The principal executive office of the Company is located at 140 Broadway, New York, New York 10005, and consist of approximately 50,000 square feet of office space. The Company and its subsidiaries also maintain leased space in London (England), Singapore and Orlando (Florida). The Company and its subsidiaries do not own any material real property. The Company believes that these facilities are adequate and suitable for its current needs. The Company’s telephone number at its principal executive office is (212) 375-2000.
The following discussion relates to our consolidated financial statements and should be read in conjunction with the financial statements and notes thereto appearing elsewhere in this report. Statements contained in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” that are not historical facts may be considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, and are subject to the safe harbor created by that Act. When used in filings with the SEC, in our press releases, investor presentations, and in oral statements made by or with the approval of one of our executive officers, the words or phrases like “believe”, “anticipate”, “project”, “plan”, “expect”, “intend”, “may”,”will likely result”, “looking forward” or “will continue”, or variations of such words and similar expressions are intended to identify such forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions, including, among other things, information set forth in Part I, Item 1A - ”Risk Factors.” In making these statements, we are not undertaking to address or update these factors in future filings or communications regarding our business or results except as required by law. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this report might not occur. There may also be other risks that we are unable to predict at this time. Any of these risks and uncertainties may cause actual results to differ materially from the results discussed in the forward-looking statements.
Within Structured Credit, our principal revenues are net insured credit swap revenue and net investment income, which includes amounts received from the Credit Fund and its allocated portion of ACA Financial Guaranty’s investment portfolio income. Generally, we receive insured credit swap fees in quarterly installments over the life of the related swaps which is typically in the range of 5 to 7 years. The principal expenses of this line of business are its allocated portion of corporate-wide operating expenses, interest expense and depreciation and amortization. It also incurs direct interest expense related to the financing of our consolidated Credit Fund purchased investments. We enter into our insured credit swaps with an intent that they remain outstanding for the entire term of the contract. These insured credit swaps are accounted for at fair value because they do not qualify for the financial guarantee scope exception under FAS No. 133, “Accounting for Derivative Instruments and Certain Hedging Activities,” as amended (“FAS 133”). Changes in the fair value of these contracts are required to be marked to market under the requirements of FAS 133 and are recorded, together with the related fixed quarterly premium payments payable to us under the insured credit swaps, under the caption net insured credit swap revenue. Since our insured credit swap transactions are not actively traded securities and have no observable market price, we utilize comprehensive internally developed models to estimate changes in fair value. We expect the fair values of these insured credit swaps to fluctuate primarily based on changes in credit spreads and the credit quality of the underlying referenced entities. When we hold these insured credit swaps for the entire term of the contract, the cumulative changes in fair value will net to zero at the end of the term, provided that we do not incur credit losses on the contract. In certain circumstances, we may agree with a counterparty to terminate an insured credit swap transaction prior to its maturity (such as on request of the counterparty or for risk management purposes, such as in connection with a deterioration of the underlying portfolio) and may experience realized gains or losses in connection with the early termination of such transactions.
In our Public Finance line of business, we provide financial guaranty insurance policies guaranteeing the timely payment of interest and the ultimate payment of principal on municipal debt obligations. Our principal revenues in this line of business are premiums earned on our financial guaranty insurance policies and its allocated portion of corporate-wide investment income. The principal expenses of this line of business include its allocated portion of corporate-wide operating expenses, interest expense and depreciation and amortization. We also incur loss and loss adjustment expenses, related to the non-derivative exposure we insure, and policy acquisition costs, which are expenses that vary with and are
Our Other line of business includes business in areas and markets in which we are no longer active. Principal direct items are premiums earned, loss and loss adjustment expenses and policy acquisition costs. This line of business also was allocated a portion of investment income, interest expense and operating expenses in 2006, 2005 and 2004. Beginning in 2004, expenses were not allocated to this line of business.
not subject to FAS 133, if they meet certain specified criteria. Installment premiums are earned over each installment period, which is generally one year or less. Up front premiums are earned in proportion to the expiration of risk, which is par. Premium is allocated to each par maturity (e.g., principal payment) included in an insured bond and earned on a straight-line basis for the period the related insured risk is outstanding. Unearned premiums represent that portion of premiums which is applicable to coverage of risk to be provided in the future on policies in-force. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining unearned premiums, less any amount credited to the refunding issue insured by us, are recognized as earned premium. The amounts earned from refundings were approximately $9.4 million, $6.6 million and $1.8 million, for the years ended December 31, 2006, 2005 and 2004, respectively.
Loss and Loss Adjustment Expenses. Financial guaranty loss and loss adjustment expense reserves are established on our non-derivative exposure in an amount equal to our estimate of identified or case-
specific reserves and non-specific reserves, including cost of settlement, on the obligations ACA Financial Guaranty has incurred. In determining our accounting policy for loss reserves, we rely primarily on FAS 60, “Accounting and Reporting by Insurance Enterprises” (“FAS 60”). However, FAS 60 was adopted when the financial guaranty industry was just beginning. As a result, FAS 60 did not contemplate the specific attributes of financial guaranty insurance as distinct from other forms of insurance. In particular, financial guaranty insurance is considered a short-duration insurance product; however, it has features that are more akin to long-duration contracts in that the term of some insured obligations can be as long as 30 years or more and the contracts are generally irrevocable. Under FAS 60, accounting for losses differs for short-duration and long-duration contracts. Because of this inconsistency, we also apply FAS 5, “Accounting for Contingencies” (“FAS 5”) in the determination of our loss reserves. Specifically, FAS 5 requires the establishment of reserves when it is probable that a liability has been incurred at the reporting date, but only to the extent the loss can be reasonably estimated. We understand that methods of determining non-specific reserves vary within the financial guaranty industry. FASB is considering whether additional accounting guidance is necessary to address the calculation of the reserves in the financial guaranty industry. It is possible that as a result of FASB’s deliberations, the financial guaranty industry, including us, may have to change aspects of its accounting policies in this regard. The FASB’s proposed guidance in the form of an exposure draft is expected to be issued in early 2007. See “-FASB Financial Guaranty Insurance Project” for further explanation of potential changes.
Consolidation of Variable Interest Entities (VIEs) and Other Restricted Investments. From an accounting perspective, funded and partially funded CDOs are deemed to be issued out of VIEs. As such, each time a CDO is formed that includes the issuance of debt instruments to third parties and the purchase of investment assets, we perform an analysis to determine whether we are the primary beneficiary and thus required to consolidate the CDO under the provisions of Financial Interpretation 46R, “Consolidation of Variable Interest Entities” (“FIN 46(R)). Prior to 2005, we retained all or most of the equity position in our CDOs, and these CDOs are therefore consolidated in our financial statements (a total of seven CDOs are consolidated). Although the VIE is consolidated, we do not have the right to use the assets of the VIE for general operations and the debt liabilities of the VIE are without recourse to any assets other than those of the VIE. Our investment exposure to our CDOs is therefore limited to our equity investment, which is a first loss position of the CDO. In the instances that we own less than 100% of the CDO VIE’s equity, but are the primary beneficiary and thus consolidate the CDO VIE, we establish minority interests for the unowned portion. As of December 31, 2006 and 2005, consolidated liabilities included non-recourse debt from consolidated CDOs of $4,711.8 million and $4,833.2 million, respectively. Also, as of December 31, 2006 and 2005, consolidated assets included investment in fixed maturity securities of $4,536.7 million and $4,810.9 million, respectively, and cash of $265.0 and $125.2 million, respectively, related to CDOs.
In May of 2006, we began managing our Credit Fund. The Credit Fund was created to leverage our expertise in the capital and credit markets and as an asset manager. The Credit Fund invests in fixed maturity securities, particularly in the asset-backed sector. The Credit Fund had net assets under management of $25.6 million as of December 31, 2006, of which we owned $17.0 million and third party investors owned the remaining $8.6 million. In addition to receiving a return on our investment in the Credit Fund, we are paid a management fee to select and manage the assets for the Credit Fund’s third party investors. Although the Credit Fund is consolidated pursuant to the requirements of FIN 46(R), we do not have the right to use the assets for general operations. See “-Results of Operations-Structured Credit.”
attributable are allocated to each operating line of business. Allocated items consist of investment income from ACA Financial Guaranty’s investment portfolio, realized gains and losses on that investment portfolio, interest expense on the corporate debt at the holding company level, all operating expenses, non-CDO related depreciation and amortization expenses and income taxes. Income and expense items that are directly attributable to a business line are recorded as such.
The following table summarizes the contribution of each line of business to net consolidated income for the years 2006, 2005 and 2004:
Structured Credit. Net income increased to $25.3 million in 2006 compared to $11.0 million in 2005 primarily as a result of an increase in the volume of credit swap transactions completed in prior periods and impact of premiums received on current year originations and the full-year effect of premiums originated over the course of 2005. The increase in revenues was partially offset by increased operating expenses attributable to a reallocation of internal resources, effective January 1, 2006, to support the growth in this line of business. The increase in 2005 net income for this line of business compared to 2004 was the result of increased insured credit swap premiums earned partially offset by a decrease in premiums earned on traditional financial guaranty insurance. This decrease in premiums was the result of our shift in focus from traditional financial guaranty insurance to the insurance of credit swaps in this line of business.
Public Finance. Net income increased to $10.7 million in 2006 compared to $8.9 million in 2005 primarily resulting from a higher level of refunding activity, which accelerates the earnings of up front premiums paid on the refunded transactions, and slightly lower loss and loss adjustment expenses. Premiums earned from refundings were $9.4 million in 2006, compared to $6.6 million in 2005. This increase was partially offset by increased operating expenses. The increase in 2005 net income for this line of business to $8.9 million compared to $7.1 million in 2004 was the result of lower loss and loss adjustment expenses and an increase in premiums earned. The increase in our non-specific reserve was a direct result of the increase in premiums earned and application of our non-specific reserve model, and represents management’s estimate of losses on our insured book of business.
management fees in 2005, while in 2004, we recognized unrealized gains on the valuation of our insured credit swap and other credit swap transaction in the amount of $9.2 million. Assets under management increased to $9.9 billion at year end 2005, compared to $7.8 billion at year end 2004.
Net Realized and Unrealized Gains and Losses on Investments. Allocated net unrealized and realized gains and losses on investments represent those gains and losses incurred on the ACA Financial Guaranty investment portfolio discussed above and are similarly allocated to the lines of business. In 2006, the net realized loss of $(1.1) million was the result of a sector reallocation of bonds within the portfolio, while the loss of $0.9 million in 2005 was primarily related to certain impairments recognized.
Other Operating Expenses. Allocated other operating expenses is comprised of all costs related to personnel, office leases and expenses, legal, accounting and rating agencies. Allocated other operating expenses does not include expenses related to the consolidation of our CDOs or the Credit Fund. Those expenses are treated as direct expenses of the CDO Asset Management line of business and the Credit Fund, respectively, for this purpose. For the year ended December 31, 2006, allocated other operating expenses increased to $47.1 million from $34.7 million for the year ended December 31, 2005. The increase in expenses was attributable to additional personnel hired to support the businesses as well as in connection with our new status as a public company. We also incurred greater corporate expenses such as legal, insurance, and accounting and auditing related to our public status. Incentive compensation also increased in 2006 due to greater headcount as well as the achievement of performance targets. Finally, we incurred expenses in connection with the opening of our United Kingdom and Singapore offices in 2006. The decline in allocated other operating expenses in 2005 to $34.7 million from $36.5 million in 2004 resulted from a decrease in general corporate overhead, owing to the absence of certain legal, accounting and other costs incurred in 2004 in connection with our recapitalization. This decrease has partially offset by an increase in 2005 of employee compensation, benefits and litigation expenses, on aggregate, of $5.9 million. Employee compensation and benefits increased in 2005 due to an increase in our workforce to support our growing lines of business and an increase in incentive compensation due to the achievement of certain performance targets.
Interest Expense. Allocated interest expense is related to debt issued out of our holding company. It is allocated to our lines of business based on capitalization of the respective lines of business as described above with respect to net investment income but also provides for the fact that a certain portion of corporate debt was issued in connection with the start-up costs related to our CDO Asset Management business. As a result, this line of business receives an increased allocation for this fact. The increase in allocated interest expense for the three year period from $3.3 million in 2004 to $5.7 million in 2005 and $7.2 million in 2006 was primarily related to the increase in LIBOR since this debt pays interest on a floating rate basis. No new debt was issued in 2005 or 2006, however, an additional $20 million was issued at the end of 2004. This issuance contributed to the increase in allocated interest expense for the 2005 year compared to 2004.
The following table summarizes the operations of our Structured Credit line of business for the years ended December 31, 2006, 2005 and 2004:
Gross Premiums Written. Gross premiums written within this line of business declined to $0.7 million for the year ended 2006 from $2.6 million for the year ended 2005. This decline occurred because
As reflected in unrealized gains (losses), a net narrowing of credit spreads caused valuation gains on insured credit swaps of $4.8 million in 2006 while the net widening of spreads caused net valuation losses of $(2.5) million in 2005 and $(0.8) million in 2004. Additionally, we realized gains of approximately $2.0 million in 2006 as a result of the termination of three insured credit swap transactions. No termination gains or losses were recognized in 2005 or 2004.
The Credit Fund had net assets under management of $25.6 million as of December 31, 2006. ACA Financial Products, Inc., one of our wholly-owned indirect subsidiaries, owned $17.0 million of the equity of the Credit Fund. The remaining $8.6 million was owned by third party investors. In addition to receiving a return on our investment in the Credit Fund, we are paid a management fee to select and manage the assets of the fund for third parties. As of December 31, 2006, the Credit Fund had total assets of $264.6 million, including investments in fixed-maturity securities trading of $251.8 million and securities purchased under agreements to resell of $10.2 million, and total liabilities and minority interest of $247.7 million, including securities sold under agreements to repurchase of $232.2 million and payable for securities purchased of $5.0 million, all of which are included on our consolidated balance sheet.
Net Realized and Unrealized Gains (Losses) on Investments. Net realized gains (losses) are derived from our investment in the Credit Fund as well as allocated amounts related to ACA Financial Guaranty’s investment portfolio. The following table shows the components of net realized (losses) for 2006, 2005 and 2004:
Other Operating Expenses. Other operating expenses increased to $18.4 million in 2006 from $7.4 million in 2005 and $8.9 million in 2004. The increase in 2006 compared to 2005 was in part related to the allocation of additional personnel related to the credit function in 2006 to this line of business in connection with its growth in transaction volume. Additionally, higher allocated costs related to our newly acquired status as a public company in 2006 and increased headcount in support of the insured credit swap portion of this line of business contributed to the growth in expenses. The decrease from $8.9 million in 2004 to $7.4 million in 2005 was related to the absence of expenses resulting from the negative ratings actions experienced by ACA Financial Guaranty in 2004 and the resulting reorganization, which did not recur in 2005.
Gross Premiums Written. Public Finance gross premiums written totaled $29.7 million in 2006, $34.2 million in 2005 and $26.3 million in 2004. The decline in 2006 compared to 2005 was related to the tightening of credit spreads in our target market, which is the low investment grade and high non-investment grade segment of the municipal bond market. These spreads were at historically tight levels through much of the year, and which, in order to meet our risk-adjusted return expectations, caused us to be highly selective in our underwriting decisions. Because we are a net retainer of the risks we underwrite, gross premiums written approximates net premiums written. The growth of $7.9 million of gross premiums written in 2005 compared to 2004 was driven by increased market acceptance of our insurance product in our target markets due to the completion of our recapitalization following the negative ratings actions in 2004.
Net Realized Gains (Losses) on Investments. Net realized gains (losses) are derived entirely from allocated amounts.
In 2006 and 2005, the case specific reserve amounts were fairly equivalent and vast majority of the case specific activity was related to loss adjustment expense reserves established for certain insured credits that were in varying stages of work-out. In 2004, the provision for case specific reserves included the re-assumption of a previously ceded case reserve on a single municipal credit in the amount of $1.2 million, as well as additional loss development of $1.2 million on that insured credit. Non-specific reserves are based on the application of our reserving model and take into account transactional characteristics such as rating, sector and assumed recoveries. The increase in non-specific reserves was a result of the increase in premiums earned and application of our non-specific reserve model.
Other Operating Expenses. Other operating expenses were $8.8 million in 2006, $7.2 million in 2005 and $7.1 million in 2004. These costs are non-policy acquisition related costs and are allocated. The
increase of $1.6 million in 2006 was primarily related to increased head count to support the business as well as costs associated with our new status as a public company.
The following table summarizes the operations of our CDO Asset Management line of business for the years ended December 31, 2006, 2005 and 2004:
Net Insured Credit Swap Revenue. Net insured credit swap revenue was $4.1 million in 2006, $1.0 million in 2005 and $10.4 million in 2004. As set forth in the table below, net insured credit swap revenue is the sum of premiums earned, net realized gains (losses), which may result from time to time result from any termination or credit events related to such transactions and unrealized gains (losses) resulting from the changes in fair value of these transactions. We receive insured credit swap premiums from two synthetic CDOs we closed in 2003 and 2002 in which our insurance subsidiary, ACA Financial Guaranty, insured the equity tranche of each CDO. Because these were the only two transactions generating insured credit swap premiums in the three year period, the year over year variances were relatively minor. The following table shows the components of net insured credit swap revenue for 2006, 2005 and 2004:
As reflected in unrealized gains (losses), generally wide credit spreads caused valuation losses with respect to the two synthetic CDOs described above in both 2006 and 2005 of $(0.3) million and $(3.1) million, respectively. In 2004, the opposite was true, as tightening credit spreads caused valuation gains of $7.0 million. The valuation or unrealized losses in 2006 and 2005 were also related to the fact that these transactions are in a net valuation gain position and as they approach maturity, those unrealized gains reverse, resulting in unrealized losses. Both transactions will expire by mid-2008.
Net Investment Income. Net investment income was $309.4 million in 2006, $236.6 million in 2005, and $114.8 million in 2004. Net investment income includes income from assets of our consolidated CDO portfolios as well as allocated investment from ACA Financial Guaranty’s investment portfolio. No new consolidated CDOs were added in 2006 or 2005, however two were added in 2004. The portion of net investment income related to our consolidated CDO portfolio was $307.4 million in 2006, $233.9 million in 2005 and $113.1 million in 2004. The increase in net investment income from 2004 to 2005 and 2005 to 2006 was principally related to the increase in short-term rates, namely one and three month LIBOR. Additionally in 2005, we benefited from the full year effect of interest income related to the two consolidated CDOs that were added in 2004. The portion of net investment income from ACA Financial Guaranty’s investment portfolio allocated to the CDO Asset Management line of business was $2.0 million in 2006, $2.7 million in 2005 and $1.7 million in 2004. The decline from 2005 to 2006 was related to a decrease of the allocation percentage assigned to this line of business in 2006. The decrease was due to the reduced amount of estimated capital utilized by the CDO Asset Management line of business, which resulted principally from the reduced size of our equity investments in CDOs closed beginning in 2005.
The most significant derivative instruments reported in this line item are interest rate swaps that are included in our consolidated CDOs. We have four such swaps and we pay fixed amounts and receive floating amounts based on three month LIBOR and pre-determined notional schedules. Unrealized valuation gains have been recognized on these four swaps as a result of a steady increase in short-term interest rates over the three year period. Interest rate caps are also used within consolidated CDOs to manage interest rate risk and have conversely generated unrealized losses over the three year period. We also recognized an unrealized gain in the amount of $95 thousand related to a small leveraged loan trading program that began in December 2006 that is structured in the form of a total return swap. Changes in the values of the underlying leveraged loans represent unrealized gains or losses to us until such time that the loans may be sold. Warehouse facility losses were recognized in 2004 in connection with two consolidated CDOs. Unrealized and realized gains associated with the warehouse or ramp up phase of the two CDOs which are consolidated in our financial statements were recognized in 2004. Subsequent to 2004, we have not been determined to be the primary beneficiary of our CDOs, thus no warehouse unrealized or realized gains (losses) were recognized.
Fee Income. Fee income is principally related to quarterly management fees, warehouse fees and structuring fees received in connection with our unconsolidated CDOs. Total fee income for CDO Asset Management was $23.5 million in 2006, $10.3 million in 2005 and $5.2 million in 2004. The increase was the result of increased assets under management which grew to $15.7 billion at December 31, 2006 from $9.9 billion at December 31, 2005 and $7.8 billion at December 31, 2004. We also received increased warehouse fees in 2006, compared to 2005 and 2004. The increase was principally due to the larger size of the transactions closed during 2006. In general, structuring fees and to some extent warehousing fees are highly negotiated and vary from transaction to transaction. The change in structuring fees is attributable to these negotiations. The following table shows the components of fee income for 2006, 2005 and 2004:
Other Operating Expenses. Other operating expenses totaled $22.2 million in 2006, $19.0 million in 2005 and $18.9 million in 2004. Other operating expenses is made up of direct expenses of consolidated CDOs and includes items such as ongoing rating agency fees, trustee fees, accounting fees and other direct expenses related to the maintenance of the CDO. Also included in other operating expenses are allocated expenses. The following table shows the components of other operating expenses for 2006, 2005 and 2004:
Interest Expense. Interest expense totaled $285.6 million in 2006, $212.1 million in 2005 and $99.9 million in 2004. Interest expense is made up of the allocated portion of interest expense on corporate debt issued by our holding company, debt issued in connection with the purchase of certain of our CDO equity positions (CDO debt: operating) and debt issued by our consolidated CDOs (CDO debt: non-recourse). The following table shows the components of interest expense for 2006, 2005 and 2004:
The following table summarizes our outstanding CDO transactions as of December 31, 2006:
(1) Investment grade collateral is rated “BBB-” or better; however certain of our investment grade CDOs include the ability to invest a minority portion (20% or less) in non-investment grade assets. High-grade is “A-” or better.
(3) Argon 49 and Argon 57 are denominated in Euros. For purposes of this chart, we have converted the amounts to U.S. dollars at the prevailing currency exchange rate on December 31, 2006.
(1) The purchaser of the equity. For illustration purposes we assume the purchase of equity is made with cash, although we sometimes finance our purchases of equity.
For purposes of this hypothetical CDO, we assume we do not earn warehouse or structuring fees, which we do on a number of our CDOs. This example also excludes the effects of any mark to market adjustments on derivatives contained within the CDO vehicle. Following the closing of this hypothetical CDO, we record the activity of the CDO on our assets and liabilities, as well as ongoing expenses of the CDO as follows, assuming one year has passed and we have realized a 10% return on our $20 million equity position and earned management fees of $1.8 million:
These line items, however, do not appear in our financial statements because of the U.S. GAAP rules of consolidation.
Conversely, if we were to close the same hypothetical CDO, but only purchase 10% of the equity, we would not be deemed the primary beneficiary and therefore would not consolidate. Our balance sheet on the date of closing would then include the following:
After one year, assuming the same return rates as in the consolidated example above but began having only purchased 10% of the equity, our statement of operations would include the following from this CDO:
We would view the component parts of this CDO as follows:
(1) Represents the sum of management fees for all CDOs paid by CDO entities to ACA Management, whether the CDO is consolidated or unconsolidated. For CDOs that we consolidate, management fees are eliminated from our consolidated financial statements under U.S. GAAP.
(5) Represents adjustments for the investment income and expenses which are allocated to the CDO Asset Management line of business but do not relate to the direct economics of our managed CDOs.
(5a) Direct expenses of our consolidated CDOs are included above as a reduction of our equity return and include items such as ongoing rating agency CDO expenses, trustee fees, accounting fees, etc. Direct
(5c) Represents a portion of corporate depreciation and amortization expense allocated to this line of business. Direct amortization of debt issuance costs of consolidated CDOs is included above as a reduction of equity returns (see note 3 above) and totaled $7.3 million in 2006, $7.0 million in 2005 and $5.1 million in 2004.
fees payable by the CDO on the credit protection that it purchased. This income is reflected in the consolidated statements of operations as other net credit swap revenue. This income is used to pay the interest on the liabilities of the CDO and other expenses of the CDO, including the management fee. Similar to the fully funded and consolidated CDOs, all management fees in this partially funded CDS CDO are paid to ACA Management, but eliminated in consolidation. Our return on our equity investment is the net of the CDO’s revenues (interest income and other credit swap income) and the CDO’s expenses, including the management fee paid to ACA Management.
We may experience increased volatility in our financial statements which is not related to the underlying economic value of our investment in these CDOs because we consolidate VIEs where we are the primary beneficiary. This may make the evaluation of our financial statements more difficult. Our investment exposure to our CDOs is limited to our equity interest; however, we record fluctuations in the fair value of the assets and liabilities of our consolidated CDOs. These valuation fluctuations, in the form
of unrealized mark to market adjustments that are recorded in Accumulated Other Comprehensive Income, have exceeded our economic exposure in the form of our equity investment in the past and could exceed our economic exposure in the future. These valuation adjustments reverse themselves over time, to the extent the gains or losses are not realized by sales or other than temporary impairments. We may have realized losses from the assets (from sales and OTTI) in our consolidated CDOs and those losses could exceed the amount of our equity exposure. These losses are recorded in our consolidated statement of operations as realized losses. When there are realized losses in the CDO asset portfolios, other CDO investors will bear those losses to the extent the losses exceed our equity exposure to that CDO. When this occurs, the financial statement impact of the realized losses is offset at CDO maturity, when the associated non-recourse liabilities are written off. For example, if we had a $400 million CDO in which we owned 100% of the $20 million in equity in the form of preference shares, we would consolidate the CDO, including all of its income, expenses, gains, losses and mark to market valuations. Third party investors would own the $380 million in debt securities issued by the CDO. The maximum economic loss we could sustain on the CDO is $20 million. However, as we consolidated the CDO in our financial statements, we could record realized losses, for example, greater than $20 million, should they occur in the $400 million asset portfolio of the CDO. The reversal of those losses above our $20 million share would be recorded in our statement of operations at the CDO’s maturity as the CDO writes down the principal amount of liabilities. The third party investors of the debt securities issued by the CDO would as an economic matter sustain those losses as they would not receive all of their principal investment back in this scenario.
Our fourth line of business, Other, encompasses insurance products in which we are no longer active, including industry loss warranty transactions, trade credit reinsurance and insurance of certain classes of assets in asset-backed securitizations, principally manufactured housing. At December 31, 2006, all of the exposure in this line of business had either expired or was in run-off. Run-off indicates that while we will not add new exposure, we have some current exposure that has not yet expired. The following table summarizes the results of our Other line of business the years ended December 31, 2006, 2005 and 2004:
In 1999, we insured 12 securitized manufactured housing bonds with a collective balance of $213.3 million. In response to an increase in the rate of delinquencies observed in the mortgages underlying four of these securitizations, we established a case specific reserve in 2004 in the amount of $20.3 million. This reserve represented the present value of expected losses, discounted at the applicable treasury rate. Due to the very long tenor of these bonds, payments are projected to continue through 2033. Each year we increase the reserve for accretion to adjust to the proper present value. Additionally, we regularly review the underlying asset performance and assess the need for additional reserves. As of December 31, 2006, our case specific reserve was $23.4 million. While the reserve represents our best estimate at the time of establishment of ultimate losses on a present value basis, facts and circumstances may change such that the estimate is required to be revalued. Three of the bonds in our securitized manufactured housing portfolio experienced losses in 2006, 2005 and 2004. A fourth bond incurred losses in 2006. Losses incurred for these securitizations totaled $1.7 million in 2006, of which approximately $1.0 million was related to normal
accretion of the existing reserve which is reported at the discounted value. In 2005, losses incurred were $3.4 million and also included accretion of approximately $1.0 million.
· net realized and unrealized gains (losses) on derivative instruments; and
· the portion of interest expense related to the principal payments on borrowings that were financed with derivatives.
Unrealized gains (losses) on derivatives are excluded because (i) they widely vary with changes in the credit market and interest rate environment and are not necessarily indicative of the performance of our underlying businesses and (ii) the Company intends to hold the positions to the derivative contracts’ expiration, at which time the mark to market values would revert to zero, to the extent no realized derivative gains or losses had occurred. Realized gains (losses) on non-CDO investments are excluded because our investment strategy is focused on the preservation of capital and generation of current income as opposed to the generation of trading gains and losses. We include the unrealized gains (losses) on derivatives and investments generated by trading activity, if any. Also excluded is a portion of interest expense on borrowings that were financed with interest rate swaps to pay the up front issuance costs of some of our consolidated CDOs. FAS 133 requires that all payments made under the interest rate swaps, representing both principal and interest, be recorded as interest expense. In order to approximate the economic expense on these borrowings, the portion of interest expense that is excluded is related to what would be principal payments if these borrowings had been financed with debt obligations.
We are a holding company, and as such, have no direct operations of our own. Our liquidity, both on a short-term basis (for the next 12 months) and a long-term basis (beyond the next 12 months) is dependent upon how much of our initial public offering proceeds we retain at the holding company level, the ability of our operating subsidiaries, which excludes our consolidated CDO entities, to pay dividends or make other payments to us, and our ability to incur indebtedness and otherwise access the capital markets. As of December 31, 2006, we held at our holding company approximately $36.9 million of the approximately $79.3 million in net proceeds from our initial public offering of common stock that was completed in November 2006. For further discussion regarding the balance of proceeds after December 31, 2006, see Part II, Item 5 of this report. Our principal liquidity requirement is the payment of interest on our debt and operating expenses. Our outstanding indebtedness is described under “-Indebtedness.” We may also incur additional indebtedness in the future to fund acquisitions, working capital, growth in our business or for other general corporate purposes. We also may require liquidity to make periodic capital investments in our operating subsidiaries. We do not currently intend to pay dividends. In the ordinary course of our business, we evaluate our liquidity needs and capital resources in light of holding company expenses and debt-related expenses. Based on the amount of dividends we expect to receive from our subsidiaries, existing cash, including the remaining proceeds from our initial public offering retained at our holding company, and availability under our revolving credit facility, management believes that we will have sufficient liquidity to satisfy our needs over the next 12 months. Beyond the next 12 months, the ability of our operating subsidiaries to declare and pay dividends may be influenced by a variety of factors including market conditions, insurance and rating agencies actions and general economic conditions as well as other items described in our risk factors in Part I, Item 1A of this report. Consequently, although management believes that we will continue to have sufficient liquidity to meet our debt service and other obligations over the long term, we cannot guarantee that we will not be required to seek external debt or equity financing in order to meet our operating expenses and debt service obligations.
We have audited the accompanying consolidated balance sheets of ACA Capital Holdings, Inc. and subsidiaries (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of ACA Capital Holdings, Inc. and subsidiaries at December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
ACA Capital Holdings, Inc. (“ACA” or the “Company”), is a Delaware domiciled holding company that provides financial guaranty insurance products to participants in the global credit derivatives markets, structured finance capital markets and municipal finance capital markets, as well as providing asset management services. The Company’s principal activities include financial guaranty insurance of public finance obligations, structured credit risk assumption through insured credit derivatives and collateralized debt obligation asset management. ACA conducts its business through three principal wholly-owned indirect subsidiaries. Its financial guaranty insurance business is conducted through ACA Financial Guaranty Corporation (“ACA Financial Guaranty”), a Maryland domiciled insurance company. ACA Financial Guaranty is licensed to conduct financial guaranty insurance business, which provides credit enhancement on municipal and other public finance obligations, in all 50 states, the District of Columbia, Guam, the U.S. Virgin Islands and Puerto Rico. Standard & Poor’s Rating Services (“S&P”) has assigned a financial strength rating of “A” to ACA Financial Guaranty. ACA Financial Guaranty also provides the credit support for the Company’s Structured Credit business activities. Through ACA Service L.L.C. and ACA Management, L.L.C., the Company conducts its CDO Asset Management business. This business encompasses the origination (in collaboration with investment banks), structuring and management of collateralized debt obligations (including collateralized loan obligations and other similarly securitized asset classes, collectively “CDOs”). In January 2007, the Company’s wholly-owned indirect subsidiary, ACA Capital Management (U.K.) Pte. Limited, became authorized and regulated by the Financial Services Authority as an investment manager to manage CDOs in the United Kingdom and most of Europe.
The Company defines its business as being composed of three distinct continuing lines of business or segments. They are Public Finance, Structured Credit and CDO Asset Management. A fourth line of business, Other, includes business in areas and markets in which the Company is no longer active. Although the Public Finance and Structured Credit businesses are reported in separate segments, together they form the Company’s financial guaranty insurance business. Public Finance provides financial guaranty insurance policies guaranteeing the timely payment of scheduled principal and interest on municipal debt obligations. Structured Credit structures and sells credit protection, principally in the form of insured credit swaps (“CDS”), against a variety of asset classes in the institutional fixed income markets. CDO Asset Management focuses on CDO origination, structuring and management. The Company will at times assume risk in the CDOs it manages through investment in some portion of the capital structure.
of $13 per share on the newly issued common stock, or $89.4 million. Net proceeds to the Company were $79.3 million, after issuance costs. On November 10, 2006, the Company’s common stock commenced trading on the New York Stock Exchange under the symbol “ACA.” In conjunction with the initial public offering, the Company’s senior convertible preferred stock, convertible preferred stock and series B senior convertible preferred stock all converted to common stock concurrently with the closing of our offering on November 15, 2006 at their conversion ratios of 6,000:1 shares, 6,000:1 shares and 6:1 shares, respectively.
Principles of Consolidation-The consolidated financial statements include the accounts of the Company and its subsidiaries, which includes variable interest entities (“VIEs”) that are under the Company’s control or where the Company is the primary beneficiary (see Note 4). All intercompany accounts and transactions have been eliminated in consolidation.
Investments-The major components of the Company’s investment portfolio are the fixed maturity securities of ACA Financial Guaranty, the Company’s consolidated CDOs and its Credit-focused Absolute Return Fixed Income Fund (the “Credit Fund”) (see Notes 6 and 12). The Company accounts for its investments in fixed maturity securities in accordance with the Financial Accounting Standards Board’s (“FASB”) Statement of Financial Accounting Standards (“FAS”) 115, “Accounting for Certain Investments in Debt and Equity Securities” (“FAS 115”) and Emerging Issues Task Force (“EITF”) Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets” (“EITF 99-20”) Management determines the appropriate classification of securities at the time of purchase. As of December 31, 2006 and 2005, all investments in fixed maturity securities, with the exception of the Company’s investments in the Credit Fund, were designated as available-for-sale and were carried at fair value. Fixed maturity securities in the Credit Fund are designated as trading and are also carried at fair value. The difference between fair value and amortized cost of available for sale securities is included in the accumulated other comprehensive income component of stockholders’ equity, net of applicable deferred income tax. The Company recognized investment gains (losses) in its Statement of Operation related to amounts included in other comprehensive income in prior years of $(4.1) million, $0.4 million and $(0.6) million for the years ended December 31, 2006, 2005 and 2004, respectively. These amounts net of tax were $(2.7) million, $0.3 million and $(0.4) million for the years ended December 31, 2006, 2005 and 2004, respectively. Changes in fair value of trading securities are included in net income. The fair values of these securities are based on independent market quotations, broker quotes or, when such quotations are not readily available because the securities are infrequently traded in the public market, from internal valuation models. These models include estimates, made by management, which utilize current market information. The valuation results from these models could differ materially from amounts realizable in an open market sale or exchange.
would be recorded as an adjustment to the investment. As of December 31, 2006 and 2005, fair value approximates contract value.
Bond discounts and premiums are amortized over the remaining terms of the securities using the effective-yield method. Investment income is recorded as earned. For mortgaged-backed securities and any other holdings for which there is prepayment risk, prepayment assumptions are evaluated at least annually and revised as necessary. Any adjustments required due to the resulting change in effective yields and maturities are recognized currently in the Company’s consolidated statements of operations.
Realized gains and losses on the sale of investments are determined on the basis of specific identification and are included in net income.
Cash and Cash Equivalents-Cash and cash equivalents include cash on hand, money market accounts and time deposits with banks with original maturities of three months or less. Included in cash and cash equivalents is $213.5 million and $106.3 million in cash of consolidated VIEs at December 31, 2006 and 2005, respectively.
Restricted Cash-The Company, principally as collateral for certain credit default swap (“CDS”) exposures, has restricted cash on deposit not available for general operating purposes (see Note 22).
Derivative Contracts-All derivative instruments are recognized in the consolidated balance sheets as either assets or liabilities depending on the rights or obligations under the contracts. All derivative instruments are measured at estimated fair value. The fair values of derivative instruments are determined by broker quotes or valuation models when broker quotes are not available. Valuation models include estimates made by management utilizing current market information. The valuation results from these models could differ materially from amounts that would actually be realized in the open market.
The Company has three main types of derivative instruments, each reported in different captions of the consolidated statements of operations. The three types are insured credit swaps, principally recorded in the Structured Credit line of business, credit swaps in consolidated CDOs that are not insured and interest swaps and caps included in consolidated CDOs.
on the Company’s effectiveness assessment methodology, the hedges have been deemed highly effective since designation. Prior to July 1, 2005, the Company had not met the documentation standards to achieve cash flow hedge accounting as required by FAS 133. As a result, these derivative contracts were not designated as cash flow hedges and the associated mark to market adjustments were included in the Company’s consolidated statements of operations.
The non-specific reserve is derived from the calculation of expected loss, which is estimated using a Monte Carlo simulation. A Monte Carlo simulation is a technique that is commonly used to estimate the probability of certain mathematical outcomes. It randomly selects values to create scenarios of outcomes and this random selection process is repeated many times to create multiple scenarios. Each time a value is
Deferred Debt Issuance Costs-Costs to issue debt, including debt of consolidated CDOs, are deferred and amortized over the estimated life of the debt, which normally ranges from five to ten years. Such costs include debt placement fees, legal fees, rating agency fees and external advisory fees. The amortization of these costs is included in depreciation and amortization expense.
Intangibles-The Company purchased all of the outstanding common stock of ACA Financial Guaranty on September 24, 1997. The acquisition was accounted for as a purchase and the price was allocated to the fair market value of the investments acquired of $15.1 million. In addition to the investments acquired, the Company paid $5.5 million for 54 certificates of authority (licenses) to transact financial guaranty insurance in 50 states, the District of Columbia, Guam, the U.S. Virgin Islands and Puerto Rico. The licenses through 2001 were being amortized over a 40-year life, beginning with ACA Financial Guaranty’s commencement of operations on September 24, 1997.
Effective January 1, 2002, the Company adopted FAS No. 142, “Goodwill and Other Intangible Assets” (“FAS 142”). FAS 142 requires that an entity no longer amortize intangible assets that have an indefinite life but rather test for impairment losses on an annual basis. The Company believes these licenses have an indefinite life and therefore ceased amortizing them commensurate with its adoption of FAS 142. The Company’s annual assessment for impairment involves a two-step process whereby an initial assessment for potential impairment is performed, followed by a measurement of the amount of impairment, if any. In its measurement for impairment the Company also considered triggering events in terms of FAS 144, which would more likely than not reduce the fair market value. As of December 31, 2006, the Company had not recorded an impairment loss. The unamortized balance of these licenses at December 31, 2006 and 2005 was $4.9 million.
Prior to the adoption of FAS 123(R), the Company applied APB No. 25 to account for its stock-based compensation awards and provided the required pro forma disclosures of FAS 123. The following table illustrates the effect on net income and earnings per share had compensation expense for all stock-based compensation awards been recorded in the years ended December 31, 2006, 2005 and 2004 based on the fair value method under FAS 123 (see Note 15) (dollars in thousands, except per share amounts):
Earnings Per Share-Basic and diluted earnings per share are calculated by dividing net income available to stockholders by the applicable weighted average number of shares outstanding during the year (see Note 24). In August 2006, the Company’s Board of Directors authorized a dividend of stock in order to effect a six-for-one stock split. All prior share and per share amounts have been restated to reflect the stock split. Additionally, in conjunction with the initial public offering, the Company’s senior convertible preferred stock, convertible preferred stock and series B senior convertible preferred stock all converted to common stock concurrently with the closing of our offering on November 15, 2006 at their conversion ratios of 6,000:1 shares, 6,000:1 shares and 6:1 shares, respectively (see Notes 1 and 17).
All potentially dilutive securities, including unexercised stock options and convertible securities, other than participating convertible stock, are excluded from the basic earnings per share calculation. Participating convertible stock consisted of series A, B and C senior convertible preferred stock. The participating convertible stockholders participated equally with the common stockholders in dividends declared. However, holders of participating convertible stock were not required to fund Company losses, nor were the contractual principal of these securities reduced as a result of losses incurred by the Company. In accordance with FAS 128, the dilutive convertible securities (i.e., the senior convertible preferred stock and convertible preferred stock classes of securities) converted at November 15, 2006 are included in the denominator for the period prior to actual conversion. The common shares issued upon November 15, 2006 conversion are included in the denominator for the period after the date of conversion. Consequently, shares assumed issued are weighted for the period the convertible securities were outstanding, and common shares actually issued are weighted for the period the shares were outstanding.
In accordance with EITF 03-6, “Participating Securities and the Two-Class Method under FASB Statement No. 128, ‘Earnings Per Share,” the participating preferred stock were considered participating securities requiring the use of the two-class method for computation of basic earnings per share. The two-class method for each period reflects the cash dividends paid per share class of stock, if any, plus the amount of allocated undistributed earnings per share computed using the participation percentage which reflects the dividend rights of each class of stock. The shares of participating convertible stock were considered to be participating convertible securities since the shares of series A, B and C senior convertible preferred stock were convertible on a share-for-share basis into shares of common stock. Diluted earnings per share were computed assuming the conversion of the series A, B and C senior convertible preferred stock into shares of common stock as of the beginning of each period the stock was outstanding.
(“SOP 05-1”), was issued. This SOP provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacement of insurance and investment contracts other than those specifically described in FAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments’’. SOP 05-01 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. Management believes the impact, if any, as a result of the adoption of SOP 05-1, will not be material to the Company’s financial statements.
In April 2006, the FASB issued Staff Position (“FSP”) FIN 46(R)-6, “Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)” (“FSP FIN 46(R)-6”), FSP FIN 46(R)-6 addresses whether certain arrangements associated with variable interest entities (VIEs) should be treated as variable interests or considered as creators of variability, and indicates that the variability to be considered shall be on based on an analysis of the design of the entity. FSP FIN 46(R)-6 was adopted on June 15, 2006. The adoption of this statement did not have a material impact on the Company’s financial statements.
In July 2006, the FASB issued FASB Interpretation No. (“FIN”) 48, “Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Interpretation also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.
In September 2006, the FASB issued FAS 157, “Fair Value Measurements” (“FAS 157”). FAS 157 enhances existing guidance for measuring assets and liabilities using fair value, such as emphasizing that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the highest priority being quoted prices in active markets. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Management is currently evaluating the potential impact, if any, which the adoption of FAS 157 will have on the Company’s financial statements.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” which provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The provisions of SAB 108 were put in effect at December 31, 2006. The adoption of this statement did not have a material impact on the Company’s financial statements.
One of the ways the Company participates in the structured finance market is through structuring and managing CDOs originated in collaboration with investment banks. CDOs can be issued in funded, unfunded or partially funded form. Funded CDOs issue debt instruments and purchase investment assets, while unfunded CDOs synthetically acquire assets and issue liabilities (i.e., assets and liabilities are in derivative form). Partially funded CDOs are a combination of these two forms. From an accounting perspective, funded and partially funded CDOs are determined to be VIEs. Each time such CDOs are formed, the Company performs an analysis to determine whether it is the primary beneficiary and thus required to consolidate the CDO under the provisions of FSP FIN 46(R)-6.
(2) Notional deal size is defined as total face value of liabilities at the deal’s inception.
As of December 31, 2006 and 2005, consolidated liabilities include non-recourse debt from consolidated CDOs of $4,711.8 million and $4,833.2 million, respectively. Also, as of December 31, 2006 and 2005, consolidated assets includes investment in fixed maturity securities of $4,536.7 million and $4,810.9 million, respectively, and cash of $265.0 and $125.2 million, respectively, related to CDOs.
Fully funded CDOs contain investments in interest bearing financial assets such as fixed maturity securities or guaranteed investment contracts. The Company has six fully funded and one partially funded CDO that are consolidated. The assets and liabilities of these CDOs are included in the Company’s consolidated balance sheets. The income generated by the investments is reflected in net investment income in the consolidated statements of operations. The debt liabilities issued in the form of notes pay interest that is also included in interest expense in the consolidated statements of operations. A management fee is paid by the CDO to ACA Management, L.L.C. that is eliminated in consolidation. The return on the Company’s equity is represented by the net of the CDO’s revenue (interest income) and the CDO’s expenses including management expenses paid to ACA Management, L.L.C.
Partially funded synthetic CDOs sell credit protection on referenced assets by entering into credit swaps with various protection buyers in the market. The CDO also issues securities, both liabilities and equities, in order to use the proceeds from the sale of these securities to collateralize the CDO’s obligations under its credit swaps, except with respect to the most senior tranche of the CDO’s credit exposure, in connection with which a partially funded CDO typically purchases credit protection rather than issuing funded liability securities. The proceeds of the securities issued by the partially funded CDO are invested in a guaranteed investment contract, or GIC. The Company has one partially funded CDS CDO that is consolidated. From this consolidated CDO, the Company consolidates investment income, relating to the return on the GIC, and interest expense in connection with the liability securities issued by the CDO. The Company also consolidates derivative income relating to net revenues from the fixed fees payable to the CDO under the terms of the credit swaps pursuant to which the CDS CDO sold credit protection on referenced assets and the fixed fees payable by the CDO on the credit protection that it purchased. This income is reflected in the consolidated statements of operations as other net credit swap revenue. This income is used to pay the interest on the liabilities of the CDO and other expenses of the CDO, including the management fee. Similar to the fully funded and consolidated CDOs, all management fees in this partially funded CDS CDO are eliminated in consolidation. The return on the Company’s equity is represented by the net of the CDO’s revenue (interest income and derivative income) less the CDO’s expenses, including management fees paid to ACA Management, L.L.C.
For funded unconsolidated CDOs, the Company reflects management fees and investment income in its consolidated statements of operations. In these instances, the investment income recorded is only on the equity investment made by the Company as compared to all of the assets in a consolidated CDO. Partially funded, unconsolidated CDOs in which the Company invests in the funded equity securities are reflected in the Company’s consolidated financial statements in the same way as funded unconsolidated CDOs.
The Company originated a fully synthetic, or unfunded, CDS CDO in each of 2002 and 2003. In these transactions, the Company acts as asset manager and, through ACA Financial Guaranty, insures the equity or first loss position of the CDO. No SPEs are created and, therefore, no variable interest entities, or VIEs, exist in these structures; rather, the sponsoring investment bank acts as the counterparty in the various credit swaps that constitute the assets and liabilities of the synthetic CDO. CDOs that do not use SPEs are not subject to consolidation under FIN 46(R), “Consolidation of Variable Interest Entities.” For its various roles in the unfunded CDS CDOs, the Company receives structuring fees, management fees, premium and residual equity returns. In the Company’s consolidated statements of operations, these revenues are reflected as fee income, net insured credit swap revenue and other net credit swap revenue. Net insured credit swap revenue also includes the changes in fair value of the related credit swaps. The combined equity position of the Company in its two unfunded CDS CDOs, which is the aggregate notional balance of the Company’s credit swaps insuring the equity tranches of these two CDOs, was $47.5 million at December 31, 2006 and 2005.
Other net credit swap revenue includes revenues received from a partially funded CDS CDO which sells credit protection under credit swaps for which it receives fixed quarterly fees as well as the residual returns on two synthetic equity participations. Other net credit swap revenue also includes net realized and unrealized gains and losses associated with these transactions. These revenues are included in the Company’s consolidated statements of operations.
The following table disaggregates other net credit swap revenue into its component parts for the periods ended December 31, 2006, 2005 and 2004 (dollars in thousands):
The Company accounts for its investments in fixed maturity securities in accordance with the FAS 115 and EITF 99-20. Management determines the appropriate classification of securities at the time of purchase. As of December 31, 2006 and 2005, all investments in fixed maturity securities, with the exception of the Company’s investments in the Credit Fund (see Note 12), were designated as available-for-sale and were carried at fair value. Fixed maturity securities in the Credit Fund are designated as trading and are also carried at fair value. The difference between fair value and amortized cost of available-for-sale securities is included in the accumulated other comprehensive income component of stockholders’ equity, net of applicable deferred income tax. Changes in fair value of trading securities are included in net income. The fair value of these securities is based on independent market quotations or, when such quotations are not readily available because the securities are infrequently traded in the public market, from internal valuation models. These models include estimates, made by management, which utilize current market information. The valuation results from these models could differ materially from amounts realizable in an open market sale or exchange.
Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations which may or may not include call or prepayment penalties.
The Company’s process for identifying declines in the fair value of investments that are other than temporary involves consideration of several factors. These factors include (i) the duration of a significant decline in value, (ii) the liquidity, business prospects and overall financial condition of the issuer, (iii) the magnitude of the decline, (iv) the collateral structure and other credit support, as applicable, (v) the Company’s intent and ability to hold the investment until the values recover, and (vi) for asset-backed securities, the estimated cash flows. When the analysis of the above factors results in a conclusion that a decline in fair values is other than temporary, the cost of the security is written down to fair value as of the reporting date and any previously unrealized loss is realized in the period such a determination is made.
On November 3, 2005, the FASB issued FSP FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” This FSP addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary and the measurement of an impairment loss. This FSP also includes accounting considerations subsequent to the recognition of other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in this FSP also
amends FAS 115. We adopted this FSP effective January 1, 2006. Accordingly, we are now required to assess our investments for impairment in each reporting period and to use existing guidance in assessing whether an impairment is other than temporary. The impact of the adoption of this guidance was not material.
The following table shows the gross unrealized losses and fair value of our fixed maturity securities available for sale with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2006 (dollars in thousands).
A substantial portion of the unrealized loss in VIE asset-backed securities is related to collateralized residential mortgage backed securities, including both sub-prime and mid-prime quality mortgages. The last quarter of 2006 saw significant disruption and consolidation in the sub-prime mortgage market, with some mortgage originators being purchased or exiting the business. This disruption translated into decreased liquidity and wider spreads across the market, decreasing the market value of the portfolios. In particular, securities backed by mortgages from what are currently perceived as originators with weaker underwriting standards experienced a decrease in price late in 2006, even when the credit performance of the securities had not suffered. An additional factor weighing on the market valuations for the Company’s positions is the limited liquidity associated with the seasoned securities which have already received or are about to receive a significant return of principal. Since the Company, at December 31, 2006, believed that it would be able to collect amounts due on its RMBS positions and has the ability and intent to hold these investments until a recovery of fair value, which may be at their maturities, we did not consider these investments to be other-than-temporarily impaired at December 31, 2006.
Included in the tables above are 578 fixed maturity securities, 170 in the non-VIE portfolios, and 408 in the VIE portfolios. At December 31, 2006, there were 21 fixed maturity securities each of whose amortized cost exceeded its respective fair value by greater than 20%. In addition, 99% of these securities are rated investment grade in the non-VIE portfolios while over 97% are rated investment grade in the VIE portfolios. Management has assessed these and other factors and concluded that there were no other than temporarily impaired fixed maturity securities included in the above table as of December 31, 2006.
For the years ended December 31, 2006, 2005 and 2004, investment income was derived from the following sources (dollars in thousands):
In 2002, the Company invested in a GIC through one of its consolidated CDO VIEs. Management considers the GIC’s fair value to approximate contract value. At both December 31, 2006 and 2005, the fair value and contract value of the investment contract was $119.3 million. The GIC earns interest at a rate of LIBOR less 0.02%, matures in 2007 and is issued by an affiliate of Financial Security Assurance Inc., an “AAA” rated financial guaranty company.
Deferred policy acquisition costs (“DAC”) and the related amortization charged to expense were as follows (dollars in thousands):
Reserves include case specific losses and loss adjustment expenses and non-specific losses as described in Note 2. At December 31, 2006, net case specific reserves were $20.2 million, net of estimated recoveries of $5.5 million, and non-specific reserves were $21.9 million. At December 31, 2005, net case specific reserves were $17.7 million, net of estimated recoveries of $8.1 million, and non-specific reserves were $16.6 million. At December 31, 2004, net case specific reserves were $25.7 million, net of estimated recoveries of $7.7 million, and non-specific reserves were $10.3 million. Estimated recoveries represent loss payment amounts which have been paid by the Company that it expects to recover in future periods. Changes in non-specific reserves are reported as current year activity. Included in net case-specific reserves in 2006 and 2005 is $23.4 million and $23.0 million, respectively, related to a portfolio of insured securitized manufactured housing bonds. These insurance contracts were issued in 1999. Of the portfolio, one bond defaulted in July of 2005, while the remaining bonds are expected to default subsequent December 31, 2006. Losses are expected to be paid through 2033. The 2006 reserve for these bonds includes $14.0 million of adverse development offset by $13.6 million of additional cash flows within the bond structure that will accrue to the benefit of the Company.
Incurred losses for the year ended December 31, 2006, 2005 and 2004, were $8.8 million, $14.0 million and $46.6 million, respectively. Incurred losses for 2006, 2005 and 2004 include $2.7 million, $4.2 million and $2.4 million, respectively, of prior period development. In 2006, the Company did not establish any new case based loss reserves. The Company did incur loss adjustment expenses in the amount of $1.2 million in connection with several insured municipal credits in varying stages of work-out. Additionally, the Company increased its reserve related to the portfolio of securitized manufactured housing bonds discussed above by $1.7 million, of which $1.0 million was related to accretion. In 2005, the Company increased its reserve related to the portfolio of securitized manufactured housing bonds discussed above by
$3.4 million which included approximately $1.0 million in accretion. Included in incurred losses and loss adjustment expenses in 2004 were $21 million related to the Company’s discontinued industry loss warranty business, $20.3 million for the initial establishment of the reserve on the manufactured housing portfolio and $2.4 million of unfavorable development on a specific municipal case reserve.
Prior period development arises from changes to loss estimates recognized in the current year that relate to loss reserves first reported in previous calendar years and excludes the effect of losses from the development of earned premium from previous accident years.
Loss and loss adjustment expenses paid, net of reinsurance, for the years ended December 31, 2006, 2005 and 2004 were $1.0 million, $15.7 million and $14.4 million, respectively. Payments made in 2005 and 2004 include $10.0 million and $11.0 million, respectively, related to two contracts in the discontinued industry loss warranty business. The Company had no remaining reserve or exposure on this business as of December 31, 2006 and 2005. Also included in claim payments is $3.1 million in 2005 related to a municipal bond and $3.9 million in 2004 on two insured mortgage-backed bonds. For the 2004 payment, approximately $0.8 million in salvage was received. Based on the circumstances of the bonds’ default, the Company expects to fully recover all payments and accordingly recorded anticipated salvage in an amount equal to net payments made.
During 2005, a facultative reinsurance agreement covering a municipal obligation with ACE American Insurance Company (“ACE”) was cancelled. As a result of the cancellation, $0.8 million in ceded unearned premium reserve was returned to the Company.
The Company also cancelled reinsurance contracts with Partner Reinsurance Company Ltd. and Royal & Sun Alliance Insurance PLC during 2004 which resulted in premiums reassumed of $0.7 million and $0.2 million, respectively.
written premiums of $0.4 million, $3.3 million and $12.6 million and earned premiums of $1.1 million, $5.5 million and $10.4 million in 2006, 2005 and 2004, respectively.
Interest on the ACA CDS 2002-1 Limited Class A senior interest only note issued by the VIE is computed based on a notional value of $48 million. The interest rate on this note was 5.484% until April 15, 2005, 3.565% from April 15, 2005 until July 15, 2005, and 2.742% from July 15, 2005 until maturity.
The Company issued floating rate junior subordinated deferrable interest debentures, structured as trust preferred securities, of $20.6 million in 2004, bringing the total outstanding issuances to $79.9 million. The trust preferred securities have an initial stated term of 30 years with a call provision at five years from the date of each issuance. The current interest rates on the $79.9 million of outstanding trust preferred securities range from 8.71% to 9.47% at December 31, 2006. The effective interest rate of these securities is calculated based on 3-Month LIBOR plus a margin of 3.35% to 4.1% per annum subject to certain interest rate caps during the lives of the securities.
In 2004, the Company re-domesticated from Bermuda to Delaware (see Note 1), which under IRS regulations will preclude it from filing a consolidated federal income tax return with its operating subsidiaries until 2008. In 2005, in an effort to reduce federal and state filing requirements and to simplify the organization, the Company re-aligned its tax-paying structure. As a result of the 2005 re-alignment, the Company has two federal corporate taxpayers.
The components of income tax expense for the years ended December 31, 2006, 2005 and 2004, were as follows (dollars in thousands):
The Company and its subsidiaries lease office space for their corporate headquarters in New York City and, beginning in 2006, for newly established offices in London and Singapore under noncancelable operating leases, which expire at various dates through 2020. In addition to base rental costs, the leases for office space provide for rent escalations resulting from increased assessments for real estate taxes, utilities, and maintenance. Rent expense for 2006, 2005 and 2004 was $2.4 million, $2.0 million and $2.1 million, respectively.
Future minimum lease payments under the noncancelable operating leases at December 31, 2006 were as follows (dollars in thousands):
The following methods and assumptions were used by the Company in estimating its fair value disclosure for financial instruments. These determinations were based on available market information and appropriate valuation methodologies. Considerable judgment is required to interpret market data to develop the estimates and therefore, they may not necessarily be indicative of the amount the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
Guaranteed Investment Contract-The Contract’s fair value approximates contract value, as the interest rate is variable at LIBOR less 0.02% and resets on an annual basis.
Accrued interest payable-The fair value of accrued interest payable approximates carrying value.
Present Value of Installment Premiums-The fair value for financial guarantees written (net insurance contracts written) with installment premiums is derived by calculating the present value of the estimated future premiums at a risk adjusted rate of 4.7% and 5.0% in 2006 and 2005, respectively, net of normal ceding commissions.
The carrying value and estimated fair value of financial instruments are presented below (dollars in millions):
In 2001, the Company adopted the American Capital Access Holdings, Incorporated Omnibus Incentive Compensation Plan (the “Prior Plan”) under which 2,188,584 shares of the Company’s common shares were reserved for issuance to employees, directors and consultants. In 2003, the Company’s Board of Directors approved the increase of the number of shares reserved for issuance by 72,954. In 2004, the
Unless otherwise specified, each option vests ratably annually either over 3 years or every 6 months over 3 12 years, beginning at the date of grant. As long as the grantee is still with the Company, if not vested by its terms, each option fully vests upon the earliest of (i) the grantee’s normal retirement date; (ii) the grantee’s death or disability; or (iii) the occurrence of a change of control of the Company.
In December 2004, the FASB issued FAS 123(R) that requires compensation cost related to share-based payment transactions to be recognized in an issuer’s financial statements. The compensation cost, with limited exceptions, is measured based on the grant-date fair value of the equity or liability instrument issued. FAS 123(R) replaces FAS 123 and supersedes APB No. 25. Effective January 1, 2006, the Company adopted FAS 123(R) using the prospective application as permitted by FAS 123(R). Accordingly, prior period amounts have not been restated. Under this application, we are required to record compensation expense for all awards granted after the date of adoption. Awards granted prior to the date of adoption of FAS 123(R) continue to be accounted for under APB No. 25. Compensation cost is recognized over the periods that an employee provides service in exchange for the award.
In 2006, the adoption of FAS 123(R) resulted in incremental stock-based compensation expense of $1.0 million, $0.2 million of which was deferred related to policy acquisition costs. The incremental stock-based compensation expense caused income before income taxes and net income to decrease by $0.8 million and $0.5 million, respectively, and basic and diluted earnings per share each to decrease both by $0.02 per share, respectively. There was no effect on cash provided by operating activities and cash provided by financing activities related to excess tax benefits from stock-based payment arrangements in 2006.
The fair value of the stock options granted was estimated on the date of grant using a Black-Scholes option valuation model that uses the assumptions noted in the following table. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant. The expected term (estimated period of time outstanding) of the stock options granted was estimated using the simplified method, in which the expected term equals the average of the graded vesting term and the contractual term. Expected volatility was estimated based on the historical volatility of comparable public companies for a period equal to the stock option’s expected term, ending on the day of grant, and calculated on a monthly basis.
The following table summarizes information regarding fully vested share options as of December 31, 2006:
On September 30, 2004, the Company granted 335,214 restricted shares of its series B senior convertible preferred stock, par value $0.10 (“the Restricted Stock”) at a fair market value of $10.38 per share, to the Company’s new president and chief executive officer (the “Executive”). This stock is included in the amounts converted to common stock commensurate with the closing of the Company’s initial public offering of common stock. The total value at the grant date of the restricted stock totaled $3.5 million. The restricted stock vests as follows: 33.33% vested on September 30, 2005; 33.33% will vest on September 30, 2006; and the remaining 33.34% will vest on September 30, 2007, provided the Executive has been continuously employed by the Company or a subsidiary throughout the applicable vesting period. In 2006, 2005 and 2004, the vested portion of the restricted stock totaled $1.2 million, $1.2 million and $0.3 million, respectively, which was recognized in the Company’s consolidated statements of operations.
On June 4, June 28, and July 12, 2004, the Company issued 268,471, 26,847 and 11,813 shares of series A senior convertible preferred stock for $25.0 million, $2.5 million and $1.1 million, respectively, to existing stockholders. All of these shares were converted to series B senior convertible preferred stock on September 30, 2004. On the same day, the Company issued an additional 2,247,551 shares of series B senior convertible preferred stock for $140.0 million to new stockholders. Of the capital raised in 2004, $146 million was invested in the capital of ACA Financial Guaranty to increase its statutory capital to meet the redefined minimum capital requirements of S&P, ACA Financial Guaranty’s rating agency.
As of December 31, 2006, ACA Financial Guaranty’s policyholders’ surplus, as determined in accordance with statutory accounting practices, was $273.6 million. Such amount was in excess of the minimum capital and surplus level of $75.0 million required to satisfy a key state regulatory requirement.
In December 2005 and May 2005, the MIA approved ACA Financial Guaranty’s request to make dividend payments to the Company in amounts equal to the interest payments on $40 million of the Company’s trust preferred issuance outstanding as well as to pay interest on a $10 million surplus note issued by ACA Financial Guaranty to the Company during the years ended December 31, 2006 and 2005, respectively. Accordingly, ACA Financial Guaranty paid dividends of $2.7 million and $2.1 million for the ultimate benefit of its parent, ACA, and $0.8 million and $0.5 million in interest on the surplus note in 2006 and 2005, respectively.
ACA Financial Guaranty policies insure the scheduled payments of principal and interest on municipal obligations and asset-backed and corporate financings. The outstanding principal amount of insured obligations in the insured portfolio, net of amounts ceded aggregating $50 million at both December 31, 2006 and 2005, respectively, included the following types of issues (dollars in millions):
During 2006 and 2005, the Company received management and structuring fee income from its non-consolidated CDOs of $18.5 million and $4.2 million, respectively (see Note 4). No CDOs were considered related parties in 2004. This amount is included in fee income.
During 2004, a Bear Stearns & Co. Inc. sponsored investment vehicle, BSMB/ACA LLC (“BSMB”) invested $105 million in the Company in exchange for series B senior convertible preferred stock. BSMB is the private equity affiliate of the Bear, Stearns Companies, Inc. a subsidiary of Bear, Stearns & Co. Inc. During 2006 and 2005, Bear, Stearns & Co. Inc. performed investment banking services for the Company on various transactions and was paid structuring and placement fees of $1.6 and $1.1 million, respectively. In March 2005, the Company borrowed $100 million via an investment trust structure sponsored by Bear Stearns. The Company is required to make quarterly interest payments to the trust at a rate equal to the three-month LIBOR plus 125 basis points (see Note 10).
on the promissory notes of those senior executives remaining with the Company on March 1, 2005 and the remaining two thirds on March 1, 2006, in the amount of $0.3 million and $0.5 million respectively.
In May 2006, the Company paid a judgment in the amount of $3.7 million in satisfaction of a damages award in connection with an employment contract dispute with a former officer of the Company plus accrued interest through the date of payment. Also in May 2006, the Company settled the former officer’s attorney’s fees at an additional amount of $0.6 million. The Company had recorded a reserve of $4.2 million to cover these costs in December 2005. A judicial satisfaction of the judgment has been filed and the Company has no additional liability with respect to this matter.
The Company is not aware of any pending or threatened material litigation that it believes could reasonably be likely to result in a material adverse effect on the Company’s financial position, results of operations or cash flows.
(3) CDO Asset Management, which originates, structures and manages assets, primarily corporate obligations or asset-backed securities, in funded, partially funded or synthetic CDOs; and
The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates segment performance based on its income (loss) before income taxes. Reportable segment results are presented net of material inter-segment transactions.
The following tables summarize the Company’s operations and allocation of assets as of and for the years ended December 31, 2006, 2005 and 2004 (dollars in thousands):
The following table sets forth the computation of basic and diluted earnings (loss) per share for the years ended December 31, 2006, 2005 and 2004:
The 2006, 2005 and 2004 computation of diluted earnings (loss) per share did not include the effects of 1.86 million, 0.30 million and 0.30 million options, respectively, to purchase shares of common stock because they would have an anti-dilutive effect on the computation.
As a result of the net loss for the quarter ended June 30, 2005, 16.68 million weighted average shares of participating convertible stock were excluded from the computation of basic earnings (loss) per share. Participating convertible stockholders do not participate in losses with the common stockholders. Additionally, 6.66 million and 0.30 million weighted average shares of dilutive potential common stock, resulting from convertible preferred stock and stock options, respectively, were not included in the computation of diluted earnings (loss) per share for the quarter ended June 30, 2005. In the absence of the net loss, diluted weighted average shares would have totaled 29.73 million.