
| Forfeited                         |       | (105,369     | )          | $                                                          | 12.28      |   | (51,402 | ) | $ | 10.52 |   |
| Expired                           |       | —       |       | —                                                     |       | — |   | — |   |
| Outstanding, end  of period       |       | 4,169,929    |       | $                                                          | 11.84      |   | 3,345,708 |   | $ | 11.25 |   |
| Options vested, end of  period    |       | 2,237,946    |       | $                                                          | 11.02      |   | 1,526,922 |   | $ | 10.70 |   |

 

As of June 30,2007, there was $8.4 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 2.92 years.

During the firstquarter of 2007, the Company granted 106,500 shares of restricted stock. As of June 30, 2007, the Company had 346,654 shares of unvested restrictedstock outstanding 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 tablesummarizes information regarding fully vested share options as of June 30, 2007(dollars in thousands, except per share amounts):
| Number of options vested                                             |   | 2,237,946 |   |
|----------------------------------------------------------------------|--------|-----------|--------|
| Weighted average  exercise price per share                           |   | $         | 11.02  |   |
| Aggregate  intrinsic value (excess market price over exercise price) |   | $         | 24,654 |   |
| Weighted average  remaining contractual term of options (in years)   |   | 5.33      |   |

 

The followingtable summarizes information concerning outstanding and exercisable options atJune 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                    |       | 1,827,916                    |       | 5.31                                                             |       | $ | 10.33 |   | 1,522,639 |   | $ | 10.32 |   |
| $10.52-$12.01                               |       | 96,000                       |       | 7.62                                                             |       | $ | 11.63 |   | 55,453 |   | $ | 11.63 |   |
| $12.02-$13.51                               |       | 1,811,013                    |       | 7.92                                                             |       | $ | 12.70 |   | 659,854 |   | $ | 12.58 |   |
| $13.52-$15.01                               |       | 435,000                      |       | 9.63                                                             |       | $ | 14.63 |   | — |   | — |   |
|                                        |       | 4,169,929                    |       | 6.95                                                             |       | $ | 11.84 |   | 2,237,946 |   | $ | 11.02 |   |

 

Prior to theadoption of FAS 123(R), the Company applied APB 25 to account for itsstock-based compensation awards and provided the required pro forma disclosuresof FAS 123.  The following table illustrates the effect on net incomeand earnings per share had compensation expense for stock-based compensationawards been recorded in the six months ended June 30, 2007 and 2006, based onthe fair value method under FAS 123 (dollars in thousands, except pershare amounts).

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| ** **                                                                                                                                                        | ** ** | **Six Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                                                        | ** ** | **June 30, 2007**    | ** ** | **June 30, 2006**    | ** ** |
| Net income  (loss), as reported                                                                                                                                   |       | $                              | (81,919    | )                              | $          | 26,189 |   |
| 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 |       | (152                           | )          | (212                           | )          |
| Pro forma net  income (loss)                                                                                                                                      |       | $                              | (82,071    | )                              | $          | 25,977 |   |
|                                                                                                                                                              |       |                           |       |                           |       |
| Basic earnings  (loss) per share                                                                                                                                  |       |                           |       |                           |       |
| As reported                                                                                                                                                       |       | $                              | (2.24      | )                              | $          | 1.15 |   |
| Pro forma                                                                                                                                                         |       | $                              | (2.24      | )                              | $          | 1.14 |   |
| Diluted earnings  (loss) per share                                                                                                                                |       |                           |       |                           |       |
| As reported                                                                                                                                                       |       | $                              | (2.24      | )                              | $          | 0.87 |   |
| Pro forma                                                                                                                                                         |       | $                              | (2.24      | )                              | $          | 0.87 |   |

 

**10. INVESTMENTS**

The Companyaccounts for its investments in fixed maturity securities in accordance withthe FAS 115, “*Accounting for CertainInvestments in Debt and Equity Securities*” (“FAS 115”) and EmergingIssues Task Force (“EITF”) Issue  99-20, “*Recognitionof Interest Income and Impairment on Purchased and Retained BeneficialInterests in Securitized Financial Assets.*”  Managementdetermines the appropriate classification of securities at the time ofpurchase.  As of June 30, 2007 and December 31, 2006, all investmentsin fixed maturity securities, with the exception of the Company’s investmentsin its Credit-Focused Absolute Return Fixed Income Fund (the “Credit Fund”)(see Note 11), were designated as available-for-sale and were carried atfair value.  Fixed maturity securities in the Company’s Credit Fund aredesignated as trading securities and are also carried at fair value.  Thedifference between fair value and amortized cost of available-for-salesecurities is included in the accumulated other comprehensive income componentof stockholders’ equity, net of applicable deferred income tax.  Changesin fair value of trading securities are included in net income.  The fair valueof these securities is based on independent market quotations or, when suchquotations are not readily available because the securities are infrequentlytraded in the public market, from internal valuation models.  These modelsinclude estimates, made by management, which utilize current marketinformation.  The valuation results from these models could differmaterially from amounts realizable in an open market sale or exchange.

The Company’sprocess for identifying declines in the fair value of investments that areother than temporary involves consideration of several factors.  Thesefactors include (i) the duration of a significant decline in value,(ii) the liquidity, business prospects and overall financial condition ofthe issuer, (iii) the magnitude of the decline, (iv) the collateralstructure and other credit support, as applicable, (v) the Company’sintent and ability to hold the investment until the values recover, and(vi) for asset-backed securities, the estimated cash flows. When the analysisof the above factors results in a conclusion that a decline in fair value isother than temporary, the cost of the security is written down to fair value asof the reporting date and any previously unrealized loss is realized in theperiod such a determination is made.

The followingtable shows the gross unrealized losses and fair value of our fixed maturitysecurities available 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 June 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                            |       | $                                      | 38,304     |                                 | $          | (1,135    | )          | $ | 1,818 |   | $ | (77 | ) | $ | 40,122 |   | $ | (1,212 | ) |
| Federal-agency  securities                           |       | 62,502                                 |       | (1,501                               | )          | 4,370     |       | (180 | ) | 66,872 |   | (1,681 | ) |
| Obligations of  states and political subdivisions    |       | 69,094                                 |       | (986                                 | )          | 51,629    |       | (1,461 | ) | 120,723 |   | (2,447 | ) |
| Corporate  securities                                |       | 24,993                                 |       | (731                                 | )          | 54,821    |       | (2,855 | ) | 79,814 |   | (3,586 | ) |
| Asset-backed  securities                             |       | 4,956                                  |       | (43                                  | )          | 4,967     |       | (111 | ) | 9,923 |   | (154 | ) |
| Mortgage-backed  securities                          |       | 49,819                                 |       | (1,568                               | )          | 90,859    |       | (4,332 | ) | 140,678 |   | (5,900 | ) |
| Total non-VIE  securities                            |       | 249,668                                |       | (5,964                               | )          | 208,464   |       | (9,016 | ) | 458,132 |   | (14,980 | ) |
| Available for  sale-VIE—asset-backed securities |       | 1,804,091                              |       | (160,467                             | )          | 656,447   |       | (45,918 | ) | 2,460,538 |   | (206,385 | ) |
| Total                                                |       | $                                      | 2,053,759  |                                 | $          | (166,431  | )          | $ | 864,911 |   | $ | (54,934 | ) | $ | 2,918,670 |   | $ | (221,365 | ) |

 

A substantialportion of the unrealized loss in CDO VIE asset-backed securities is related toRMBS, including both sub-prime and mid-prime quality mortgages.  The lastquarter of 2006 and first quarter of 2007 saw significant disruption in thesub-prime and second lien mortgage markets, with some mortgage originatorsbeing purchased or exiting the business. This severe disruption 

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continued into the secondquarter with other types of market participants (i.e., hedge funds, insurancecompanies) announcing significant losses in connection with their sub-prime andsecond lien mortgage exposure.  Thisdisruption further translated into decreased liquidity and wider spreads acrossthe market, decreasing the market value 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 second quarter of 2007, theCompany determined that certain of its holdings in RMBS through itsconsolidated CDOs were other than temporarily impaired.  As a result, write-offs relating primarily tothose securities, aggregating $109.4 million were recorded as a reduction ofnet income during the quarter.  Thewrite-downs related to consolidated CDOs included approximately $46.9 millionin excess of the Company’s true economic exposure or its equity investment inthe CDOs that was recorded in the Company’s statement of operations.  The Company has no right to use these CDOassets.  Moreover, the CDO liabilities,which are non-recourse to the Company, can only be extinguished from the cashflows on these assets.  The Company’smaximum economic loss from a consolidated CDO is limited to its equityinvestment in the CDO.  Under currentrules governing consolidation accounting, the Company’s consolidated incomestatement would reflect 100% of the CDOs realized losses and its balance sheetwould reflect 100% of the CDOs unrealized losses despite the fact that its lossexposure is limited to its equity investment in the CDOs.  Upon maturity, or the occurrence of a deconsolidationevent, the equity and debt holders would absorb these losses and the Companywould recognize a gain equal to all previous losses recognized in excess of itsequity.  The amount of realized andunrealized losses in excess of the Company’s equity investment is $(46.9)million and $(72.8) million, respectively, as of June 30, 2007.

Regarding theunimpaired securities carried at an unrealized loss position as of June 30,2007, the Company believed that it would be able to collect 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.  The Company, therefore, did not considerthese investments to be other-than-temporarily impaired at June 30, 2007.

For certain of theCompany’s consolidated CDOs, realized and unrealized losses exceed the amountof the Company’s true economic exposure or equity investment in the CDO.  This impairment in excess of the Company’sequity investment is a result of the consolidation of CDO assets and liabilitieson the Company’s balance sheet in accordance with FIN 46(R).

The Company’saccumulated other comprehensive loss of $(106.6) million at June 30, 2007,includes $(116.1) million related to unrealized losses on fixed maturitysecurities available for sale.  Includedin the $(116.1) million is $(72.8) million of unrealized losses in theconsolidated CDOs mentioned above in excess of the Company’s equity investment.

Included in thetable above are 916 fixed maturity securities, 212 in the non-VIE portfolios,and 704 in the VIE portfolios.  At June 30, 2007, there were 127 fixedmaturity securities, all of which are in the VIE portfolios, whose fair valuewas less than 80% of its amortized cost.  Over 99% 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 June 30, 2007.

**11. CREDIT-FOCUSED ABSOLUTE RETURN FIXED INCOME FUND**

In May 2006,the Company launched the Credit Fund to leverage its expertise in the capitaland credit markets and as an asset manager.  The fund invests in fixedincome securities, particularly in the asset-backed sector.  Through June30, 2007, the Credit Fund had received capital contributions of $38.0 million,of which the Company had invested $26.4 million and third parties hadinvested $11.6 million.  In addition to receiving a return on itsinvestment in the Credit Fund, the Company is paid a management fee to selectand manage the assets of the fund for the Credit Fund’s third partyinvestors.  For accounting purposes, the Credit Fund is consolidated inthe Company’s financial statements as of June 30, 2007 and its financialresults are recorded in the Structured Credit line of business.   As of June 30, 2007, the Credit Fund hadtotal assets of $413.0 million, including investments in fixed-maturitysecurities trading of $406.4 million, and total liabilities and minorityinterest of $386.1 million, including securities sold under agreements torepurchase of $372.9 million, included in the Company’s unauditedcondensed consolidated balance sheet.

**12. SENIOR CONVERTIBLE PREFERRED 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 effecta six-for-one stock split on the Company’s outstanding shares of common stockand on 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 

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capital account to thecommon stock account in an amount equal to the par value of the incrementalshares issued under the stock split.  Upon the conversion of the variousclasses of the Company’s preferred stock, each holder of convertible preferredstock, senior convertible preferred stock and series B senior convertiblepreferred stock was issued, in the case of convertible preferred stockholdersand senior convertible preferred stockholders, 6,000 shares for each share ofpreferred stock held by such holder and, in the case of the series Bsenior convertible preferred stockholders, 6 shares of each share of preferredstock held by such holder. All earnings per share and related stock optioninformation presented in these financial statements and accompanying footnoteshave been retroactively adjusted to reflect the increased number of sharesresulting from this action.

On November 9,2006, ACA Capital priced its initial public offering of common stock.  TheCompany sold 6,875,000 shares of common stock in the offering, at $13.00 pershare, with net proceeds to ACA Capital of $79.2 million.  The transactionclosed on 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 senior convertible preferred stock converted to 16,714,614shares of common stock.

**14. LIQUIDITY FACILITY**

The Companyentered into a new credit agreement dated as of April 26, 2007 with a syndicateof banks.  The new credit agreement provides for a three-year seniorunsecured revolving credit facility in an aggregate principal amount of up to$150 million.  The Company may borrow cash under the new creditfacility bearing interest based on either (i) LIBOR plus an applicable margindepending on our leverage ratio (the ratio of debt to capital reflected in ourthen most current consolidated financial statements), or (ii) the greatestof the federal funds effective rate or prime rate in effect, plus 50 basispoints.  The Company pays a facility fee between 0.08% up to 0.15% perannum of the total commitments under the new credit facility depending on ourleverage ratio.  In addition, the Company also agreed to pay a utilizationfee at a rate of 0.125% per annum on the average daily amount of theoutstanding principal under the new credit facility, but only payable when suchoutstanding principal amount exceeds 50% of the commitments under the revolvingcredit facility.  The credit agreementcontains certain financial covenants that require, among other things, theCompany to maintain a minimum net worth and a maximum leverage ratio.  The net worth covenant includes in itscalculation the mark to market valuations recorded in the FAS 133unrealized gains (losses) on derivatives in our statement of operations. While asof June 30, 2007, the Company was in compliance with these financialcovenants, if credit spread widening continues beyond that which has occurredsince June 30, 2007, the Company may violate the net worth covenant in thefuture. The Company intends to seek a waiver of or an amendment to this calculation.The Company may not, however, be able to obtain such waiver or amendment on atimely basis, or at all.

This new revolvingcredit facility replaces the Company’s prior 364-day $75 million seniorunsecured revolving credit facility dated as of May 1, 2006.  The Companyhad no amounts outstanding nor made any borrowing under the new credit facilityas of June 30, 2007 and for the six month period then ended.

**15.  SUBSEQUENT EVENT-STOCK REPURCHASE PLAN**

On July 24, 2007,the Company’s Board of Directors authorized a $20 million stock repurchaseprogram of the Company’s outstanding common stock. As of August 9, 2007,the Company has repurchased 1,301,600 shares of common stock at a cost of$9.2 million in the aggregate.

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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 holdingcompany that provides financial guaranty insurance products to participants inthe global 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, our “A” rated, regulatedinsurance subsidiary.  Approximately 80% of our assets on anunconsolidated basis represent our 100% indirect ownership interest in ACAFinancial Guaranty. ACA Financial Guaranty provides financial guarantyinsurance policies for our Public Finance business, for the credit swaps in ourStructured Credit business and for certain other transactions described in “Other.” We primarily conduct our asset management business through ACA Management,L.L.C., a wholly-owned indirect subsidiary of ACA Financial Guaranty. Additionally, in January 2007, we obtained a license from the FSA toconduct a European asset management business, which will be done through ourwholly-owned indirect subsidiary ACA Capital Management (U.K.) Pte.Limited.  As of June 30, 2007, we had credit exposure of$68.0 billion and our assets under management for third parties were $17.9billion.

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

Through ourStructured Credit line of business, we select, structure and sell creditprotection, principally in the form of insured credit swaps, against a varietyof asset classes in the institutional fixed income markets. Structured Creditalso included the consolidated results of the Credit Fund.  The Credit Fund was created in 2006 toleverage our expertise in the capital and credit markets and as an assetmanager. The fund primarily invests in fixed income securities, particularly inthe asset-backed sector.

Within StructuredCredit, our principal revenues are net insured credit swap revenue and netinvestment income, which includes amounts received from the Credit Fund and itsallocated portion of corporate-wide investment income. Generally, we receiveinsured credit swap premiums in quarterly installments over the life of therelated swaps which is typically in the range of 5 to 7 years. The principalexpenses of this line of business are its allocated portion of corporate-wideoperating expenses, interest expense and depreciation and amortization. It alsoincurs direct interest expense related to the financing of our consolidatedCredit Fund’s purchased investments. We enter into our insured credit swapswith intent that they remain outstanding for the entire term of thecontract.  These insured credit swaps are accounted for at fair valuebecause they do not qualify for the financial guarantee scope exception underFAS No. 133, “*Accounting for DerivativeInstruments and Certain Hedging Activities*”, as amended (“FAS 133”). Changes in the fair value of these contracts are required to be marked tomarket under the requirements of FAS 133 and are recorded, together with therelated fixed quarterly premium payments payable to us under the insured creditswaps, under the caption net insured credit swap revenue.  We expect thefair values of these insured credit swaps to fluctuate primarily based onchanges in credit spreads and the credit quality of the underlying referencedentities.  When we hold these insuredcredit swaps for the entire term of the contract, which is our intent, thecumulative 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 certain circumstances, we may agree with acounterparty to terminate an insured credit swap transaction prior to itsmaturity (such as on request of the counterparty or for risk managementpurposes, such as in connection with a deterioration of the underlyingportfolio) and may experience realized gains or losses in connection with theearly termination of such transactions. See “—Critical Accounting Policies and Estimates and—Net Insured CreditSwap Revenue.”

In our PublicFinance line of business, we primarily provide financial guaranty insurancepolicies guaranteeing the timely 

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payment of principal andinterest on public finance and other debt obligations. Our principal revenuesin this line of business are premiums earned on our financial guarantyinsurance policies and its allocated portion of corporate-wide investmentincome. The principal expenses of this line of business include its allocatedportion of corporate-wide operating expenses, interest expense and depreciationand amortization. We also incur loss and loss adjustment expenses, related tothe non-derivative exposure we insure, and policy acquisition costs, which areexpenses that vary with and are directly attributable to the generation ofinsurance premiums and are deferred and recognized over the period in which therelated premiums are earned. Typically, public finance premiums are received byus on an up front basis. However, under current accounting standards, they arerecognized into income over the term of the underlying instrument.

In our CDO AssetManagement line of business, we focus on CDO origination, structuring and assetmanagement. Our principal revenues in this line of business are investmentincome, management fees, warehouse income, other credit swap revenue andpremiums for credit swaps on insured equity tranches of unfunded 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 of Operations—CDO AssetManagement—Supplementary Information” for a discussion on the accounting issuesassociated 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 six monthsended June 30, 2007 and 2006.

We believe it ismore meaningful to analyze our financial performance on an annual, rather thana quarterly, basis in order to give our lines of business flexibility to selectonly those opportunities that meet our risk-adjusted return expectations. We believethis maximizes our profitability and allows our lines of business to avoidunfavorable pricing, credit spreads and general market conditions that mayoccur in any particular quarter. Furthermore, during any given year we enterinto a limited number of transactions in each of our lines of business and donot set corporate goals based on closing a specified number of transactions inany particular quarter or year. The transactions in which we participate areoften highly negotiated and often take a significant period of time from startto finish, up to one year in Public Finance and up to nine months for a CDO.Accordingly, our financial performance can vary significantly from quarter toquarter and the operating results for any quarter are not indicative of resultsfor any future period.

Additionally,management reviews our performance using a measure known as net economicincome. 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.”

**Critical Accounting Policies andEstimates**

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

*Financial Guaranty RevenueRecognition*

*PremiumsEarned—*Premiums on financial guaranty insurance products inthe form of traditional insurance policies are typically received on an upfront basis, although certain policies pay premium in periodic installments.The vast majority of our Public Finance business is conducted through theissuance of traditional policies. Traditional policies are those that meet thescope exception of the guidance of FAS 133, paragraph 10d, as amendedby FAS 149, “*Amendment ofStatement 133 on Derivative Instruments and Hedging Activities*”(“FAS 149”).  The scope exceptionprovides that financial guaranty contracts are not subject to FAS 133, ifthey meet certain specified criteria. Installment premiums are earned over eachinstallment period, which is generally one year or less. Up front premiums areearned in proportion to the expiration of risk, which is par. Premium isallocated to each par maturity (*e.g.*,principal payment) included in an insured bond and earned on a straight-linebasis for the period the related insured risk is outstanding.  Unearned premiums represent that portion ofpremiums which is applicable to coverage of risk to be provided in the futureon policies in-force. When an insured issue is retired or defeased prior to theend of the expected period of coverage, the remaining unearned premiums, lessany amount credited to the refunding issue insured by us, are recognized asearned premium. The amounts earned from refundings were approximately $4.4 millionand $3.3 million for the three months ended June 30, 2007 and 2006,respectively, and $5.0 million and $3.5 million for the comparable six monthsthen ended.

On April 18, 2007,the FASB released an exposure draft entitled “*Accountingfor Financial Guarantee Insurance Contracts—An Interpretation of FASB StatementNo. 60*” (the “Proposed Statement”).  While FASB Statement No.60, “*Accounting and Reporting by InsuranceEnterprises”,*  sets outaccounting standards for property and casualty and life insurance enterprises,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 claim 

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reserves and disclosuresaround such reserves.  The Proposed Statement would be effective forfinancial statements issued for fiscal years beginning after December 15,2007.  While certain provisions of the Proposed Statement are still beinganalyzed, management believes that the cumulative effect of initially applyingthe Proposed Statement could be material to our financial statements. 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.

*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. These instruments arevalued using pricing models based on the net present value of expected futurecash flows and observed prices for other transactions bearing similar riskcharacteristics. The fair value of these instruments is included in derivativeassets or derivative liabilities. We do not believe that our insured creditswaps meet the scope exception of FAS 133, paragraph 10d, as amended byFAS 149, because there is no contractual requirement that the protectionpurchaser be exposed to the underlying risk.

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

We value our insuredcredit swap transactions either by obtaining market quotes from dealers orthrough the application of our valuation model. During the quarter ended June 30, 2007, we refined our valuation modelto estimate fair value of our insured 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 relatively young market for credit swapshas continued to evolve over time and, while there is still substantialvariance in valuation models among market participants, the trend is towardincreasing convergence in this area. Under our refined model, we fully usemarket spread data as a proxy for default probabilities in the determination offair value. For transactions in which the underlying exposure is to corporate credits,we use individual market spreads as proxies for defaults as they are readilyavailable. For synthetic asset-backed transactions, we use a current weightedaverage portfolio spread because individual spread information historically hasnot been consistently reliable and often has been unavailable. As theavailability and quality of individual asset-backed spread data improves, wemay make further refinements to our valuation model. We believe that our newmodel will inherently increase the volatility of these valuations, but providea better estimate of the cost or benefit of unwinding the related transaction.

*DerivativeContracts. *Allderivative instruments are recognized in our consolidated balance sheet aseither assets or liabilities depending on the fair value to us as a creditprotection seller as of the determination date. All derivative instruments aremeasured at estimated fair value. We value derivative contracts based on quotedmarket prices, when available. However, if quoted prices are not available, thefair value is estimated using valuation models specific to the type of creditprotection. Valuation models include the use of management estimates andcurrent market information.  We utilizeboth proprietary and vendor based models (including rating agency models) and avariety of market data to provide the best estimate of fair value. Some of themore significant types of market data that influence our models include, butare not limited to, credit ratings, interest rates, credit spreads, defaultprobabilities and recovery rates. If management’s underlying assumptions forevaluating fair value prove to be inaccurate, there could be material changesin our consolidated operating results.

*PolicyAcquisition Costs.  * Policy acquisition costsinclude those expenses that relate primarily to and vary with premiumproduction. Such costs are comprised primarily of premium taxes, personnel andpersonnel related expenses of individuals involved in underwriting, and certainrating-agency and legal fees for municipal and non-derivative structuredfinance business. Anticipated claims and claim adjustment expenses areconsidered in determining the recoverability of acquisition costs. Netacquisition costs are deferred and amortized over the period in which therelated premiums are earned. In connection with its review of certainaccounting standards for financial guaranty insurance contracts, the FASB isconsidering potential changes relating to deferred policy acquisition costs.See “—Critical Accounting Policies and Estimates—Financial Guaranty RevenueRecognition—Premiums Earned” for further explanation of potential changes.

*Lossand Loss Adjustment Expenses.* Financial guaranty loss and loss adjustment expense reserves areestablished on our non-derivative exposure in an amount equal to our estimateof identified or case-specific reserves and non-specific reserves, includingcost of settlement, on the obligations ACA Financial Guaranty has incurred. Indetermining our accounting policy for loss reserves, we rely primarily on FAS60,*“Accounting and Reporting by InsuranceEnterprises”* (“FAS 60”).  However, FAS 60 was adopted when thefinancial guaranty industry was just beginning. As a result, FAS 60 did notcontemplate the specific attributes of financial guaranty insurance as distinctfrom other forms of insurance. In particular, financial guaranty insurance isconsidered a short-duration insurance product; however, it has features thatare more akin to long-duration contracts in that the term of some insuredobligations can be as long as 30 years or more and the contracts aregenerally irrevocable. Under FAS 60, accounting for losses differs forshort-duration and long-duration contracts. Because of this inconsistency, wealso apply FAS 5, “*Accounting forContingencies*” (“FAS 5”) in the determination of our lossreserves.  Specifically, FAS 5 requires the establishment of reserves whenit is probable that a liability has been incurred at the reporting date, butonly to the extent the loss can be reasonably estimated. The Proposed Statementincludes guidance on the establishment of claim reserves and disclosure aroundsuch reserves.  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.  The comment period for the exposuredraft ended June 18, 2007.  No revisedstatement has yet been published.  See “—Critical Accounting Policies andEstimates—Financial Guaranty Revenue Recognition—Premiums Earned” for furtherexplanation of potential changes.

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The financialguaranty insurance policies we issue insure scheduled payments of principal andinterest due on various types of financial obligations against a paymentdefault on such payments by the issuers of the obligations. Active surveillanceof our insured portfolio tracks the performance of insured obligations from periodto period. We establish loss and loss adjustment expenses, or LAE, reservesbased on surveillance group reports, the latest available industry data, andanalysis of historical default and recovery experience for the relevant sectorsof the fixed-income market. Together the case reserves and non-specificreserves represent management’s estimate of incurred losses on ournon-derivative insured portfolio exposures.

Case specificreserves are reserves created on those obligations identified as currently orlikely to be in default, and represent the present value, discounted at theU.S. Treasury Note rate applicable to the term of the underlying insuredobligations, of the expected LAE payments, net of estimated recoveries (undersalvage, subrogation or other recovery rights). Gross case-specific reserves, net of estimated recoveries, were$21.4 million and $20.2 million as of June 30, 2007 and December 31,2006, respectively.  We take into accounta number of variables that depend primarily on the nature of the underlyinginsured obligation when we establish case specific reserves for individualpolicies.  These variables include thenature and creditworthiness of the underlying issuer of the insured obligation,whether the obligation is secured or unsecured and the expected recovery rateson the insured obligation, the projected cash flow or market value of anyassets that support the insured obligation and the historical and projectedloss rates on such assets.  The state ofthe economy, 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 believethat changes to these factors would materially change the amount of our casespecific loss reserves, with the exception of significant changes in salvagevalues of specific collateral.  However,case specific reserves are regularly reviewed in order to incorporate relevantcurrent facts and circumstances and changes to these factors may in the futurematerially change the amount of our case specific loss reserves.

Our non-specificreserve was derived from the calculation of expected loss, which we estimateusing a Monte Carlo simulation.  A MonteCarlo simulation is a technique that is commonly used to estimate theprobability of certain mathematical outcomes. It randomly selects values to create scenarios of outcomes and thisrandom selection process is repeated many times to create multiple scenarios.  Each time a value is randomly selected, itforms one possible scenario and outcome. Together, these scenarios give a range of possible outcomes, some ofwhich are more probable and some less probable. By definition, the average solution will give the most likely potentialoutcome.  Our risk management teamtypically runs at least 100,000 trials in order to determine future expectedlosses.  The model uses the currentratings and default frequency (net of recovery) applied to each transactionwith outstanding exposure to determine the expected probability distribution ofloss.  Default frequency and recoveryamounts are published periodically by each of the major rating agencies.  From the model output, we can estimate arange of expected loss.  The amount ofnon-specific reserve recorded in the financial statements is based on the lossratio resulting from the calculation of total losses, including past incurredlosses and expected future losses divided by premium.  For this purpose, premium is defined asever-to-date written premium as of June 30, 2007 plus future installmentpremium on closed transactions.  Thisderived loss ratio is applied to total ever-to-date earned premiums as of June30, 2007.  Case specific reserves are subtractedfrom this amount to arrive at net non-specific reserves.  The table below shows our case andnon-specific reserves as of June 30, 2007 and December 31, 2006.
| ** **              | ** ** | **As of June 30,** | ** ** | **As of December 31,** | ** ** |
|-------------------------|------------|-----------------------------------|------------|---------------------------------------|------------|
| ** **              | ** ** | **2007**                          | ** ** | **2006**                              | ** ** |
| ** **              | ** ** | **(in thousands)**           | ** ** |
| Case specific  reserves |       | $                                 | 21,421     |                                  | $          | 20,232 |   |
| Non specific  reserves  |       | 24,502                            |       | 21,881                                |       |
| Total                   |       | $                                 | 45,923     |                                  | $          | 42,113 |   |

 

*InvestmentPortfolio.*  The primarycomponents of our investment portfolio are the fixed maturity securities of ACAFinancial Guaranty, our CDO investments and the investments of the Credit Fund.As per FAS 115, “*Accounting for CertainInvestments in Debt and Equity Securities*” (“FAS 115”) managementdetermines the appropriate classification of these securities at the time ofpurchase.  As of June 30, 2007, all investments in fixed maturitysecurities except for those related to the Credit Fund were designated asavailable for sale and were carried at fair value. Unrealized gains and lossesfor available for sales securities are the difference between fair value andamortized cost included in the accumulated other comprehensive income componentof stockholders’ equity, net of applicable deferred income tax. As of June 30,2007, the investments of the Credit Fund were designated as trading securitiesand were also carried at fair value. Unrealized gains and losses for tradingsecurities are included in net income. The fair values of our securities arebased on independent market quotations or, when such quotations are not readilyavailable because the securities are infrequently traded in the public market,from internal valuation models. The valuation results from these models coulddiffer materially from amounts realizable in an open market sale or exchange.

*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”*(“FIN 46(R)”). Prior to 2005, we retained all or most of the equity position inour CDOs, and these CDOs are therefore consolidated in our financial statements(a total of seven CDOs are consolidated). Although the CDO is consolidated, wedo not have the right to use the 

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assets of the CDO forgeneral operations and the debt liabilities of the CDO are without recourse toany assets other than those of the CDO. Our investment exposure to our CDOs istherefore limited to our equity investment, which is a first loss position ofthe CDO. In the instances that we own less than 100% of the CDO’s equity, butare the primary beneficiary and thus consolidate the CDO, we establish minorityinterests for the unowned portion.  As ofJune 30, 2007 and December 31, 2006, consolidated liabilities includednon-recourse debt from consolidated CDOs of $4,525.9 million and $4,711.8million, respectively.  Also, as of June30, 2007 and December 31, 2006, consolidated assets included investment infixed maturity securities and guaranteed investment contracts of $4,193.3million and $4,656.0 million, respectively, and cash of $238.0 million and$265.0 million, respectively, related to CDOs.

Beginning in 2005,we have retained a lesser share of the equity position of our newly issuedCDOs.  Based on analyses under FIN 46(R),we are not deemed to be the primary beneficiary of these VIEs.  As a result, these CDOs are not consolidatedin our financial statements.  Rather, ournon-majority investment is recorded as an investment in a single fixed maturitysecurity under the provisions of FAS 115 and Emerging Issues Task Force (“EITF”)Issue No. 99-20, “*  Recognition of Interest Income and Impairmenton Purchased and Retained Beneficial Interests in Securitized Financial Assets*  “ (“EITF 99-20”).  During the first six months of 2007, weclosed eight CDOs and purchased an equity interest in three.  During 2006, we closed eight CDOs andpurchased an equity interest in four. During 2005, we closed five CDOs and purchased an equity interest infour.  We were not determined to be theprimary beneficiary in any of these CDOs and therefore do not consolidate them.

In May of2006, we began managing our Credit Fund. The Credit Fund was created to leverage our expertise in the capital andcredit markets and as an asset manager. The Credit Fund invests in fixed maturity securities, particularly inthe asset-backed sector.  Through June30, 2007, the Credit Fund had received capital contributions of$38.0 million, of which the Company had invested $26.4 million andthird parties had invested $11.6 million. In addition to receiving a return on our investment in the Credit Fund,we are paid a management fee to select and manage the assets for the CreditFund’s third party investors.  Althoughthe Credit Fund is consolidated pursuant to the requirements of U.S. GAAPaccounting, we do not have the right to use the assets for generaloperations.  See “—Results ofOperations—Structured Credit.”

**Results of Operations**

*Summary of Consolidated Results*

The followingdescribes our consolidated financial results for the three months and the sixmonths ended June 30, 2007 and 2006 and our financial condition as of June 30,2007 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, the followingconsolidated discussion has been prepared to describe (1) revenue andexpense items that are allocated to our four lines of business and (2) theresults of our lines of business:  Structured Credit, Public Finance, CDOAsset Management and Other.

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

The Company’sconsolidated net income (loss) for the three months ended June 30, 2007 was$(93.3) million, or $(2.55) per diluted share, as compared to $12.0 million, or$0.40 per diluted share, for the three months ended June 30, 2006, a decreaseof $105.3 million.  The decrease in netincome was principally related to after-tax other than temporary impairments ofinvestments in our CDOs of $(71.1) million and after-tax net unrealizedmark-to-market valuation losses on our portfolio of Structured Credittransactions of $(43.9) million.

The Company’sconsolidated net income (loss) for the six months ended June 30, 2007 was$(81.9) million, or $(2.24) per diluted share, as compared to $26.2 million, or$0.87 per diluted share, for the six months ended June 30, 2006, a decrease of$108.1 million, which were primarily the result of other than temporaryimpairments in our CDOs and unrealized mark-to-market valuation losses on ourportfolio of Structured Credit transactions discussed above.

The followingtable summarizes the contribution of each line of business to net consolidatedincome (loss) for the three and six months ended June 30, 2007 and 2006:

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|                                        | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                             | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                             | ** ** | **(in thousands)**                             | ** ** |
| Net income  (loss) by line of business |       |                                                |       |                                              |       |   |   |   |   |
| Structured Credit                      |       | $                                                   | (32,700    | )                                                 | $          | 2,543 |   | $ | (33,094 | ) | $ | 8,919 |   |
| Public Finance                         |       | 3,487                                               |       | 3,121                                             |       | 6,438 |   | 4,917 |   |
| CDO Asset Management                   |       | (64,577                                             | )          | 5,611                                             |       | (56,222 | ) | 11,399 |   |
| Other                                  |       | 454                                                 |       | 767                                               |       | 959 |   | 954 |   |
| Net income  (loss)                     |       | $                                                   | (93,336    | )                                                 | $          | 12,042 |   | $ | (81,919 | ) | $ | 26,189 |   |

 

*StructuredCredit*

For the threemonths ended June 30, 2007, a net loss of $(32.7) million was recognizedcompared to net income of $2.5 million for the same period of 2006.  The pre-tax net unrealized loss included$(67.5) million in the second quarter of 2007 relating to the mark to marketvaluation of insured credit swap transactions.  This unrealized loss wasprimarily related to insured credit swap transactions for which the underlyingexposure is pools of sub-prime and second-lien residential mortgage-backedsecurities (“RMBS”) and the associated widening of credit spreads on thoseassets that occurred during the quarter.  The spread widening was inresponse to the pronounced increase in homeowner delinquencies and defaultswith respect to sub-prime and second lien residential mortgages originated in2006.  For the three months ended June 30,2006, we recognized pre-tax net unrealized losses in the amount of $(4.1)million.  Insured credit swap premiums earned from credit swaptransactions increased to $22.8 million for the three months ended June 30,2007 from $10.0 million for the same period of 2006.

For the six monthsended June 30, 2007, a net loss of $(33.1) million was recognized compared tonet income of $8.9 million for the same period in 2006.  The pre-tax net unrealized loss included anamount of $(80.3) million in the six months ended June 30, 2007 related to themark to market valuation of insured credit swap transactions, compared with apre-tax net unrealized loss in the amount of $0.4 million over the same periodin 2006.  Insured credit swap premiumsearned from credit swap transactions increased to $40.3 million for the sixmonths ended June 30, 2007 from $18.8 million for the same period in 2006.  Other operating expenses increased in thethree and six months ended June 30, 2007 compared to the same period in2006.  This increase was in connection with the additional expensesincurred due to our status as a public company as well as additional expensesincurred, mainly personnel related, in direct support of the Structured Creditbusiness.

*PublicFinance*

For the threemonths ended June 30, 2007, net income increased to $3.5 million from $3.1million for the same period in 2006.  Growth in net income was primarilyrelated to increased premiums earned, mark to market valuation gains on twotransactions that are in the form of insured credit swaps and higher netinvestment income based on increases in ACA Financial Guaranty’s investmentportfolio.  The growth in net income was partially offset by higheroperating expenses incurred due to our status as a public company andadditional expenses incurred, namely personnel related, in direct support ofthe Public Finance business.  Grosspremiums written was $15.4 million for the three months ended June 30, 2007compared to $15.3 million for the same period of 2006.

For the six monthsended June 30, 2007, net income increased to $6.4 million from $4.9 million forthe same period in 2006, while gross premiums written over the same periodincreased to $20.0 million from $19.4 million in 2006.

*CDOAsset Management*

For the three monthsended June 30, 2007, a net loss of $(64.6) million was recognized compared tonet income of $5.6 million for the same period in 2006.  The Company recognized pre-tax other thantemporary impairments related to eight CDO equity positions totaling $(109.4)million, or $(71.1) million after-tax, during the three months ended June 30,2007.  The impairment losses on six ofthese eight CDOs were largely due to the deterioration in the form of increasedmortgage delinquencies and rates of defaults on mortgages underlying RMBSoriginated, primarily, in 2006.  Two ofthese eight CDOs realized impairment losses because of the increased speed,relative to original projections, at which the underlying mortgages prepaid.  A pre-tax total of $46.9 million of theseimpairments were in excess of the Company’s equity investment in the CDO.  This impairment in excess of the Company’s equity investment in the CDO(“over-impairment”) is a direct result of the consolidation of CDO assets andliabilities in accordance with FIN 46(R). As a result of consolidation, the Company records $4.4 billion of assetsat fair value related to CDOs and $4.5 billion of related non-recourse debt onits balance sheet.  Losses in excess ofthe Company’s actual investment will reverse upon the maturity of the CDO, orthe occurrence of a deconsolidation event.

For the six monthsended June 30, 2007, a net loss of $(56.2) million was recorded compared to netincome of $11.4 million for the same period in 2006.  The other than temporary impairments relatedto investments was the primary driver of this decline as well.

*Other*

Other representedan immaterial portion of our reported results for the three and six monthsended June 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.

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*ItemsAllocated to Business Lines*

Within ourstatement of operations, we have income and expense items that are directlyattributable to our lines of business and items that are indirectly attributable.Examples of items that are directly attributable to lines of business are grosspremiums written, premiums earned, insured credit swap revenue, net realizedand unrealized gains and losses on derivatives, losses and loss adjustmentexpenses and depreciation and amortization related to the consolidation of ourCDOs.  Certain operating expenses,including those related to personnel and other expenses dedicated to a line ofbusiness are allocated to that line of business. Remaining expenses areallocated to lines of business based on time and expense studies conductedannually. Due to its run-off status beginning in 2004, other operating expensesare not allocated to our Other line of business.  Items allocated to linesof business include net investment income on the corporate-wide cash investmentportfolios and other non-VIE entities within the consolidated group, netrealized gains and losses on those portfolio, operating expenses, interestexpense related to our corporate debt, depreciation and amortization and incometaxes. The net investment income and net realized gains and losses oninvestments related to our CDO Asset Management business and the Credit Fundare considered direct revenues. The following table summarizes the principalitems in our consolidated statement of operations that are allocated forpurposes of line of business reporting for the three months and the six monthsended June 30, 2007 and 2006. All other revenue and expense items included inthe consolidated statement of operations are directly attributable to aspecific line of business.
| ** **                                         | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                         | ** ** | **(in thousands)**                             | ** ** |
| Net investment  income                             |       |                                                |       |                                              |       |   |   |   |   |
| Allocated                                          |       | $                                                   | 7,483      |                                              | $          | 6,358 |   | $ | 14,988 |   | $ | 12,315 |   |
| Direct to Business Lines                           |       | 83,144                                              |       | 76,094                                            |       | 165,559 |   | 147,849 |   |
| Total                                              |       | $                                                   | 90,627     |                                              | $          | 82,452 |   | $ | 180,547 |   | $ | 160,164 |   |
| Net realized and  unrealized losses on investments |       |                                                |       |                                              |       |   |   |   |   |
| Allocated                                          |       | $                                                   | 3          |                                              | $          | (123 | ) | $ | (48 | ) | $ | (1,257 | ) |
| Direct to Business Lines                           |       | (110,145                                            | )          | (1,133                                            | )          | (113,802 | ) | (1,966 | ) |
| Total                                              |       | $                                                   | (110,142   | )                                                 | $          | (1,256 | ) | $ | (133,850 | ) | $ | (3,223 | ) |
| Other operating  expenses                          |       |                                                |       |                                              |       |   |   |   |   |
| Allocated                                          |       | $                                                   | 15,117     |                                              | $          | 12,310 |   | $ | 30,748 |   | $ | 22,386 |   |
| Direct to Business Lines                           |       | 447                                                 |       | 371                                               |       | 969 |   | 908 |   |
| Total                                              |       | $                                                   | 15,564     |                                              | $          | 12,681 |   | $ | 31,717 |   | $ | 23,294 |   |
| Interest expense                                   |       |                                                |       |                                              |       |   |   |   |   |
| Allocated                                          |       | $                                                   | 1,858      |                                              | $          | 1,783 |   | $ | 3,698 |   | $ | 3,459 |   |
| Direct to Business Lines                           |       | 74,479                                              |       | 69,181                                            |       | 149,047 |   | 133,924 |   |
| Total                                              |       | $                                                   | 76,337     |                                              | $          | 70,964 |   | $ | 152,745 |   | $ | 137,383 |   |
| Depreciation and  amortization                     |       |                                                |       |                                              |       |   |   |   |   |
| Allocated                                          |       | $                                                   | 440        |                                              | $          | 393 |   | $ | 819 |   | $ | 1,006 |   |
| Direct to Business Lines                           |       | 1,838                                               |       | 1,832                                             |       | 3,718 |   | 3,711 |   |
| Total                                              |       | $                                                   | 2,278      |                                              | $          | 2,225 |   | $ | 4,537 |   | $ | 4,717 |   |
| Provision for  income tax expense                  |       |                                                |       |                                              |       |   |   |   |   |
| Allocated                                          |       | $                                                   | (47,260    | )                                                 | $          | 6,323 |   | $ | (41,392 | ) | $ | 13,615 |   |
| Direct to Business Lines                           |       | —                                              |       | —                                            |       | — |   | — |   |
| Total                                              |       | $                                                   | (47,260    | )                                                 | $          | 6,323 |   | $ | (41,392 | ) | $ | 13,615 |   |

 

*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 June 30, 2007, allocated net investment income increased to $7.5 millionfrom $6.4 million for the three months ended June 30, 2006. This increasewas related to growth in the investment portfolio from $571.9 million at June30, 2006 to $698.7 million at June 30, 2007. The growth in the investmentportfolio between periods was primarily related to positive cash flowsgenerated by our businesses and, from $79.2 million raised from the proceeds ofour initial public offering in November 2006 (“IPO”).

For the six monthsended June 30, 2007, allocated net investment income increased to $15.0 millionfrom $12.3 million for the six months ended June 30, 2006 primarilyrelated to growth in the respective investment portfolio.

25

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*NetRealized and Unrealized Gains and Losses on Investments.  *Allocated net unrealized and realized gains and losses on investments representthose gains and losses incurred on the investment portfolio discussed above andare similarly allocated to the lines of business. For the three months and sixmonths ended June 30, 2007, the direct-to-business-line net realized loss of$(110.1) million and $(113.8) million, respectively, was primarily the resultof other than temporary impairments related to sub-prime and second lien RMBSin consolidated CDOs.

Allocated netunrealized and realized gains and losses on investments for the six monthsended June 30, 2007 was $0 million, as compared with $(1.3) million for thesame period in 2006.  The loss in 2006was primarily driven by a sector reallocation of bonds within the ACA FinancialGuaranty portfolio.

*OtherOperating Expenses. *Allocatedother operating expenses is comprised of all costs related to personnel, officeleases and expenses, legal, accounting and rating agencies. Allocated otheroperating expenses does not include expenses related to the consolidation ofour CDOs or the Credit Fund. Those expenses are treated as direct expenses ofthe CDO Asset Management line of business and the Credit Fund (part of theStructured Credit line of business), respectively, for this purpose. For thethree months ended June 30, 2007, allocated other operating expenses increasedto $15.1 million from $12.3 million for the three months ended June 30,2006.  For the six months ended June 30,2007, allocated other operating expenses increased to $30.7 million from $22.4million for the six months ended June 30, 2006. The increase in expenses was attributable to additional personnel hiredto support the businesses and expenses in connection with the opening of ourUnited Kingdom and Singapore offices in 2006.

*InterestExpense. *Allocatedinterest expense is related to our holding company floating rate debt.  It is allocated to our lines of businessbased on capitalization of the respective lines of business as described abovewith respect to net investment income.  Allocated interest expense for thethree months ended June 30, 2007 and 2006 remained stable at $1.9 million and$1.8 million, respectively.  Allocatedinterest expense for the six months ended June 30, 2007 and 2006 was alsorelatively stable at $3.7 million and $3.5 million, respectively.  No new debt was issued in 2007 or 2006 andthree month LIBOR, on which the floating interest rates are based, was largelyunchanged.

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

*IncomeTaxes.  * Income taxes are generally allocated toline of business based upon the overall corporate effective tax rate applied topre-tax income.

*StructuredCredit*

The followingtable summarizes the operations of our Structured Credit line of business forthe three months and the six months ended June 30, 2007 and 2006:
| ** **                                                   | ** ** | **Three Months Ended June 30,** | ** **  | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------------|-------------|---------------------------------------------------|------------|
| ** **                                                   | ** ** | **2007**                                            | ** **  | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                   | ** ** | **(in thousands)**                             | ** **  |
| **REVENUES:**                                                | ** ** | ** **                                          | ** **  | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Gross premiums  written                                      |       | $                                                   | 47          |                                              | $          | 192 |   | $ | 134 |   | $ | 470 |   |
| Premiums earned                                              |       | $                                                   | 47          |                                              | $          | 210 |   | $ | 134 |   | $ | 506 |   |
| Net insured  credit swap revenue                             |       | (44,628                                             | )           | 7,699                                             |       | (39,983 | ) | 20,439 |   |
| Net investment  income                                       |       | 6,973                                               |        | 882                                               |       | 12,718 |   | 1,734 |   |
| Net realized and  unrealized losses on investments           |       | (714                                                | )           | (35                                               | )          | (2,226 | ) | (171 | ) |
| Net realized and  unrealized gains on derivative instruments |       | 292                                                 |        | —                                            |       | 288 |   | — |   |
| Other net credit  swap revenue                               |       | (237                                                | )           | (11                                               | )          | (274 | ) | (25 | ) |
| Fee income                                                   |       | 210                                                 |        | 135                                               |       | 307 |   | 248 |   |
| Other income                                                 |       | 20                                                  |        | 18                                                |       | 38 |   | 35 |   |
| **Total  revenues**                                          | ** ** | **(38,037**                                         | **)**       | **8,898**                                         | ** ** | **(28,998** | **)** | **22,766** | ** ** |
| **EXPENSES:**                                                | ** ** | ** **                                          | ** **  | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Other operating  expenses                                    |       | 6,408                                               |        | 4,746                                             |       | 12,698 |   | 8,663 |   |
| Interest expense                                             |       | 4,475                                               |        | 90                                                |       | 7,765 |   | 173 |   |
| Depreciation and  amortization                               |       | 159                                                 |        | 161                                               |       | 297 |   | 367 |   |
| **Total  Expenses**                                          | ** ** | **11,042**                                          | ** **  | **4,997**                                         | ** ** | **20,760** | ** ** | **9,203** | ** ** |
| Income of  minority interest                                 |       | (141                                                | )           | (7                                                | )          | (58 | ) | (7 | ) |
| Income (loss)  before income taxes                           |       | (49,220                                             | )           | 3,894                                             |       | (49,816 | ) | 13,556 |   |
| Provision for  income tax expense (benefit)                  |       | (16,520                                             | )           | 1,351                                             |       | (16,722 | ) | 4,637 |   |
| **Net Income (loss)**                                        | ** ** | **$**                                               | **(32,700** | **)**                                             | **$**      | **2,543** | ** ** | **$** | **(33,094** | **)** | **$** | **8,919** | ** ** |

 

26

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*GrossPremiums Written.*   Gross premiums written withinthis line of business decreased to less than $0.1 million for the three monthsended June 30, 2007 from $0.2 million for the three months ended June 30,2006.  Forthe six months ended June 30, 2007 and 2006, we wrote premiums of$0.1 million and $0.5 million, respectively, in this business line.  These declines occurred becausetransactions with respect to this line of business have been conducted in theform of insured credit swaps.  No newtraditional insurance contracts have been written in 2007 for this line ofbusiness and the decline relates to the decreased premium for contracts thatwere 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 $(44.6) million for the three months ended June 30,2007 from $7.7 million for the same period in 2006.  As set forth in thetable below, insured credit swap revenue is the sum of premiums earned on ourinsured credit swap transactions, unrealized gains (losses) resulting from thechanges in fair value of these transactions and net realized gains (losses)which may, from time to time, result from any termination or credit eventsrelated to such transactions.  The secondquarter 2007 over second quarter 2006 decline in net insured credit swaprevenue was directly related to net unrealized mark to market losses recordedduring 2007.  Valuation losses in the second quarter 2007 were principallyrelated to the widening credit spreads associated with insured credit swaptransactions for which the underlying exposure was to pools of sub-prime andsecond lien RMBS.  The $(67.5) million unrealized loss is comprised of anunrealized loss of $(253.0) million on our ABS/MBS portfolio, partially offsetby an unrealized gain of $185.5 million on our corporate credit portfolio.

We value our insuredcredit swap transactions either by obtaining market quotes from dealers orthrough the application of our valuation model. During the quarter ended June 30, 2007, we refined our valuation modelto estimate fair value of our insured 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 relatively young market for credit swapshas continued to evolve over time and, while there is still substantialvariance in valuation models among market participants, the trend is towardincreasing convergence in this area. Under our refined model, we fully usemarket spread data as a proxy for default probabilities in the determination offair value. For transactions in which the underlying exposure is to corporate credits,we use individual market spreads as proxies for defaults as they are readilyavailable. For synthetic asset-backed transactions, we use a current weightedaverage portfolio spread because individual spread information historically hasnot been consistently reliable and often has been unavailable. As theavailability and quality of individual asset-backed spread data improves, wemay make further refinements to our valuation model.  We believe that our new model will inherentlyincrease the volatility of these valuations, but provide a better estimate ofthe cost or benefit of unwinding the related transaction.

Premiums earnedfrom our insured credit swap transactions increased to $22.8 million for thethree months ended June 30, 2007 from $10.0 million for the three months endedJune 30, 2006.  The primary reason for the increase was the higher volumeof transactions completed.  As of June 30, 2007, the notional creditexposure in this line of business increased to $61.0 billion from $24.4 billionat June 30, 2006.

For the six months ended June 30, 2007 and 2006, net insuredcredit swap revenue was $(40.0) millionand $20.4 million, respectively.  Asdiscussed above, the decrease is primarily related to the net unrealized markto market losses during the first six months of 2007, partially offset bypremiums earned from our insured credit swap transactions of $40.3 million forthe six months ended June 30, 2007 compared to $18.8 million for the six monthsended June 30, 2006.

The followingtable shows the components of net insured credit swap revenue for the threemonths and the six months ended June 30, 2007 and 2006:

|                                            | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** |
|--------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                 | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                 | ** ** | **(in thousands)**                         | ** ** |
| Insured credit swap premiums  earned       |       | $                                               | 22,825     |                                          | $          | 9,985 |   | $ | 40,339 |   | $ | 18,831 |   |
| Unrealized  losses on insured credit swaps |       | (67,453                                         | )          | (4,074                                        | )          | (80,322 | ) | (401 | ) |
| Realized gains on insured  credit swaps    |       | —                                          |       | 1,788                                         |       | — |   | 2,009 |   |
| Net insured  credit swap revenue           |       | $                                               | (44,628    | )                                             | $          | 7,699 |   | $ | (39,983 | ) | $ | 20,439 |   |

 

*NetInvestment Income.*   Net investment income was $7.0million for the three months ended June 30, 2007 compared to $0.9 million forthe three months ended June 30, 2006.  Ofthe total net investment income of $7.0 million in 2007, $5.8 million relatedto the Credit Fund and $1.2 million related to allocated investment income. In2006, allocated investment income was $0.6 million. 

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Allocated investmentincome increased due to growth within the overall allocated investmentportfolio because of net positive cash flows from our businesses, whichgenerated $46.3 million of operating cash flows during 2006, as well as the netproceeds from our IPO of $79.2 million.  We also increased the allocationof investment income to this business in 2007 based upon our expectedutilization of IPO proceeds across business lines.  For thesix months ended June 30, 2007 and 2006, net investment income was$12.7 million and $1.7 million, respectively.  Of the total net investment income of$12.7 million in 2007, $10.3 million related to the Credit Fund and $2.4million related to allocated investment income.
| ** **                          | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** |
|-------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                          | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                          | ** ** | **(in thousands)**                         | ** ** |
| Investment  income from Credit Fund |       | $                                               | 5,775      |                                          | $          | 256 |   | $ | 10,320 |   | $ | 256 |   |
| Allocated  investment income        |       | 1,198                                           |       | 626                                           |       | 2,398 |   | 1,478 |   |
| Total investment  income            |       | $                                               | 6,973      |                                          | $          | 882 |   | $ | 12,718 |   | $ | 1,734 |   |

 

The Credit Fundhad net assets under management of $38.0 million as of June 30,2007.  In addition to receiving a return on our investment in the CreditFund, we are paid a management fee to select and manage the assets of the fundfor third parties.  As of June 30, 2007,the Credit Fund had total assets of $413.0 million, including investments infixed-maturity securities trading of $406.4 million and total liabilities andminority interest of $386.1 million, including securities sold underagreements to repurchase of $372.9 million, all of which are included on ourunaudited condensed consolidated balance sheet.

*NetRealized and Unrealized Losses on Investments.*  Net realized losses are derived from ourinvestment in the Credit Fund as well as allocated amounts related to ourallocated investment portfolio. The following table shows the components of netrealized losses for the three months and the six months ended June 30, 2007 and2006:
| ** **                                           | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                           | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                           | ** ** | **(in thousands)**                         | ** ** |
| Net unrealized  and realized losses from Credit Fund |       | $                                               | (714       | )                                             | $          | (20 | ) | $ | (2,218 | ) | $ | (20 | ) |
| Allocated net  realized losses                       |       | —                                          |       | (15                                           | )          | (8 | ) | (151 | ) |
| Net realized and  unrealized losses on investments   |       | $                                               | (714       | )                                             | $          | (35 | ) | $ | (2,226 | ) | $ | (171 | ) |

 

Credit Fund losseswere principally 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.

*OtherOperating Expenses.*   Other operating expensesincreased to $6.4 million for the three months ended June 30, 2007 from $4.7million for the same period in 2006. Other operating expenses increased to $12.7 million for the six monthsended June 30, 2007 from $8.7 million for the same period in 2006.  These increases are related to the allocationof additional corporate and asset backed credit analyst personnel in 2007 tothis line of business in connection with its growth in transaction volume andthe opening and staffing of our Singapore office, in late 2006.

*InterestExpense.*   Interest expense results from debt costsat the Credit Fund as well as allocated interest costs associated withcorporate debt at our holding company. The Credit Fund finances its assetpurchases in part through the use of security repurchase agreements. Totalinterest expense related to the Credit Fund in the three months ended June 30,2007 was $4.3 million.  Allocatedinterest expense totaled $0.2 million and $0.1 million in the three monthsended June 30, 2007 and 2006, respectively.

For the six months ended June 30, 2007, total interestexpense related to the Credit Fund was $7.5 million.  Allocated interest expense totaled $0.3million and $0.2 million in the six months ended June 30, 2007 and 2006,respectively.

*Incomeof Minority Interest.* Income of minority interest is related to our investment in the CreditFund. While we consolidate the fund, we are not the sole equity investor in thefund.  Income related to the portion of the Credit Fund not owned by us inboth the three and six months ended June 30, 2007 was $0.1 million.

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*PublicFinance*

The followingtable summarizes the operations of our Public Finance line of business for thethree months and the six months ended June 30, 2007 and 2006:
| ** **                                  | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                  | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                  | ** ** | **(in thousands)**                             | ** ** |
| **REVENUES:**                               | ** ** | ** **                                          | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Gross premiums written                      |       | $                                                   | 15,371     |                                              | $          | 15,301 |   | $ | 20,043 |   | $ | 19,383 |   |
| Premiums earned                             |       | $                                                   | 8,228      |                                              | $          | 7,575 |   | $ | 13,106 |   | $ | 11,752 |   |
| Net insured credit swap  revenue            |       | 284                                                 |       | (30                                               | )          | 1,430 |   | 632 |   |
| Net investment income                       |       | 4,266                                               |       | 4,133                                             |       | 8,543 |   | 8,004 |   |
| Net realized gains  (losses) on investments |       | 2                                                   |       | (81                                               | )          | (27 | ) | (817 | ) |
| Fee income                                  |       | 14                                                  |       | 22                                                |       | 88 |   | 120 |   |
| Other income                                |       | 239                                                 |       | 32                                                |       | 256 |   | 32 |   |
| **Total revenues**                          | ** ** | **13,033**                                          | ** ** | **11,651**                                        | ** ** | **23,396** | ** ** | **19,723** | ** ** |
| **EXPENSES:**                               | ** ** | ** **                                          | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loss and loss  adjustment expenses          |       | 1,614                                               |       | 1,539                                             |       | 2,639 |   | 2,915 |   |
| Policy acquisition  costs                   |       | 2,841                                               |       | 2,518                                             |       | 4,304 |   | 3,790 |   |
| Other operating  expenses                   |       | 2,832                                               |       | 2,292                                             |       | 5,739 |   | 4,404 |   |
| Interest expense                            |       | 391                                                 |       | 427                                               |       | 777 |   | 830 |   |
| Depreciation and  amortization              |       | 132                                                 |       | 121                                               |       | 246 |   | 309 |   |
| **Total Expenses**                          | ** ** | **7,810**                                           | ** ** | **6,897**                                         | ** ** | **13,705** | ** ** | **12,248** | ** ** |
| Income before income  taxes                 |       | 5,223                                               |       | 4,754                                             |       | 9,691 |   | 7,475 |   |
| Provision for income  tax expense           |       | 1,736                                               |       | 1,633                                             |       | 3,253 |   | 2,558 |   |
| **Net Income**                              | ** ** | **$**                                               | **3,487**  | ** **                                        | **$**      | **3,121** | ** ** | **$** | **6,438** | ** ** | **$** | **4,917** | ** ** |

 

*GrossPremiums Written.*   Public Finance gross premiumswritten totaled $15.4 million for the three months ended June 30, 2007 comparedto $15.3 million for the three months ended June 30, 2006.  Public Finance gross premiums written totaled$20.0 million for the six months ended June 30, 2007 compared to $19.4 millionfor the six months ended June 30, 2006. Since we are essentially a net retainer of the risks we underwrite,gross premiums written approximate net premiums written.

*PremiumsEarned.*   Premiums earned were $8.2 million for thethree months ended June 30, 2007 compared to $7.6 million for the same periodin 2006.  Premiums earned from refundingswere $4.4 million and $3.3 million for the three months ended June 30, 2007 and2006, respectively.  Premiums earned were $13.1 million for the six monthsended June 30, 2007 compared to $11.8 million for the same period in 2006.  Premiums earned from refundings were $5.0million and $3.5 million for the six months ended June 30, 2007 and 2006,respectively.  Essentially, premiumsearned before refundings were flat when comparing the first quarter of 2007 to2006.  This is primarily because gross par exposure has remainedrelatively flat at approximately $6.3 billion.

*NetInsured Credit Swap Revenue.* Net insured credit swap revenue was $0.3 million for the three monthsended June 30, 2007 compared to $(30) thousand for the same period in 2006. Weclosed two transactions in the Public Finance line of business that were in theform of insured 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”.  Theunrealized gains or losses resulting from the changes in fair value of thesetransactions are included in net insured credit swap revenue. An unrealizedgain of $0.1 million was included in insured credit swap revenue for the threemonths ended June 30, 2007. An unrealized loss of $(0.2) million was includedin insured credit swap revenue for the three months ended June 30, 2006.

Net insured creditswap revenue was $1.4 million for the six months ended June 30, 2007 comparedto $0.6 million for the same period in 2006. An unrealized gain of $1.1 millionand $0.4 million was included in net insured credit swap revenue for the sixmonths ended June 30, 2007 and 2006, respectively.

*NetInvestment Income.*   Net investment income totaled$4.3 million for the three months ended June 30, 2007 and $4.1 million for thethree months ended June 30, 2006.  The entireamount of net investment income for the Public Finance line of business isderived from the allocation of investment income. Allocated investment incomeincreased due to growth within the overall allocated investment portfoliobecause of net positive cash flows from our businesses, which generated $46.3million of operating cash flows during 2006 and $41.0 million during the firstsix months of 2007.  This increase waspartially offset by a lower overall capital allocation in 2007 resulting fromthe additional IPO proceeds that were principally allocated to the StructuredCredit and CDO Asset Management lines of business.

29

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Net investmentincome totaled $8.5 million for the six months ended June 30, 2007 and $8.0million for the six months ended June 30, 2006.

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

*Lossand Loss Adjustment Expenses.* Loss and loss adjustment expenses was $1.6 million for the three monthsended June 30, 2007 compared to $1.5 million for the three months ended June30, 2006.

Loss and lossadjustment expenses was $2.6 million for the six months ended June 30, 2007compared to $2.9 million for the six months ended June 30, 2006. The followingtable shows the components of the loss and loss adjustment expenses for thethree months and the six months ended June 30, 2007 and 2006:
|                                           | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                | ** ** | **(in thousands)**                             | ** ** |
| Incurred Losses Related To |       |                                                |       |                                              |       |   |   |   |   |
| Case specific and LAE reserves            |       | $                                                   | (32        | )                                                 | $          | 2 |   | $ | 18 |   | $ | 512 |   |
| Non-specific reserves                     |       | 1,646                                               |       | 1,537                                             |       | 2,621 |   | 2,403 |   |
| Total loss and  loss adjustment expenses  |       | $                                                   | 1,614      |                                              | $          | 1,539 |   | $ | 2,639 |   | $ | 2,915 |   |

 

Loss adjustmentexpenses are costs associated with insured credits that are in varying stagesof work-out or remediation. Non-specific reserves are based on the applicationof our reserving model and take into account transactional characteristics suchas rating, 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 $2.8 million for the three months ended June 30, 2007 compared to$2.5 million for the same period in 2006. Net policy acquisition costs totaled $4.3 million for the six monthsended June 30, 2007 compared to $3.8 million for the same period in 2006.  Generally, such costs vary in accordance withthe changes in premiums earned during each period.

*OtherOperating Expenses*.   Other operating expenses were$2.8 million for the three months ended June 30, 2007 compared to $2.3 millionfor the three months ended June 30, 2006. These costs are non-policyacquisition related costs and are allocated. The increase of $0.5 million wasprimarily related to increased headcount to support the business.  Similarly, increased headcount drives theincrease in other operating expenses to $5.7 million for the six months endedJune 30, 2007 compared to $4.4 million for the six months ended June 30, 2006.

*InterestExpense*.   Interest expense was $0.4 million foreach of three months ended June 30, 2007 and 2006.  Interest expense was$0.8 million for each of the six months ended June 30, 2007 and 2006. Interest expense results from the allocated interest cost associated withcorporate debt at our holding company.

*CDOAsset Management*

The followingtable summarizes the operations of our CDO Asset Management line of businessfor the three months and the six months ended June 30, 2007 and 2006:
| ** **                                                   | ** ** | **Three Months Ended June 30,** | ** **  | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------------|-------------|---------------------------------------------------|------------|
| ** **                                                   | ** ** | **2007**                                            | ** **  | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                   | ** ** | **(in thousands)**                             | ** **  |
| **REVENUES:**                                                | ** ** | ** **                                          | ** **  | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net insured  credit swap revenue                             |       | $                                                   | 161         |                                              | $          | 262 |   | $ | (1,931 | ) | $ | 1,040 |   |
| Net investment  income                                       |       | 78,337                                              |        | 76,482                                            |       | 157,183 |   | 148,577 |   |
| Net realized and  unrealized losses on investments           |       | (109,430                                            | )           | (1,120                                            | )          | (111,590 | ) | (2,046 | ) |
| Net realized and  unrealized gains on derivative instruments |       | 2,964                                               |        | 2,497                                             |       | 5,048 |   | 6,139 |   |
| Other net credit  swap revenue                               |       | 4,088                                               |        | 2,642                                             |       | 16,431 |   | 5,569 |   |
| Fee income                                                   |       | 7,372                                               |        | 6,782                                             |       | 13,534 |   | 10,705 |   |
| Other income                                                 |       | 40                                                  |        | 19                                                |       | 60 |   | 37 |   |
| **Total  revenues**                                          | ** ** | **(16,468**                                         | **)**       | **87,564**                                        | ** ** | **78,735** | ** ** | **170,021** | ** ** |
| **EXPENSES:**                                                | ** ** | ** **                                          | ** **  | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Other operating  expenses                                    |       | 6,322                                               |        | 5,643                                             |       | 13,267 |   | 10,227 |   |
| Interest expense                                             |       | 71,378                                              |        | 70,359                                            |       | 144,018 |   | 136,207 |   |
| Depreciation and  amortization                               |       | 1,987                                               |        | 1,943                                             |       | 3,994 |   | 4,041 |   |
| **Total  Expenses**                                          | ** ** | **79,687**                                          | ** **  | **77,945**                                        | ** ** | **161,279** | ** ** | **150,475** | ** ** |
| Income of  minority interest                                 |       | (1,124                                              | )           | (1,067                                            | )          | (2,086 | ) | (2,222 | ) |
| Income (loss)  before income taxes                           |       | (97,279                                             | )           | 8,552                                             |       | (84,630 | ) | 17,324 |   |
| Provision for  income tax expense (benefit)                  |       | (32,702                                             | )           | 2,941                                             |       | (28,408 | ) | 5,925 |   |
| **Net  Income (loss)**                                       | ** ** | **$**                                               | **(64,577** | **)**                                             | **$**      | **5,611** | ** ** | **$** | **(56,222** | **)** | **$** | **11,399** | ** ** |
| ** **                                                   | ** ** | ** **                                          | ** **  | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| CDO assets under  management (end of period, in millions)    |       | $                                                   | 17,929      |                                              | $          | 12,120 |   | $ | 17,929 |   | $ | 12,120 |   |

 

30

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*NetInsured Credit Swap Revenue*.   Net insured creditswap revenue was $0.2 million for the three months ended June 30, 2007 comparedto $0.3 million for the three months ended June 30, 2006. Net insured creditswap revenue was $(1.9) million and $1.0 million for the six months ended June30, 2007 and June 30, 2006, respectively.

As set forth inthe table below, net insured credit swap revenue is the sum of insured creditswap premiums earned, net realized gains (losses), which may result from timeto time from any termination or credit events related to such transactions andunrealized gains (losses) resulting from the changes in fair value of thesetransactions. We receive insured credit swap premiums from two synthetic CDOswe closed in 2003 and 2002 in which our insurance subsidiary, ACA FinancialGuaranty, insured the equity tranche of each CDO. One of these credit swap transactionsexpired at the end of the first quarter 2007. The following table shows the components of net insured credit swaprevenue for the three months and the six months ended June 30, 2007 and 2006:
|                                            | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** |
|--------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                 | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                 | ** ** | **(in thousands)**                         | ** ** |
| Insured credit  swap premiums earned       |       | $                                               | 618        |                                          | $          | 1,103 |   | $ | 1,706 |   | $ | 2,189 |   |
| Unrealized  losses on insured credit swaps |       | (457                                            | )          | (841                                          | )          | (3,637 | ) | (1,149 | ) |
| Net insured  credit swap revenue           |       | $                                               | 161        |                                          | $          | 262 |   | $ | (1,931 | ) | $ | 1,040 |   |

 

The unrealizedloss recorded for the six months ended June 30, 2007 is affected by theexpiration of one of the credit swap transactions as of the end of the firstquarter.  As a result of the expiration, the remaining unrealizedvaluation amount carried on our balance sheet was reversed to zero.  The valuation or unrealized loss for the sixmonths ended June 30, 2006 was also related to the fact that these transactionswere in a net valuation gain position and as they approach maturity, thoseunrealized gains reverse, resulting in unrealized losses. The second and lastof the credit swap transactions included herein will expire by mid-2008.

*NetInvestment Income*.   Net investment income was$78.3 million for the three months ended June 30, 2007 compared to $76.5million for the three months ended June 30, 2006.  Net investment income includes income fromassets of our consolidated and unconsolidated CDO portfolios as well as allocatedamounts.  No new consolidated CDOs wereadded in the second quarter of 2007 or 2006. Unconsolidated CDO equity of $12.0 million was added since June 2006 andis the primary cause of the increase in direct net investment income withinthis line of business.  The portion ofnet investment income related to our consolidated and unconsolidated CDOs was$77.4 million for the three months ended June 30, 2007 compared to $76.0million for the three months ended June 30, 2006.  The portion of net non-CDO investment incomeallocated to the CDO Asset Management line of business was $0.9 million in thesecond quarter of 2007, compared to $0.5 million in the second quarter of2006.  Allocated investment incomeincreased due to overall growth within the allocated non-CDO investmentportfolio, as a result of net positive operating cash flows from ourbusinesses, as well as an increase in allocation percentage to this businessline based on the expected usage of the net proceeds from our IPO.

Net investmentincome was $157.2 million for the six months ended June 30, 2007 compared to$148.6 million for the six months ended June 30, 2006. The portion of netinvestment income related to our consolidated and unconsolidated CDO portfoliowas $155.2 million for the six months ended June 30, 2007 compared to $147.6million for the six months ended June 30, 2006. As discussed above, theincrease is primarily due to the increase in investments in unconsolidatedCDOs. The portion of net non-CDO investment income allocated to the CDO AssetManagement line of business was $2.0 million in the second quarter of 2007,compared to $1.0 million in the second quarter of 2006.

31

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|                                  | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** |
|----------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                       | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                       | ** ** | **(in thousands)**                         | ** ** |
| Investment  income from CDOs     |       | $                                               | 77,363     |                                          | $          | 75,971 |   | $ | 155,234 |   | $ | 147,592 |   |
| Allocated net  investment income |       | 974                                             |       | 511                                           |       | 1,949 |   | 985 |   |
| Total net  investment income     |       | $                                               | 78,337     |                                          | $          | 76,482 |   | $ | 157,183 |   | $ | 148,577 |   |

 

*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 six months ended June 30, 2007 and 2006.
|                                                    | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                         | ** ** | **(in thousands)**                         | ** ** |
| Net realized  losses from CDOs                     |       | $                                               | (109,429   | )                                             | $          | (1,110 | ) | $ | (111,583 | ) | $ | (1,945 | ) |
| Allocated net  realized losses                     |       | (1                                              | )          | (10                                           | )          | (7 | ) | (101 | ) |
| Net realized and  unrealized losses on investments |       | $                                               | (109,430   | )                                             | $          | (1,120 | ) | $ | (111,590 | ) | $ | (2,046 | ) |

 

Net realizedlosses from CDOs include losses from other than temporary impairments (“OTTI”),in the amounts of $(109.4) million for the three months ended June 30, 2007compared to $(1.1) million for the three months ended June 30, 2006.  Net realized losses from CDOs include lossesfrom OTTI, in the amounts of $(111.6) million for the six months ended June 30,2007 compared to $(1.9) million for the six months ended June 30, 2006.

OTTI is recognizedwhen the fair value of investments in fixed maturity securities is determinedto be below amortized cost for stated periods of time.  In the case of asset-backed securities, ofwhich the vast majority of our CDO portfolio is comprised, the market valuedecline is also coupled with a decline in future expected cash flows.  The last quarter of 2006 and first quarter of2007 saw significant disruption and consolidation in the sub-prime and secondlien mortgage markets, with some mortgage originators being purchased orexiting the business.  This severedisruption continued into the second quarter with other types of marketparticipants announcing significant losses in connection with their sub-primeand second lien mortgage exposure.  Thisdisruption further translated into decreased liquidity and wider spreads acrossthe market, decreasing the market value of the portfolios.  During the second quarter of 2007, theCompany determined that certain of its holdings in RMBS through itsconsolidated CDOs were other than temporarily impaired related to thesesub-prime and second lien RMBS market issues. As a result, write-offs relating primarily to those securities,aggregating $109.4 million were recorded as a reduction of net income duringthe quarter.

The write-downsrelated to consolidated CDOs included approximately $46.9 million in excess ofthe Company’s true economic exposure or its equity investment in the CDOs thatwas recorded in the Company’s statement of operations under the rules of GAAPconsolidation accounting.  We have noright to the use the CDO assets, other than returns we received on our equityinvestment, and the CDO liabilities are non-recourse to us and can only beextinguished from the cash flows of the CDO assets.  Our maximum net economic loss from aconsolidated CDO is limited to our equity investment in it.  However, under the rules governingconsolidation accounting, our income statement reflects 100% of the OTTI lossesrelated to consolidated CDO assets.  Uponmaturity, or the occurrence of a deconsolidation event, the equity and debtholders would absorb these OTTI losses and we would recognize a gain equal toall previously recognized losses recorded in excess of our equity position.

*NetRealized and Unrealized Gains on Derivative Instruments.*  The following table illustrates the type ofderivative instruments reported in this line item:
|                                                                    | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** |
|--------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                         | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                         | ** ** | **(in thousands)**                         | ** ** |
| Interest rate  swaps                                               |       | $                                               | 1,909      |                                          | $          | 2,240 |   | $ | 3,580 |   | $ | 5,670 |   |
| Interest rate  caps                                                |       | 301                                             |       | 257                                           |       | 112 |   | 469 |   |
| Trading  derivatives                                               |       | 754                                             |       | —                                        |       | 1,356 |   | — |   |
| Total net  realized and unrealized gains on derivative instruments |       | $                                               | 2,964      |                                          | $          | 2,497 |   | $ | 5,048 |   | $ | 6,139 |   |

 

The mostsignificant derivative instruments reported in this line item are interest rateswaps that are included in our consolidated 

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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.Interest rate caps are also used within consolidated CDOs to manage interestrate risk. In the three months and six months ended June 30, 2007 we recognizedincome of $0.8 million and $1.4 million, respectively, related to a leveragedloan trading program that began in December 2006 and is structured in theform of a total return swap.  Changes in the values of the underlyingleveraged loans represent unrealized gains or losses to us until such time thatthe loans may be sold. Income received under the total return swap is alsoincluded in net realized and unrealized gains on derivative instruments.

*OtherNet Credit Swap Revenue*.   Other net credit swaprevenue was $4.1 million for the three months ended June 30, 2007 compared to$2.6 million for the three months ended June 30, 2006.  As set forth in the table below, other netcredit swap revenue is the sum of credit swap fees earned, net realized gains(losses) which may result from time to time result from any termination of suchtransactions, unrealized gains on credit protection we purchased to mitigateour exposure to 2006 origination sub-prime and second lien RMBS and any creditevents and unrealized gains (losses) resulting from the changes in fair valueof these transactions.  Credit swap feesresult from a partially funded consolidated synthetic CDO, in which theunderlying instruments are credit swaps sold by the CDO to third parties. Also,included as revenue in the second quarters of 2007 and 2006 is $0.3 million and$0.8 million, respectively, that represents distributions to us as equityholder of two synthetic CDOs.

Other net creditswap revenue was $16.4 million for the six months ended June 30, 2007 comparedto $5.6 million for the six months ended June 30, 2006.  Included as revenue in the first halves of2007 and 2006 is $2.6 million and $1.6 million, respectively, that representsdistributions to us as equity holder of two synthetic CDOs.  The followingtable shows the components of other net credit swap revenue for the threemonths and the six months ended June 30, 2007 and 2006:
|                                                 | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                      | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                      | ** ** | **(in thousands)**                         | ** ** |
| Credit swap fees                                |       | $                                               | 1,884      |                                          | $          | 2,545 |   | $ | 5,805 |   | $ | 5,278 |   |
| Unrealized gain  on credit protection purchased |       | 3,108                                           |       | —                                        |       | 11,565 |   | — |   |
| Unrealized gains  (losses) on credit swaps      |       | (904                                            | )          | 97                                            |       | (939 | ) | 291 |   |
| Total other net  credit swap revenue            |       | $                                               | 4,088      |                                          | $          | 2,642 |   | $ | 16,431 |   | $ | 5,569 |   |

 

Net unrealizedgains related to changes in value were recorded for each period.  Theunrealized gain recorded for the six months ended June 30, 2007 was almostentirely related to the change in the value of two credit swap transactions weentered into in late 2006 to hedge our exposure to certain classes of RMBS,which arises from the equity we own in our CDOs.  These swaps reference representative marketindices to moderate the impact to us of impairments related to 2006 vintagesubprime residential mortgage exposure.  We did this in light of therecent negative developments that we have noted in this asset class.  Specifically, the relaxed underwritingstandards of certain sub-prime originators in 2006 have led to significantlyhigher early stage delinquencies. Market participants have speculated thatthese RMBS may ultimately represent the worst performing sub-prime bonds onrecord to date.  In light of the uncertainty in the market around thisvintage of RMBS, we determined it prudent to purchase the credit swaps. ThroughJune 30, 2007, we had recorded a cumulative net unrealized gain of $11.6 millionrelated to these credit swaps.  In July2007, we closed out these two positions and realized a cumulative net gain of$14.8 million.

*Feeand Other Income*.  Feeand other income is principally related to quarterly management fees, warehousefees and structuring fees received in connection with our unconsolidatedCDOs.  Total fee and other income for CDOAsset Management was $7.4 million for the three months ended June 30, 2007compared to $6.8 million for the three months ended June 30, 2006. Total feeand other income for CDO Asset Management was $13.5 million for the six monthsended June 30, 2007 compared to $10.7 million for the six months ended June 30,2006.  These increases were primarily theresult of increased assets under management which grew to $17.9 billion at June30, 2007 from $12.1 billion at June 30, 2006, partially offset by a decrease inwarehouse and structuring fees.  Ingeneral, structuring fees and warehouse fees are highly negotiated and vary fromtransaction to transaction.

The followingtable shows the components of fee income for the three months and the sixmonths ended June 30, 2007 and 2006:
|                                   | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** |
|-----------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                        | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                        | ** ** | **(in thousands)**                         | ** ** |
| Asset management  fees            |       | $                                               | 6,574      |                                          | $          | 3,227 |   | $ | 12,877 |   | $ | 6,118 |   |
| Warehousing and  structuring fees |       | 798                                             |       | 3,555                                         |       | 657 |   | 4,587 |   |
| Total fee income                  |       | $                                               | 7,372      |                                          | $          | 6,782 |   | $ | 13,534 |   | $ | 10,705 |   |

 

33

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*OtherOperating Expenses*.   Other operating expensestotaled $6.3 million for the three months ended June 30, 2007 compared to $5.6million for the three months ended June 30, 2006.  Other operating expenses totaled $13.3million for the six months ended June 30, 2007 compared to $10.2 million forthe six months ended June 30, 2006. Other operating expenses is made up of direct expenses of consolidatedCDOs and includes items such as ongoing rating agency fees, trustee fees,accounting fees and other direct expenses related to the maintenance of theCDO. Also included in other operating expenses are allocated expenses.

The followingtable shows the components of other operating expenses for the three months andthe six months ended June 30, 2007 and 2006:
|                               | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** |
|-------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                    | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                    | ** ** | **(in thousands)**                         | ** ** |
| Direct operating  expenses    |       | $                                               | 399        |                                          | $          | 416 |   | $ | 928 |   | $ | 951 |   |
| Allocated  operating expenses |       | 5,923                                           |       | 5,227                                         |       | 12,339 |   | 9,276 |   |
| Total operating  expenses     |       | $                                               | 6,322      |                                          | $          | 5,643 |   | $ | 13,267 |   | $ | 10,227 |   |

 

The first half of2007 increase compared to the first half 2006 in allocated expenses was relatedto two principal items.  First, our status as a publicly traded company inNovember 2006 caused an increase in certain corporate expenses. Additionally, we incurred expenses for our new office in the UnitedKingdom, established in the second half of 2006.  This office wasestablished in connection with the expansion of our asset management businessin Europe.

*InterestExpense*.  Interestexpense totaled $71.4 million for the three months ended June 30, 2007 comparedto $70.4 million for the three months ended June 30, 2006. Interest expensetotaled $144.0 million for the six months ended June 30, 2007 compared to$136.2 million for the six months ended June 30, 2006.  Interest expense is made up of the allocatedportion of interest expense on corporate debt issued by our holding company,debt issued in connection with the purchase of certain of our CDO equitypositions (CDO debt: operating) and debt issued by our consolidated CDOs (CDOdebt: non-recourse).

The followingtable shows the components of interest expense for the three months and the sixmonths ended June 30, 2007 and 2006:
|                         | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** |
|-------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **              | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **              | ** ** | **(in thousands)**                         | ** ** |
| Corporate debt          |       | $                                               | 1,247      |                                          | $          | 1,184 |   | $ | 2,499 |   | $ | 2,283 |   |
| CDO debt:  operating    |       | 1,897                                           |       | 1,832                                         |       | 3,788 |   | 3,617 |   |
| CDO debt:  non-recourse |       | 68,234                                          |       | 67,343                                        |       | 137,731 |   | 130,307 |   |
| Total interest  expense |       | $                                               | 71,378     |                                          | $          | 70,359 |   | $ | 144,018 |   | $ | 136,207 |   |

 

All outstandingdebt pays interest based on a floating rate above one or three monthLIBOR.  No new long term debt was issuedin 2007 or 2006 and three month LIBOR, on which the floating interest rates arebased, was largely unchanged. Interest expense also includes interest expenseon debt incurred to finance our CDO equity investments. As of June 30, 2007, wehad $110.1 million of debt related to the financing of CDO equity and $79.9million of corporate debt issued through trust-preferred vehicles.

*Depreciationand Amortization*.   Depreciation and amortizationwas relatively flat over each of the three months ended June 30, 2007 and2006.  Depreciation and amortization is comprised of the recognition ofcosts deferred in connection with our consolidated CDOs as well as allocatedamounts. Depreciation and amortization related to consolidated CDOs totaled$2.0 million for the three months ended June 30, 2007 and $1.9 million for thethree months ended June 30, 2006. Depreciation and amortization was $4.0 million for both the six monthsended June 30, 2007 and 2006.

*Incomefrom Minority Interest*. Income from minority interest totaled $(1.1) million for both the threemonths ended June 30, 2007 and 2006. Income from minority interest totaled $(2.1) million and $(2.2) millionfor the six months ended June 30, 2007 and 2006, respectively.  Income from minority interest results fromthe fact that we consolidate two CDOs in which we own less than 100% of theequity.  Minority interest reflected inthe statement of operations represents the share of the income or loss of theCDO that represents the third party equity ownership. In both three monthperiods, the two CDOs recognized net income and as a result we recordedminority interest income to reduce our net income.

34

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*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 investment exposure to our CDOs istherefore limited to our retained equity, which is the first loss position ofthe CDO. In the transactions in which we own less than 100% of the CDO’sequity, but are deemed to be the primary beneficiary and thus consolidate theCDO, we establish minority interests for the portion not owned.  Total non-recourse debt of the CDOs includedon our balance sheet at June 30, 2007 and December 31, 2006 was $4.5billion and $4.7 billion, respectively.  Fixed maturity securities, aguaranteed investment contract and cash related to consolidated CDOs includedon our balance sheet at June 30, 2007 and December 31, 2006 were $4.4 billionand $4.9 billion, respectively.

Beginning in 2005,we have retained a lesser share of the equity position of our newly issuedCDOs. Based on our analysis of FIN 46(R) we are not deemed to be theprimary beneficiary and, as a result, these CDOs are not consolidated in ourfinancial statements. Rather, our non-majority investment is recorded as aninvestment in a single fixed maturity security under the provisions ofFAS 115 and EITF 99-20. During the first six months of 2007, we closedeight CDOs and retained equity interest in three. During 2005 and 2006, weclosed thirteen CDOs and purchased equity interests in eight. The fair value ofour total investment in unconsolidated CDOs at June 30, 2007 was$19.3 million, not including synthetic CDOs in which we take derivativeexposure but make no investment. We do not anticipate consolidating new CDOs inthe future given our intention to buy minority portions.

CDOs can be issuedin funded, unfunded or partially funded form. Funded CDOs issue debtinstruments and purchase investment assets, while unfunded CDOs syntheticallyacquire assets and issue liabilities synthetically (i.e., assets and liabilities are in derivative form).  Partially funded CDOs are a combination ofthese two forms.

The following table summarizes our outstanding CDO transactions as ofJune 30, 2007:
| **CDO name**                | ** ** | **Year  Deal  Closed** | ** ** | **Transaction  Type** | ** ** | **Collateral Type(1)** | ** ** | **Current  AUM**       | ** ** | **Consolidated** | ** ** | **Current  Investment in  Retained Equity** | ** ** | **Retained  Equity %** | ** ** | **First  Optional  Call Date(2)** | ** ** | **Maturity  Date** | ** ** |
|----------------------------------|------------|------------------------|------------|-----------------------|------------|-----------------------------|------------|------------------------|------------|------------------|------------|-------------------------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|--------------------|------------|
| ** **                       | ** ** | ** **             | ** ** | ** **            | ** ** | ** **                  | ** ** | **(in millions)** | ** ** | ** **       | ** ** | ** **                                            | ** ** | ** **                  | ** ** | ** **                             | ** ** | ** **         | ** ** |
| **Asset-Backed  CDOs:**          | ** ** | ** **             | ** ** | ** **            | ** ** | ** **                  | ** ** | ** **             | ** ** | ** **       | ** ** | ** **                                            | ** ** | ** **                  | ** ** | ** **                             | ** ** | ** **         | ** ** |
| ACA ABS 2002-1                   |       | 2002                   |       | Funded                |       | Investment  Grade           |       | $                      | 198        |             | Yes        |                                                  | $          | 4.9                         |       | 100                                    |       | 8/2005             |       | 8/2037 |   |
| ACA ABS 2003-1                   |       | 2003                   |       | Funded                |       | Investment  Grade           |       | 392                    |       | Yes              |       | —                                                |       | 100                         |       | 6/2007                                 |       | 6/2038             |       |
| Grenadier Funding                |       | 2003                   |       | Funded                |       | High-Grade                  |       | 1,484                  |       | Yes              |       | 16.5                                                  |       | 100                         |       | 8/2008                                 |       | 8/2038             |       |
| ACA ABS 2003-2                   |       | 2003                   |       | Funded                |       | Investment  Grade           |       | 629                    |       | Yes              |       | —                                                |       | 100                         |       | 12/2007                                |       | 12/2038            |       |
| ACA ABS 2004-1                   |       | 2004                   |       | Funded                |       | Investment  Grade           |       | 361                    |       | Yes              |       | 10.0                                                  |       | 61                          |       | 7/2007                                 |       | 7/2039             |       |
| Zenith Funding                   |       | 2004                   |       | Funded                |       | High-Grade                  |       | 1,499                  |       | Yes              |       | 13.0                                                  |       | 52                          |       | 12/2009                                |       | 12/2039            |       |
| ACA ABS 2005-1                   |       | 2005                   |       | Funded                |       | Investment  Grade           |       | 421                    |       | No               |       | 1.1                                                   |       | 24                          |       | 4/2008                                 |       | 4/2040             |       |
| ACA ABS 2005-2                   |       | 2005                   |       | Funded                |       | Investment  Grade           |       | 396                    |       | No               |       | 0.9                                                   |       | 10                          |       | 9/2009                                 |       | 12/2044            |       |
| Khaleej II                       |       | 2005                   |       | Partially  funded     |       | Investment  Grade           |       | 750                    |       | No               |       | 4.4                                                   |       | 14                          |       | 9/2009                                 |       | 9/2040             |       |
| Lancer Funding                   |       | 2006                   |       | Funded                |       | High-Grade                  |       | 1,443                  |       | No               |       | 1.4                                                   |       | 10                          |       | 7/2010                                 |       | 4/2046             |       |
| ACA Aquarius  2006-1             |       | 2006                   |       | Partially  funded     |       | Investment  Grade           |       | 1,990                  |       | No               |       | —                                                |       | —                      |       | 9/2010                                 |       | 9/2046             |       |
| ACA ABS 2006-1                   |       | 2006                   |       | Funded                |       | Investment  Grade           |       | 747                    |       | No               |       | 0.7                                                   |       | 5                           |       | 12/2009                                |       | 6/2041             |       |
| ACA ABS 2006-2                   |       | 2006                   |       | Funded                |       | Investment  Grade           |       | 746                    |       | No               |       | 0.4                                                   |       | 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           |       | 67                     |       | No               |       | —                                                |       | —                      |       | 3/2010                                 |       | 10/2052            |       |
| Abacus                           |       | 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                  |       | 999                    |       | No               |       | —                                                |       | —                      |       | 7/2011                                 |       | 7/2047             |       |
| **Total  Asset-Backed CDOs**     |       |                   |       |                  |       |                        |       | 14,564                 |       |             |       | 54.7                                                  |       |                        |       |                                   |       |               |       |
| ** **                       | ** ** | ** **             | ** ** | ** **            | ** ** | ** **                  | ** ** | ** **             | ** ** | ** **       | ** ** | ** **                                            | ** ** | ** **                  | ** ** | ** **                             | ** ** | ** **         | ** ** |
| **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           |       | 68                     | (3)        | No               |       | —                                                |       | —                      |       | N/A                                    |       | 6/2015             |       |
| Argon 57                         |       | 2006                   |       | Funded                |       | Investment  Grade           |       | 68                     | (3)        | No               |       | —                                                |       | —                      |       | N/A                                    |       | 6/2013             |       |
| Tribune                          |       | 2006                   |       | Unfunded              |       | Investment  Grade           |       | 356                    | (4)        | No               |       | —                                                |       | —                      |       | N/A                                    |       | 9/2016             |       |
| Dolomite                         |       | 2007                   |       | Unfunded              |       | Investment  Grade           |       | 67                     | (3)        | No               |       | —                                                |       | —                      |       | N/A                                    |       | 7/2014             |       |
| **Total  Corporate Credit CDOs** |       |                   |       |                  |       |                        |       | 1,559                  |       |             |       | 25.0                                                  |       |                        |       |                                   |       |               |       |
| ** **                       | ** ** | ** **             | ** ** | ** **            | ** ** | ** **                  | ** ** | ** **             | ** ** | ** **       | ** ** | ** **                                            | ** ** | ** **                  | ** ** | ** **                             | ** ** | ** **         | ** ** |
| **Leveraged  Loan CDOs:**        | ** ** | ** **             | ** ** | ** **            | ** ** | ** **                  | ** ** | ** **             | ** ** | ** **       | ** ** | ** **                                            | ** ** | ** **                  | ** ** | ** **                             | ** ** | ** **         | ** ** |
| ACA CLO 2005-1                   |       | 2005                   |       | Funded                |       | Non-Investment  Grade       |       | 299                    |       | No               |       | 4.6                                                   |       | 21                          |       | 10/2009                                |       | 10/2017            |       |
| ACA CLO 2006-1                   |       | 2006                   |       | Funded                |       | Non-Investment  Grade       |       | 342                    |       | No               |       | —                                                |       | —                      |       | 7/2009                                 |       | 7/2018             |       |
| ACA CLO 2006-2                   |       | 2006                   |       | Funded                |       | Non-Investment  Grade       |       | 302                    |       | No               |       | 2.2                                                   |       | 10                          |       | 1/2011                                 |       | 1/2021             |       |
| ACA CLO Euro  2007-1             |       | 2007                   |       | Funded                |       | Non-Investment  Grade       |       | 527                    | (3)        | No               |       | 5.4                                                   |       | 10                          |       | 6/2010                                 |       | 6/2024             |       |
| ACA CLO 2007-1                   |       | 2007                   |       | Funded                |       | Non-Investment  Grade       |       | 336                    |       | No               |       | 2.6                                                   |       | 10                          |       | 6/2011                                 |       | 6/2022             |       |
| **Total  Leveraged Loan CDOs**   |       |                   |       |                  |       |                        |       | 1,806                  |       |             |       | 14.8                                                  |       |                        |       |                                   |       |               |       |
| **Total**                        | ** ** | ** **             | ** ** | ** **            | ** ** | ** **                  | ** ** | **$**                  | **17,929** | ** **       | ** ** | ** **                                            | **$**      | **94.5**                    | ** ** | ** **                             | ** ** | ** **         | ** ** | ** ** | ** ** |

 

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*Note: As of June 30, 2007, the Company’s risk undercorporate credit CDO ACA CDS 2002-1 expired.*

(1)   Investment grade collateral is rated “BBB-” or better; however certainof 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 orgreater vote of the equity holders on a specific date as negotiated, which isreferred to as the First Optional Call Date.

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(3)   Argon 49, Argon 57, Dolomite and ACA CLO Euro 2007-1 are denominated inEuros. For purposes of this chart, we have converted the amounts toU.S. dollars at the prevailing currency exchange rate on June 30, 2007.

(4)   Tribune is comprised of 13 distinct trades some of which are denominatedin Euros or Yen. For purposes of this chart, we have converted the respectiveamounts to U.S. dollars at the prevailing currency exchange rates on June 30,2007.

*Accountingfor a Consolidated CDO as Compared to an Unconsolidated CDO*.  When we consolidate a typical funded CDO, foraccounting purposes, the CDO issuing vehicle is treated essentially as ourwholly owned operating subsidiary.  “Funded”means that at the CDO’s closing, it issues liabilities in the form of debt andequity and the assets are purchased out of a warehouse facility with theproceeds from the issuance.  Thefollowing shows 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 |   |

 

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

(2)   Theentity that earns management fees.

For purposes ofthis hypothetical CDO, we assume we do not earn warehouse or structuring fees,which we do on a number of our CDOs. This example also excludes the effects ofany mark to market adjustments on derivatives contained within the CDO vehicle.Following the closing of this hypothetical CDO, we record the activity of theCDO on our assets and liabilities, as well as ongoing expenses of the CDO asfollows, assuming one year has passed and we have realized a 10% return on our$20 million equity position and earned management fees of $1.8 million:
| ** **                    | ** ** | **One Year Later** | ** ** |
|-------------------------------|------------|------------------------------|------------|
| ** **                    | ** ** | ** **                   | ** ** | **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 |   |

 

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

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

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The presentationabove would be proper from a U.S. GAAP reporting perspective.  When management considers the financialperformance of the CDO in relation to the economic benefit to the Company,management considers the income that the CDO generates in the following twocomponent parts:

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

 

These line items,however, do not appear in our financial statements because of the U.S. GAAPrules of consolidation.

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

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

 

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

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

 

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

We would view thecomponent parts of this CDO as follows:

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

 

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

The table belowsets forth the economic impact of our CDOs assuming all CDOs wereunconsolidated for the first quarter of 2007 and 2006.  Investors shouldneither place undue reliance on this presentation nor use it as a substitutefor our segment financial statements which are prepared in accordance with U.S.GAAP. This presentation should be utilized only as a supplemental measure offinancial performance in evaluating our CDO Asset Management line of business.

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| ** **                                                                | ** ** | **Three Months Ended June 30,**                       | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                | ** ** | **2007**                                                                  | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                                | ** ** | **(in thousands, except where otherwise noted)** | ** ** |
| Assets under  management (in millions)                                    |       | $                                                                         | 17,929     |                                              | $          | 12,120 |   | $ | 17,929 |   | $ | 12,120 |   |
|                                                                      |       |                                                                      |       |                                              |       |   |   |   |   |
| Management and  other fees(1)                                             |       | $                                                                         | 9,457      |                                              | $          | 6,230 |   | $ | 18,645 |   | $ | 12,176 |   |
| Warehouse and  structuring fees(2)                                        |       | 837                                                                       |       | 3,555                                             |       | 697 |   | 4,587 |   |
| Equity  returns(3)                                                        |       | (45,060                                                                   | )          | 4,988                                             |       | (39,941 | ) | 10,421 |   |
| CDO Asset  Management revenue, unconsolidated basis                       |       | $                                                                         | (34,766    | )                                                 | $          | 14,773 |   | $ | (20,599 | ) | $ | 27,184 |   |
| Reconciliation  to CDO Asset Management pre-tax income:                   |       |                                                                      |       |                                              |       |   |   |   |   |
| CDO Asset  Management revenue, unconsolidated basis                       |       | $                                                                         | (34,766    | )                                                 | $          | 14,773 |   | $ | (20,599 | ) | $ | 27,184 |   |
| Impairments in  excess of equity investment                               |       | (46,936                                                                   | )          | —                                            |       | (46,936 | ) | — |   |
| Net realized and  unrealized gains (losses) on CDO related derivatives(4) |       | (7,693                                                                    | )          | 1,753                                             |       | (969 | ) | 5,281 |   |
| Allocated  investment income(5)                                           |       | 974                                                                       |       | 511                                               |       | 1,949 |   | 985 |   |
| Allocated  expenses(5)(5a)                                                |       | (5,923                                                                    | )          | (5,227                                            | )          | (12,339 | ) | (9,276 | ) |
| Allocated  interest expenses(5)(5b)                                       |       | (1,263                                                                    | )          | (1,184                                            | )          | (2,514 | ) | (2,283 | ) |
| Allocated  depreciation(5)(5c)                                            |       | (277                                                                      | )          | (141                                              | )          | (489 | ) | (360 | ) |
| Allocated  realized gains (losses)(5)(5d)                                 |       | (1                                                                        | )          | (10                                               | )          | (7 | ) | (101 | ) |
| Interest  expense—operating(6)                                       |       | (1,897                                                                    | )          | (1,832                                            | )          | (3,788 | ) | (3,617 | ) |
| Minority  interest (mark to market portion)(7)                            |       | (304                                                                      | )          | (203                                              | )          | (365 | ) | (529 | ) |
| Loan Trading  Program(8)                                                  |       | 754                                                                       |       | —                                            |       | 1,356 |   | — |   |
| Other                                                                     |       | 53                                                                        |       | 112                                               |       | 71 |   | 40 |   |
| Total CDO Asset  Management pre-tax income (loss) -U.S. GAAP              |       | $                                                                         | (97,279    | )                                                 | $          | 8,552 |   | $ | (84,630 | ) | $ | 17,324 | ** ** |

 

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(1)         Represents the sum of management fees for allCDOs paid by CDO entities to ACA Management, whether the CDO is consolidated orunconsolidated.  For CDOs that weconsolidate, management fees are eliminated from our consolidated financialstatements under U.S. GAAP.

(2)         Represents fees received during or at the endof the warehouse, or asset accumulation, phase of the CDO.

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

(4)         Represents the sum of net unrealized gains andlosses included in net insured credit swap revenue, net realized and unrealizedgains (losses) on derivative instruments and other net credit swaprevenue.  This adjustment (subtracts)adds back mark to market gains (losses) on derivatives and realized gains(losses) on warehouse facilities because they represent non-cash adjustments thatare expected to reverse themselves over time as the related contracts mature orexpire.

(5)       Represents adjustments for the investmentincome and expenses which are allocated to the CDO Asset Management line ofbusiness but do not relate to the direct economics of our managed CDOs.

(5a)   Direct expenses of our consolidated CDOs areincluded above as a reduction of our equity return and include items such asongoing rating agency CDO expenses, trustee fees, accounting fees, etc. Direct expenses equal total segment expense less allocated amounts.  Direct CDO expenses were $0.4 million in thesecond quarter of 2007 and $0.6 million in the second quarter of2006.  When we consider the resultsrelated to our managed CDOs, allocated expenses are excluded and must be addedback in order to reconcile to segment based income before taxes.  For the six months ended June 30, 2007 and2006, direct CDO expenses were $0.9 million and $1.1 million, respectively.

(5b)  Represents a portion of our corporate debt interest expense allocated tothis line of business.  This allocated interest expense, combined with CDOdebt operating and CDO debt-non-recourse interest expense, equals total segmentinterest expense.

(5c)   Represents a portion of corporate depreciationand amortization expense allocated to this line of business.  Directamortization of debt issuance costs of consolidated CDOs is included above as areduction of equity returns (see note 3 above) and totaled $1.9 million in thesecond quarter of 2007 and $1.8 million in the second quarter of2006.  These amounts totaled $3.7 millionfor both the six months ended June 30, 2007 and 2006.

(5d)  Represents a portion of our corporate realized(losses) gains allocated to this line of business.  Direct net realized losses includingimpairments were $101.8 million in the second quarter of 2007 and$0.8 million in the first quarter of 2006.  These direct realizedlosses are included above as a reduction of our equity return.  Direct net realized losses includingimpairments for the six months ended June 30, 2007 and 2006 were$104.0 million and $1.9 million, respectively.

(6)         Represents interest expense incurred inconnection with the financing of our equity purchases.  We view these costs as indirect costs of ourCDO Asset Management business and exclude them when we consider direct resultsof this line of business.  Therefore,management subtracts them to arrive at segment

38

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income before taxes.

(7)         Represents the minority interest portion of net unrealized gains(losses) on derivatives for two consolidated CDOs in which we own less than100% of the equity.  We exclude this itemwhen we examine the results related to our managed CDOs.

(8)         Represents return and unrealized gains (losses) on a leveraged loantrading program that is structured in the form of a total return swap.  We exclude this item when we examine theresults related to our managed CDOs.

*CDO Structures and Related RevenueRecognition*

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

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

Partially funded synthetic, or CDS, CDOs sell creditprotection on referenced assets by entering into credit swaps with variousprotection buyers in the market. The CDO also issues securities, bothliabilities and equity, in order to use the proceeds from the sale of thesesecurities to collateralize the CDO’s obligations under its credit swaps,except with respect to the most senior tranche of the CDO’s credit exposure, inconnection with which a partially funded CDO typically purchases creditprotection rather than issuing funded liability securities. The proceeds of thesecurities issued by the partially funded CDO are invested in a guaranteedinvestment contract, or GIC. We consolidate one partially funded CDS CDO. Fromthis consolidated CDO, we consolidate investment income, relating to the returnon the GIC, and interest expense in connection with the liability securitiesissued by the CDO. We also consolidate derivative income relating to netrevenues from the fixed fees payable to the CDO under the terms of the creditswaps pursuant to which the CDS CDO sold credit protection on referenced assetsand the fixed fees payable by the CDO on the credit protection that itpurchased. This income is reflected in the consolidated statements ofoperations as other net credit swap revenue. This income is used to pay theinterest on the liabilities of the CDO and other expenses of the CDO, includingthe management fee. Similar to the fully funded and consolidated CDOs, allmanagement fees in this partially funded CDS CDO are paid to ACA Management,but eliminated in consolidation. Our return on our equity investment is the netof the CDO’s revenues (interest income and other credit swap income) and theCDO’s expenses, including the management fee paid to ACA Management.  As of June 30, 2007, this partially fundedCDS CDO expired, however the disbursement of funds related to the CDO did notoccur until July 2007.  As a result, theCDO will be deconsolidated from the Company’s financial statements in the thirdquarter of 2007.

For funded and partially funded unconsolidated CDOs,we reflect management fees and investment income in our consolidated statementsof operations.  As of June 30, 2007, wehave 17 funded and partially funded CDOs that are not consolidated. In theseinstances, the investment income recorded is only on the equity investment madeby us as compared to all of the assets in a consolidated CDO. Partially funded,unconsolidated CDOs in which we invest in the funded equity securities arereflected in our financial statements in the same way as funded unconsolidatedCDOs.

We originated 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 non-recourse notes by our subsidiaries.These notes are insured as to the repayment of principal and interest by ACAFinancial Guaranty. The premium on the policy insuring the notes payable to ACAFinancial Guaranty is payable by our subsidiary that invested in the preferredshares. These subsidiaries and ACA Financial Guaranty are wholly owned by usand therefore this inter-company premium eliminates in consolidation.

In structuring our CDOs, we collaborate withsponsoring investment banks to develop the type of CDO, either fully funded,partially funded or unfunded, to meet the demand of market participants. At anygiven time, different types of CDOs may be 

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attractive to different potential investors. Whether a CDO isconsolidated is a function of the amount of our equity position in the CDO and therelated accounting rules. See “—CDO Asset Management—SupplementaryInformation-Consolidation of VIEs.” Whether or not a CDO will be consolidatedonto our financial statements is not a factor that we consider in determiningthe types of CDOs that we agree to manage.

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

We may 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 second quarter of 2007.  These losses are recorded in our consolidatedstatement of operations as realized losses. Excess impairments when realized byactual defaults are absorbed by other CDO investors, since as an economicmatter, excess impairments by the Company indicate those parties willultimately not receive repayment of all of their principal investment.  For the Company, the financial statementimpact of the realized losses is offset at CDO maturity, when the associatednon-recourse liabilities are written off. For example, during the second quarter of 2007, we incurred $95.4million in impairment losses related to two consolidated CDOs wherein our totalremaining economic exposure was $48.5 million. This amount represents our equity investment and, ultimately, themaximum investment that we can lose under the two transactions.  We consolidate the CDOs, including all of theincome, expenses, gains, losses and mark to market valuations.  Third party investors own $1.0 billionin debt securities issued by the two CDOs. The excess impairment amount of $46.9 million will be reversed in ourstatement of operations at the CDO’s maturity as the CDO writes down theprincipal amount of liabilities or upon deconsolidation to the extent a triggerevent occurs under FIN 46(R) and we determine we are no longer the primarybeneficiary.  Losses in excess of oureconomic exposure will be realized at that time by third-party investors of thedebt securities issued by the CDO.

*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 June 30, 2007, all of the exposure in this line of business hadeither expired or was in run-off. Run-off indicates that while we will not addnew 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 six months ended June 30, 2007 and 2006:
| ** **                                         | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                         | ** ** | **(in thousands)**                             | ** ** |
| **REVENUES:**                                      | ** ** | ** **                                          | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Gross premiums  written                            |       | $                                                   | 60         |                                              | $          | 234 |   | $ | 342 |   | $ | 662 |   |
| Premiums earned                                    |       | $                                                   | 170        |                                              | $          | 690 |   | $ | 354 |   | $ | 1,099 |   |
| Net investment  income                             |       | 1,051                                               |       | 955                                               |       | 2,103 |   | 1,849 |   |
| Net realized and  unrealized losses on investments |       | —                                              |       | (20                                               | )          | (7 | ) | (189 | ) |
| **Total  revenues**                                | ** ** | **1,221**                                           | ** ** | **1,625**                                         | ** ** | **2,450** | ** ** | **2,759** | ** ** |
| **EXPENSES:**                                      | ** ** | ** **                                          | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loss and loss  adjustment expenses                 |       | 245                                                 |       | 122                                               |       | 593 |   | 767 |   |
| Policy  acquisition costs                          |       | 201                                                 |       | 250                                               |       | 215 |   | 370 |   |
| Other operating  expenses                          |       | 2                                                   |       | —                                            |       | 13 |   | — |   |
| Interest expense                                   |       | 93                                                  |       | 88                                                |       | 185 |   | 173 |   |
| **Total  Expenses**                                | ** ** | **541**                                             | ** ** | **460**                                           | ** ** | **1,006** | ** ** | **1,310** | ** ** |
| Income before  income taxes                        |       | 680                                                 |       | 1,165                                             |       | 1,444 |   | 1,449 |   |
| Provision for  income tax expense                  |       | 226                                                 |       | 398                                               |       | 485 |   | 495 |   |
| **Net Income**                                     | ** ** | **$**                                               | **454**    | ** **                                        | **$**      | **767** | ** ** | **$** | **959** | ** ** | **$** | **954** | ** ** |

 

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*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 second quarter of 2007 from$0.7 million in the second quarter of 2006.  Premiums earned for the six monthsended June 30, 2007 and 2006 were $0.4 million and $1.1 million,respectively.  Our exposure in the tradecredit business, a component of this line of business, continues to rapidlydecline.  Premiums earned for the otherinsurance contracts accounted for in this line of business also continue todecline.  We still continue to receive a small amount of installmentpremium for in-force asset-backed securitizations, principally manufacturedhousing, that were insured several years ago.

*NetInvestment Income.*  Netinvestment income was $1.1 million and $1.0 million for the three months endedJune 30, 2007 and 2006, respectively. Net investment income was $2.1 million and $1.8 million for the sixmonths ended June 30, 2007 and 2006, respectively.  Net investment income is derived from theallocation of income from ACA Financial Guaranty’s investment portfolio.  A portion of our capital is allocated to thisline of business because we have outstanding exposure, principally related toour exposure to insured manufactured housing securitizations. Notwithstandingthe run-off or expiration of our exposure overall in our Other line ofbusiness, allocated investment income increased due to the increase in the sizeof the ACA Financial Guaranty investment portfolio.

*Lossesand Loss Adjustment Expenses.* We continue to record losses for the trade credit business. Likepremium, losses incurred on these contracts continued to decline as theunderlying exposures run off.  This lossactivity has been within management’s expectations.

In 1999, weinsured 12 securitized manufactured housing bonds with a collective balance of$213.3 million.  In response to anincrease in the level of realized losses observed in the mortgages underlyingfour of these securitizations, we established a case specific reserve in 2004in the amount of $20.3 million. This reserve represented the present value ofexpected losses, discounted at the applicable treasury rate. Due to the verylong tenor of these bonds, payments are projected to continue through 2033.Each year we increase the reserve for accretion to adjust to the proper presentvalue. Additionally, we regularly review the underlying asset performance andassess the need for additional reserves. As of June 30, 2007, our case specificreserve was $23.2 million.  While thereserve represents our best estimate at the time of establishment of ultimatelosses on a present value basis, facts and circumstances may change such thatthe estimate is required to be revalued. Three of the bonds in our securitizedmanufactured housing portfolio experienced losses in 2006, 2005 and 2004. Afourth bond incurred losses in 2006. Losses incurred for these securitizationstotaled $0.2 million in the second quarter of 2007, all related to normalaccretion of the existing reserve which is reported at the discounted value. Inthe second quarter of 2006, losses incurred were $0.2 million and alsorepresented accretion. Losses incurred for these securitizations in the sixmonths ended June 30, 2007 and 2006 were $0.6 million and $0.5 million,respectively.

**Net Economic Income**

In managing our businessand assessing growth and profitability from a strategic and financial planningperspective, our management and Board of Directors consider U.S. GAAP netincome results as well as a measurement called net economic income. We believethat net economic income enhances the understanding of our results ofoperations by highlighting income attributable to our ongoing operatingperformance. However, net economic income is not a measurement of financialperformance or liquidity under U.S. GAAP. It should not be considered inisolation or as a substitute for net income, cash flows from operating,investing or financing activities, or any other measure calculated in accordancewith U.S. GAAP.

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

1.               Unrealized gains(losses) on derivatives included in:

·                  Net insuredcredit swap revenue;

·                  Net realized andunrealized gains (losses) on derivative instruments; and

·                  Other net creditswap revenue;

2.               Realized gains(losses) on non-CDO investments;

3.               The portion ofinterest expense related to the principal payments on borrowings that werefinanced with derivatives; and

4.               Net realized lossesrelated to the impairment of non-recourse CDO assets in excess of our equityinvestment.

Also, included innet economic income (loss) are net recognized gains from credit protectionpurchased on the ABX indices.  Thiscredit protection was purchased to moderate impairments on our ABS CDO equityand is included in the net economic results given the amount of impairmentsrecorded in the second quarter of 2007.

Unrealized gains(losses) on derivatives are excluded because (i) they widely vary withchanges in the credit market and interest rate environment and are notnecessarily indicative of the performance of our underlying businesses and(ii) the Company intends to hold the positions to the derivative contracts’expiration, at which time the mark to market values would revert to zero, tothe extent no realized derivative gains or losses had occurred. Realized gains(losses) on non-CDO investments are excluded because our investment strategy isfocused on the preservation of capital and generation of current income asopposed to the generation of trading gains and losses. We include theunrealized gains (losses) on derivatives and investments generated by tradingactivity, if any. Also 

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excluded is a portion ofinterest expense on borrowings that were financed with interest rate swaps topay the up front issuance costs of some of our consolidated CDOs. FAS 133requires that all payments made under the interest rate swaps, representingboth principal and interest, be recorded as interest expense.  In order toapproximate the economic expense on these borrowings, the portion of interestexpense that is excluded is related to what would be principal payments ifthese borrowings had been financed with debt obligations.  Net realized losses related to the impairmentof non-recourse CDO assets in excess of the Company’s equity investment in theCDO are excluded because they do no represent economic losses to the Company,rather result from the effects of consolidation.

We had after-taxunrealized losses of $(44.1) million in the second quarter of 2007, and $(3.3)million in the second quarter of 2006 on our insured credit swaps included innet insured credit swap revenue. We had after-tax unrealized gains of $1.3million in the second quarter of 2007, and $1.5 million in 2006 on ourderivatives included in net realized and unrealized gains (losses) onderivative instruments. We had unrealized gains of $1.4 million in the secondquarter of 2007 and $0.1 million in the second quarter of 2006 on our creditswaps included in other net insured credit swap revenue.  We had realizedlosses of $0 million in the second quarter of 2007 and $(0.1) million in thesecond quarter of 2006 on our non-CDO investments.  We had after-tax expenses of $0.8 million inthe second quarter of 2007 and $1.0 million in the second quarter of 2006,which effectively constituted principal payments on our interest rateswaps.  We had after-tax realized lossesin the second quarter of 2007 related to the impairment of non-recourse CDOassets of $30.5 million.  Lastly, we hadafter-tax net recognized gains in the second quarter of 2007 related to creditprotection purchased of $7.5 million.

We had after-taxunrealized losses of $(53.9) million in the first half of 2007 and $(0.8)million in the first half of 2006 on our insured credit swaps included in netinsured credit swap revenue.  We hadafter-tax unrealized gains of $2.2 million in the first half of 2007 and $3.7million in the first half of 2006 on our derivatives included in net realizedand unrealized gains (losses) on derivative instruments.  We had unrealized gains of $6.9 million inthe first half of 2007 and $0.2 million in first half of 2006 on our creditswaps included in other net insured credit swap revenue.  We had realizedlosses of $0 million in the first half of 2007 and $(0.8) million in the firsthalf of 2006 on our non-CDO investments. We had after-tax expenses of $1.6 million in the first half of 2007 and$2.0 million in the first half of 2006, which effectively constituted principalpayments on our interest rate swaps.  Wehad after-tax realized losses in the first half of 2007 related to theimpairment of non-recourse CDO assets of $30.5 million.  Lastly, we had after-tax net recognized gainsin the first half of 2007 related to credit protection purchased of $7.5million

**Liquidityand Capital Resources**

We are a holdingcompany, and as such, have no direct operations of our own. Our liquidity, bothon a short-term basis (for the next 12 months) and a long-term basis (beyondthe next 12 months) is dependent upon how much of our initial publicoffering proceeds we retain at the holding company level, the ability of ouroperating subsidiaries, which excludes our consolidated CDO entities, to paydividends or make other payments to us, and our ability to incur indebtednessand otherwise access the capital markets. As of June 30, 2007, we held at ourholding company approximately $20.1 million of the approximately $79.2 millionin net proceeds from our IPO. For further discussion regarding the balance ofproceeds after June 30, 2007, see Part II, Item 2 of this report.  Our liquidity is also a function of certainassets of our non-insurance subsidiaries which can be readily converted tocash. When assessing our liquidity, we generally exclude the resources of ourinsurance subsidiary, ACA Financial Guaranty, except for amounts that have beenapproved as dividends, since those funds are required to be maintained in theinsurance company to pay claims incurred and insurance company expenses only.  Including our other non-insurancesubsidiaries, as of August 9, 2007, we have approximately $80 million inassets that are in the form of cash or investments. Additionally, we have a$150 million liquidity facility which is discussed in detail under “—Indebtedness”.Our principal 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. Based on the amount of dividends we expect to receivefrom our subsidiaries, existing cash, including the remaining proceeds from ourinitial public offering retained at our holding company, and availability underour revolving credit facility, management believes that we will have sufficientliquidity to satisfy our needs over the next 12 months. Beyond the next12 months, the ability of our operating subsidiaries to declare and paydividends may be influenced by a variety of factors including marketconditions, insurance and rating agencies actions and general economicconditions as well as other items described in our risk factors herein and inour Form 10-K.  Consequently, although management believes that we willcontinue to have sufficient liquidity to meet our debt service and otherobligations over the long term, we cannot guarantee that we will not berequired to seek external debt or equity financing in order to meet ouroperating expenses, debt service obligations or increased capital requirements.

As discussedabove, one source of our liquidity, for the next 12 months and for thelonger term, will be amounts paid by our operating subsidiaries as dividends tous. ACA Financial Guaranty is our principal subsidiary through which we operateall our lines of business. ACA Financial Guaranty is subject to restrictionsunder state insurance law on its ability to pay dividends. InDecember 2005, the Maryland Insurance Commissioner approved ACA FinancialGuaranty’s request to pay a dividend in an amount equal to the interestpayments on $40 million of the $80 million of our trust preferredissuance outstanding through the year ended 

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December 31,2006.  The Maryland Insurance Commissioner also approved interest paymentsby ACA Financial Guaranty on the $10 million surplus note due in the2006 fiscal year.  Accordingly, during 2006 ACA Financial Guaranty paid dividendsof $2.7 million for the ultimate benefit of its parent, ACA Capital, and$0.8 million in interest on the surplus note.  Approval of theMaryland Insurance Commissioner to make dividend and surplus note interestpayments due in 2007 on the $40 million of trust preferred securities and the$10 million surplus note, respectively, was received by us inDecember 2006.  As of June 30, 2007, ACA Financial Guaranty paiddividends of $0.9 million and $0.4 million in interest on the surplusnote.  We have not received dividends from our operating subsidiariesother than ACA Financial Guaranty.

If S&P was toreduce ACA Financial Guaranty’s financial strength rating to below the “A”category, we would be severely limited in our ability to insure additionalmunicipal bonds or insure additional Structured Credit transactions. Inaddition, if the financial strength rating was reduced below “A-”, we could berequired to contribute capital to ACA Financial Guaranty as may be required torestore its rating into the “A” category or otherwise to provide collateral forthe benefit of counterparties in the form of cash or securities to back certainof our Structured Credit transactions. In the case of certain insured creditswaps, if the underlying portfolio incurs losses to a pre-agreed point, we aregenerally required to post collateral in an amount that is the lesser of theamount by which actual losses exceed this pre-agreed point and the amount ofany negative mark to market value of the insured credit swap. Moreover, thelosses on these portfolios could result in downgrades on the tranches that weinsure, resulting in increased capital charges. If any of these eventsoccurred, it could materially hurt our financial performance and liquidity andseverely strain our capital resources. See “Part I, Item 3—Quantitativeand Qualitative Disclosures About Market Risk.”

Liquidity at ouroperating subsidiaries is used to pay operating expenses, claim payments andincome taxes. Positive cash flow at ACA Financial Guaranty is only available topay operating expenses of other operating subsidiaries subject to the approvalof the Maryland Insurance Commissioner. In addition, certain of our operatingsubsidiaries may be required to post collateral in connection with creditderivatives. We had $18.9 million of collateral posted related to certainsynthetic equity transactions in our CDO Asset Management and Structured Creditbusinesses as of June 30, 2007.  On anongoing basis, our sources of funds at our operating subsidiaries primarilyresult from premiums written, asset management fees, investment income andproceeds from the sale and redemption of investments. Cash is used primarily topay losses and loss expenses, policy acquisition costs, other operatingexpenses and interest expenses. Our cash flow from operations generallyrepresents the difference between premiums collected along with the investmentincome realized, and investment earnings realized and the losses and lossexpenses paid, policy acquisition and other operating expenses and investment lossesrealized.  Cash flow from operations may differ substantially from netincome.

Subsequent to thequarter ended June 30, 2007, our Board of Directors approved a stock repurchaseprogram of up to $20 million.  Suchpurchases of stock will be funded from the holding company and othernon-insurance subsidiaries as necessary. As of August 9, 2007, we have repurchased 1,301,600 shares ofcommon stock at a cost of $9.2 million in the aggregate.

See “—Indebtedness.”

*CashFlows for the Six Months Ended June 30, 2007*

For the six monthsended June 30, 2007, we generated positive net operating cash flow of$41.0 million, primarily related to income from operations, taking intoaccount the non-cash effects of other than temporary impairments and unrealizedmark to market losses on net insured credit swap revenue, and investmentincome.  This amount is net of our $10.0 million investment in ourCredit Fund in the first quarter of 2007.  In the first six months of2007, we had net proceeds from invested assets of $91.9 million principallyfrom the sale and maturity of fixed maturity securities available for sale,primarily in our consolidated CDOs.  We had net cash outflows of$184.0 million related to financing activities, which included the paydownof $187.4 million of long-term debt, primarily in our consolidated CDOs. As of June 30, 2007, we had contributed $59.1 million of the proceeds from ourinitial public offering to our subsidiaries.  As of June 30, 2007, we hada cash balance of $328.8 million.

*CashFlows for the Six Months Ended June 30, 2006*

For the six monthsended June 30, 2006, we generated positive net operating cash flow of$38.2 million, primarily related to income from operations and investmentincome. During the same period, we had net cash provided by investingactivities of $84.0 million principally from the sale and maturity offixed maturity securities available for sale, primarily in our consolidatedCDOs.  We had net cash outflows of $74.0 millionthrough financing activities, which included the paydown of $72.5 million oflong-term debt, primarily related to our consolidated CDOs.  As of June30, 2006, we had a cash balance of $222.7 million.

**CapitalExpenditures**

We did not makesignificant capital expenditures for or during the three months ended June 30,2007 and 2006. We do not anticipate significant capital expenditures for theremainder of 2007.

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**Off-BalanceSheet Arrangements**

We do not have any“off-balance sheet arrangements” (as such term is defined in Item 303 ofRegulation S-K of the General Rules and Regulations under theSecurities Act of 1933, as amended) that are reasonably likely to have acurrent or future effect on our financial condition, changes in financialcondition, revenues or expenses, results of operations, liquidity, capitalexpenditures or capital resources. We do, however, have off-balance sheetexposure in the form of our financial guaranty exposure or par in force. Par inforce as of June 30, 2007 was $68.0 billion and includes exposure to PublicFinance, Structured Credit and CDO Asset Management and other transactions inwhich ACA Financial Guaranty has issued insurance policies. Par in force as ofJune 30, 2006, was $31.4 billion.

**ContractualObligations**

The followingtable summarized our contractual obligations as of June 30, 2007(1):
|                                                    | ** ** | ** **              | ** ** | **Less Than** | ** ** | ** **         | ** ** | ** **         | ** ** | ** **                  | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|--------------------|------------|--------------------|------------|--------------------|------------|-----------------------------|------------|
| ** **                                         | ** ** | **Total**               | ** ** | **One Year**  | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **After 5 Years** | ** ** |
| ** **                                         | ** ** | **(in thousands)** | ** ** |
| Debt                                               |       |                    |       |               |       |               |       |               |       |                        |       |
| Corporate debt                                     |       | $                       | 79,899     |               | $          | —             |       | $                  | —     |                        | $          | — |   | $ | 79,899 |   |
| CDO  debt—operating                           |       | 110,145                 |       | —             |       | 100,000            |       | —             |       | 10,145                      |       |
| CDO  debt—non-recourse, net of discounts(2)   |       | 4,525,930               |       | 2,779,513          |       | —             |       | —             |       | 1,746,417                   |       |
| Total debt                                         |       | 4,715,974               |       | 2,779,513          |       | 100,000            |       | —             |       | 1,836,461                   |       |
| Securities sold  under agreements to repurchase(3) |       | 372,936                 |       | 372,936            |       | —             |       | —             |       | —                      |       |
| Lease  obligations                                 |       | 36,509                  |       | 2,910              |       | 9,469              |       | 5,310              |       | 18,820                      |       |
| Loss reserves(4)                                   |       | 45,923                  |       | 5,926              |       | 5,278              |       | 3,451              |       | 31,268                      |       |
| Total                                              |       | $                       | 5,171,342  |               | $          | 3,161,285          |       | $                  | 114,747    |                        | $          | 8,761 |   | $ | 1,886,549 |   |

 

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(1)     Does not include any potential borrowingsunder our credit facility, for which there were no outstanding borrowings as ofJune 30, 2007, described below under “—Indebtedness.”

(2)     Represents debt incurred by our CDOs thatare consolidated under U.S. GAAP and that are without recourse to anyassets other than those of the applicable CDO.

(3)     Represents debt incurred by our Credit Fundthat are consolidated under U.S. GAAP and that are without recourse to anyassets other than those of the Credit Fund.

(4)     The loss and loss adjustment expensespayments due by period in the table above are based upon the present value ofloss and loss adjustment expenses estimates as of June 30, 2007 and are notcontractual liabilities with specified times of payment. Our contractualliability is to provide benefits under our policies. As a result, ourcalculation of loss and loss adjustment expenses payments due by period issubject to the same uncertainties associated with determining the level ofunpaid loss and loss adjustment expenses reserves generally and to theadditional uncertainties arising from the difficulty of predicting when claims(including claims that have not yet been reported to us) will be paid. Actualpayments of losses and loss adjustment expenses by period will vary, perhapsmaterially, from the above table to the extent that current estimates of lossand loss adjustment expenses vary from actual ultimate claims and amounts andas a result of variations between expected and actual payout patterns. Ourfailure to accurately set our loss reserves may result in having to increaseour loss reserves or make payments in excess of our loss reserves, which couldmaterially and adversely impact our financial condition.

**RestrictedBalances**

Our insurancesubsidiary, ACA Financial Guaranty, has assets on deposits with variousregulatory authorities. At June 30, 2007, such assets on deposit were in theamount of $4.9 million. In connection with our CDO Asset Management andStructured Credit businesses, we had on deposit $45.5 million for thebenefit of various counterparties.

**Indebtedness**

*CreditFacilities*

*$75million Credit Facility*

We had a $75million 364-day senior unsecured revolving credit facility (the “Prior CreditFacility”) with a syndicate of banks, which was replaced with the New CreditFacility (defined below) in April 2007. The Prior Credit Facility required usto maintain a net worth not less than the sum of (i) $298,500,000, (ii) 60% ofour cumulative Consolidated Net Income (as defined in the credit agreement forthe Prior Credit Facility) for each fiscal quarter (beginning with the fiscalquarter ending June 30, 2006), and (iii) 60% of the net cash proceeds of anyoffering of common equity consummated after the facility’s closing date. We were further required to not permit our debt to capital ratio to be greaterthan 35% at any time and to maintain a minimum financial strength rating fromS&P of “A-” for ACA Financial Guaranty.  We had met all of theserequirements as of the date of termination of the prior credit facility.

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*$150million Credit Facility*

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

The New CreditFacility provides for borrowings by us on a revolving basis up to an aggregateof $150 million at any one time outstanding and includes a $25 millionsub-commitment for the issuance of letters of credit and a $20 million sub-commitmentfor the making of swingline loans.  At our request and subject to theterms and conditions of the credit agreement for the New Credit Facility, themaximum amount of facility commitments may be increased up to $250 million atthe lenders’ discretion. As of June 30, 2007, no amounts were outstanding underthe New Credit Facility nor had there been any borrowings under the facility.

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

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

The terms of theNew Credit Facility include various restrictive covenants.  Thesecovenants include restrictions on indebtedness, liens, fundamental changes,sales of assets, certain payments and transactions with affiliates.  TheNew Credit Facility also includes a covenant requiring us to maintain a NetWorth (as defined in the credit agreement for the New Credit Facility) not lessthan the sum of (i) $400,000,000, (ii) 50% of our cumulative Consolidated NetIncome (as defined in the credit agreement for the New Credit Facility) foreach fiscal quarter (beginning with the fiscal quarter ending June 30, 2007)and (iii) 50% of the net cash proceeds of any offering of common equityconsummated after the facility’s closing date.  We must further not permitour debt to capital ratio to be greater than 35% at any time and must maintaina minimum financial strength rating from S&P of “A-” for ACA FinancialGuaranty.  The nature of these covenants is similar to or more favorablethan the covenants contained in the Prior Credit Facility.  The Net Worth covenant includes in itscalculation the mark to market valuations recorded in the FAS 133unrealized gains (losses) on derivatives in our statement of operations. Whileas of June 30, 2007, we were in compliance with these restrictive covenants, ifcredit spread widening continues beyond that which has occurred since June 30,2007, we may violate the Net Worth covenant in the future. We intend to seek awaiver of or an amendment to this calculation. We may not, however, be able toobtain such waiver or amendment on a timely basis, or at all.

The New CreditFacility contains various events of default customary for investment grade loanfacilities of this type (subject to certain materiality thresholds and graceperiods), including failure to pay principal and interest on loans when due, afailure to reimburse under, or pay fees in connection with, letters of creditwhen due, breach of covenants, default in payment of principal or interest inrespect of certain material indebtedness, including the acceleration of suchmaterial indebtedness, bankruptcy or insolvency, including in respect ofcertain significant subsidiaries, entry of certain enforceable judgments nototherwise stayed, and the occurrence of a change of control.  The 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 New Credit Facility could be accelerated by the requiredlenders.  In the case of bankruptcy or insolvency, acceleration of ourobligations under the New Credit Facility is automatic.

*TrustPreferred Securities*

We issued floatingrate junior subordinated deferrable interest debentures, structured as trustpreferred securities, of $20.6 million, $20.6 million,$20.6 million and $18.0 million on December 29, 2004,October 29, 2003, May 15, 2003, and December 4, 2002,respectively. The trust preferred debt securities have an initial stated termof 30 years with a call provision at five years from the date of eachissuance. The current interest rates on the $79.9 million of outstandingtrust preferred debt securities range from 8.71% to 9.46% at June 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 indenturesgoverning the debentures limit our ability to pay dividends and incur otherindebtedness. Events of default under the indentures include failure to maketimely principal or interest payments, continuation of a breach of theindentures 60 days after proper notice, bankruptcy, liquidation anddissolution.

*OtherFinancings*

To the extent wepurchase equity in our CDOs, we may issue notes to finance such purchases.These notes are debt obligations secured by our equity interest in the CDO andinsured as to the repayment of principal and interest by ACA FinancialGuaranty. The notes generally may be redeemed prior to the scheduled maturitydate at our option.  For the six monthsended June 30, 2007, no 

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amounts of equitypurchased were financed.  Rather, theseinvestments, totaling $8.2 million were purchased with cash from the holdingcompany.

InMarch 2005, one of our subsidiaries, ACA Parliament, L.L.C. (“ACAParliament”) entered into an agreement with an investment trust, pursuant towhich $99 million was deposited in a fund that is maintained and investedby ACA Parliament in exchange for a medium term note. ACA Parliament isrequired to make quarterly interest payments at a rate equal to the three-monthLIBOR plus 125 basis points and the maturity date of the medium term note is2010. We will have to refinance this medium term note program upon maturity in2010 since the maturity date is in advance of the maturity date of many of theassets acquired with the proceeds of such issuance. Notes outstanding inconnection with the financing of our equity purchases, including the aforementionedterm note, totaled $110.1 million and $112.0 million as of June 30,2007 and December 31, 2006, respectively.

**InvestmentPortfolio**

As of June 30,2007, our investment portfolio consisted of $5.0 billion of fixed maturitysecurities, of which $4.0 billion were from VIEs that we consolidate underFIN 46(R), $24.8 million from our unconsolidated CDOs, $562.1 million wereheld in our insurance company investment portfolio and $406.4 million werefrom our Credit Fund.  The vast majority of our fixed maturity securitiesare designated as available for sale in accordance with FAS 115. Theremaining fixed maturity securities are designated as part of a tradingportfolio. These securities were purchased by our Credit Fund.  Fixedmaturity securities available for sale are reported at fair value in accordancewith FAS 115, and the change in fair value is reported as part ofaccumulated other comprehensive income in stockholders’ equity while changes inthe fair value of trading securities are recorded in the income statement.Other than temporary impairments on our VIE and non-VIE investments arerecorded in net income as realized losses.

The followingtable summarizes our investment portfolio as of June 30, 2007:
|                                                  | ** ** | **Amortized  Cost**     | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated Fair  Value** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| ** **                                       | ** ** | **(in thousands)** | ** ** |
| Available for  sale-non-VIE:                     |       |                    |       |                         |       |                          |       |                           |       |
| U.S. treasury  securities                        |       | $                       | 41,334     |                         | $          | —                        |       | $                              | (1,212     | ) | $ | 40,122 |   |
| Federal-agency  securities                       |       | 71,552                  |       | —                       |       | (1,681                        | )          | 69,871                         |       |
| Obligations of  sales and political subdivisions |       | 186,766                 |       | 270                          |       | (2,447                        | )          | 184,589                        |       |
| Corporate  securities                            |       | 101,841                 |       | 225                          |       | (3,586                        | )          | 98,480                         |       |
| Asset-backed  securities                         |       | 13,395                  |       | 4                            |       | (155                          | )          | 13,244                         |       |
| Mortgage-backed  securities                      |       | 161,641                 |       | 100                          |       | (5,899                        | )          | 155,842                        |       |
| Total non-VIE securities                         |       | 576,529                 |       | 599                          |       | (14,980                       | )          | 562,148                        |       |
| Available for  sale VIE asset-backed securities  |       | 4,267,393               |       | 12,949                       |       | (206,385                      | )          | 4,073,957                      |       |
| Total available  for sale                        |       | 4,843,922               |       | 13,548                       |       | (221,365                      | )          | 4,636,105                      |       |
| Held for  trading- Credit Fund:                  |       |                    |       |                         |       |                          |       |                           |       |
| Securities held  for trading- assets             |       | 408,627                 |       | 308                          |       | (2,503                        | )          | 406,432                        |       |
| Securities held  for trading- liabilities        |       | —                  |       | —                       |       | —                        |       | —                         |       |
| Total held for  trading- Credit fund             |       | 408,627                 |       | 308                          |       | (2,503                        | )          | 406,432                        |       |
| Total                                            |       | $                       | 5,252,549  |                         | $          | 13,856                        |       | $                              | (223,868   | ) | $ | 5,042,537 |   |

 

The amortized costand estimated fair value of fixed maturity securities available for sale andheld for trading as of June 30, 2007, by contractual maturity, are shownbelow.  Expected maturities will differfrom contractual maturities because borrowers may have the right to call orprepay obligations with or without penalties.
|                                         | ** ** | **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                |       | $                                 | 24,720     |                    | $          | 24,651        |       | $                   | 31,001     |   | $ | 31,055 |   | $ | 55,721 |   | $ | 55,706 |   |
| Due after one  year through five years  |       | 81,414                            |       | 80,069                  |       | 132,980       |       | 134,090             |       | 214,394 |   | 214,159 |   |
| Due after five  years through ten years |       | 174,073                           |       | 169,847                 |       | 360,359       |       | 361,160             |       | 534,432 |   | 531,007 |   |
| Due after ten  years                    |       | 296,322                           |       | 287,581                 |       | 3,743,053     |       | 3,547,652           |       | 4,039,375 |   | 3,835,233 |   |
| Total available  for sale               |       | 576,529                           |       | 562,148                 |       | 4,267,393     |       | 4,073,957           |       | 4,843,922 |   | 4,636,105 |   |
| Held for  trading- Credit Fund(1):      |       |                              |       |                    |       |          |       |                |       |   |   |   |   |
| Due after ten  years                    |       | —                            |       | —                  |       | 408,627       |       | 406,432             |       | 408,627 |   | 406,432 |   |
| Total held for  trading                 |       | —                            |       | —                  |       | 408,627       |       | 406,432             |       | 408,627 |   | 406,432 |   |
| Total                                   |       | $                                 | 576,529    |                    | $          | 562,148       |       | $                   | 4,676,020  |   | $ | 4,480,389 |   | $ | 5,252,549 |   | $ | 5,042,537 |   |

 

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

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

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

The followingtable summarizes the ratings distributions of the fixed maturity securities inour investment portfolio and the investment portfolio of our consolidated VIEsas of June 30, 2007 and December 31, 2006: 
|                                       | ** ** | **Estimated Fair Value** | ** ** |
|---------------------------------------|------------|------------------------------------|------------|
| ** **                            | ** ** | **As of**                     | ** ** | **As of** | ** ** |
| **Rating(1)**                         | ** ** | **June 30, 2007**        | ** ** | **December 31, 2006** | ** ** |
| ** **                            | ** ** | **(in thousands)**            | ** ** |
| AAA or  equivalent                    |       | $                                  | 409,629    |   | $ | 346,352 |   |
| AA                                    |       | 81,509                             |       | 55,687 |   |
| A                                     |       | 42,890                             |       | 52,125 |   |
| BBB                                   |       | 21,983                             |       | 24,213 |   |
| Below investment  grade and non-rated |       | 6,137                              |       | 11,205 |   |
| Total non-VIE  securities             |       | 562,148                            |       | 489,582 |   |
| VIE securities                        |       | 4,073,957                          |       | 4,536,694 |   |
| Held for  trading- Credit Fund        |       | 406,432                            |       | 251,825 |   |
| Total                                 |       | $                                  | 5,042,537  |   | $ | 5,278,101 |   |

 

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

The followingtable summarizes the unrealized losses in our investment portfolio by type ofsecurity and the length of time such securities have been in a continuousunrealized loss position as of June 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                            |       | $                                      | 38,304     |                                 | $          | (1,135    | )          | $ | 1,818 |   | $ | (77 | ) | $ | 40,122 |   | $ | (1,212 | ) |
| Federal-agency  securities                           |       | 62,502                                 |       | (1,501                               | )          | 4,370     |       | (180 | ) | 66,872 |   | (1,681 | ) |
| Obligations of  states and political subdivisions    |       | 69,094                                 |       | (986                                 | )          | 51,629    |       | (1,461 | ) | 120,723 |   | (2,447 | ) |
| Corporate  securities                                |       | 24,993                                 |       | (731                                 | )          | 54,821    |       | (2,855 | ) | 79,814 |   | (3,586 | ) |
| Asset-backed  securities                             |       | 4,956                                  |       | (43                                  | )          | 4,967     |       | (111 | ) | 9,923 |   | (154 | ) |
| Mortgage-backed  securities                          |       | 49,819                                 |       | (1,568                               | )          | 90,859    |       | (4,332 | ) | 140,678 |   | (5,900 | ) |
| Total non-VIE  securities                            |       | 249,668                                |       | (5,964                               | )          | 208,464   |       | (9,016 | ) | 458,132 |   | (14,980 | ) |
| Available for  sale-VIE—asset-backed securities |       | 1,804,091                              |       | (160,467                             | )          | 656,447   |       | (45,918 | ) | 2,460,538 |   | (206,385 | ) |
| Total                                                |       | $                                      | 2,053,759  |                                 | $          | (166,431  | )          | $ | 864,911 |   | $ | (54,934 | ) | $ | 2,918,670 |   | $ | (221,365 | ) |

 

A substantialportion of the unrealized loss in CDO VIE asset-backed securities is related toRMBS, including both sub-prime and mid-prime quality mortgages.  The lastquarter of 2006 and first quarter of 2007 saw significant disruption andconsolidation in the sub-prime and second lien mortgage markets, with somemortgage originators being purchased or exiting the business.  This severe disruption continued into thesecond quarter with other types of market participants (i.e., hedge funds,insurance companies) announcing significant losses in connection with theirsub-prime and second lien mortgage exposure. This disruption further translated into decreased liquidity and widerspreads across the market, decreasing the market value 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 second quarter of 2007, theCompany determined that certain of its holdings in RMBS securities through itsconsolidated CDOs were other than temporarily impaired.  As a result, write-offs relating primarily tothose securities, aggregating $109.4 million were recorded as a reduction ofnet income during the quarter.  Thewrite-downs related to consolidated CDOs included approximately $46.9 millionin excess of the

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Company’s true economicexposure or its equity investment in the CDOs that was recorded in the Company’sstatement of operations under the rules of GAAP consolidation accounting.

Regarding theunimpaired securities carried at an unrealized loss position as of June 30,2007, the Company believed that it would be able to collect 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.  We, therefore, did not consider theseinvestments to be other-than-temporarily impaired at June 30, 2007.

For certain of theCompany’s consolidated CDOs, realized and unrealized losses exceed the amountof the Company’s true economic exposure or equity investment in the CDO.  This impairment in excess of the Company’sequity investment is a result of the consolidation of CDO assets andliabilities on the Company’s balance sheet in accordance with FIN 46(R).  The Company has no right to use the CDOassets.  Moreover, the CDO liabilities,which are non-recourse to the Company, can only be extinguished from the cashflows on these assets.  The Company’smaximum economic loss from a consolidated CDO is limited to its equityinvestment in the CDO.  Under currentrules governing consolidation accounting, the Company’s consolidated incomestatement would reflect 100% of the CDOs realized losses and its balance sheetwould reflect 100% of the CDOs unrealized losses despite the fact that its lossexposure is limited to its equity investment in the CDOs.  Upon maturity, or the occurrence of adeconsolidation event, the equity and debt holders would absorb these lossesand the Company would recognize a gain equal to all previous losses recognizedin excess of its equity.  The amount ofrealized and unrealized losses in excess of the Company’s equity investment is$(46.9) million and $(72.8) million, respectively, as of June 30, 2007.

The Company’saccumulated other comprehensive loss of $(106.6) million at June 30, 2007,includes $(116.1) million related to unrealized losses on fixed maturitysecurities available for sale.  Includedin the $(116.1) million is $(72.8) million of unrealized losses in consolidatedCDOs mentioned above in excess of our equity investment.

Included in thetable above are 916 fixed maturity securities, 212 in the non-VIE portfolios,and 704 in the VIE portfolios.  At June 30, 2007, there were 127 fixedmaturity securities, all of which are in the VIE portfolios, whose fair valuewas less than 80% of its amortized cost.  Over 99% 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 June 30, 2007.

**Item 3.Quantitative and Qualitative Disclosures About Market Risk**

**MarketRisk**

Market riskrepresents the potential for losses that may result from changes in the valueof a financial instrument as a result of changes in market conditions.  The primary market risks that impact ourfinancial instruments are due to interest rates, credit spreads, assetcorrelation, asset-backed security prepayments, CDO reinvestment and CDOcommercial paper refunding.  Each ofthese risks and the specific types of financial instruments which they impactare described below.  Senior managers inour risk management department are responsible for monitoring risk limits andapplying risk measurement methodologies. The estimation of potential losses arising from adverse changes inmarket conditions is a key element in managing market risk.  We use various systems, models and stresstest scenarios to monitor and manage market risk.  These models include estimates made by managementthat use current and historic market information.  The valuation results from these models coulddiffer materially from amounts that actually are realized in the market.  See “—Critical Accounting Policies andEstimates—Investment Portfolio” and “—Critical Accounting Policies andEstimates—Derivative Contracts” in Part I, Item 2.

During the firsthalf of 2007, we have witnessed severe disruption in the residential mortgagemarket, which in turn has caused disruption in the sector of the fixed income securitiesmarket backed by residential mortgages. This disruption is caused by the stark increase in mortgage paymentdelinquencies and defaults particularly in connection with sub-prime and secondlien mortgage exposure which has materially adversely affected the valuation offixed income securities backed by such mortgages.  Many securities are projected to suffer theloss of principal while others are being priced at very depressed levels.  The Company is subject to added risk in thismarket through its CDO Asset Management and Structured Credit lines ofbusiness.

*InterestRate Risk*

Interest rate riskis the risk that the fair value of our interest rate sensitive assets orliabilities will change with changes in market interest rates.  We own both fixed rate and floating ratebonds in our non-CDO corporate-wide investment portfolios and consolidated CDOportfolios.  Also, our unconsolidated CDOequity investments have fair values that are sensitive to yield curve movements.

We use interestrate swaps and caps to hedge differences in the cash flow of assets andliabilities within many of our CDOs. These hedges also act to reduce the net sensitivity to fair valuechanges.  We do not hedge the interestrate risk of our non-CDO corporate-wide investment portfolios since we preferthe income from this portfolio be predominantly fixed coupon.  As interest rates 

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go up or down, the yieldof that investment portfolio will be fairly stable, however, the fair valuewill fluctuate and the fluctuation can be material.  While this portfolio holds both fixed-andfloating-rate debt obligations, it is predominantly fixed rate.  Conversely, our funded CDO assets areprimarily comprised of floating rate securities.  While the values of these securities aregenerally not sensitive to interest rate movements, the associated yields aresensitive to changes in interest rates.

The followingtable shows the change in fair value for all business activities withsignificant interest rate risk.  Weemploy proprietary cash flow models to derive these values.
| Business Activity        | ** ** | **Fair Value at   June 30, 2007** | ** ** | **+100 bps  per annum  Shift** | ** ** | **-100 bps  per annum  Shift** | ** ** |
|-------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| ** **                    | ** ** | **(in millions)**                                     | ** ** |
|                          |       |                                                       |       |                                     |       |                                     |       |
| Non-CDO  investment portfolio |       | $                                                          | 562.2      |                                     | $          | (27.4                                    | )          | $ | 30.4 |   |
| CDOs (1)                      |       | 4,193.3                                                    |       | (11.4                                    | )          | 12.0                                     |       |
| Interest rate  swaps          |       | (8.3                                                       | )          | 11.7                                     |       | (12.3                                    | )          |
|                          |       | $                                                          | 4,747.2    |                                     | $          | (27.1                                    | )          | $ | 30.1 |   |

 

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

*CreditSpread Risk*

Credit spread riskis the risk that the fair value of our credit sensitive assets or other riskexposure will change with changes in the credit spreads of the referencedentities.  Generally speaking, the term “creditspread” refers to the additional yield above the risk-free benchmark yield thata borrower must pay to its lenders.  Thecredit spread increases as investor perception of the risk of default of theborrower increases.  Fluctuations ofcredit spreads behave like movements in the market yield curve (interest raterisk) for simple fixed-income investments and impact fixed- and floating-ratedebt equally.  Our credit swap exposurein our Structured Credit and CDO Asset Management transactions is generallymore sensitive to movements in credit spreads than to movements in interestrates since the mathematical models that determine fair value use changingspreads as a proxy for changing likelihood of default in the future.

We value ourinsured credit swap transactions either by obtaining market quotes from dealersor through the application of our 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 implementedto be more consistent with models that we understand other market participantsutilize, including many of our insured credit swap counterparties.  The relatively young market for credit swapshas continued to evolve over time and, while there is still substantialvariance in valuation models among market participants, the trend is towardincreasing convergence in this area. Under our refined model, we fully usemarket spread data as a proxy for default probabilities in the determination offair value. For transactions in which the underlying exposure is to corporate credits,we use individual market spreads as proxies for defaults as they are readilyavailable. For synthetic asset-backed transactions, we use a current weightedaverage portfolio spread because individual spread information historically hasnot been consistently reliable and often has been unavailable. As theavailability and quality of individual asset-backed data improves, we may makefurther refinements to our valuation model. We believe that our new model willinherently increase the volatility of these valuations, but provide a betterestimate of the cost or benefit of unwinding the related transaction.

The followingtable shows the change in fair value for all business activities withsignificant credit spread risk.  Weemploy proprietary cash flow and stochastic default models to derive thesevalues.
| Business Activity        | ** ** | **Fair Value at  June 30, 2007** | ** ** | **+25 bps  per annum  Credit Spread Shift** | ** ** | **-25 bps  per annum  Credit Spread Shift** | ** ** |
|-------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                    | ** ** | **(in millions)**                               | ** ** |
| Non-CDO  investment portfolio |       | $                                                    | 562.2      |                                                            | $          | (8.0                                                            | )          | $ | 8.0 |   |
| CDOs (1)                      |       | 4,193.3                                              |       | (29.8                                                           | )          | 34.9                                                            |       |
| Structured  Credit            |       | (77.1                                                | )          | (378.5                                                          | )          | 131.3                                                           |       |
|                          |       | $                                                    | 4,678.4    |                                                            | $          | (416.3                                                          | )          | $ | 174.2 |   |

 

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

*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.

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The followingtable shows the change in fair value for these two business activities withsignificant asset correlation risk.  Weemploy proprietary cash flow, asset correlation, and stochastic default modelsto derive these values.
| Business Activity | ** ** | **Fair Value at  June 30, 2007** | ** ** | **+5% Shift in Asset  Correlation** | ** ** | **-5% Shift in Asset  Correlation** | ** ** |
|------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **             | ** ** | **(in millions)**                               | ** ** |
| CDOs (1)               |       | $                                                    | 4,193.3    |                                               | $          | (3.7                                               | )          | $ | 4.1 |   |
| Structured  Credit     |       | (77.1                                                | )          | (197.1                                             | )          | 125.9                                              |       |
|                   |       | $                                                    | 4,116.2    |                                               | $          | (200.8                                             | )          | $ | 130.0 |   |

 

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

*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 are ABS prepayment risk, reinvestmentrisk and commercial paper refunding risk. ABS CDO equity returns depend on theleverage of a transaction (total portfolio size divided by the equity tranchesize).  Early prepayments on the ABSunderlying the CDO would quickly de-lever the transaction and, thus, diminishthe returns to the equity holders.  Sincethe majority of the underlying CDO ABS pay interest based on a floating rate,the fair value of these assets are not overly sensitive to prepayments.  Our non-CDO corporate-wide investmentportfolios could also be impacted by prepayments. We limit this exposure byimposing limits on the amount of such securities held in these portfolios.

Some of our CDOtransactions are currently in the “reinvestment period”.  This means that as the asset-backedsecurities or the leveraged loans return principal to the CDO portfolios, were-invest the principal proceeds rather than repay CDO debt. Since the CDOliability cost is established at inception (either as a fixed coupon, or, moretypically, as a fixed spread to LIBOR), we, as equity investor bear the riskthat reinvestment spreads will decrease. Conversely, increasing reinvestment spreads benefit our equityinvestment.

In two of ourconsolidated CDO transactions, the senior liability (of approximately$1.3 billion in each as at June 30, 2007) is comprised of commercial paper(“CP”).  Hence, our balance sheet carriesapproximately $2.8 billion of short-term debt or commercial paper as atJune 30, 2007 that we refund, on average, monthly.  The typical yield cost of this CP (includingdealer cost) is LIBOR-flat.  Morerecently the CP yield has exceeded LIBOR. We manage this refunding risk by negotiating into the CDO transaction,caps on the spread to LIBOR. As a result, the CP yield cannot exceed LIBOR +40basis points per annum due to the presence of put option contracts.  An increase in the spread above LIBORnegatively impacts our equity investment. When the CP spread widens, we receiveless cash distributions.

*CreditFund*

While the CreditFund is consolidated for financial reporting purposes, our net investment inthe fund at June 30, 2007 is $26.4 million. Total invested assets of the fund were approximately $406.4 million atJune 30, 2007.  The fund hedges interest rate risk on its fixed rate assetsto remain close to market neutral with respect to interest rate risk.  AtJune 30, 2007, the weighted modified duration of the portfolio was less thanone year; however the duration on our $26.4 million investment is longer due tothe leverage inherent in the fund.  Additionally, at June 30, 2007, thevast majority of the bonds held in the fund were floating interest rate payerswhich have minimal interest rate risk.  Regarding credit spread risk, theFund’s assets are mostly comprised of “AAA” rated assets, but include amaterial amount of assets with lower investment grade and non-investment graderatings.  All of the Fund’s assets havebecome more sensitive to negative price changes given the recent re-pricing ofmortgage and other credit-sensitive assets, and the non-“AAA” rated assets havebecome extremely sensitive.  In thecurrent market environment, we view the Fund has having a material amount ofcredit spread risk.

**Item 4.Controls and Procedures**

*Evaluationof Disclosure Controls and Procedures*. As of the end of theperiod covered by this report, an evaluation was carried out by our management,with the participation of the Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of our disclosure controls and procedures (as definedin Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, asamended).  Based on that evaluation, our Chief Executive Officer and ChiefFinancial Officer concluded that these disclosure controls and procedures wereeffective as of the end of the period covered by this report.

*Changesin Internal Controls Over Financial Reporting*. No change inour internal control over financial reporting (as defined in Rules 13a-15(f)and 15d-15(f) under the Securities Exchange Act of 1934, as amended) occurredduring the period covered by this report that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

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**PART II- OTHER INFORMATION**

**Item 1.Legal Proceedings**

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

**Item 1A.Risk Factors**

In addition to theother information 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 risksand uncertainties are not the only ones facing the Company and itssubsidiaries.  Additional risks and uncertainties, not presently known tous or otherwise, may also impair our business operations. If any of the risksdescribed below and in our Form 10-K or such other risks actually occur, ourbusiness, financial condition or results of operations could be materially andadversely affected.

**We face risks from concentrationto sub-prime and second lien mortgage-backed RMBS in our CDO Asset Managementand Structured Credit lines of business**

A large portion ofthe financial assets included in our ABS CDOs are RMBS.  As of June 30, 2007, we had RMBS assets undermanagement of $11.3 billion in our CDOs, with remaining related equity exposureof $54.7 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, as of June 30, 2007, we impaireda portion of the underlying assets on our financial statements in four of theCDOs which we assumed exposure to RMBS below the A-/A3 level reducing ouraggregate equity exposure in our mezzanine ABS transactions to approximately$23.8 million.  Additionally, we impaireda portion of the underlying assets on our financial statements on one of ourfour high-grade ABS CDOs that are backed by RMBS rated higher than A-/A3, andcurrently have an aggregate of approximately $30.9 million of equity exposureremaining in these transactions.  If thecurrent market trend continues, each of these transactions may experiencereduced returns or additional impairments of the underlying assets andcorresponding write downs of our equity positions in the future.  Reduced returns and/or additional impairmentsin future may materially and adversely impact our financial condition orresults of operations.  See “Management’sDiscussion and Analysis of Financial Condition and Results of Operations —Results of Operations – CDO Asset Management.”

In our StructuredCredit line of business, as of June 30, 2007, we had written 37 insured creditdefault swaps providing credit protection on tranches of RMBS portfolios,materially comprised of late 2005 and 2006 vintage sub-prime RMBS.  Virtually all of these transactions havesubordination available to us at levels in excess of the “AAA” rated category,which must be used to absorb losses prior to any payment being made by us.  Published commentary from research analystsand rating agencies on the likely levels of cumulative default rates variessignificantly. If default and delinquency rates in the mortgages underlyingthese RMBS continue to increase to the more severe scenarios, which assumehistorically unprecedented losses, we could be required to pay material claimson one or more transactions.  Payment ofsuch claims could materially and adversely impact our financial condition andcapital adequacy and that of our insurance subsidiary.

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

Certain of ourRMBS backed ABS CDOs have experienced greater than expected prepayment speedson the underlying mortgages which caused us to impair a portion of these RMBSand to take associated equity write-downs in the second quarter of 2007.  Should prepayment speeds in these ABS CDOtransactions continue at the current level or increase, additional equitywrite-downs may occur in the future, which could adversely impact our resultsof operations.  See “Management’sDiscussion and Analysis of Financial Condition and Results of Operations –Results of Operations – CDO Asset Management.”

**Continued severe levels ofdefaults and delinquencies on mortgages underlying RMBS assets referenced byour insured credit defaults in our Structured Credit line of business couldresult in downgrades of our insured tranches, resulting in increases in therelated S&P capital charges and a need for additional capital in ourinsurance subsidiary.  This could have amaterial and adverse impact on our liquidity resources.**

In our StructuredCredit line of business, we had written 37 insured credit swaps providing creditprotection on tranches of ABS portfolios at greater than “AAA” rated levels ofattachment.  While none of thesereferenced portfolios have experienced defaults at a level to warrantdowngrades on the tranches to which we have provided credit protection, continueddelinquencies and defaults on the RMBS underlying these portfolios could resultin downgrades on the tranches that we insure, resulting in increased capitalcharges.  While we believe, based on our andS&P’s stressed case models, that our insurance subsidiary has sufficientcapital to address these potential increased charges, significant increases ofour capital charges beyond those scenarios modeled by us could materially andadversely impact the capital adequacy of our insurance subsidiary and requireadditional contributions of capital from us. The need to use our current liquid resources to add to the capital ofour insurance company could have a material negative impact on our liquidityposition as a whole.  Further, should ourcurrent liquid resources prove insufficient, we could be required to raiseadditional capital in order to 

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meet the capitalrequirements of our insurance subsidiary and our ability to do this will besubject to prevailing market conditions and other factors.

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

Recently, thecredit markets have generally experienced a significant correction associatedwith the sub-prime and second lien mortgage issues which has stalled ABS CDOorigination.  We expect that thisdisruption will continue through 2007 and, potentially, for a significantlylonger period of time.  This dislocationin the credit markets, in addition to impacting our CDO Asset Managementbusiness, may also negatively impact the demand for the credit protection thatwe have historically provided through insured credit swaps in our StructuredCredit line of business on “super AAA” tranches of fully distributed ABS CDOs,commonly referred to as negative basis trades. Additionally, the CLO market has also experienced a slow downsignificantly in response to perceived aggressive loan structures and spreadwidening, which could materially and adversely impact the rate at which we areable to add assets under management in this sector.  Prolonged dislocation of these markets couldmaterially and adversely impact our results of operations or financialcondition.

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

The price of ourcommon stock has fluctuated widely since our initial public offering andcurrently, in the face of the disruption in the credit markets, experienced asignificant decline.  These fluctuationsand the recent decline could impact the perception of our financial conditionby our insured bond holders and counterparties and affect their willingness topurchase our insured bonds or continue to enter into transactions with us.  The failure of bond holders to continue topurchase our insured bonds or our counterparties to purchase credit protectionin the form of insured credit swaps could materially and adversely impact therate of growth of our Public Finance and Structured Credit lines of business, whichcould, in turn, materially and adversely impact our financial results.

Additionally,since the close of the second quarter 2007, credit spreads on our insured bondshave widened, which limits our ability to obtain sufficient pricing for assumedrisk in our Public Finance line of business. Should our insured bonds continue to trade at these widened spreads therate of growth of our Public Finance line of business could be materially andadversely impacted which could, in turn, also materially and adversely impactour financial results.

**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 withGAAP accounting, we are required to mark to market its insured creditswaps.  While we expect periodicvolatility on our financial statements in connection with these unrealizedvaluations, because we intend to hold the insured credit swaps to maturitywhen, absent credit losses, the mark to market will revert to zero, ourstrategy is to continue to grow our Structured Credit business withoutconsideration of the related valuations. Currently, credit spreads in the ABS market, in particular, have widenedand, as of June 30, 2007, we posted an aggregate net negative mark to marketunrealized loss of $(44.1) million, after tax. Continued large negative marks could continue to negatively impact theperception of our financial condition by the equity market, our insuredbondholders and counterparties and affect their willingness to purchase ourinsured bonds or continue to enter into transactions with us.  The failure of bondholders to continue topurchase our insured bonds or our counterparties to purchase credit protectionin the form of insured credit swaps could materially and adversely impact therate of growth of our Public Finance and Structured Credit lines of business,which could, in turn, materially and adversely 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 withGAAP accounting, we are required to consolidate CDO transactions in which wewere determined to be the primary beneficiary. For certain of our consolidated CDOs, realized and unrealized lossesexceed the amount of our true economic exposure or equity investment in theCDO.  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 of a deconsolidation event, we willrecognize a gain equal to all previous losses recognized in excess of our equitypositions.  The amount of realized andunrealized losses in excess of our equity investment as of June 30, 2007 was$(30.5) million and $(72.8) million on an after-tax basis, respectively.  Continued adverse trends in delinquency andforeclosure rates for 2005 and 2006 vintage RMBS could mean that we continue toreflect realized and unrealized losses on our income statement and balancesheet in excess of our economic exposure. Though these additional losses are not economic losses to us, as aresult of consolidation, the recorded losses could materially and adverselyimpact the perception of our financial condition by the equity market, ourinsured bondholders and counterparties. This could negatively impact the value of our stock and could affect bondholdersand counterparties willingness to purchase our insured bonds or continue toenter into transactions with us.  Thefailure of bondholders to continue to purchase our insured bonds or ourcounterparties to purchase credit protection in the form of insured creditswaps could materially and adversely impact the rate of growth of our PublicFinance and Structured Credit lines of business, which could, in turn,materially and adversely impact our financial results.

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**The stock repurchase programcommenced by us on August 1, 2007 will decrease liquidity in our shares ofcommon stock which could negatively impact the price of our common stock.**

Our Board ofDirectors recently approved a stock repurchase program of our outstandingcommon stock in an amount of up to $20 million and we commenced buying sharesas a part of this program on August 1, 2007. If we repurchase a substantial portion of our common stock under thisprogram, the liquidity of the remaining outstanding shares of our common stockmay be substantially decreased which could materially and adversely impact thestock price of those shares.

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

OnNovember 9, 2006, the SEC declared effective our Registration Statement inconnection with our IPO. The underwriters were Credit Suisse Securities (USA)LLC, J.P. Morgan Securities Inc., Bear Stearns & Co. Inc., StephensInc. and Keefe, Bruyette & Woods, Inc. Our offering did notterminate before any securities were sold, but as of the date of the filing ofthis report, our offering had terminated and 6,875,000 shares of our commonstock were sold by us.

All 6,875,000shares of our common stock registered in our offering were sold by us at aprice per share of $13.00. The aggregate purchase price of the offering was$89.4 million and we incurred total estimated expenses, including theunderwriters’ discount and commissions and transaction expenses paid tounaffiliated third parties in connection with the offering, of approximately$10.2 million. The net offering proceeds to us after deducting these expenseswas approximately $79.2 million.

Of the $79.2million raised for the account of the Company, as of December 31, 2006,$10.0 million 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 first half of 2007, we contributed an additional$10.0 million to one of our subsidiaries to fund an additional investment inthe Credit Fund, purchased $2.5 million in equity of a CDO and refinanced anintercompany note in the amount of $4.3 million. The balance of approximately$20.1 million has been retained at the holding company. We continue to expectthat the remainder of the proceeds from the IPO will be used for investments,as working capital and for general corporate purposes.  Pending such uses, the balance of theapproximately $20.1 million is currently invested by us in short-terminvestments.

**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: August 14,  2007 |       | /s/ Alan S. Roseman                             |
|                   |       | Alan S. Roseman                                 |
|                   |       | President and Chief Executive Officer |
|                   |       | (Principal Executive Officer)                   |
|                   |       |                                            |
|                   |       |                                            |
| Date: August 14,  2007 |       | /s/ Edward U. Gilpin                            |
|                   |       | Edward U. Gilpin                                |
|                   |       | Executive Vice President and Chief Financial    |
|                   |       | Officer                                         |
|                   |       | (Principal Financial Officer)                   |

 

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