**Exhibit 99.1**

 

CONSOLIDATED FINANCIAL STATEMENTS

 

Financial****Guaranty Insurance Company andSubsidiaries

December 31, 2007

With Report ofIndependent Registered Public Accounting Firm

 

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Financial Guaranty Insurance Company and Subsidiaries

 

Consolidated Financial Statements

 

December 31,2007

 

 

**Contents**

 
| Report of  Independent Registered Public Accounting Firm | 1      |
|----------------------------------------------------------|--------|
|                                                     |   |
| Consolidated  Balance Sheets                             | 2      |
| Consolidated  Statements of Income                       | 3      |
| Consolidated  Statements of Stockholder’s Equity    | 4      |
| Consolidated  Statements of Cash Flows                   | 5      |
| Notes to  Consolidated Financial Statements              | 6      |

 

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Report of Independent Registered Public AccountingFirm

 

The Board of Directorsand Stockholder of

Financial GuarantyInsurance Company

 

We have audited the accompanying consolidated balancesheets of Financial Guaranty Insurance Company and Subsidiaries (the Company)as of December 31, 2007 and 2006, and the related consolidated statementsof income, stockholder’s equity, and cash flows for each of the three years inthe period ended December 31, 2007. These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audits.

 

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. We were not engaged to perform an audit of the Company’s internalcontrol over financial reporting. Our audit included consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

 

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of the Company at December 31, 2007 and 2006, and theconsolidated results of its operations and its cash flows for each of the threeyears in the period ended December 31, 2007 in conformity with U.S.generally accepted accounting principles.

 

 

March 14, 2008, except for Note 23,

as to which the date is March 25, 2008

 

1

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Financial Guaranty Insurance Company and Subsidiaries

 

Consolidated BalanceSheets

 

*(Dollarsin thousands, except per share amounts)*

 
| ** **                                                                                                                   | ** ** | **December 31** | ** **    |
|------------------------------------------------------------------------------------------------------------------------------|------------|----------------------|---------------|
| ** **                                                                                                                   | ** ** | **2007**             | ** **    | **2006** | ** ** |
| **Assets**                                                                                                                   |       |                 |          |   |   |
| Fixed maturity securities, available for  sale, at fair value (amortized cost of $3,927,752 in 2007 and $3,627,344 in  2006) | ** ** | **$**                | **3,960,907** | ** ** | $ | 3,627,007 |   |
| Variable interest entity fixed maturity  securities, held to maturity at amortized cost                                      | ** ** | **750,000**          | ** **    | 750,000 |   |
| Short-term investments                                                                                                       | ** ** | **115,687**          | ** **    | 211,726 |   |
| Total investments                                                                                                            | ** ** | **4,826,594**        | ** **    | 4,588,733 |   |
|                                                                                                                         |       |                 | ** **    |   |   |
| Cash and cash equivalents                                                                                                    | ** ** | **125,355**          | ** **    | 29,963 |   |
| Accrued investment income                                                                                                    | ** ** | **55,596**           | ** **    | 49,843 |   |
| Reinsurance recoverable on losses                                                                                            | ** ** | **8,693**            | ** **    | 1,485 |   |
| Prepaid reinsurance premiums                                                                                                 | ** ** | **225,516**          | ** **    | 156,708 |   |
| Policy acquisition costs deferred, net                                                                                       | ** ** | **107,854**          | ** **    | 93,170 |   |
| Receivable from related parties                                                                                              | ** ** | **—**           | ** **    | 2,483 |   |
| Property and equipment, net of accumulated  depreciation of $3,870 in 2007 and $2,107 in 2006                                | ** ** | **16,414**           | ** **    | 2,617 |   |
| Deferred income taxes                                                                                                        | ** ** | **800,770**          | ** **    | 3,491 |   |
| Income taxes receivable                                                                                                      | ** ** | **146,775**          | ** **    | — |   |
| Derivative assets                                                                                                            | ** ** | **267**              | ** **    | 314 |   |
| Other assets                                                                                                                 | ** ** | **26,541**           | ** **    | 17,275 |   |
| Total assets                                                                                                                 | ** ** | **$**                | **6,340,375** | ** ** | $ | 4,946,082 |   |
|                                                                                                                         |       |                 | ** **    |   |   |
| **Liabilities and stockholder’s equity**                                                                                |       |                 | ** **    |   |   |
| Liabilities:                                                                                                                 |       |                 | ** **    |   |   |
| Unearned premiums                                                                                                            | ** ** | **$**                | **1,458,476** | ** ** | $ | 1,347,592 |   |
| Loss and loss adjustment expense reserves                                                                                    | ** ** | **1,267,420**        | ** **    | 40,299 |   |
| Ceded reinsurance balances payable                                                                                           | ** ** | **3,696**            | ** **    | 7,524 |   |
| Accounts payable, accrued expenses and  other liabilities                                                                    | ** ** | **55,991**           | ** **    | 41,588 |   |
| Derivative liabilities                                                                                                       | ** ** | **1,938,930**        | ** **    | 1,817 |   |
| Payable for securities purchased                                                                                             | ** ** | **—**           | ** **    | 10,770 |   |
| Variable interest entity floating rate  notes                                                                                | ** ** | **750,000**          | ** **    | 750,000 |   |
| Accrued interest expense – variable  interest entity                                                                    | ** ** | **1,208**            | ** **    | 1,298 |   |
| Capital lease obligations                                                                                                    | ** ** | **1,562**            | ** **    | 2,941 |   |
| Federal and foreign income taxes payable                                                                                     | ** ** | **—**           | ** **    | 17,520 |   |
| Deferred income taxes                                                                                                        | ** ** | **—**           | ** **    | 76,551 |   |
| Payable to related parties                                                                                                   | ** ** | **105**              | ** **    | — |   |
| Dividends payable                                                                                                            | ** ** | **10,000**           | ** **    | 10,000 |   |
| Total liabilities                                                                                                            | ** ** | **5,487,388**        | ** **    | 2,307,900 |   |
|                                                                                                                         |       |                 | ** **    |   |   |
| Stockholders’ equity:                                                                                                   |       |                 | ** **    |   |   |
| Common stock, par value $1,500 per share;  10,000 shares authorized, issued and outstanding                                  | ** ** | **15,000**           | ** **    | 15,000 |   |
| Additional paid-in capital                                                                                                   | ** ** | **1,911,252**        | ** **    | 1,901,799 |   |
| Accumulated other comprehensive income, net  of tax                                                                          | ** ** | **36,215**           | ** **    | 6,500 |   |
| Retained (loss) earnings                                                                                                     | ** ** | **(1,109,480**       | **)**         | 714,883 |   |
| Total stockholder’s equity                                                                                              | ** ** | **852,987**          | ** **    | 2,638,182 |   |
| Total liabilities and stockholder’s equity                                                                              | ** ** | **$**                | **6,340,375** | ** ** | $ | 4,946,082 |   |

 

*Seeaccompanying notes.*

 

2

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**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

ConsolidatedStatements of Income

 

*(Dollars in thousands)*

 
| ** **                                                           | ** ** | **Year Ended December 31** | ** **     |
|----------------------------------------------------------------------|------------|-------------------------------------------|----------------|
| ** **                                                           | ** ** | **2007**                                  | ** **     | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                                            |       |                                      |           |   |   |   |   |
| Gross direct and assumed premiums written                            | ** ** | **$**                                     | **451,268**    | ** ** | $ | 441,231 |   | $ | 410,202 |   |
| Ceded premiums written                                               | ** ** | **(103,907**                              | **)**          | (74,417 | ) | (29,148 | ) |
| Net premiums written                                                 | ** ** | **347,361**                               | ** **     | 366,814 |   | 381,054 |   |
| Change in net unearned premiums                                      | ** ** | **(42,076**                               | **)**          | (100,357 | ) | (156,485 | ) |
| Net premiums earned                                                  | ** ** | **305,285**                               | ** **     | 266,457 |   | 224,569 |   |
|                                                                 |       |                                      | ** **     |   |   |   |   |
| Net investment income                                                | ** ** | **156,352**                               | ** **     | 138,475 |   | 117,072 |   |
| Interest income – investments held by  variable interest entity | ** ** | **41,691**                                | ** **     | 35,893 |   | — |   |
| Net realized gains                                                   | ** ** | **872**                                   | ** **     | 274 |   | 101 |   |
| Net mark-to-market (losses) gains on credit  derivative contracts    | ** ** | **(1,936,536**                            | **)**          | 507 |   | (167 | ) |
| Other income                                                         | ** ** | **560**                                   | ** **     | 1,815 |   | 762 |   |
| Total revenues                                                       | ** ** | **(1,431,776**                            | **)**          | 443,421 |   | 342,337 |   |
|                                                                 |       |                                      | ** **     |   |   |   |   |
| Expenses:                                                            |       |                                      | ** **     |   |   |   |   |
| Loss and loss adjustment expenses                                    | ** ** | **1,226,775**                             | ** **     | (8,700 | ) | 18,506 |   |
| Underwriting and other operating expenses                            | ** ** | **94,895**                                | ** **     | 91,614 |   | 82,064 |   |
| Policy acquisition costs deferred, net                               | ** ** | **(29,615**                               | **)**          | (39,728 | ) | (38,069 | ) |
| Amortization of policy acquisition costs  deferred                   | ** ** | **15,652**                                | ** **     | 11,486 |   | 8,302 |   |
| Interest expense – debt held by variable  interest entity       | ** ** | **41,691**                                | ** **     | 35,893 |   | — |   |
| Total expenses                                                       | ** ** | **1,349,398**                             | ** **     | 90,565 |   | 70,803 |   |
|                                                                 |       |                                      | ** **     |   |   |   |   |
| (Loss) income before income tax (benefit)  expense                   | ** ** | **(2,781,174**                            | **)**          | 352,856 |   | 271,534 |   |
|                                                                 |       |                                      | ** **     |   |   |   |   |
| Income tax (benefit) expense:                                        |       |                                      | ** **     |   |   |   |   |
| Current                                                              | ** ** | **(91,559**                               | **)**          | 67,895 |   | 32,370 |   |
| Deferred                                                             | ** ** | **(885,252**                              | **)**          | 21,123 |   | 32,738 |   |
| Total income tax (benefit) expense                                   | ** ** | **(976,811**                              | **)**          | 89,018 |   | 65,108 |   |
| Net (loss) income                                                    | ** ** | **$**                                     | **(1,804,363** | **)** | $ | 263,838 |   | $ | 206,426 |   |

 

*Seeaccompanying notes.*

 

3

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Financial Guaranty Insurance Company and Subsidiaries

 

Consolidated Statementsof Stockholder’s Equity

 

*(Dollarsin thousands)*

 
| ** **                                                          | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Accumulated  Other  Comprehensive  (Loss) Income,  Net of Tax** | ** ** | **Retained  (Loss)  Earnings** | ** ** | **Total**      | ** ** |
|---------------------------------------------------------------------|------------|-------------------|------------|----------------------------------|------------|----------------------------------------------------------------------------------|------------|--------------------------------|------------|----------------|------------|
|                                                                |       |              |       |                             |       |                                                                             |       |                           |       |           |       |
| Balance at January 1, 2005                                     |       | $                 | 15,000     |                             | $          | 1,882,772                                                                        |       | $                              | 15,485     |           | $          | 264,619 |   | $ | 2,177,876 |   |
| Net income                                                          |       | —            |       | —                           |       | —                                                                           |       | 206,426                        |       | 206,426        |       |
| Other comprehensive income:                                         |       |              |       |                             |       |                                                                             |       |                           |       |           |       |
| Change in fixed maturity securities  available for sale, net of tax |       | —            |       | —                           |       | (23,550                                                                          | )          | —                         |       | (23,550        | )          |
| Change in foreign currency translation  adjustment, net of tax      |       | —            |       | —                           |       | (5,532                                                                           | )          | —                         |       | (5,532         | )          |
| Total comprehensive income                                          |       |              |       |                             |       |                                                                             |       |                           |       | 177,344        |       |
| Capital contribution                                                |       | —            |       | 12,211                           |       | —                                                                           |       | —                         |       | 12,211         |       |
| Balance at December 31, 2005                                   |       | 15,000            |       | 1,894,983                        |       | (13,597                                                                          | )          | 471,045                        |       | 2,367,431      |       |
| Net income                                                          |       | —            |       | —                           |       | —                                                                           |       | 263,838                        |       | 263,838        |       |
| Other comprehensive income:                                         |       |              |       |                             |       |                                                                             |       |                           |       |           |       |
| Change in fixed maturity securities  available for sale, net of tax |       | —            |       | —                           |       | 11,901                                                                           |       | —                         |       | 11,901         |       |
| Change in foreign currency translation  adjustment, net of tax      |       | —            |       | —                           |       | 8,196                                                                            |       | —                         |       | 8,196          |       |
| Total comprehensive income                                          |       |              |       |                             |       |                                                                             |       |                           |       | 283,935        |       |
| Dividends declared to FGIC Corp.                                    |       | —            |       | —                           |       | —                                                                           |       | (20,000                        | )          | (20,000        | )          |
| Amortization of stock options and  restricted stock                 |       | —            |       | 6,816                            |       | —                                                                           |       | —                         |       | 6,816          |       |
| Balance at December 31, 2006                                   |       | 15,000            |       | 1,901,799                        |       | 6,500                                                                            |       | 714,883                        |       | 2,638,182      |       |
| Net loss                                                            | ** ** | **—**        | ** ** | **—**                       | ** ** | **—**                                                                       | ** ** | **(1,804,363**                 | **)**      | **(1,804,363** | **)**      |
| Other comprehensive income (loss):                                  | ** ** | ** **        | ** ** | ** **                       | ** ** | ** **                                                                       | ** ** | ** **                     | ** ** | ** **     | ** ** |
| Change in fixed maturity securities  available for sale, net of tax | ** ** | **—**        | ** ** | **—**                       | ** ** | **21,818**                                                                       | ** ** | **—**                     | ** ** | **21,818**     | ** ** |
| Change in foreign currency translation  adjustment, net of tax      | ** ** | **—**        | ** ** | **—**                       | ** ** | **7,897**                                                                        | ** ** | **—**                     | ** ** | **7,897**      | ** ** |
| Total comprehensive income (loss)                                   | ** ** | **—**        | ** ** | **—**                       | ** ** | **—**                                                                       | ** ** | **—**                     | ** ** | **(1,774,648** | **)**      |
| Dividends declared to FGIC Corp.                                    | ** ** | **—**        | ** ** | **—**                       | ** ** | **—**                                                                       | ** ** | **(20,000**                    | **)**      | **(20,000**    | **)**      |
| Amortization of stock options and  restricted stock                 | ** ** | **—**        | ** ** | **9,453**                        | ** ** | **—**                                                                       | ** ** | **—**                     | ** ** | **9,453**      | ** ** |
| Balance at December 31, 2007                                   | ** ** | **$**             | **15,000** | ** **                       | **$**      | **1,911,252**                                                                    | ** ** | **$**                          | **36,215** | ** **     | **$**      | **(1,109,480** | **)** | **$** | **852,987** | ** ** |

 

*Seeaccompanying notes.*

 

4

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**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Consolidated Statementsof Cash Flows

 

*(Dollars in thousands)*

* *
| ** **                                                                                                 | ** ** | **Year Ended December 31** | ** **     |
|------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|----------------|
| ** **                                                                                                 | ** ** | **2007**                                  | ** **     | **2006** | ** ** | **2005** | ** ** |
| **Operating activities**                                                                                   |       |                                      |           |   |   |   |   |
| Net (loss) income                                                                                          | ** ** | **$**                                     | **(1,804,363** | **)** | $ | 263,838 |   | $ | 206,426 |   |
| Adjustments to reconcile net (loss) income  to net cash provided by operating activities:                  |       |                                      | ** **     |   |   |   |   |
| Amortization of policy acquisition costs  deferred                                                         | ** ** | **15,652**                                | ** **     | 11,486 |   | 8,574 |   |
| Policy acquisition costs deferred, net                                                                     | ** ** | **(29,615**                               | **)**          | (39,728 | ) | (38,069 | ) |
| Depreciation of property and equipment                                                                     | ** ** | **1,737**                                 | ** **     | 1,222 |   | 721 |   |
| Amortization of fixed maturity securities                                                                  | ** ** | **35,374**                                | ** **     | 33,774 |   | 31,504 |   |
| Amortization of short-term investments                                                                     | ** ** | **(119**                                  | **)**          | 131 |   | 481 |   |
| Net realized gains on investments                                                                          | ** ** | **(872**                                  | **)**          | (274 | ) | (101 | ) |
| Stock compensation expense                                                                                 | ** ** | **9,453**                                 | ** **     | 6,816 |   | — |   |
| Change in accrued investment income,  prepaid expenses, and other assets, net                              | ** ** | **(15,039**                               | **)**          | (14,725 | ) | (8,504 | ) |
| Change in mark-to-market losses on credit  derivative contracts                                            | ** ** | **1,937,160**                             | ** **     | 1,336 |   | 167 |   |
| Change in reinsurance recoverable on losses                                                                | ** ** | **(7,208**                                | **)**          | 1,786 |   | (217 | ) |
| Change in prepaid reinsurance premiums                                                                     | ** ** | **(68,808**                               | **)**          | (46,072 | ) | (1,344 | ) |
| Change in receivable from related parties                                                                  | ** ** | **2,588**                                 | ** **     | 7,056 |   | (8,737 | ) |
| Change in unearned premiums                                                                                | ** ** | **111,121**                               | ** **     | 147,589 |   | 157,829 |   |
| Change in loss and loss adjustment expenses                                                                | ** ** | **1,227,121**                             | ** **     | (14,513 | ) | 15,631 |   |
| Change in ceded reinsurance balances  payable, accounts payable and accrued expenses and other liabilities | ** ** | **9,198**                                 | ** **     | 10,529 |   | 8,923 |   |
| Change in current income taxes                                                                             | ** ** | **(164,295**                              | **)**          | 19,678 |   | (6,559 | ) |
| Change in accrued interest expense –  variable interest entity                                        | ** ** | **(90**                                   | **)**          | 1,298 |   | — |   |
| Change in deferred income taxes                                                                            | ** ** | **(882,351**                              | **)**          | 20,878 |   | 19,252 |   |
| Net cash provided by operating activities                                                                  | ** ** | **376,644**                               | ** **     | 412,105 |   | 385,977 |   |
|                                                                                                       |       |                                      | ** **     |   |   |   |   |
| **Investing activities**                                                                                   |       |                                      | ** **     |   |   |   |   |
| Sales and maturities of fixed maturity  securities                                                         | ** ** | **229,718**                               | ** **     | 198,186 |   | 122,638 |   |
| Purchases of fixed maturity securities                                                                     | ** ** | **(563,300**                              | **)**          | (576,386 | ) | (520,089 | ) |
| Purchases, sales and maturities of  short-term investments, net                                            | ** ** | **97,298**                                | ** **     | (52,126 | ) | (19,342 | ) |
| Receivable for securities sold                                                                             | ** ** | **20**                                    | ** **     | — |   | (20 | ) |
| Payable for securities purchased                                                                           | ** ** | **(10,770**                               | **)**          | 10,770 |   | (5,715 | ) |
| Purchase of fixed assets                                                                                   | ** ** | **(15,501**                               | **)**          | (477 | ) | (1,405 | ) |
| Purchase of investments held by variable  interest entity                                                  | ** ** | **—**                                | ** **     | (750,000 | ) | — |   |
| Net cash used in investing activities                                                                      | ** ** | **(262,535**                              | **)**          | (1,170,033 | ) | (423,933 | ) |
|                                                                                                       |       |                                      | ** **     |   |   |   |   |
| **Financing activities**                                                                                   |       |                                      | ** **     |   |   |   |   |
| Proceeds from issuance of debt held by  variable interest entity                                           | ** ** | **—**                                | ** **     | 750,000 |   | — |   |
| Capital contribution                                                                                       | ** ** | **—**                                | ** **     | — |   | 12,211 |   |
| Dividends paid                                                                                             | ** ** | **(20,000**                               | **)**          | (10,000 | ) | — |   |
| Net cash (used in) provided by financing  activities                                                       | ** ** | **(20,000**                               | **)**          | 740,000 |   | 12,211 |   |
| Effect of exchange rate changes on cash                                                                    | ** ** | **1,283**                                 | ** **     | 2,814 |   | 1,530 |   |
|                                                                                                       |       |                                      | ** **     |   |   |   |   |
| Net increase (decrease) in cash and cash  equivalents                                                      | ** ** | **95,392**                                | ** **     | (15,114 | ) | (24,215 | ) |
| Cash and cash equivalents at beginning of  period                                                          | ** ** | **29,963**                                | ** **     | 45,077 |   | 69,292 |   |
| Cash and cash equivalents at end of period                                                                 | ** ** | **$**                                     | **125,355**    | ** ** | $ | 29,963 |   | $ | 45,077 |   |
|                                                                                                       |       |                                      | ** **     |   |   |   |   |
| **Supplemental disclosure of cash flow  information**                                                      |       |                                      | ** **     |   |   |   |   |
| Income taxes paid                                                                                          | ** ** | **$**                                     | **75,545**     | ** ** | $ | 47,507 |   | $ | 49,613 |   |
| Interest paid – debt held by variable  interest entity                                                | ** ** | **$**                                     | **41,781**     | ** ** | $ | 34,595 |   | $ | — |   |

 

*See accompanying notes.*

 

5

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Financial Guaranty Insurance Company andSubsidiaries

 

Notes toConsolidated Financial Statements

 

December 31, 2007

*(Dollars in thousands, except per shareamounts)*

 

**1. Business and Organization**

** **

Financial Guaranty Insurance Company (FGIC) is awholly owned subsidiary of FGIC Corporation (FGIC Corp.). The Company providesfinancial guaranty insurance and other forms of credit enhancement for publicfinance and structured finance obligations. FGIC typically guarantees thescheduled payments of principal and interest on an issuer’s obligations whendue. FGIC is licensed to write financial guaranty insurance in all 50 states,the District of Columbia, the Commonwealth of Puerto Rico, the U.S. VirginIslands, and, through a branch, the United Kingdom. In addition, FGIC UKLimited, a wholly owned United Kingdom subsidiary of FGIC (FGIC UK Ltd) isauthorized to write financial guaranty business in the United Kingdom and haspassport rights to write business in other European Union member countries.When credit enhancement is provided in credit default swap (CDS) form, the CDSare entered into by FGIC Credit Products, LLC (FGIC Credit Products), a whollyowned subsidiary of FGIC. As used in these notes, the term “Company” refers toFGIC and its subsidiaries.

 

The PMI Group, Inc. (PMI) is the largeststockholder of FGIC Corp., owning approximately 42% of its common stock at December 31, 2007and 2006. Affiliates of the Blackstone Group L.P. (Blackstone), the CypressGroup L.L.C. (Cypress) and CIVC Partners L.P. (CIVC) owned approximately 23%,23% and 7% of FGIC Corp.’s common stock, respectively, at December 31,2007 and 2006. As of December 31, 2007, an affiliate of General ElectricCapital Corp. (GE Capital) owned 2,346 shares, or 100%, of FGIC Corp.’s seniorparticipating mandatorily convertible modified preferred stock (the SeniorPreferred Shares), with an aggregate liquidation preference of $301,921 andapproximately 5% of FGIC Corp.’s outstanding common stock.

 

**2. RecentDevelopments**

** **

The recent deterioration inthe U.S. housing and mortgage markets and the global credit markets, whichaccelerated in the fourth quarter of 2007, has adversely affected the Company’sbusiness, results of operations and financial condition. As described below, (i) theCompany’s financial strength and credit ratings were recently downgraded byvarious rating agencies and (ii) for the fourth quarter of 2007significant loss reserves were established for the Company’s exposure tocertain collateralized debt obligations of asset-backed securities (ABSCDOs), which are backed primarily by subprime residential mortgage-backedsecurities, and to certainresidential mortgage-backed securities (RMBS), primarily backed by second-lienmortgages.

 

6

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**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**2. RecentDevelopments (continued)**

** **

As a result of thesedevelopments, the Company has ceased writing new business for a period of timeto preserve capital and is considering various alternatives to enhance itscapital, restructure its operations and mitigate losses. However, no assurancecan be given that any action taken by the Company will improve its currentratings, that further rating downgrades will not occur, or that the Company will be able to recommencewriting new business in the near term or at all.

 

FGIC has proposed asignificant restructuring of its insurance operations to the New YorkState Insurance Department (the NYSID), including the organization of a new financial guaranty insurer to bedomiciled in New York to provide support for global public finance and infrastructureobligations previously insured by FGIC and to write new business to serve thosemarkets. Any restructuring will require approval from the NYSID, among otherrequirements, and significant new capital investment. No assurance can be giventhat such restructuring or investment will be completed.

 

Prior to the fourth quarter of 2007, FGIC’s financialstrength was rated “Aaa” by Moody’s Investors Service, Inc. (Moody’s), “AAA”by Standard & Poor’s Rating Services, a division of The McGraw-HillCompanies, Inc. (S&P), and “AAA” by Fitch Ratings, Inc (Fitch). Moody’s,S&P and Fitch have since completed several assessments of FGIC’s capitaladequacy in relation to the Company’s exposure to ABS CDOs which are backedprimarily by subprime RMBS, and its exposure to first-lien and second-lienRMBS. As a result of these assessments, Moody’s, S&P and Fitch downgradedthe financial strength ratings of FGIC and FGIC UK Ltd. In connection withthese downgrades, Moody’s, S&P and Fitch also downgraded the ratings of theMoney Market Committed Preferred Custodial Trust Securities (CPS Securities)issued by Grand Central Capital Trusts I - VI (see Note 18). These ratings asof March 14, 2008 are summarized in the table below.

 
| ** **                            | ** ** | **Fitch Ratings**                                                                              | ** ** | **Moody’s**                                                                                         | ** ** | **Standard & Poor’s**                                                                     |
|---------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
| ** **                            | ** ** | ** **                                                                                     | ** ** | ** **                                                                                               | ** ** | ** **                                                                                              |
| **FGIC**                              | ** ** | **Insurer Financial Strength Rating lowered from AAA to AA** Remains on Ratings Watch Negative | ** ** | **Insurance Financial Strength Rating lowered from Aaa to A3** Remains on review for possible  downgrade | ** ** | **Financial Strength Rating lowered from AAA to A**Remains on CreditWatch with developing  implications |
| ** **                            | ** ** | ** **                                                                                     | ** ** | ** **                                                                                               | ** ** | ** **                                                                                              |
| **FGIC UK Ltd**                       | ** ** | **Insurer Financial Strength Rating lowered from AAA to AA** Remains on Ratings Watch Negative | ** ** | **Insurance Financial Strength Rating lowered from Aaa to A3** Remains on review for possible downgrade  | ** ** | **Financial Strength Rating lowered from AAA to A**Remains on CreditWatch with developing  implications |
| ** **                            | ** ** | ** **                                                                                     | ** ** | ** **                                                                                               | ** ** | ** **                                                                                              |
| **Grand Central Capital Trusts I-VI** | ** ** | **NA**                                                                                         | ** ** | **Rating lowered from Aa2 to Baa3** Remains on review for possible downgrade                             | ** ** | **Rating lowered from AA to BBB** Remains on CreditWatch with developing  implications                  |

 

7

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**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**2. Recent Developments (continued)**

 

The financial strength ratings downgrades haveadversely impacted the Company’s ability to generate new business and, unlessrestored, will impact the Company’s future business, operations and financial results.

 

FGIC has established statutory loss reserves relatedto its exposure on certain ABS CDOs and RMBS, which has substantially reducedFGIC’s statutory capital and surplus position as of December 31, 2007. Asa result of this reduction, as of December 31, 2007, FGIC’s aggregate netliability under its insured exposures exceeded the aggregate risk limitprescribed by New York State Insurance Law and FGIC’s insured exposure undercertain individual policies exceeded the applicable single risk limits prescribedby New York State Insurance Law. As required by New York State Insurance Law,FGIC intends to submit a plan to the Superintendent of the NYSID detailing thesteps that FGIC has taken and will seek to take to reduce its exposure to lossto no more than the permitted amounts. Following the submission of such plan,after notice and hearing, the Superintendent could require FGIC to ceasetransacting any new financial guaranty business until its exposure to loss nolonger exceeds said limits. As noted above, FGIC has already voluntarily ceasedwriting new business for a period of time to preserve capital.

 

As a result of establishingloss reserves related to its potential exposure on certain ABS CDOs, thestatutory capital and surplus of FGIC UK Ltd as of December 31, 2007, fellbelow certain minimum statutory requirements. FGIC UK Ltd is prohibitedfrom writing new business until the shortfall is corrected. FGIC UK Ltd intends to submit a plan to itsprimary regulator to address this shortfall.

 

FGIC’s ability to pay dividends to FGIC Corp. issubject to restrictions contained in the New York Insurance Law (see Note 16). Due to FGIC’s statutory earned surplusdeficit at December 31, 2007, FGIC does not currently have the capacity topay dividends without the prior approval of the NYSID.

 

**3. Basis ofPresentation**

** **

The consolidated financial statements include theaccounts of FGIC and all other entities in which FGIC has a controllingfinancial interest. All significant intercompany balances have been eliminated.

 

8

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**3. Basis ofPresentation (continued)**

** **

The preparation of consolidated financial statementsin conformity with accounting principles generally accepted in the UnitedStates (GAAP) requires management to make estimates and assumptions that affectthe amounts reported in the consolidated financial statements and theaccompanying notes. Actual results could differ from those estimates, and thosedifferences could be material.

 

Certain 2006 and 2005 amounts have been reclassifiedto conform to the 2007 presentation.

 

**4. Summary ofSignificant Accounting Policies**

** **

The Company’s significant accounting policies are asfollows:

 

**a. Investments**

** **

All of the Company’s fixed maturity securities areclassified as available for sale and are recorded at fair value on the tradedate. Unrealized gains and losses are recorded as a separate component ofaccumulated other comprehensive income (loss), net of applicable income taxes,in the consolidated statements of stockholders’ equity. Short-term investmentsare carried at fair value, which approximates cost.

 

Bond discounts and premiums are amortized over theremaining terms of the respective securities. Realized gains or losses on thesale of investments are determined based on the specific identification method.

 

Securities that have been determined to be other thantemporarily impaired are reduced to realizable value, establishing a new costbasis, with a charge to realized loss at such date.

 

**b. Cash and CashEquivalents**

** **

The Company considers all bank deposits, highly liquidsecurities and certificates of deposit with maturities of three months or lessat the date of purchase to be cash equivalents. These cash equivalents arecarried at cost, which approximates fair value.

 

9

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Financial Guaranty Insurance Company andSubsidiaries

 

Notes to Consolidated Financial Statements(continued)

 

*(Dollars in thousands, except per shareamounts)*

 

**4. Summary ofSignificant Accounting Policies (continued)**

 

**c. Premium RevenueRecognition**

** **

Direct and assumed premiums are received eitherup-front or over time on an installment basis. The premium collection method isdetermined at the time the policy is issued.

 

Up-front premiums are paid in full at the inception ofa policy and are earned over the period of risk based upon the principal andinterest amortized during the period as compared to the original principal andinterest outstanding. Installment premiums, including premiums received onCDS’s (see Note 8) are collected periodically and are reflected in income prorata over the payment period.

 

Gross direct and assumed premiums written for theyears ended December 31, 2007, 2006 and 2005 include $3,639, $15,989 and$965, respectively, of assumed premiums written.

 

Unearned premiums represent the portion of premiumsreceived applicable to future periods on insurance policies in force. When anobligation insured by the Company is refunded by the issuer prior to the end ofthe expected policy coverage period, any remaining unearned premium is recognized.A refunding occurs when an insured obligation is retired or legally defeasedprior to stated maturity.

 

Premiums earned on refundings were $43,717,****$41,836, and $54,795 for the years ended December 31,2007, 2006, and 2005, respectively.

 

Ceded premiums are recognized in a manner consistentwith the premium earned on the underlying policies.

 

**d. PolicyAcquisition Costs**

** **

Policy acquisition costs include only those expensesthat relate directly to and vary with premium production. Such costs include compensationof employees involved in marketing, underwriting and policy issuance functions,rating agency fees, premium taxes, ceding commissions paid on assumed policiesand certain other expenses.

 

10

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**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**4. Summary ofSignificant Accounting Policies (continued)**

** **

In determining policy acquisition costs, the Companymust estimate and allocate the percentage of its costs and expenses that areattributable to premium production. Policy acquisition costs, net of cedingcommission income on premiums ceded to reinsurers, are deferred and amortizedover the period in which the related premiums are earned.

 

Anticipated loss and loss adjustment expenses, futuremaintenance costs on in-force business and net investment income are consideredin determining the recoverability of acquisition costs.

 

**e. Loss and LossAdjustment Expense Reserves**

** **

Provision for loss and loss adjustment expenses fallsinto two categories: case reserves and watchlist reserves. Case reserves areestablished for the value of estimated losses on specific non-derivative publicfinance and structured finance insured obligations that are currently or likelyto be in payment default and for which future loss is probable and can bereasonably estimated. The amounts of these reserves are determined usinginternally developed models and represent an estimate of the present value ofthe anticipated shortfall between (1) payments on insured obligations plusanticipated loss adjustment expenses and (2) anticipated cash flow from,and proceeds to be received on, sales of any collateral supporting the obligationand/or other anticipated recoveries. The discount rate used in calculating thenet present value of estimated losses is based upon the risk-free rate for theduration of the anticipated shortfall. The Company’s case reserve models aredependent on a number of assumptions that require management to make judgmentsabout the outcome of future events using historical and current market data.Significant assumptions include the liquidation value of the assets supportingthe insured obligations, the volume and timing of collateral cash flows and thebehavior of the underlying borrower. Changes in any significant assumptionsfrom time to time will affect the Company’s case reserves and financialresults, possibly materially.

 

The Company establishes watchlist reserves torecognize the potential for claims against the Company on insured obligationsthat are not currently in payment default, but that have migrated to animpaired level where there is a substantially increased probability of default.These reserves reflect a reasonable estimate of probable loss given evidence ofimpairment, and a reasonable estimate of the amount of loss given default. Themethodology for establishing and calculating the watchlist reserve relies on acategorization and assessment of the probability of default, and loss severityin the event of default, of the specific impaired obligations on the Company’swatchlist based on historical trends and other factors. Watchlist reserves areadjusted as necessary to reflect changes in the loss expectation inherent inthe group of impaired credits.

 

11

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**4. Summary ofSignificant Accounting Policies (continued)**

** **

Loss reserves and loss adjustment expenses areregularly reviewed and updated based on claim payments and the results ofongoing insured portfolio surveillance. The Company conducts ongoing insuredportfolio surveillance seeking to identify a complete population of impairedobligations and enable the Company to establish reserves that recognizepotential losses for each accounting period.

 

The Company’s loss reserves are necessarily based uponestimates and subjective judgments by management, including estimates andjudgments with respect to the probability of default, the severity of loss upondefault and the outcome of other future events. As such, the ultimate liabilityassociated with claims will likely differ, possibly materially, from estimates.Adjustments of estimates made in prior years may result in additions to orreductions of loss and loss adjustment expense reserves for the period in whichsuch adjustments are made, and those additions or deductions could be material.

 

Reinsurance recoverable on losses is calculated in amanner consistent with the calculation of loss and loss adjustment expenses.

 

**f. Income Taxes**

** **

Deferred tax assets and liabilities are recognized to reflectthe tax impact attributable to differences between the financial statementcarrying amounts of assets and liabilities and their respective tax bases.

 

Deferred tax assets and liabilities are measured usingstatutory tax rates expected to apply to taxable income in the years in whichtemporary differences are expected to be recovered or settled. The effect of achange in tax rates on deferred tax assets and liabilities is recognized inincome in the period in which the change occurs.

 

The Company recognizes accrued interest and penaltiesrelated to unrecognized tax benefits where the ultimate recognition isuncertain. The Company adopted Financial Accounting Standards Board (FASB)Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes-an Interpretation of FASB Statement 109*(FIN 48,) onJanuary 1, 2007 (see Note 9).

 

12

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**4. Summary ofSignificant Accounting Policies (continued)**

** **

**g. Property andEquipment**

** **

Property and equipment consists of office furniture,fixtures, computer equipment and software and leasehold improvements that arereported at cost less accumulated depreciation. Office furniture and fixturesare depreciated on a straight-line basis over five years. Leaseholdimprovements are amortized over their estimated service lives or over the lifeof the lease, whichever is shorter. Computer equipment and software aredepreciated over three years. Maintenance and repairs are charged to expense asincurred.

 

The Company capitalizes certain computer software anddevelopment costs when incurred in connection with developing or obtainingcomputer software for internal use. Capitalized software costs are amortizedover three years.

 

**h. ForeignCurrency Translation**

** **

The Company has an established foreign branch andthree subsidiaries in the United Kingdom and insured exposure from a formerbranch in France. The Company has determined that the functional currencies ofthese operations are their respective local currencies. Accordingly, the assetsand liabilities of these operations are translated into U.S. dollars at therates of exchange at December 31, 2007 and 2006, and revenues and expensesare translated at average monthly exchange rates. The cumulative translationgains at December 31, 2007 and 2006 were $14,648 and $6,751, respectively,net of tax expense of $3,419 and $3,580, respectively, and are reported asseparate components of accumulated other comprehensive income in theconsolidated statements of stockholders’ equity.

 

**i. StockCompensation Plan**

** **

FGIC Corp. has a stock incentive plan that providesfor stock-based compensation, including stock options, restricted stock awardsand restricted stock units. Stock options are granted for a fixed number ofshares with an exercise price equal to or greater than the estimated fair valueof the common stock at the date of the grant. Restricted stock awards and unitsare valued at the estimated fair value of the common stock on the grant date.

 

13

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**4. Summary ofSignificant Accounting Policies (continued)**

** **

Prior to January 1,2006, the Company accounted for grants under this plan in accordance with therecognition and measurement provisions of Accounting Principles Board (APB)Opinion No. 25, *Accounting for StockIssued to Employees*, and related interpretations, as permitted byStatement of Financial Accounting Standards (SFAS) No. 123, *Accounting for Stock-Based Compensation*.

 

Effective January 1, 2006, the Company adoptedthe fair value recognition provisions of SFAS No. 123(R), *Share-Based Payment*, using themodified-prospective-transition method. Under that method, compensation costincludes all share-based compensation granted prior to, but not yet vested asof, January 1, 2006, based on the fair value at the grant date estimatedin accordance with SFAS No. 123(R). The Company has estimated the fairvalue of all stock options at the date of grant using the Black-Scholes-Mertonoption pricing model. Results for prior periods have not been restated.

 

**j. VariableInterest Entities**

** **

Financial Interpretation No.46-R, *Consolidationof Variable Interest Entities*(FIN 46-R), provides accounting anddisclosure rules for determining whether certain entities should beconsolidated in the Company’s consolidated financial statements. An entity issubject to FIN 46-R, and is called a Variable Interest Entity (VIE), if it has (i) equitythat is insufficient to permit the entity to finance its activities withoutadditional subordinated financial support or (ii) equity investors thatcannot make significant decisions about the entity’s operations or that do notabsorb the majority of expected losses or receive the majority of expectedresidual returns of the entity.

 

Under FIN 46-R, a VIE is consolidated by its primarybeneficiary, which is the party that has a majority of the expected losses ofthe VIE or a majority of the expected residual returns of the VIE, or both. FIN46-R requires disclosures for companies that have either a primary orsignificant variable interest in a VIE. All other entities not considered VIEsare evaluated for consolidation under SFAS No. 94, *Consolidation of all Majority-Owned Subsidiaries.*

 

As part of its structured finance business, theCompany insures debt obligations or certificates issued by special purposeentities. The Company has evaluated the relevant transactions and does notbelieve any such transactions require consolidation or disclosure under FIN46-R, other than as disclosed in Note 12.

 

14

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**4. Summary ofSignificant Accounting Policies (continued)**

** **

**k. DerivativeInstruments**

** **

Under SFAS No. 133, Accounting for DerivativeInstruments and Hedging Activities, as amended by SFAS No. 149, Amendmentof Statement 133 on Derivative Instruments and Hedging Activities, allderivative instruments are recognized on the consolidated balance sheet attheir fair value, and changes in fair value are recognized immediately inearnings unless the derivatives qualify as cash flow hedges.

 

Certain financial guaranty contracts (primarily CDS’s)issued by the Company are considered derivatives under SFAS No.133.Accordingly, these contracts are recognized on the Consolidated Balance Sheetat their fair value, and changes in fair value are recognized currently inearnings. The Company considers these contracts to be a normal extension of itsfinancial guaranty insurance business. Under the terms of these creditderivative contracts, the Company is not required to post collateral, and ifthe underlying obligation were to be in default, payments would not beaccelerated and would be made on a pay-as-you-go basis.

 

The Company records premium installments on thesecontracts as a component of premiums, and records claims payments, expectedclaims, loss and loss adjustment expenses, and changes in fair value on thesecontracts as “Net mark-to-market (losses) gains on credit derivative contracts”in the Consolidated Statements of Income.

 

**l. Commitments**

** **

Although commitments are not insurance policies,commitments to issue financial guaranty insurance policies are generallyaccounted for in the same manner as issued insurance policies. However, feesreceived related to a commitment to issue a financial guaranty insurance policyare deferred until a policy is issued, if any, and if the Company determinesthat it is unlikely that an insurance policy will be issued, the commitment feereceived is earned over the commitment period.

 

**m. New AccountingPronouncements**

** **

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements*. SFAS No. 157defines fair value, establishes a framework for measuring fair value underGAAP, and requires additional disclosures about fair value measurements. SFAS No. 157does not require any new fair value measurements, but its application couldchange current practices in determining 

 

15

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**4. Summary of Significant Accounting Policies(continued)**

 

fair value. SFAS No. 157 is effective forfinancial statements issued for fiscal years beginning after November 15,2007. The Company is adopting SFAS No.157 effective January 1, 2008.Adoption of SFAS No. 157 is not expected to have a material effect on theCompany’s consolidated financial position or results of operation.

 

In February 2007, the FASB issued SFAS No. 159,**The FairValue Option for Financial Assets and Financial Liabilities – Including anAmendment of FASB Statement No. 115**. SFAS No. 159 permitsentities to choose to measure many financial instruments and certain otheritems at fair value but does not require any new fair value measurements. SFAS No. 159is effective for financial statements issued for fiscal years beginning after November 15,2007. At this time, the Company does not contemplate changing the measurementof any financial instruments not already measured at fair value.

 

In December 2007, the FASB issued SFAS No. 160,*Noncontrolling Interests in Consolidated FinancialStatements*, an amendment of Accounting Research Bulletin (ARB) No. 51.SFAS No. 160 requires reporting entities to present noncontrolling(minority) interests as equity (rather than as a liability or mezzanine equity)and provides guidance on accounting for transactions between an entity andnoncontrolling interests. SFAS No. 160 is effective for fiscal yearsbeginning on or after December 15, 2008.

 

The Company is currently evaluating the provisions ofSFAS No. 160, and adoption of this guidance is not expected to have amaterial effect on the Company’s consolidated financial position or results ofoperation.

 

**n. Review ofFinancial Guaranty Industry Accounting Practices**

** **

On April 18, 2007, the FASB issued an ExposureDraft of a Proposed SFAS entitled *Accounting for FinancialGuarantee Insurance Contracts, an Interpretation of FASB Statement No. 60.*The proposed statement addresses accounting for loss reserving, premiumrecognition and additional disclosures regarding financial guaranty insurancecontracts. Currently, the financial guaranty industry accounts for financialguaranty insurance contracts under SFAS No. 60, *Accounting and Reporting by Insurance Enterprises,*which wasdeveloped prior to the emergence of the financial guaranty industry. As SFAS No. 60does not specifically address financial guaranty contracts, there has beendiversity in the manner in which different financial guarantors account forthese contracts.

 

16

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**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**4. Summary ofSignificant Accounting Policies (continued)**

** **

The purpose of the proposed SFAS****isto provide authoritative guidance on accounting for financial guarantycontracts that are not accounted for as derivative contracts under SFAS No. 133,*Accounting for Derivative Instruments and HedgingActivities*, as amended by SFAS No. 149, *Amendment ofStatement 133 on Derivative Instruments and Hedging Activities*. Thefinal pronouncement is expected to be issued in the first quarter of 2008 withan effective date of January 1, 2009. Upon the issuance of the finalpronouncement, the Company, along with other companies in the financialguaranty industry, may be required to change certain aspects of accounting forloss reserves, premium income and disclosures.

 

**5. StatutorySurplus and Accounting Practices**

** **

Statutory-basis surplus of FGIC at December 31,2007 and 2006 was $260,909 and $1,130,779, respectively. Statutory-basis net(loss) income for the years ended December 31, 2007, 2006 and 2005 was($1,502,511), $220,519 and $192,009, respectively. The Company’s statutorycontingency reserves were $575,785 and $1,274,274 as of December 31, 2007and 2006, respectively.

 

Under the New York StateInsurance Law, FGIC must maintain surplus to policy holders of at least$65,000. Should FGIC be required to increase its loss reserves in futureperiods, this could cause FGIC’s surplus to fall below that minimum amount.While FGIC has additional capital resources available to it (see Note 18),there can be no assurance that FGIC would be able to obtain sufficient capitalto meet any such requirement. In the event that FGIC is unable to meet suchrequirement, the Superintendent of the NYSID has discretion to take variousremedial actions, including suspending FGIC’s ability to write new policies andseeking an order to place FGIC under regulatory control.

 

17

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**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**5. StatutorySurplus and Accounting Practices (continued)**

** **

The following is a reconciliation of net (loss) incomeand stockholder’s equity for FGIC presented on a GAAP basis to thecorresponding amounts prepared and reported under statutory accountingprinciples:

 

| ** **                                                                                | ** ** | **2007**      | ** **     | **2006**               | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------|----------------|------------------------|------------|
| ** **                                                                                | ** ** | **Net**       | ** **     | **Stockholder’s** | ** ** | **Net** | ** ** | **Stockholder’s** | ** ** |
| ** **                                                                                | ** ** | **(Loss)**    | ** **     | **Equity**             | ** ** | **Income** | ** ** | **Equity** | ** ** |
| GAAP-basis amount                                                                         | ** ** | **$**         | **(1,804,363** | **)**                  | **$**      | **852,987** | ** ** | $ | 263,838 |   | $ | 2,638,182 |   |
| Unrealized gains on fixed maturity  securities held at fair value, net of tax             | ** ** | **—**    | ** **     | **(21,614**            | **)**      | — |   | 230 |   |
| Unrealized losses from subsidiaries:                                                      |       |          |           |                   | ** ** |   |   | — |   |
| FGIC Credit Products LLC (CDS issuer)                                                     | ** ** | **1,846,381** | ** **     | **1,846,381**          | ** ** | — |   | — |   |
| All other subsidiaries                                                                    | ** ** | **108,150**   | ** **     | **—**             | ** ** | 11,048 |   | — |   |
| Tax and loss bonds                                                                        | ** ** | **—**    | ** **     | **24,375**             | ** ** | — |   | 24,375 |   |
| Premium revenue recognition                                                               | ** ** | **(33,911**   | **)**          | **(311,255**           | **)**      | (36,858 | ) | (277,344 | ) |
| Deferral of acquisition costs                                                             | ** ** | **(13,963**   | **)**          | **(107,854**           | **)**      | (28,242 | ) | (93,170 | ) |
| Mark-to-market losses on financial  guarantee insurance treated as derivatives under GAAP | ** ** | **89,503**    | ** **     | **89,503**             | ** ** | — |   | — |   |
| Non-admitted assets                                                                       | ** ** | **—**    | ** **     | **(471,067**           | **)**      | — |   | (11,116 | ) |
| Loss reserves (primarily related to  insurance of CDS contracts)                          | ** ** | **(800,323**  | **)**          | **(789,702**           | **)**      | (7,038 | ) | 10,619 |   |
| Contingency reserve                                                                       | ** ** | **—**    | ** **     | **(575,785**           | **)**      | — |   | (1,274,274 | ) |
| Unauthorized reinsurance reserve                                                          | ** ** | **—**    | ** **     | **(660**               | **)**      | — |   | — |   |
| Deferral of income taxes                                                                  | ** ** | **(890,341**  | **)**          | **(285,939**           | **)**      | 21,091 |   | 98,472 |   |
| Recognition of profit commission                                                          | ** ** | **(529**      | **)**          | **(4,654**             | **)**      | (24 | ) | (4,125 | ) |
| Purchase accounting adjustments, net of tax                                               | ** ** | **(1,737**    | **)**          | **16,022**             | ** ** | (1,844 | ) | 17,758 |   |
| Capital lease obligation                                                                  | ** ** | **(1,378**    | **)**          | **1,562**              | ** ** | (1,321 | ) | 2,941 |   |
| Other                                                                                     | ** ** | **—**    | ** **     | **(1,391**             | **)**      | (131 | ) | (1,769 | ) |
| Statutory-basis amount                                                                    | ** ** | **$**         | **(1,502,511** | **)**                  | **$**      | **260,909** | ** ** | $ | 220,519 |   | $ | 1,130,779 |   |

 

Statutory practices differ in some respects from GAAP.Significant accounting policies, and variances from GAAP, where applicable, areas follows:

 

**a. Investments**

** **

Under statutory reporting, bonds and short-terminvestments are stated at amortized cost. Under GAAP, bond and short-terminvestments are stated at fair value.

 

18

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**5. StatutorySurplus and Accounting Practices (continued)**

** **

Under GAAP, subsidiaries are consolidated with theCompany. For statutory reporting purposes, investments in wholly ownedsubsidiaries are recorded under the statutory equity method based on theunderlying GAAP equity and reported as common stock investments.

 

Changes in the value of subsidiaries are recorded asunrealized gains and losses and reported as a component of unassigned surplus.Under statutory reporting, the reporting entity can discontinue applying theequity method when the investment in a subsidiary is reduced to zero, andstatutory reporting does not provide for additional losses unless the reportingentity has guaranteed obligations of the investee or is otherwise committed toprovide further financial support for the investee. In connection with theissuance of a CDS by FGIC Credit Products, FGIC issues a financial guarantycontract for the benefit of the counterparty guaranteeing timely payment ofFGIC Credit Products’ payment obligations under the CDS. For statutorypurposes, FGIC accounts for the financial guaranty as insurance, and recordslosses as incurred.

 

Tax and loss bonds are required to be stated at costfor statutory purposes. Under GAAP, tax and loss bonds are recorded as federalincome tax payments.

 

**b. Premium RevenueRecognition**

** **

For statutory purposes, premiums collected in a singlepayment at a policy’s inception are earned in proportion to the scheduledprincipal and interest payments under the policy rather than in proportion tothe total exposure outstanding at any point in time, as is the case under GAAP.

 

**c. PolicyAcquisition Costs**

** **

For statutory purposes, policy acquisition costs arecharged to expense as incurred; under GAAP, they are deferred and amortizedover the period during which the related premiums are earned.

 

**d. CreditDerivative Contracts**

** **

Under GAAP, financial guaranty contracts, includingthe guarantee of a CDS, that guarantee the payment obligation under aderivative contract are recorded at fair value. These financial guarantycontracts are accounted for as insurance for statutory purposes.

 

19

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**5. StatutorySurplus and Accounting Practices (continued)**

** **

**e. Non-admittedAssets**

** **

Certain assets are charged directly against surplus,but are reflected as assets under GAAP. Such assets principally include prepaidexpenses, property and equipment, and deferred tax assets.

 

**f. Loss and LossAdjustment Expense and Loss Reserves**

** **

Case reserves are established for the value ofestimated losses on particular insured obligations that are currently or likelyto be in payment default, and for which a future loss is probable and can bereasonably estimated. These reserves represent an estimate of the present valueof the anticipated shortfall, net of reinsurance, between (1) payments oninsured obligations plus anticipated loss adjustment expenses and (2) anticipatedcash flow from, and proceeds to be received on, sales of any collateralsupporting the obligation and/or other anticipated recoveries. The discountrate is based upon the pretax yield of admitted assets. Under GAAP, unpaidlosses and loss adjustment expenses are reported on a gross basis (i.e., beforereinsurance), and are discounted based on the risk-free rate for theanticipated shortfall.

 

In addition, under GAAP, the Company establisheswatchlist reserves to recognize the potential for claims against the Company oninsured obligations that are not currently in payment default, but that havemigrated to an impaired level, where there is a substantially increasedprobability of default. These reserves reflect a reasonable estimate ofprobable loss given evidence of impairment, and a reasonable estimate of theamount of loss in the event of default.

 

**g. Contingency Reserves**

 

Contingency reserves are computed on the basis ofstatutory requirements for the security of all policyholders, regardless ofwhether loss contingencies actually exist. Changes in the contingency reserveare charged directly to statutory surplus. In February 2008, the Companyreceived approval from the NYSID to release $979,714 from the December 31,2007 contingency reserves. Under GAAP, contingency reserves are not permitted.

 

20

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**5. StatutorySurplus and Accounting Practices (continued)**

** **

**h. UnauthorizedReinsurance**

** **

**A liability is recorded for uncollateralized amounts duefrom reinsurers not authorized to do business in New York State. Changes inthis liability are charged or credited directly to unassigned surplus.**

** **

**i. Federal IncomeTaxes**

** **

Federal income tax expenses are provided only withrespect to taxable income for which income taxes are currently payable.Deferred income tax assets and liabilities arising from differences between thefinancial reporting and tax bases of assets and liabilities are recorded as acomponent of surplus. Under GAAP, deferred income tax assets and liabilitiesarising from differences between financial reporting and tax bases of assetsand liabilities are recorded as a component of federal income tax expense.

 

**j. ProfitCommission**

** **

Under the terms of certain reinsurance agreements, theCompany is entitled to receive profit commissions if the actual loss experiencefor a particular underwriting year is less than a prescribed level. Forstatutory purposes, the Company records such profit commissions when received.For GAAP purposes, management’s best estimate of the ultimate amountrecoverable by the Company is accrued and the change each year is recorded inthe statement of income.

 

**k. PurchaseAccounting**

** **

In a business combination under GAAP, the assets andthe liabilities of the acquired entity are recorded at fair value and thepurchase price is pushed down to the subsidiary, with the differences betweenthe purchase price and the sum of the fair value of tangible and identifiableintangible assets acquired less liabilities assumed recorded as goodwill. Forstatutory purposes, these adjustments are not recorded.

 

21

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to Consolidated FinancialStatements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**5. StatutorySurplus and Accounting Practices (continued)**

** **

**l. Capital Leases**

 

Under GAAP reporting, certain leases are treated ascapital leases, and a liability is established for the present value of theminimum payments under such leases. For statutory purposes, these leases aretreated as operating leases and rental payments are charged to expense over thelease term.

 

**6. Investments**

** **

The amortized cost and fair values of investments classified as fixedmaturity securities are as follows:

 
| ** **                                                                             | ** ** | ** **    | ** **    | **Gross**      | ** ** | **Gross**      | ** ** | ** **          | ** ** |
|----------------------------------------------------------------------------------------|------------|---------------|---------------|----------------|------------|----------------|------------|---------------------|------------|
| ** **                                                                             | ** ** | **Amortized** | ** **    | **Unrealized** | ** ** | **Unrealized** | ** ** | ** **          | ** ** |
| ** **                                                                             | ** ** | **Cost**      | ** **    | **Gains**      | ** ** | **Losses**     | ** ** | **Fair Value** | ** ** |
| **At December 31, 2007**                                                          |       |          |          |           |       |           |       |                |       |
| **Available for sale:**                                                                |       |          |          |           |       |           |       |                |       |
| Obligations of states and political  subdivisions                                      | ** ** | **$**         | **3,376,228** | ** **     | **$**      | **38,798**     | ** ** | **$**               | **7,605**  | ** ** | **$** | **3,407,421** | ** ** |
| Asset- and mortgage-backed securities                                                  | ** ** | **307,218**   | ** **    | **2,376**      | ** ** | **1,485**      | ** ** | **308,109**         | ** ** |
| U.S. Treasury securities and obligations of  U.S. government corporations and agencies | ** ** | **83,851**    | ** **    | **2,700**      | ** ** | **—**     | ** ** | **86,551**          | ** ** |
| Corporate bonds                                                                        | ** ** | **81,116**    | ** **    | **262**        | ** ** | **1,184**      | ** ** | **80,194**          | ** ** |
| Debt securities issued by foreign  governments                                         | ** ** | **65,840**    | ** **    | **1,219**      | ** ** | **175**        | ** ** | **66,884**          | ** ** |
| Preferred stock                                                                        | ** ** | **13,499**    | ** **    | **—**     | ** ** | **1,751**      | ** ** | **11,748**          | ** ** |
| Total fixed maturity securities                                                        | ** ** | **3,927,752** | ** **    | **45,355**     | ** ** | **12,200**     | ** ** | **3,960,907**       | ** ** |
| Short-term investments                                                                 | ** ** | **115,682**   | ** **    | **35**         | ** ** | **30**         | ** ** | **115,687**         | ** ** |
| **Held to maturity:**                                                                  | ** ** | ** **    | ** **    | ** **     | ** ** | ** **     | ** ** | ** **          | ** ** |
| Variable interest entity fixed maturity  securities                                    | ** ** | **750,000**   | ** **    | **—**     | ** ** | **—**     | ** ** | **750,000**         | ** ** |
| Total investments                                                                      | ** ** | **$**         | **4,793,434** | ** **     | **$**      | **45,390**     | ** ** | **$**               | **12,230** | ** ** | **$** | **4,826,594** | ** ** |

 

22

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**6. Investments (continued)**

 
| ** **                                                                             | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** **          | ** ** |
|----------------------------------------------------------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|---------------------|------------|
| ** **                                                                             | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | ** **          | ** ** |
| ** **                                                                             | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Fair Value** | ** ** |
| **At December 31, 2006**                                                          |       |          |       |           |       |           |       |                |       |
| **Available for sale:**                                                                | ** ** | ** **    | ** ** | ** **     | ** ** | ** **     | ** ** | ** **          | ** ** |
| Obligations of states and political  subdivisions                                      |       | $             | 3,117,989  |           | $          | 27,105         |       | $                   | 20,879     |   | $ | 3,124,215 |   |
| Asset- and mortgage-backed securities                                                  |       | 275,647       |       | 814            |       | 3,574          |       | 272,887             |       |
| U.S. Treasury securities and obligations of  U.S. government corporations and agencies |       | 90,978        |       | 528            |       | 1,655          |       | 89,851              |       |
| Corporate bonds                                                                        |       | 87,805        |       | 85             |       | 1,776          |       | 86,114              |       |
| Debt securities issued by foreign  governments                                         |       | 41,426        |       | 15             |       | 245            |       | 41,196              |       |
| Preferred stock                                                                        |       | 13,499        |       | —         |       | 755            |       | 12,744              |       |
| Total fixed maturity securities                                                        |       | 3,627,344     |       | 28,547         |       | 28,884         |       | 3,627,007           |       |
| Short-term investments                                                                 |       | 211,749       |       | —         |       | 23             |       | 211,726             |       |
| **Held to maturity:**                                                                  |       |          |       |           |       |           |       |                |       |
| Variable interest entity fixed maturity  securities                                    |       | 750,000       |       | —         |       | —         |       | 750,000             |       |
| Total investments                                                                      |       | $             | 4,589,093  |           | $          | 28,547         |       | $                   | 28,907     |   | $ | 4,588,733 |   |

 

The following table shows gross unrealized losses andthe fair value of fixed maturity securities, aggregated by investment categoryand the length of time that individual securities have been in a continuousunrealized loss position, at December 31, 2007:

 
| ** **                                                                             | ** ** | **Less Than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total**                   | ** ** |
|----------------------------------------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|
| ** **                                                                             | ** ** | **Fair  Value**                        | ** ** | **Unrealized  Losses**               | ** ** | **No. of  Securities** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **No. of  Securities** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **No. of  Securities** | ** ** |
| Obligations of  states and political subdivisions                                      |       | $                                      | 321,749    |                                 | $          | 4,080                       |       | 60 |   | $ | 670,911 |   | $ | 3,525 |   | 218 |   | $ | 992,660 |   | $ | 7,605 |   | 278 |   |
| Asset- and mortgage-backed  securities                                                 |       | 8,775                                  |       | 28                                   |       | 3                           |       | 101,774 |   | 1,457 |   | 30 |   | 110,549 |   | 1,485 |   | 33 |   |
| U.S. Treasury  securities and obligations of U.S. government corporations and agencies |       | —                                 |       | —                               |       | —                      |       | — |   | — |   | — |   | — |   | — |   | — |   |
| Other                                                                                  |       | 7,065                                  |       | 34                                   |       | 11                          |       | 73,695 |   | 1,325 |   | 92 |   | 80,760 |   | 1,359 |   | 103 |   |
| Preferred stock                                                                        |       | —                                 |       | —                               |       | —                      |       | 11,748 |   | 1,751 |   | 1 |   | 11,748 |   | 1,751 |   | 1 |   |
| Total temporarily  impaired securities                                                 |       | $                                      | 337,589    |                                 | $          | 4,142                       |       | 74 |   | $ | 858,128 |   | $ | 8,058 |   | 341 |   | $ | 1,195,717 |   | $ | 12,200 |   | 415 |   |

 

23

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**6. Investments(continued)**

** **

The unrealized losses in the Company’s investmentportfolio reflect interest rate increases and credit spread widening on insuredinvestments. The Company has evaluated the credit ratings of the securities inits investment portfolio and noted no deterioration. Because the decline inmarket value is attributable to changes in interest rates and credit spreads oninsured investments and not to the credit quality of the underlyinginvestments, and because the Company has the ability and intent to hold theseinvestments until their fair value exceeds their amortized cost or untilmaturity, the Company did not consider these investments to be other thantemporarily impaired at December 31, 2007.

 

Investments in fixed maturity securities carried atfair value of $4,641 and $4,456 as of December 31, 2007 and 2006,respectively, were on deposit with various regulatory authorities, as requiredby law.

 

The amortized cost and fair values of investments infixed maturity securities available for sale at December 31, 2007 areshown below by contractual maturity date. Actual maturities may differ fromcontractual maturities because borrowers may have the right to call or prepayobligations with or without penalties.

 

**Fixed Maturity Securities by ContractualMaturity Date**

**As of December 31, 2007**

 

| ** **                             | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
|----------------------------------------|------------|---------------------|------------|-----------------|------------|
| **Fixed Maturity Securities**          |       |                |       |            |       |
| Due within one year                    |       | $                   | 102,332    |            | $          | 102,272 |   |
| Due after one year through five years  |       | 781,343             |       | 779,875         |       |
| Due after five years through ten years |       | 1,466,090           |       | 1,482,423       |       |
| Due after ten years                    |       | 1,270,769           |       | 1,288,229       |       |
| Mortgage-backed securities             |       | 307,218             |       | 308,108         |       |
| Total                                  |       | $                   | 3,927,752  |            | $          | 3,960,907 |   |

 

For the years ended December 31, 2007, 2006 and2005, proceeds from sales of fixed maturity securities, available for sale,were $20,935, $20,781 and $31,380, respectively. For the years ended December 31,2007, 2006 and 2005, gross gains of $1,066, $382, and $185, respectively, andgross losses of $194, $108, and $84, respectively, were realized on such sales.In 2007 and 2006, $543 and $62 of gross gains realized on sales of short-terminvestments were included in the Net realized gains on the ConsolidatedStatements of Income, respectively.

 

24

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**6. Investments(continued)**

** **

Net investment income of the Company was derived fromthe following sources:

 

| ** **                                                           | ** ** | **Year Ended December 31** | ** **  |
|----------------------------------------------------------------------|------------|-------------------------------------------|-------------|
| ** **                                                           | ** ** | **2007**                                  | ** **  | **2006** | ** ** | **2005** | ** ** |
|                                                                 |       |                                      |        |   |   |   |   |
| Income from fixed maturity securities                                | ** ** | **$**                                     | **148,048** | ** ** | $ | 130,498 |   | $ | 112,616 |   |
| Income from short-term investments                                   | ** ** | **11,562**                                | ** **  | 10,556 |   | 6,801 |   |
| Total investment income                                              | ** ** | **159,610**                               | ** **  | 141,054 |   | 119,417 |   |
| Investment expenses                                                  | ** ** | **(3,258**                                | **)**       | (2,579 | ) | (2,345 | ) |
| Net investment income                                                | ** ** | **156,352**                               | ** **  | 138,475 |   | 117,072 |   |
| Interest income – investments held by  variable interest entity | ** ** | **41,691**                                | ** **  | 35,893 |   | — |   |
| Total                                                                | ** ** | **$**                                     | **198,043** | ** ** | $ | 174,368 |   | $ | 117,072 |   |

 

As of December 31, 2007, the Company did not have more than 4% ofits investment portfolio (excluding variable interest entity fixed maturitysecurities) concentrated in a single issuer or industry; however, the Companyhad the following investment concentrations by state:

 

| ** **            | ** ** | **Fair Value** | ** ** |
|-----------------------|------------|---------------------|------------|
|                  |       |                |       |
| New York              |       | $                   | 324,357    |   |
| Texas                 |       | 305,909             |       |
| California            |       | 254,243             |       |
| Florida               |       | 231,263             |       |
| Illinois              |       | 211,350             |       |
| Massachusetts         |       | 205,059             |       |
| New Jersey            |       | 190,201             |       |
| Michigan              |       | 127,091             |       |
|                  |       | 1,849,473           |       |
| All other states      |       | 1,431,075           |       |
| All other investments |       | 796,046             |       |
| Total investments     |       | $                   | 4,076,594  |   |

 

25

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**7. Property andEquipment**

** **

The components of property and equipment at December 31,2007 and 2006 were as follows:

 

| ** **                                | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|-------------------------------------------|------------|------------|------------|------------|------------|
|                                      |       |       | ** ** |       |       |
| Artwork                                   | ** ** | **$**      | **371**    | ** ** | $          | 371 |   |
| Computer equipment                        | ** ** | **1,685**  | ** ** | 1,104      |       |
| Furniture and fixtures                    | ** ** | **3,639**  | ** ** | 1,324      |       |
| Leasehold improvements                    | ** ** | **13,661** | ** ** | 1,515      |       |
| Capitalized software                      | ** ** | **928**    | ** ** | 410        |       |
| ** **                                |       | **20,284** | ** ** | 4,724      |       |
| Accumulated depreciation and amortization | ** ** | **(3,870** | **)**      | (2,107     | )          |
| Total Property and equipment, net         | ** ** | **$**      | **16,414** | ** ** | $          | 2,617 |   |

 

As of December 31, 2007 and 2006, the unamortizedcosts related to capitalized development stage application cost for significantinternally developed software projects were $483 and $0, respectively.

 

For the years ended December 31, 2007, 2006 and2005, depreciation expense was $1,736, $1,222 and $721, respectively.

 

**8. DerivativeInstruments**

** **

The Company previously provided CDS to certain buyersof credit protection by entering into contracts that referenced collateralizeddebt obligations from cash and synthetic structures backed by pools ofcorporate, consumer or structured finance debt. It also offered creditprotection on public finance and structured finance obligations in CDS form.These CDS agreements and certain other financial guaranty contracts areconsidered derivatives under SFAS No. 133. The Company’s total outstandingprincipal insured, net of reinsurance, on these contracts was $34,114,661 as ofDecember 31, 2007 and $22,696,360 as of December 31, 2006. TheCompany recorded net earned premiums under these contracts of $30,127, $18,740and $3,036 for the years ended December 31, 2007, 2006 and 2005,respectively.

 

26

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**8. DerivativeInstruments (continued)**

** **

Since quoted market values are not available for theCompany’s credit derivative contracts, the estimated unrealized gains andlosses attributable to these contracts are recognized in the ConsolidatedStatements of Income by recording their fair value, as determined each quarterbased on internally developed models. These models require market-driveninputs, including dealer quotes for the underlying bonds, credit spreads andyield curves. The models calculate a theoretical exit price and reflectmanagement’s best judgment about current market conditions.

 

There is likely to be volatility in the market-driveninputs obtained from an illiquid market for CDS and the underlying bonds andother obligations, and differences are likely to exist between available marketdata and assumptions used by management to estimate the fair value of theseinstruments. Accordingly, the valuation results from the model are likely todiffer, possibly materially, from amounts that would be realized in the market ifthe derivatives were traded. Moreover, volatile market conditions are likely tocause future valuations to differ, possibly materially, from those reflected inthe current period.

 

The following table summarizes the net mark-to-market(losses) gains on credit derivative contracts.

 

| ** **                                                        | ** ** | **Year Ended December 31** |
|-------------------------------------------------------------------|------------|-------------------------------------------|
| ** **                                                        | ** ** | **2007**                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                              |       |                                      |   |   |   |   |   |
| Mark-to-market (losses)                                           | ** ** | **$**                                     | **(1,937,160** | **)** | $ | (1,336 | ) | $ | (167 | ) |
| Realized gains                                                    | ** ** | **624**                                   | ** ** | 1,843 |   | — |   |
| Net mark-to-market (losses) gains on credit  derivative contracts | ** ** | **$**                                     | **(1,936,536** | **)** | $ | 507 |   | $ | (167 | ) |

 

The increase in net mark-to-market losses for the yearended December 31, 2007 is primarily related to large increases in creditspreads and the deterioration of the credit quality of the underlyingcollateral on certain structured finance obligations insured by the Company,most significantly ABS CDOs backed primarily by subprime RMBS.

 

27

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**8. DerivativeInstruments (continued)**

** **

The Company’s estimate of fair value at December 31,2007 does not reflect the potential impact, if any, of ongoing commutation,settlement and restructuring efforts. As discussed above, the fair value of theCompany’s CDS contracts has been determined based on internally developedmodels. At each reporting date, the Company’s fair value assessment isevaluated to reflect the current credit quality and spread environment, and thefair value may be adjusted to reflect the impact of the commutation, settlementor restructuring efforts.

 

**9. Income Taxes**

** **

The Company files a consolidated federal income taxreturn with FGIC Corp. The method of allocation between FGIC Corp. and itssubsidiaries is determined under a tax sharing agreement approved by theCompany’s Board of Directors and the NYSID, and is based upon separate returncalculations.

 

The Company is permitted a tax deduction, subject tocertain limitations, for amounts required to be set aside in statutorycontingency reserves by state law or regulation. The deduction is allowed onlyto the extent the Company purchases U.S. Government non-interest-bearing taxand loss bonds in an amount equal to the tax benefit attributable to suchdeductions. Purchases of tax and loss bonds are recorded as a reduction ofcurrent tax expense. The Company did not purchase any tax and loss bonds in theyears ended December 31, 2007 and 2006. During the year ended December 31,2005 the Company purchased $13,565 of tax and loss bonds.

 

28

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**9. Income Taxes(continued)**

** **

The following is a reconciliation of foreign anddomestic income taxes computed at the statutory income tax rate and the(benefit) provision for foreign and domestic income taxes:

 

| ** **                                                                                                          | ** ** | **Year Ended December 31** | ** **   |
|---------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|--------------|
| ** **                                                                                                          | ** ** | **2007**                                  | ** **   | **2006** | ** ** | **2005** | ** ** |
| Income taxes computed on (loss) income  before provision for federal income taxes, at the statutory income tax rate | ** ** | **$**                                     | **(973,411** | **)** | $ | 123,500 |   | $ | 95,037 |   |
| State and local income taxes, net of  federal income taxes                                                          | ** ** | **(775**                                  | **)**        | 756 |   | 453 |   |
| Tax effect of:                                                                                                      |       |                                      | ** **   |   |   |   |   |
| Tax-exempt interest                                                                                                 | ** ** | **(39,393**                               | **)**        | (35,646 | ) | (31,072 | ) |
| Foreign subsidiary adjustments                                                                                      | ** ** | **37,312**                                | ** **   | — |   | — |   |
| Reductions following completion of IRS  audit of 2003 and 2004                                                      | ** ** | **(5,354**                                | **)**        | — |   | — |   |
| Other, net                                                                                                          | ** ** | **4,808**                                 | ** **   | 408 |   | 690 |   |
| (Benefit) provision for income taxes                                                                                | ** ** | **$**                                     | **(976,811** | **)** | $ | 89,018 |   | $ | 65,108 |   |

 

Following are the foreign and domestic components ofthe (benefit) provision for income taxes:

 

| ** ** | ** ** | **Year Ended December 31** | ** **   |
|------------|------------|-------------------------------------------|--------------|
| ** ** | ** ** | **2007**                                  | ** **   | **2006** | ** ** | **2005** | ** ** |
| Foreign    |       |                                      |         |   |   |   |   |
| Current    | ** ** | **$**                                     | **(835**     | **)** | $ | (383 | ) | $ | 2,409 |   |
| Deferred   | ** ** | **3,128**                                 | ** **   | (752 | ) | (3,038 | ) |
| Domestic   |       |                                      | ** **   |   |   |   |   |
| Current    | ** ** | **(90,725**                               | **)**        | 68,278 |   | 29,961 |   |
| Deferred   | ** ** | **(888,379**                              | **)**        | 21,875 |   | 35,776 |   |
| Total      | ** ** | **$**                                     | **(976,811** | **)** | $ | 89,018 |   | $ | 65,108 |   |

 

As of December 31, 2007, the Company had adomestic net operating loss carryforward of $1,267,980 for tax purposes, whichwill be available to offset future taxable income. If not used, thecarryforward will expire in 2027. As of December 31, 2007, the Company hadan alternative minimum tax (AMT) credit of $8,816, which will be available tooffset future regular tax payments. AMT credits do not expire.

 

29

----

** **

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**9. Income Taxes(continued)**

** **

The tax effects of temporary differences that giverise to significant portions of the net deferred tax asset (liability) at December 31,2007 and 2006 are presented below:

 

| ** **                                                        | ** ** | **2007**    | ** **  | **2006**   | ** ** |
|-------------------------------------------------------------------|------------|-------------|-------------|------------|------------|
| Deferred tax assets:                                              |       |        |        |       |       |
| Net mark-to-market losses on credit  derivative contracts         | ** ** | **$**       | **402,245** | ** ** | $          | — |   |
| Tax and loss bonds                                                | ** ** | **24,375**  | ** **  | 24,375     |       |
| Loss and loss adjustment expense reserves                         | ** ** | **2**       | ** **  | 3,717      |       |
| AMT credit carryforward                                           | ** ** | **8,816**   | ** **  | —     |       |
| Property and equipment                                            | ** ** | **—**  | ** **  | 125        |       |
| Deferred compensation                                             | ** ** | **10,426**  | ** **  | 5,222      |       |
| Capital lease                                                     | ** ** | **2,171**   | ** **  | 2,591      |       |
| Net operating loss carryforward foreign  subsidiaries             | ** ** | **31,410**  | ** **  | 4,228      |       |
| Net operating loss carryforward                                   | ** ** | **443,794** | ** **  | —     |       |
| Other                                                             | ** ** | **2,174**   | ** **  | 586        |       |
| Total gross deferred tax assets                                   | ** ** | **925,413** | ** **  | 40,844     |       |
| Valuation allowance                                               | ** ** | **31,410**  | ** **  | —     |       |
| Total net deferred tax assets                                     | ** ** | **894,003** | ** **  | 40,844     |       |
|                                                              |       |        | ** **  |       |       |
| Deferred tax liabilities:                                         |       |        | ** **  |       |       |
| Contingency reserves                                              | ** ** | **—**  | ** **  | 42,656     |       |
| Unrealized gains on fixed maturity  securities available for sale | ** ** | **24,910**  | ** **  | 15,734     |       |
| Deferred acquisition costs                                        | ** ** | **28,528**  | ** **  | 26,558     |       |
| Premium revenue recognition                                       | ** ** | **34,102**  | ** **  | 22,915     |       |
| Profit commission                                                 | ** ** | **1,629**   | ** **  | 1,444      |       |
| Unrealized gains on foreign currency                              | ** ** | **3,419**   | ** **  | 3,581      |       |
| Property and equipment                                            | ** ** | **69**      | ** **  | —     |       |
| Other                                                             | ** ** | **576**     | ** **  | 1,016      |       |
| Total deferred tax liabilities                                    | ** ** | **93,233**  | ** **  | 113,904    |       |
| Net deferred tax asset (liability)                                | ** ** | **$**       | **800,770** | ** ** | $          | (73,060 | ) |

 

30

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to Consolidated FinancialStatements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**9. Income Taxes(continued)**

** **

Management believes that no valuation allowance isnecessary in connection with its domestic deferred tax asset because it is morelikely than not that the amortization of the unearned premium reserve,collection of future installment premiums on contracts already written, andincome from the investment portfolio will generate sufficient taxable income torealize the domestic deferred tax asset prior to its expiration.

 

As of December 31, 2007 and 2006, the Company hadgross foreign deferred tax assets of $31,664 and $4,359, respectively, andgross foreign deferred tax liabilities of $211 and $868, respectively. The netoperating losses on foreign subsidiaries of $31,410 as of December 31,2007 were generated by FGIC’s United Kingdom subsidiaries. The United Kingdomdoes not allow net operating losses to be carried back, but does permit them tobe carried forward indefinitely. Based upon projections of future taxableincome over the periods in which the deferred tax assets are deductible and theestimated reversal of future taxable temporary differences, the Company doesnot anticipate realizing the benefits of these deductible differences and,therefore, has established a valuation allowance at December 31, 2007 of$31,410.

 

The Company adopted FIN 48 effective January 1,2007. The Company’s liability forunrecognized tax benefits was not impacted as a result of the adoption of FIN48. A reconciliation of the beginning and ending amount of unrecognized taxbenefits is as follows:

 

| Balance at January 1, 2007                               |   | $      | 17,057 |   |
|---------------------------------------------------------------|--------|--------|--------|--------|
| Additions based on tax positions related to  the current year |   | — |   |
| Additions for tax positions of prior years                    |   | 916    |   |
| Reductions for tax positions of prior year                    |   | (6,024 | )      |
| Payments following completion of IRS audit  of 2003 and 2004  |   | (5,353 | )      |
| Balance at December 31, 2007                             |   | $      | 6,596  |   |

 

The Company recognizes accrued interest and penaltiesrelated to unrecognized tax benefits where the ultimate recognition isuncertain. Tax expense related to interest and penalties amounted to $440, $0,and $0 during the years ended December 31, 2007, 2006, and 2005,respectively. Approximately $265 and $0 were accrued for the payment ofinterest and penalties at December 31, 2007 and 2006, respectively, whichis included as a component of the balance of unrecognized tax benefits.

 

31

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**9. Income Taxes(continued)**

** **

In the second quarter of 2006, the Internal RevenueService (IRS) commenced an examination of FGIC Corp.’s consolidated U.S.federal income tax returns for 2003 and 2004. The examination was completed inthe second quarter of 2007. As a result, the Company is not subject to U.S.federal income tax examination by the IRS for years before 2005.

 

Upon completion of the audit, previously unrecognizedtax benefits of $5,353 relating to the years under examination were recognized.

 

The Company’s United Kingdom operations are subject toexamination by foreign tax authorities for the periods since they commencedoperation in 2004.

 

**10. Reinsurance**

** **

Reinsurance is a commitment by one insurance company(the reinsurer) to reimburse another insurance company (the ceding company) fora specified portion of the insurance risks under policies issued by the cedingcompany in consideration for a portion of the related premiums received. Theceding company typically will receive a ceding commission from the reinsurer.

 

The Company uses reinsurance to increase its capacityto write insurance for obligations of large, frequent issuers; to meetinternal, rating agency or regulatory single risk limits; to diversify risk;and to manage rating agency and regulatory capital requirements. The Companyarranges reinsurance on both a facultative (transaction-by-transaction) basisand on a proportional share basis.

 

As a primary insurer, the Company is required tofulfill all its obligations to policyholders even if a reinsurer fails toperform its obligations under the applicable reinsurance agreement. The Companyregularly monitors the financial condition of its reinsurers. The Companyevaluated the financial condition of its reinsurers and determined that noallowance for unrecoverable reinsurance was needed. Under most of the Company’sreinsurance agreements, the Company has the right to reassume all the exposureceded to a reinsurer (and receive all the remaining unearned premiums ceded) inthe event of a ratings downgrade of the reinsurer or the occurrence of certainother events. In certain of these cases, the Company also has the right toimpose additional ceding commissions.

 

32

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**10. Reinsurance(continued)**

** **

FGIC has also assumedexposure from certain other financial guarantors under reinsurance agreements.

 

As a result of the downgradein the Company’s financial strength ratings (see Note 2), the counterpartiesfrom which the Company has assumed exposures have the ability either toreassume the exposures ceded and receive the remaining unearned premiums, or toimpose additional ceding commissions.

 

Under certain reinsurance agreements, the Companyholds collateral in the form of letters of credit and trust agreements. Suchcollateral totaled $180,125 at December 31, 2007 and can be drawn on inthe event of default by a reinsurer.

 

The effect of reinsurance on premiums written and earned was asfollows:

 

| ** **   | ** ** | **Year Ended December 31** | ** **  |
|--------------|------------|-------------------------------------------|-------------|
| ** **   | ** ** | **2007**                                  | ** **  | **2006** | ** ** | **2005** | ** ** |
| ** **   | ** ** | **Written**                               | ** **  | **Earned** | ** ** | **Written** | ** ** | **Earned** | ** ** | **Written** | ** ** | **Earned** | ** ** |
|         |       |                                      |        |   |   |   |   |   |   |   |   |   |   |
| Direct       | ** ** | **$**                                     | **447,629** | ** ** | **$** | **338,245** |   | $ | 425,242 |   | $ | 293,962 |   | $ | 409,237 |   | $ | 246,914 |   |
| Assumed      | ** ** | **3,639**                                 | ** **  | **2,194** |   | 15,989 |   | 819 |   | 965 |   | 54 |   |
| Ceded        | ** ** | **(103,907**                              | **)**       | **(35,154** | **)** | (74,417 | ) | (28,324 | ) | (29,148 | ) | (22,399 | ) |
| Net premiums | ** ** | **$**                                     | **347,361** | ** ** | **$** | **305,285** |   | $ | 366,814 |   | $ | 266,457 |   | $ | 381,054 |   | $ | 224,569 |   |

 

For the years ended December 31, 2007, 2006 and2005, reinsurance recoveries reduced loss and loss adjustment expenses incurredby $7,287, $1,722 and $217, respectively.

 

33

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**11. Loss and Loss Adjustment ExpensesReserves**

 

Activity in the reserves for loss and loss adjustment expenses issummarized as follows:

 

| ** **                         | ** ** | **Year Ended December 31** | ** **    |
|------------------------------------|------------|-------------------------------------------|---------------|
| ** **                         | ** ** | **2007**                                  | ** **    | **2006** | ** ** | **2005** | ** ** |
| Balance at beginning of period:    |       |                                      |          |   |   |   |   |
| Case reserves                      | ** ** | **$**                                     | **28,558**    | ** ** | $ | 33,328 |   | $ | 15,700 |   |
| Watch list reserves                | ** ** | **11,741**                                | ** **    | 21,484 |   | 23,481 |   |
| Total                              | ** ** | **40,299**                                | ** **    | 54,812 |   | 39,181 |   |
| Less reinsurance recoverable       | ** ** | **(1,485**                                | **)**         | (3,271 | ) | (3,054 | ) |
| Net balance at beginning of period | ** ** | **38,814**                                | ** **    | 51,541 |   | 36,127 |   |
| Incurred related to:               |       |                                      | ** **    |   |   |   |   |
| Current period                     | ** ** | **1,239,069**                             | ** **    | — |   | 23,985 |   |
| Prior periods                      | ** ** | **(12,294**                               | **)**         | (8,700 | ) | (5,479 | ) |
| Total incurred                     | ** ** | **1,226,775**                             | ** **    | (8,700 | ) | 18,506 |   |
|                               |       |                                      | ** **    |   |   |   |   |
| Paid related to:                   |       |                                      | ** **    |   |   |   |   |
| Current period                     | ** ** | **(7,920**                                | **)**         | — |   | (1,993 | ) |
| Prior periods                      | ** ** | **3,894**                                 | ** **    | (4,027 | ) | (1,099 | ) |
| Total paid                         | ** ** | **(4,026**                                | **)**         | (4,027 | ) | (3,092 | ) |
|                               |       |                                      | ** **    |   |   |   |   |
| FX on UK Ltd reserves              | ** ** | **(2,836**                                | **)**         | — |   | — |   |
|                               |       |                                      | ** **    |   |   |   |   |
| Net balance                        | ** ** | **1,258,727**                             | ** **    | 38,814 |   | 51,541 |   |
| Plus reinsurance recoverable       | ** ** | **8,693**                                 | ** **    | 1,485 |   | 3,271 |   |
|                               |       |                                      | ** **    |   |   |   |   |
| Case reserves                      | ** ** | **1,259,202**                             | ** **    | 28,558 |   | 33,328 |   |
| Watchlist reserves                 | ** ** | **8,218**                                 | ** **    | 11,741 |   | 21,484 |   |
| Balance at end of period           | ** ** | **$**                                     | **1,267,420** | ** ** | $ | 40,299 |   | $ | 54,812 |   |

 

Case reserves at December 31, 2007 increased to$1,259,202 at December 31, 2007 from $28,558 at December 31, 2006 -an increase of $1,230,644. The increase was mainly attributable to theestablishment of loss reserves for financial guaranty obligations impacted bythe deterioration in mortgage underwriting quality in the U.S. mortgage marketduring 2007 and 2006. Reserves at December 31, 2007 relate predominantlyto ABS CDOs and RMBS transactions. Approximately seventy-five percent of the reserves at December 31, 2007relate to an outstanding commitment to provide financial guaranties withrespect to a referenced portfolio of ABS CDOs upon satisfaction of certainconditions.

 

34

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**11. Loss and LossAdjustment Expenses Reserves (continued)**

** **

Loss and loss adjustment expense reserves at December 31,2007 do not reflect the potential impact, if any, of ongoing loss mitigationefforts; however, there can be no assurance that any loss mitigation effortswill be successful, and it is not possible to predict the magnitude of anybenefit that might be derived from any such efforts that are successful. Lossreserves have been established based on the performance of the underlyingcollateral. If the Company identifies credit impairment, a provision for lossand loss adjustment expense is recorded. At each reporting date the reservesare evaluated and may be adjusted to reflect the impact of any loss mitigation effortsthat have yielded results that are probable and estimable. The Company believes that the reserve forestimated losses as of December 31, 2007 is adequate to cover expectedfuture net claims. However, the establishment of the appropriate level of reservesis an inherently uncertain process involving numerous estimates and subjectivejudgments by management. Small changes underlying these estimates could resultin significant changes in the Company’s loss expectations. At present, thereremains a considerable amount of uncertainty relating to risks in real estateprices, credit markets and the economy as a whole, and there is no historicalprecedent for the current conditions. There can be no assurance that theCompany’s estimates of probable and estimable losses are accurate. Accordingly,there can be no assurance that actual claims paid by the Company will notexceed its reserves at December 31, 2007, and it is possible that theycould significantly exceed those reserves. Additionally, further deteriorationin the performance of RMBS, ABS CDOs and other obligations the Company insurescould lead to the establishment of additional loss reserves and further loss orreduction to income.

 

Incurred loss reserves for the years ended December 31,2006 and 2005 related primarily to obligations impacted by Hurricane Katrina.During the year ended December 31, 2005, the Company established lossreserves of $21,833 for an investor-owned utility and other public financeobligations located in the City of New Orleans. During the years ended December 31,2007, 2006 and 2005, the Company paid claims and loss adjustment expenses of$2,000, $6,051 and $6,658, respectively, related to these obligations. Duringthe years ended December 31, 2007, 2006 and 2005, the Company receivedreimbursements of $6,927, $2,589 and $4,855, respectively, related to the paidclaims and loss adjustment expenses.

 

Case reserves were discounted at interest ratesranging from 3.5% to 5.0% and from 4.5% to 4.8% in 2007 and 2006, respectively.The amount of the discount at December 31, 2007 and 2006 was $291,522 and$6,369, respectively.

 

35

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**12. VariableInterest Entities**

** **

FIN 46-R provides accounting and disclosure rules fordetermining whether certain entities should be consolidated in the Company’sconsolidated financial statements. An entity is subject to FIN 46-R, and iscalled a variable interest entity (VIE), if it has (i) equity that isinsufficient to permit the entity to finance its activities without additionalsubordinated financial support or (ii) equity investors that cannot makesignificant decisions about the entity’s operations or that do not absorb themajority of its expected losses or receive the majority of its expectedresidual returns. A VIE must be consolidated by its primary beneficiary, whichis the party that has a majority of the VIE’s expected losses or a majority ofits expected residual returns, or both.

 

As part of its structured finance business, theCompany insures debt obligations or certificates issued by special purposeentities. During the first quarter of 2006, the Company consolidated a VIE as aresult of financial guarantees provided by the Company on one transactionrelated to the securitization of life insurance reserves.

 

This third-party VIE had assets of $750,000 and anequal amount of liabilities at December 31, 2007 and 2006*,* which are shown under “Assets – Variable interest entityfixed maturity securities, held to maturity at amortized cost” and “Liabilities– Variable interest entity floating rate notes,” respectively, on theConsolidated Balance Sheets. In addition, accrued investment income includes$1,208 and $1,298 related to the VIE’s fixed income maturity securities, andthe corresponding liability is shown under “Accrued interest expense-variableinterest entity” on the Consolidated Balance Sheets.

 

Although the third-party VIE is included in theconsolidated financial statements, its creditors do not have recourse to thegeneral assets of the Company outside of the financial guaranty policy coveringcertain obligations of the VIE. Interest income of $41,691 and $41,691 andinterest expense of $35,893 and $35,893, respectively, were recognized in theyears ended December 31, 2007 and 2006 on the assets and liabilities ofthe VIE and are included on the Consolidated Statements of Income in “Interestincome – investments held by variable interest entity” and “Interest expense –debt held by variable interest entity,” respectively.

 

The Company has evaluated its other structured financetransactions and does not believe any of the third-party entities involved inthese transactions requires consolidation or disclosure under FIN 46-R.

 

36

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**12. VariableInterest Entities (continued)**

** **

FGIC has entered into agreements providing for theissuance of contingent preferred trust securities by a group of special purposetrusts. Each trust is solely responsible for its obligations, and has beenestablished for the purpose of entering into a put agreement with FGIC thatobligates the trusts, at FGIC’s discretion, to purchase Perpetual PreferredStock of FGIC. The purpose of this arrangement is to provide capital support toFGIC by allowing it to obtain access to new capital at its sole discretion atany time through the exercise of the put options. These trusts are consideredVIEs under FIN 46-R. However, the Company is not considered a primarybeneficiary and therefore is not required to consolidate the trusts (see Note18).

 

**13. Related PartyTransactions**

** **

The Company is party to a capital lease agreement witha subsidiary of GE Capital. The lease agreement covers leasehold improvementsmade to the Company’s headquarters as well as furniture and fixtures andcomputer hardware and software used by the Company (see Note 20).

 

In 2007, FGIC engagedBlackstone Advisory Services L.P., an affiliate of Blackstone, to provideservices related to loss mitigation and remediation. For the year ended December 31,2007, the Company recorded loss adjustment expenses of $9,500 for theseservices. In addition, for the years ended December 31, 2007 and 2006,FGIC paid Blackstone $522 and $257, respectively, for loss mitigation andremediation advisory services related to an investor-owned utility located inthe City of New Orleans (see Note 11).

 

FGIC insures certain non-municipal issues with GECapital involvement as sponsor of the insured securitization and/or servicer ofthe underlying assets. For some of these issues, GE Capital also provides firstloss protection in the event of default. Gross premiums written on these issuesamounted to $2, $2 and $3 for the years ended December 31, 2007, 2006 and2005, respectively. As of December 31, 2007 and 2006, principaloutstanding on these deals before reinsurance was $5,476, and $5,667,respectively.

 

FGIC, in the normal course of operations, has enteredinto reinsurance transactions with PMI Guaranty Co. and PMI Mortgage InsuranceCo. Ltd., which are both wholly owned subsidiaries of PMI. For the years ended December 31,2007, 2006 and 2005, ceded premiums written were $6,893, $4,041 and $582,respectively, and ceding commission income was $1,000, $578 and $114,respectively, with respect to these PMI subsidiaries. Accounts payable due tothese subsidiaries were $118 and $1,283 at December 31, 2007 and 2006,respectively. Loss reserves ceded to PMI Mortgage Insurance Co. Ltd. were$2,371, $0, and $0 at December 31, 2007, 2006, and 2005, respectively.

 

37

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**13. Related PartyTransactions (continued)**

 

FGIC, in the normal course of operations, has enteredinto reinsurance transactions with RAM Reinsurance Company Ltd (RAM Re), inwhich PMI has a minority ownership interest. For the years ended December 31,2007, 2006 and 2005, ceded premiums written for these transactions were$29,517, $9,824 and $4,582, respectively, and ceding commission income was$8,831, $2,929 and $1,369, respectively. Accounts payable due to RAM Re were$945 and $91 at December 31, 2007 and 2006, respectively. Loss reservesceded to RAM Re were $513, $0, and $0 at December 31, 2007, 2006, and2005, respectively.

 

Cypress is reported to own approximately 15% ofScottish Re Group Limited (Scottish Re). During 2006, FGIC insured astructured finance transaction and also assumed exposure from anothermonoline insurer in respect of another structured finance transaction inwhich subsidiaries of Scottish Re were involved. Neither transaction involves (a) aguaranty by FGIC of any obligation of Scottish Re, or (b) the payment ofany fees or other amounts between FGIC and Scottish Re.

 

As of December 31, 2007, there were no amountsdue to or from Scottish Re. For the years ended December 31, 2007 and2006, gross premiums written of $1,160 and $699 and premiums earned of $1,141and $637, respectively, relating to these transactions are reflected in theConsolidated Statements of Income.

 

In 2005, FGIC issued a financial guaranty insurancepolicy with respect to an accounts receivable securitization sponsored by acompany in which Blackstone was contemporaneously acquiring a minorityinterest. In connection with this transaction, FGIC received premiums of$3,223, $3,260, $645, in 2007, 2006 and 2005, respectively.

 

FGIC believes that the terms of the transactionsdescribed above were completed on an arm’s length basis.

 

**14. CompensationPlans**

** **

Since January 1, 2004, the Company has offered adefined contribution savings plan under Section 401(k) of theInternal Revenue Code (the 401(k) Plan). This plan covers substantiallyall employees who meet minimum age and service requirements and allowsparticipants to defer a portion of their annual compensation on a pre-tax basis(for 2007, up to $15.5 for employees under age 50, plus an additional “catch up”contribution of up to $5 for employees 50 and older). The Company may also makediscretionary contributions to the plan on behalf of employees. The Companycontributed $5,027, $4,255 and $3,429 to the plan on behalf of employees forthe years ended December 31, 2007, 2006 and 2005, respectively.

 

38

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**14. CompensationPlans (continued)**

** **

The Company also offers a non-qualified deferredcompensation plan for certain employees whose cash compensation equals orexceeds the limit under the 401(k) Plan. These employees may defer up to100% of their pre-tax incentive compensation to a future date and accumulatetax-deferred earnings on this compensation. The Company may also makediscretionary contributions to the plan on behalf of employees.

 

The Company contributed $1,348, $827 and $583 to thePlan on behalf of employees for the years ended December 31, 2007, 2006and 2005, respectively.

 

**15. StockCompensation Plan**

** **

Employees of the Company may receive stock-basedcompensation under a FGIC Corp. incentive stock plan that provides forstock-based compensation, including stock options, restricted stock awards andrestricted stock units. Stock options are granted for a fixed number of shareswith an exercise price equal to or greater than the fair value of the shares atthe date of the grant. Restricted stock awards and restricted stock units arevalued at the fair value of the stock on the grant date, with no cost to thegrantee.

 

Prior to January 1, 2006, the Company accountedfor those plans under the recognition and measurement provisions of APB OpinionNo. 25, *Accounting for Stock Issued to Employees,*and related interpretations, as permitted by SFAS No. 123, *Accounting for Stock-Based **Compensation.***

 

No stock-based employee compensation cost related tostock options was recognized in the Consolidated Statements of Income for theyear ended December 31, 2005, as all options granted through that date hadan exercise price equal to the fair value of the underlying common stock on thedate of grant. For grants of restricted stock units, unearned compensation,equivalent to the estimated fair value of the common stock at the date ofgrant, was recorded as a separate component of stockholders’ equity andsubsequently amortized to compensation expense over the vesting period.

 

39

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**15. StockCompensation Plan (continued)**

** **

The following table illustrates the effect on netincome if the Company had applied the fair value recognition provisions of SFASNo. 123(R) to stock options granted during the year ended December 31,2005. For purposes of this pro forma disclosure, the value of the stock optionsis amortized to expense over the stock options’ vesting periods.

 

| ** **                                                                              | ** ** | **Year Ended  December 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                              | ** ** | **2005**                               | ** ** |
| Net income, as reported                                                                 |       | $                                      | 190,466    |   |
| Stock option compensation expense  determined under fair value-based method, net of tax |       | (2,109                                 | )          |
| Pro forma net income                                                                    |       | $                                      | 188,357    |   |

 

A summary of option activity for the years ended December 31,2007, 2006 and 2005 is as follows:

 

| ** **                                | ** ** | **Number of  Shares Subject  to Options** | ** ** | **Weighted  Average Exercise  Price per Share** | ** ** |
|-------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| Balance at December 31, 2004         |       | 114,153                                                  |       | $                                                              | 824        |   |
| Granted                                   |       | 27,145                                                   |       | 711                                                            |       |
| Exercised                                 |       | —                                                   |       | —                                                         |       |
| Forfeited                                 |       | (1,876                                                   | )          | 685                                                            |       |
| Expired                                   |       | —                                                   |       | —                                                         |       |
| Balance at December 31, 2005         |       | 139,422                                                  |       | 804                                                            |       |
| Granted                                   |       | 38,113                                                   |       | 850                                                            |       |
| Exercised                                 |       | —                                                   |       | —                                                         |       |
| Forfeited                                 |       | (6,504                                                   | )          | 776                                                            |       |
| Expired                                   |       | —                                                   |       | —                                                         |       |
| Balance at December 31, 2006         |       | 171,031                                                  |       | 815                                                            |       |
| Granted                                   |       | 49,058                                                   |       | 971                                                            |       |
| Exercised                                 |       | —                                                   |       | —                                                         |       |
| Forfeited                                 |       | (4,042                                                   | )          | 847                                                            |       |
| Expired                                   |       | —                                                   |       | —                                                         |       |
| Balance at December 31, 2007         |       | 216,047                                                  |       | $                                                              | 850        |   |
| Shares subject to options exercisable at: |       |                                                     |       |                                                           |       |
| December 31, 2007                    |       | 106,616                                                  |       | $                                                              | 818        |   |
| December 31, 2006                    |       | 72,585                                                   |       | $                                                              | 818        |   |
| December 31, 2005                    |       | 42,630                                                   |       | $                                                              | 840        |   |

 

40

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**15. StockCompensation Plan (continued)**

** **

Exercise prices for the stock options outstanding at December 31,2007 range from $600 to $1,080 per share. At December 31, 2007, theweighted average remaining contractual life of the outstanding options wasapproximately seven years. Stock options granted in 2007 and 2006 vest ratablyover four years and expire seven years from the date of grant. All stockoptions granted prior to December 31, 2005 vest ratably over five yearsand expire ten years from the date of grant.

 

The weighted average per share fair value of the stockoptions granted during the years ended December 31, 2007, 2006 and 2005was $234.00, $238.00 and $211.94, respectively, estimated at the date of grant,using the Black-Scholes-Merton option valuation model based on the followingassumptions:

 

| ** **              | ** ** | **Year Ended December 31** | ** ** |
|-------------------------|------------|-------------------------------------------|------------|
| ** **              | ** ** | **2007**                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected life           | ** ** | **3.8 Years**                             |       | 4 Years |   | 5 Years |   |
| Risk-free interest rate | ** ** | **4.50**                                  | **%**      | 4.46 | % | 3.691 | % |
| Volatility factor       | ** ** | **20.7**                                  | **%**      | 25.0 | % | 5.0 | % |
| Dividend yield          |       | —                                    | ** ** | — |   | — |   |

 

The total fair value of stock options granted at thetime of grant during the years ended December 31, 2007, 2006 and 2005 wasapproximately $11,480, $9,071 and $5,753, respectively.

 

As of December 31, 2007, there was $6,825 oftotal unrecognized compensation cost related to unvested stock options. Thesecosts are expected to be recognized through February 28, 2011.

 

41

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**15. StockCompensation Plan (continued)**

** **

***Restricted Stock Units***

** **

The Company recorded $1,028, $880 and $45 incompensation expense related to the grant of restricted stock units for theyears ended December 31, 2007, 2006 and 2005, respectively. A summary ofrestricted stock units is as follows:

 

| ** **                         | ** ** | **Shares** | ** ** | **Weighted  Average Grant  Date Fair  Value** | ** ** |
|------------------------------------|------------|------------|------------|---------------------------------------------------------|------------|
|                               |       |       |       |                                                    |       |
| Balance at December 31, 2004: |       | 200        |       | $                                                       | 600        |   |
| Granted                            |       | 37         |       | 710                                                     |       |
| Delivered                          | ** ** | **—** | ** ** | **—**                                              | ** ** |
| Forfeited                          | ** ** | **—** | ** ** | **—**                                              | ** ** |
| Balance at December 31, 2005: |       | 237        |       | 617                                                     |       |
| Granted                            |       | 2,949      |       | 850                                                     |       |
| Delivered                          |       | (237       | )          | 617                                                     |       |
| Forfeited                          |       | (213       | )          | 850                                                     |       |
| Balance at December 31, 2006: |       | 2,736      |       | 850                                                     |       |
| Granted                            | ** ** | **362**    | ** ** | **971**                                                 | ** ** |
| Delivered                          | ** ** | **(326**   | **)**      | **850**                                                 | ** ** |
| Forfeited                          | ** ** | **—** | ** ** | **—**                                              | ** ** |
| Balance at December 31, 2007: | ** ** | **2,772**  | ** ** | **$**                                                   | **866**    | ** ** |

 

As of December 31, 2007 there was $775 of totalunrecognized compensation cost related to unvested restricted stock units.These costs are expected to be recognized through February 28, 2009.

 

42

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**16. Dividends**

** **

Under the New York State Insurance Law, FGIC may paydividends to FGIC Corp. only from earned surplus, subject to the followinglimitations: (a) FGIC’s statutory surplus after any dividend may notbe less than the minimum required paid-in capital, which was $72,500 in 2007,2006 and 2005, and (b) dividends may not exceed the lesser of 10% of itssurplus or 100% of adjusted net investment income, as defined by New York StateInsurance Law, for the preceding twelve-month period, without the priorapproval of the New York State Superintendent of Insurance. Due to FGIC’s deficit in earned surplus at December 31,2007, FGIC does not currently have the capacity to pay dividends without theprior approval of the NYSID.

 

During the years ended December 31, 2007 and2006, FGIC declared dividends totaling $20,000 and $20,000, respectively, on itscommon stock and paid dividends of $20,000 and $10,000, respectively. Duringthe year ended December 31, 2005, FGIC did not declare or pay dividends onits common stock.

 

**17. RevolvingCredit Facility**

** **

In December 2005, FGIC Corp. and FGIC enteredinto a $250,000 senior unsecured revolving credit facility that matures on December 11,2010. The facility is provided by a syndicate of banks and other financialinstitutions. In connection with the facility, $150 in syndication costs wereprepaid and will be amortized into expense over the term of the facility. Thefacility replaced a similar one-year facility that matured in December 2005.In February 2008, FGIC Corp. borrowed $250,000 under the facility.

 

FGIC Corp. and FGIC are currently in full compliance withthe terms and conditions of the revolving credit facility.

 

**18. PreferredTrust Securities**

** **

FGIC has a $300,000 “soft capital” facility,consisting of Money Market Committed Preferred Custodial Trust Securities (CPSSecurities). Under the facility, each of six separate Delaware trusts (theTrusts), issues $50,000 in perpetual CPS Securities on a rolling 28-day auctionrate basis. Proceeds from these securities are invested in high quality,short-term securities and are held in the respective Trusts.

 

43

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**18. PreferredTrust Securities (continued)**

** **

Each Trust is solely responsible for its obligationsand has been established for the purpose of entering into a put agreement withFGIC, which obligates the Trusts, at FGIC’s discretion, to purchase perpetualPreferred Stock of FGIC. In this way, the program provides capital support toFGIC by allowing it to obtain access to new capital through the exercise of theput options.

 

Beginning in the third quarter of 2007, disruptions inthe short term market caused the auctions for these facilities to “fail”. Whenan auction fails, the existing investors are required to hold theirinvestments, and the interest rate paid on the trust securities rises to amaximum rate (150 basis points over Libor when the securities are rateddouble-A, and to a rate of 200 basis points over Libor when the securities arerated at single-A or below). The impact of the failed auctions on the Companywas an increase in the cost of the put option premium paid to the trusts. Forthe years ended December 31, 2007, 2006, and 2005, the fees incurredrelated to these put options were $2,984, $1,432, and $1,806, respectively.

 

**19. FinancialInstruments**

** **

**(a)**          Fair Value of FinancialInstruments

** **

The following methods and assumptions were used by theCompany in estimating the fair values of financial instruments. Fair valuesestimated based upon internal valuation models are not necessarily indicativeof the amount the Company could realize in a current market exchange.

 

*Fixed Maturity Securities:*Fair values for fixed maturity securities are based on quoted market prices, ifavailable. If a quoted market price is not available, fair values are estimatedusing quoted market prices for similar securities. Fair value disclosure forfixed maturity securities is included in the consolidated balance sheets and inNote 6.

 

*Short-Term Investments:*Short-term investments are carried at fair value, which approximates cost.

 

44

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to Consolidated FinancialStatements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**19. FinancialInstruments (continued)**

** **

*Cash and Cash Equivalents, AccruedInvestment Income, Receivable from Related Parties, Ceded Reinsurance BalancesPayable, and Payable for Securities Purchased:* The carryingamounts of these items approximate their fair values.

 

*Financial Guaranties:*The carrying value of the Company’s financial guaranties is represented by theunearned premium reserve net of prepaid reinsurance premiums. Estimated fairvalues of these guaranties are based on an estimate of the balance that isnecessary to bring the future returns for the Company’s embedded book ofbusiness to a market return. The Company does not record a carrying value forfuture expected installment premiums. The fair value of future expectedinstallment premiums as of December 31, 2007 and 2006 was approximately$838,533 and $630,831, respectively, both discounted at 5%.

 

*Loss and loss adjustment expensereserves, net:* The carrying amount of case reserves is anestimate of the present value of the anticipated shortfall between (1) paymentson insured obligations plus anticipated loss adjustment expenses and (2) anticipatedcash flow from, and proceeds to be received on, sales of any collateralsupporting the obligation and/or other anticipated recoveries. The discountrate used in calculating the net present value of estimated losses is basedupon the risk-free rate for the duration of the anticipated shortfall. Thecarrying amount of watchlist reserves is an estimate of probable loss givenevidence of impairment, and a reasonable estimate of the amount of loss givendefault. The carrying amounts of these items approximate their fair values.

 

*Derivative assets and liabilities:*Derivative assets and liabilities are carried at fair value, as determined eachquarter based on internally developed models. These models requiremarket-driven inputs, including dealer quotes for the underlying bonds, creditspreads and yield curves. The models calculate a theoretical exit price andreflect management’s best judgment about current market conditions. There maybe volatility in the market-driven inputs obtained from an illiquid market forCDS and the underlying bonds and other obligations, and differences may existbetween available market data and assumptions used by management to estimatethe fair value of these instruments. Accordingly, the valuation results fromthe model could differ materially from amounts that would be realized in themarket if the derivative were traded. Moreover, volatile market conditions arelikely to cause future valuations to differ, possibly materially, from thosereflected in the current period (see Note 8).

 

45

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**19. FinancialInstruments (continued)**

** **

*Put agreements on FGIC perpetualpreferred stock:* As noted in Notes 12 and 18, FGIC has putagreements with six non consolidated trusts that obligates the trusts, at FGIC’sdiscretion, to purchase Perpetual Preferred Stock of FGIC. The exercise of theput options would provide FGIC access to new capital at a pre-established rate.Given the downgrades in the Company’s financial strength and credit ratings andthe resulting increase in credit spreads on Company’s debt, the fair value ofthe put options was estimated to be $60,120 and $0 at December 31, 2007and 2006, respectively.

 

The carrying amounts and estimated fair values of theCompany’s financial instruments at December 31, 2007 and 2006 were asfollows:

 
| ** **                                                            | ** ** | **2007**             | ** **  | **2006**        | ** ** |
|-----------------------------------------------------------------------|------------|----------------------|-------------|-----------------|------------|
| ** **                                                            | ** ** | **Carrying  Amount** | ** **  | **Fair  Value** | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** |
| Financial assets:                                                     |       |                 |        |            |       |   |   |   |   |
| Cash on hand and in-demand accounts                                   | ** ** | **$**                | **125,355** | ** **      | **$**      | **125,355** |   | $ | 29,963 |   | $ | 29,963 |   |
| Short-term investments                                                | ** ** | **115,687**          | ** **  | **115,687**     |       | 211,726 |   | 211,726 |   |
| Fixed maturity securities, available for  sale                        | ** ** | **3,960,907**        | ** **  | **3,960,907**   |       | 3,627,007 |   | 3,627,007 |   |
| Variable interest entity fixed maturity  securities, held to maturity | ** ** | **750,000**          | ** **  | **750,000**     |       | 750,000 |   | 750,000 |   |
| Financial liabilities:                                                |       |                 |        |            |       |   |   |   |   |
| Liability for net financial guaranties                                | ** ** | **1,232,960**        | ** **  | **1,139,968**   |       | 1,190,884 |   | 1,124,179 |   |
| Loss and loss adjustment expense reserves,  net                       | ** ** | **1,258,727**        | ** **  | **1,258,727**   |       | 38,814 |   | 38,814 |   |
| Derivative liabilities, net                                           | ** ** | **1,938,663**        | ** **  | **1,938,663**   |       | 1,503 |   | 1,503 |   |
|                                                                       |            |                      |             |                 |            |  |  |  |  |  |  |  |  |

 

46

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to Consolidated FinancialStatements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**19. FinancialInstruments (continued)**

** **

**(b)**          Concentrations of CreditRisk

** **

The Company considers its role in providing insuranceto be credit enhancement rather than credit substitution. The Company insuresonly those securities that, in its judgment, are of investment grade quality atthe time of underwriting. The Company has established and maintains its ownunderwriting standards that are based on those aspects of credit that theCompany deems important for the particular category of obligations consideredfor insurance.

 

Credit criteria include economic and social trends,debt management, financial management and legal and administrative factors, theadequacy of anticipated cash flows, including the historical and expectedperformance of assets pledged to secure payment of securities under varyingeconomic scenarios, and underlying levels of protection, such as insurance orover-collateralization.

 

In connection with underwriting new issues, theCompany sometimes requires, as a condition to insuring an issue, thatcollateral be pledged or, in some instances, that a third-party guaranty beprovided for the term of the issue by a party of acceptable credit qualityobligated to make payment prior to any payment by the Company. The types andextent of collateral varies, but may include residential and commercialmortgages, corporate and/or government debt and consumer receivables.

 

As of December 31, 2007, the Company’s totaloutstanding principal insured was $313,949,268, net of reinsurance of$43,478,699. The Company’s insured portfolio as of December 31, 2007 wasbroadly diversified by geographic and bond market sector, with no singleobligor representing more than 1% of the Company’s principal insuredoutstanding, net of reinsurance. The insured portfolio includes exposureexecuted in the form of credit derivatives. The principal written in the formof credit derivatives was $35,614,330 at December 31, 2007. Totaloutstanding principal insured does not reflect any amounts relating tocommitment agreements.

 

47

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**19. FinancialInstruments (continued)**

** **

As of December 31, 2007, the composition ofprincipal insured by type of issue, net of reinsurance, was as follows:

 

| ** **               | ** ** | **Net Principal  Outstanding** | ** **  |
|--------------------------|------------|-------------------------------------|-------------|
| Municipal:               |       |                                |        |
| Tax-supported            |       | $                                   | 135,969,517 |   |
| Utility revenue          |       | 35,141,684                          |        |
| Transportation           |       | 23,409,842                          |        |
| Education                |       | 10,739,032                          |        |
| Health Care              |       | 7,562,002                           |        |
| Investor-owned utilities |       | 5,591,324                           |        |
| Housing                  |       | 1,911,198                           |        |
| Other                    |       | 1,751,151                           |        |
| Total Municipal          |       | 222,075,750                         |        |
| Non-municipal            |       |                                |        |
| Asset-Backed             |       | 16,533,851                          |        |
| Mortgage-Backed          |       | 29,614,582                          |        |
| Other Structured Finance |       | 93,875                              |        |
| Pooled Debt Obligations  |       | 24,406,069                          |        |
| Total Non-Municipal      |       | 70,648,377                          |        |
| International            |       | 21,225,141                          |        |
| Total                    |       | $                                   | 313,949,268 |   |

 

48

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**19. FinancialInstruments (continued)**

** **

As of December 31, 2007, the composition ofprincipal insured ceded to reinsurers was as follows:

 

| ** **                   | ** ** | **Ceded Principal** | ** ** |
|------------------------------|------------|--------------------------|------------|
| ** **                   | ** ** | **Outstanding**          | ** ** |
| Reinsurer:                   |       |                     |       |
| Radian Asset Assurance Inc.  |       | $                        | 9,564,232  |   |
| RAM Reinsurance Company Ltd. |       | 7,379,569                |       |
| Assured Guaranty Re Ltd.     |       | 7,275,619                |       |
| BluePoint RE.                |       | 5,752,860                |       |
| Assured Guaranty Corp        |       | 4,984,281                |       |
| Other                        |       | 8,522,138                |       |
| Total                        |       | $                        | 43,478,699 |   |

 

As of December 31, 2007, the Company hadrecoverables in excess of 3% of stockholders’ equity from single reinsurers asfollows:

 

| ** **                   | ** ** | **Total**       | ** ** |
|------------------------------|------------|-----------------|------------|
| ** **                   | ** ** | **Recoverable** | ** ** |
| Reinsurer:                   |       |            |       |
| Radian Asset Assurance Inc.  |       | $               | 65,078     |   |
| RAM Reinsurance Company Ltd. |       | 39,471          |       |
| Assured Guaranty Re Ltd.     |       | 38,044          |       |
| BluePoint RE.                |       | 17,654          |       |
| Total                        |       | $               | 160,247    |   |

 

The Company’s insured gross and net principal andinterest outstanding was $578,617,777 and $500,960,962, respectively, as of December 31,2007.

 

49

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**19. FinancialInstruments (continued)**

** **

FGIC is authorized to do business in all 50 states,the District of Columbia, the Commonwealth of Puerto Rico, the U.S. VirginIslands and the United Kingdom. Principal insured outstanding at December 31,2007 by state, net of reinsurance, was as follows:

 

| ** **                 | ** ** | **Net Principal** | ** **  |
|----------------------------|------------|------------------------|-------------|
| ** **                 | ** ** | **Outstanding**        | ** **  |
|                       |       |                   |        |
| California                 |       | $                      | 37,477,126  |   |
| New York                   |       | 22,275,797             |        |
| Florida                    |       | 16,910,078             |        |
| Texas                      |       | 13,047,209             |        |
| Pennsylvania               |       | 12,741,172             |        |
| Illinois                   |       | 12,270,735             |        |
| New Jersey                 |       | 10,032,445             |        |
| Michigan                   |       | 8,619,975              |        |
| Washington                 |       | 7,071,760              |        |
| Ohio                       |       | 6,589,090              |        |
|                       |       |                   |        |
| All other states           |       | 75,040,363             |        |
| Mortgage- and asset-backed |       | 70,648,377             |        |
| International              |       | 21,225,141             |        |
| Total                      |       | $                      | 313,949,268 |   |

 

50

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**20. Commitmentsand Contingencies**

** **

***Lease Obligations***

** **

The Company leases office space and equipment under operating leaseagreements in the United States and the United Kingdom. Rent expense underoperating leases for the years ended December 31, 2007, 2006 and 2005 was$6,410, $4,319 and $3,631, respectively. Future payments associated with theseleases are as follows as of December 31, 2007:

 

| ** **                           | ** ** | **Operating Lease  Commitment** | ** ** |
|--------------------------------------|------------|--------------------------------------|------------|
| ** **                           | ** ** | **Amount**                           | ** ** |
| Year:                                |       |                                 |       |
| 2008                                 |       | $                                    | 5,025      |   |
| 2009                                 |       | 6,165                                |       |
| 2010                                 |       | 6,174                                |       |
| 2011                                 |       | 6,154                                |       |
| 2012                                 |       | 6,253                                |       |
| 2013 and thereafter                  |       | 46,294                               |       |
| Total minimum future rental payments |       | $                                    | 76,065     |   |

 

In connection with the sale of FGIC Corp. by GECapital in 2003, the Company entered into a capital lease with an affiliate ofGE Capital, covering leasehold improvements and computer equipment to be usedat its headquarters. At the lease termination date of June 30, 2009, theCompany will own the leased equipment. Future payments associated with thislease are as follows as of December 31, 2007:

 

| ** **                              | ** ** | **Operating Lease  Commitment** | ** ** |
|-----------------------------------------|------------|--------------------------------------|------------|
| ** **                              | ** ** | **Amount**                           | ** ** |
| Year ending December 31:           |       |                                 |       |
| 2008                                    |       | $                                    | 1,391      |   |
| 2009                                    |       | 265                                  |       |
| Total                                   |       | 1,656                                |       |
| Less interest                           |       | 94                                   |       |
| Present value of minimum lease payments |       | $                                    | 1,562      |   |

 

51

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**21. ComprehensiveIncome**

** **

Accumulated other comprehensive income (loss) of theCompany consists of net unrealized gains and losses on investment securitiesand foreign currency translation adjustments. The components of othercomprehensive income for the years ended December 31, 2007, 2006 and 2005are as follows:

 

| ** **                                        | ** ** | **Year ended December 31, 2007** | ** ** |
|---------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                        | ** ** | **Before  Tax  Amount**                              | ** ** | **Tax** | ** ** | **Net of  Tax  Amount** | ** ** |
|                                              |       |                                                 |       |   |   |   |   |
| Unrealized holding gains arising during the  year | ** ** | **$**                                                | **34,438** | ** ** | **$** | **(12,053** | **)** | **$** | **22,385** | ** ** |
| Reclassification of gains realized in net  income | ** ** | **(872**                                             | **)**      | **305** | ** ** | **(567** | **)** |
| Unrealized gains on investments                   | ** ** | **33,566**                                           | ** ** | **(11,748** | **)** | **21,818** | ** ** |
| Foreign currency translation adjustment           | ** ** | **12,149**                                           | ** ** | **(4,252** | **)** | **7,897** | ** ** |
| Total other comprehensive income                  | ** ** | **$**                                                | **45,715** | ** ** | **$** | **(16,000** | **)** | **$** | **29,715** | ** ** |

 

| ** **                                        | ** ** | **Year Ended December 31, 2006** | ** ** |
|---------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                        | ** ** | **Before  Tax  Amount**                              | ** ** | **Tax** | ** ** | **Net of  Tax  Amount** | ** ** |
| ** **                                        | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Unrealized holding gains arising during the  year |       | $                                                    | 18,583     |   | $ | (6,504 | ) | $ | 12,079 |   |
| Reclassification of gains realized in net  income |       | (274                                                 | )          | 96 |   | (178 | ) |
| Unrealized gains on investments                   |       | 18,309                                               |       | (6,408 | ) | 11,901 |   |
| Foreign currency translation adjustment           |       | 11,583                                               |       | (3,387 | ) | 8,196 |   |
| Total other comprehensive income                  |       | $                                                    | 29,892     |   | $ | (9,795 | ) | $ | 20,097 |   |

 

| ** **                                         | ** ** | **Year Ended December 31, 2005** | ** ** |
|----------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                         | ** ** | **Before  Tax  Amount**                              | ** ** | **Tax** | ** ** | **Net of  Tax  Amount** | ** ** |
|                                               |       |                                                 |       |   |   |   |   |
| Unrealized holding losses arising during  the year |       | $                                                    | (36,050    | ) | $ | 12,566 |   | $ | (23,484 | ) |
| Reclassification of gains realized in net  income  |       | (101                                                 | )          | 35 |   | (66 | ) |
| Unrealized losses on investments                   |       | (36,151                                              | )          | 12,601 |   | (23,550 | ) |
| Foreign currency translation adjustment            |       | (8,454                                               | )          | 2,922 |   | (5,532 | ) |
| Total other comprehensive loss                     |       | $                                                    | (44,605    | ) | $ | 15,523 |   | $ | (29,082 | ) |

 

52

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**22. QuarterlyFinancial Information (Unaudited)**

 
| ** **                                                                        | ** ** | **Three Months Ended** | ** **  | **Year Ended**     | ** ** |
|-----------------------------------------------------------------------------------|------------|----------------------------------|-------------|-------------------------|------------|
| ** **                                                                        | ** ** | **March 31,  2007**         | ** **  | **June 30,  2007** | ** ** | **September 30,  2007** | ** ** | **December 31,  2007** | ** ** | **December 31,  2007** | ** ** |
| Gross direct and assumed premiums written                                         | ** ** | **$**                            | **103,175** | ** **              | **$**      | **124,976** | ** ** | **$** | **122,268** | ** ** | **$** | **100,849** | ** ** | **$** | **451,268** | ** ** |
| Net premiums written                                                              | ** ** | **90,980**                       | ** **  | **93,394**              | ** ** | **93,917** | ** ** | **69,070** | ** ** | **347,361** | ** ** |
| Net premiums earned                                                               | ** ** | **76,583**                       | ** **  | **80,593**              | ** ** | **74,619** | ** ** | **73,490** | ** ** | **305,285** | ** ** |
| Net investment income and net realized  gains                                     | ** ** | **37,400**                       | ** **  | **38,273**              | ** ** | **39,795** | ** ** | **40,884** | ** ** | **156,352** | ** ** |
| Interest income-investments held by  variable interest entity                     | ** ** | **11,357**                       | ** **  | **8,755**               | ** ** | **10,901** | ** ** | **10,678** | ** ** | **41,691** | ** ** |
| Other income and net mark-to-market gains  (losses) on credit derivative products | ** ** | **874**                          | ** **  | **(15,385**             | **)**      | **(206,041** | **)** | **(1,715,424** | **)** | **(1,935,976** | **)** |
| Total revenues                                                                    | ** ** | **126,475**                      | ** **  | **112,291**             | ** ** | **(80,706** | **)** | **(1,589,836** | **)** | **(1,431,776** | **)** |
| Losses and loss adjustment expenses                                               | ** ** | **1,182**                        | ** **  | **(5,388**              | **)**      | **(2,031** | **)** | **1,233,012** | ** ** | **1,226,775** | ** ** |
| Interest expense – debt held by variable  interest entity                    | ** ** | **11,357**                       | ** **  | **8,755**               | ** ** | **10,901** | ** ** | **10,678** | ** ** | **41,691** | ** ** |
| Underwriting expenses                                                             | ** ** | **28,387**                       | ** **  | **22,776**              | ** ** | **23,586** | ** ** | **16,905** | ** ** | **91,654** | ** ** |
| Income (loss) before taxes                                                        | ** ** | **95,343**                       | ** **  | **89,677**              | ** ** | **(108,945** | **)** | **(2,857,249** | **)** | **(2,781,174** | **)** |
| Net income (loss)                                                                 | ** ** | **70,361**                       | ** **  | **73,105**              | ** ** | **(61,536** | **)** | **(1,886,293** | **)** | **(1,804,363** | **)** |
|                                                                                   |            |                                  |             |                         |            |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                                                        | ** ** | **Three Months Ended** | ** ** | **Year Ended**     | ** ** |
|-----------------------------------------------------------------------------------|------------|----------------------------------|------------|-------------------------|------------|
| ** **                                                                        | ** ** | **March 31,  2006**         | ** ** | **June 30,  2006** | ** ** | **September 30,  2006** | ** ** | **December 31,  2006** | ** ** | **December 31,  2006** | ** ** |
| Gross direct and assumed premiums written                                         |       | $                                | 89,281     |                    | $          | 163,260 |   | $ | 85,030 |   | $ | 103,660 |   | $ | 441,231 |   |
| Net premiums written                                                              |       | 82,585                           |       | 134,373                 |       | 66,590 |   | 83,266 |   | 366,814 |   |
| Net premiums earned                                                               |       | 59,464                           |       | 71,845                  |       | 62,738 |   | 72,410 |   | 266,457 |   |
| Net investment income and net realized  gains                                     |       | 32,319                           |       | 34,038                  |       | 35,803 |   | 36,315 |   | 138,475 |   |
| Interest income-investments held by  variable interest entity                     |       | 4,937                            |       | 9,658                   |       | 10,033 |   | 11,265 |   | 35,893 |   |
| Other income and net mark-to-market gains  (losses) on credit derivative products |       | 308                              |       | (48                     | )          | 1,596 |   | 740 |   | 2,596 |   |
| Total revenues                                                                    |       | 97,028                           |       | 115,493                 |       | 110,170 |   | 120,730 |   | 443,421 |   |
| Losses and loss adjustment expenses                                               |       | (1,933                           | )          | (265                    | )          | 520 |   | (7,022 | ) | (8,700 | ) |
| Interest expense – debt held by variable  interest entity                    |       | 4,937                            |       | 9,658                   |       | 10,033 |   | 11,265 |   | 35,893 |   |
| Income before taxes                                                               |       | 77,573                           |       | 90,732                  |       | 85,119 |   | 99,432 |   | 352,856 |   |
| Net income                                                                        |       | 58,711                           |       | 67,211                  |       | 63,563 |   | 74,353 |   | 263,838 |   |
|                                                                                   |            |                                  |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |

 

53

----

 

**Financial Guaranty InsuranceCompany and Subsidiaries**

** **

Notes to ConsolidatedFinancial Statements (continued)

 

*(Dollarsin thousands, except per share amounts)*

 

**23. SubsequentEvents**

** **

In June 2007, FGIC UK Ltd entered into acommitment agreement with Havenrock II Limited (Havenrock II), a specialpurpose vehicle created by IKB Deutsche Industriebank (IKB) for the solepurpose of the transaction, to issue a financial guaranty policy in respect ofup to $1.875 billion of high-grade and mezzanine ABS CDOs contained in a $2.5billion reference portfolio (the Commitment Agreement), subject to FGIC UK Ltd’srights and defenses and to the terms and conditions of the CommitmentAgreement.

 

On March 12, 2008, FGIC and FGIC UK Ltd filed alawsuit against IKB, Havenrock II, IKB Credit Asset Management (IKB CAM) andCalyon Credit Agricole CIB (Calyon). FGIC and FGIC UK Ltd allege in theircomplaint, filed in the Supreme Court of the State of New York, that IKB andIKB CAM, through a series of fraudulent misrepresentations and omissionsregarding IKB’s financial condition and stability, induced FGIC UK Ltd to enterinto the Commitment Agreement. On March 17, 2008, Calyon issuedproceedings in the High Court of England and Wales (Queen’s Bench Division,Commercial Court) against FGIC UK Ltd and Havenrock II seeking a declarationthat the Commitment Agreement is valid and enforceable against FGIC UK Ltd.Management believes that FGIC UK Ltd has meritorious claims and defenses andintends to vigorously pursue litigation to prove that the commitment to issueinsurance under the Commitment Agreement is unenforceable.

 

In addition, management believes that, subsequent toyear-end 2007, a party failed to perform certain responsibilities under theoperative documents, and consequently management believes that substantiallyall of the assets that could potentially have qualified for coverage by FGIC UKLtd can no longer qualify and that FGIC UK Ltd therefore has no furtherobligation to insure those assets. As noted in Note 11, approximatelyseventy-five percent of the Company’s loss reserves at December 31, 2007related to the Commitment Agreement; those reserves did not reflect thedevelopments described above. Management is assessing whether the loss reserverelated to the Commitment Agreement needs to be adjusted in the future toreflect the impact of these developments; any such adjustment could bematerial.

 

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