UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

For the transition period from                  to

Commission file number 001-33111

ACA Capital Holdings, Inc.

(Exact name of Registrant as specified in its charter)

140 Broadway

New York, New York 10005

(Address of principal executive officers, including zip code)

(212) 375-2000

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   Yes o   No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.            Yes o    No x

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K  o

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

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

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

The Registrant completed the initial public offering of its common stock in November 2006. Accordingly, there was no public market for the Registrant’s common stock as of June 30, 2006, the last day of the Registrant’s most recently completed second fiscal quarter.

As of March 27, 2007, 37,038,756 shares of Common Stock, par value $0.10 per share, were outstanding.

Documents Incorporated By Reference

Part III incorporates certain information by reference from the Registrant’s definitive proxy statement for the 2007 annual meeting of stockholders, which proxy will be filed no later than 120 days after the close of the Registrant’s fiscal year ended December 31, 2006.

TABLE OF CONTENTS

CAUTIONARY STATEMENTS REGARDING
FORWARD-LOOKING STATEMENTS

Some of the statements under “Business,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this Annual Report on Form 10-K may include statements that are not historical or current facts and may be considered “forward-looking statements” under the Private Securities Litigation Reform Act of 1995. The words “believe”, “anticipate”, “project”, “plan”, “expect”, “intend”, “may”, “will likely result”, “looking forward” or “will continue,” and similar expressions identify forward-looking statements. Such statements reflect management’s current expectations or forecasts of future events based on its current views and assumptions regarding future events and economic performance.

Any or all of the forward-looking statements herein are subject to risks and uncertainties that may cause actual results to differ materially from those set forth in these statements. Among factors that could cause actual results to differ materially are:  (1) difficulties with the execution of our business strategy; (2) changes in the economic, credit spread or interest rate environment in the United States and overseas; (3) the level of activity in the national and global debt markets; (4) market spreads and pricing on derivative products insured or issued by us; (5) significant credit losses in excess of expectations and the inability to obtain expected levels of reimbursement or recoveries; (6) ratings actions with respect to the financial strength rating assigned by Standard & Poor’s Ratings Services, or S&P, to our insurance subsidiary, ACA Financial Guaranty Corporation, or a change in S&P’s ratings criteria at any time; (7) prepayment speeds on insured asset-backed securities and other factors that may influence the maturity of collateralized debt obligations, or CDOs, and related management fees paid to us; (8) decreased demand for our insurance products or asset management services, or increased competition in our markets; (9) changes in accounting policies or practices that may impact our reported financial results; (10) the amount of reserves established for losses and loss expenses and the differences between our reserves and actual losses; (11) changes in regulation or tax laws applicable to us or those with which we do business; (12) governmental action; (13) loss of key personnel; (14) technological developments; (15) the effects of mergers, acquisitions and divestitures; (16) other risks and uncertainties that have not been identified at this time; (17) management’s response to these factors; and (18) other risk factors identified under Part I, Item 1A of this report. We caution that forward-looking statements made by us speak only as of the date on which they are made, and, except as required by law, we do not undertake any obligation to update or revise such statements if management’s expectations change or we become aware that any forward-looking statement is not likely to be achieved.

If one or more of these or other risks or uncertainties materialize, or if management’s underlying assumptions prove to be incorrect, actual results may vary materially from what we projected. Any forward-looking statements you read in this report reflect management’s current views with respect to future events and are subject to these and other risks, uncertainties and assumptions relating to our operations, results of operations, growth strategy and liquidity. All subsequent written and oral forward-looking statements attributable to us or to individuals acting on our behalf are expressly qualified in their entirety by this section.

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PART I

Item 1.                        Business.

Overview

ACA Capital Holdings, Inc. (hereafter “ACA”, “we”, “us”, “our” or the “Company”) is a holding company, headquartered in New York City, that provides financial guaranty insurance products to participants in the global credit derivatives markets, structured finance capital markets and municipal finance capital markets. We also provide asset management services to specific segments of the structured finance capital markets. We participate in our target markets both as a provider of credit protection through the sale of financial guaranty insurance products, for risk-based revenues, and as an asset manager, for fee-based revenues. Our business model seeks to combine the operational leverage of our core credit and asset management capabilities with the financial leverage provided by our “A” rated financial guaranty insurance platform.

Our core competency is selecting, analyzing, structuring and managing credit risk in a variety of fixed income financial asset classes, including investment grade and non-investment grade corporate obligations (including bonds and loans), asset-backed securities, or ABS (including mortgage-backed securities, or MBS, and other asset classes) and municipal and other public finance securities. Throughout our businesses we generally assume credit risk to the scheduled maturity of the underlying credit, including credit risks that are of low investment grade quality or high non-investment grade. We apply a rigorous underwriting and credit process to analyze each transaction and its incremental effect on our existing credit portfolio, and have adopted a risk management approach which is designed to ensure that the risk profile of a given credit or transaction meets our credit, profitability and loss tolerance standards.

Business Lines

We operate our businesses through three strategic business lines, which consist of our two financial guaranty insurance lines of business, Structured Credit and Public Finance, and our CDO Asset Management business. Each of these businesses relies on our core competencies of credit analysis, transaction structuring, risk management and surveillance. Applying these competencies across our platform allows us to create efficiencies in our operations and to deliver a wide range of services and product solutions for our institutional customers.

The following is an overview of each of our three business lines. For a more detailed discussion of each business line, see “—Structured Credit”, “—Public Finance”, and “—CDO Asset Management.”

Financial Guaranty Insurance Lines of Business

Structured Credit:   As a part of our financial guaranty insurance business, we apply our substantial experience in credit analysis to select, structure and sell credit protection, principally on highly rated exposures, through insured credit swaps in the institutional fixed income markets. We generate revenues in our Structured Credit business through the premiums paid to ACA Financial Guaranty to insure against the risk of default on the assets underlying our credit swaps. Although our “A” rating affords our Structured Credit business significant flexibility to offer credit protection on any portion of a given capital structure, currently our insured credit swap portfolio is constructed primarily of exposures attaching above the “AAA” rated level of subordination.

Additionally, we recently formed a Credit—focused Absolute Return Fixed Income Fund, ACA Capital Partners I, or the Credit Fund, as a part of our Structured Credit line of business. As of December 31, 2006, our Credit Fund had net assets under management of $25.6 million. The Credit Fund was created to leverage our expertise in the capital and credit markets and as an asset manager. The Credit Fund is managed by ACA Management and invests primarily in fixed income securities.

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Public Finance:   We provide financial guaranty insurance on municipal and other public finance bonds that guarantee to the investor the timely payment of interest and ultimate payment of principal on such obligations. Through ACA Financial Guaranty, we target low investment grade, high non-investment grade and unrated sectors of the public finance market that, under our analysis, have strong credit profiles and security, or other enhancements. We also target markets that are underserved by reason of industry sector, credit characteristics or transaction size. We generate revenue in our Public Finance business through the receipt of premiums for the insurance we provide. ACA Financial Guaranty is licensed to provide financial guaranty insurance in all 50 states, the District of Columbia, Guam, Puerto Rico and the U.S. Virgin Islands.

Other Financial Services

CDO Asset Management:   We apply our core competencies of evaluating and managing credit risk for fees in our CDO Asset Management line of business. Specifically, we serve as an asset manager of collateralized debt obligations, or CDOs, for the benefit of the third party investors in these CDOs. A CDO is a securitization of fixed income assets such as bonds, loans, MBS, ABS and credit swaps. CDO assets are funded by the issuance of various liabilities with credit profiles ranging from “AAA” rated debt to non-rated equity. Our CDOs have a diverse worldwide institutional investor base.

Our CDO Asset Management revenues consist of asset management fees and risk-based revenue in the form of return on our equity investments in our CDOs. In order to align our interests as a manager with those of our investors, we typically invest in some portion of the equity of our managed CDOs, currently targeting 10% of the total equity offered. ACA Management manages U.S. based assets and ACA Capital Management (U.K.) will manage European based assets.

Based on our knowledge of the market, we believe we are one of the largest global CDO managers as ranked by assets under management. Through our Structured Credit line of business, we have taken exposure at the most senior level in three of our CDOs. We do not credit enhance any portion of our CDO liabilities for investors.

Corporate Structure

ACA is a Delaware corporation. We began operations in September 1997 with a business strategy focused on providing “A” rated financial guaranty insurance to the municipal finance market. Beginning in 2002, we extended our financial guaranty insurance products to include our Structured Credit business and expanded our operations generally by establishing our CDO Asset Management business. In 2006, we opened offices in London and Singapore to further expand our operations into the European and Asian credit markets.

Our principal subsidiary through which we currently operate our business is ACA Financial Guaranty Corporation (“ACA Financial Guaranty”), our S&P “A” rated insurance subsidiary that is organized in the State of Maryland. As of December 31, 2006, approximately 85% of our assets on an unconsolidated basis represented our 100% indirect ownership interest in ACA Financial Guaranty. ACA Service L.L.C., a wholly-owned direct subsidiary of ACA Financial Guaranty, is a Delaware limited liability company and owns the majority of the special purpose entities through which we execute our insured credit swaps. ACA Financial Guaranty insures the obligations of the special purpose entities in our Structured Credit line of business. Our CDO Asset Management services are conducted through our subsidiaries ACA Management, L.L.C. (“ACA Management”), also a wholly-owned indirect subsidiary of ACA Financial Guaranty, and ACA Capital Management (U.K.) Pte. Limited, a wholly-owned indirect subsidiary of the Company. ACA Management, a Delaware limited liability company, is registered with the Securities and Exchange Commission (“SEC”) as an investment adviser. ACA Capital Management (U.K.), a United

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Kingdom private limited company, became authorized and regulated by the Financial Services Authority (“FSA”) as an investment manager in January 2007.

Business Strategy

Our business strategy is to continue to leverage our credit management expertise to generate attractive risk-adjusted returns on our capital in our financial guaranty insurance lines of business through the insurance of targeted credit exposure and to grow our assets under management. We plan to achieve these objectives through the following strategies:

·       Grow our insured credit exposure and assets under management, in terms of the number of transactions, size of transactions and types of asset classes that we insure and manage, both in the United States and internationally.

·       Target attractive risk-adjusted returns in the credit markets.

·       Expand our existing product lines into broader geographical areas, asset classes and credit profiles and develop new credit product areas.

·       Expand counterparty and other key relationships for our insurance lines of business.

·       Maintain a capital base in excess of S&P’s requirements for “A” rated insurers so that we have excess rating agency capital to absorb unforeseen losses, while sustaining the operating flexibility of that “A” financial strength rating.

We maintain a website at www.aca.com. We are not including or incorporating by reference the information contained on our website into this report. We make available on our website, free of charge and as soon as reasonably practicable after we file with, or furnish to, the SEC, copies of our most recently filed Annual Report on Form 10-K, all Quarterly Reports on Form 10-Q and all Current Reports on Form 8-K, including all amendments to those reports. In addition, copies of our Corporate Governance Guidelines, Code of Conduct, Code of Ethics for Chief Executive Officer and Senior Financial Officers, Policy Regarding Director Independence Determinations and the governing charters for each Committee of our Board of Directors are available free of charge on our website, as well as in print to any stockholder upon request. The public may read and copy materials we file with the SEC in person at the public reference facility maintained by the SEC at its public reference room at 100 F Street, NE, Washington, DC 20549 and copies of all or any part thereof may be obtained from that office upon payment of the prescribed fees. You may call the SEC at 1-800-SEC-0330 for further information on the operation of the public reference room and you can request copies of the documents, upon payment of a duplicating fee, by writing to the SEC. In addition, the SEC maintains a web site at http://www.sec.gov that contains reports, proxy and information statements and other information regarding companies, including us, that file electronically with the SEC.

Structured Credit

General

We select, structure and sell credit protection through ACA Financial Guaranty, principally on highly rated liabilities of structured financings, including layers of risk of single tranche transactions and fully distributed CDOs, MBS and ABS transactions. Each liability or layer of risk that we insure generally references a diversified portfolio of corporate financial obligations such as bonds and loans, or structured finance securities. In addition, each layer of risk typically benefits from subordination, which means that we would not be required to make a payment until a pre-negotiated level of losses resulting from defaults on the referenced assets or a substitution of referenced assets has been reached. The pre-negotiated level of losses is referred to as an attachment point.

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We generally assume credit risk in our Structured Credit business by entering into credit swaps with various counterparties, the required payments under which are insured by, and payable under, financial guaranty insurance policies. While generally we receive a fixed payment or premium for the sale of credit protection on a quarterly basis, in certain circumstances we receive a single premium that is paid up front at the time that we enter into such insured credit swap. Additionally, our insured credit swaps typically are secured by contingent collateral arrangements pursuant to which we agree to post collateral to secure our transactions, primarily in the event we experience a corporate credit event such as a downgrade of ACA Financial Guaranty to below an “A-“ financial strength rating. Our willingness to provide such security, combined with our A-rated insurance platform, enhances counterparties’ willingness to do business with us and differentiates our business model from “AAA” rated financial guarantors and similar entities that are typically unable or unwilling to provide such collateral arrangements.

A large portion of our Structured Credit business consists of the insurance of single tranche transactions referencing a portfolio of corporate credits. In these transactions, which we refer to as Collateralized Synthetic Obligations (CSOs), we negotiate with dealers to construct a portfolio of reference entities, our attachment point and the size of our aggregate exposure that we will insure, each in accordance with the risk profile that we are willing to assume based on our risk adjusted return requirements.

For CDO, MBS and ABS transactions, we generally sell protection in the form of insured credit swaps that reference certain tranches of liabilities issued by those structures. Under our insured credit swaps we are obligated to make payments to a protection buyer in the event that the assets purchased in such structures have insufficient cash available to pay principal or interest on the referenced liability, or the assets underlying the referenced liability are written down beyond the enhancement afforded the class of securities insured.

As of December 31, 2006, over 99.7% of our insured credit swap portfolio was constructed of exposures attaching above the “AAA” rated level of subordination. However, beginning in 2005, we have assumed limited amounts of credit risk exposure that would be rated lower than “AAA.” We anticipate some growth in insuring credit exposure lower than “AAA” rated credit profiles when we believe such exposures will meet our risk-adjusted return requirements. We have also grown, and intend to continue to grow our Structured Credit business through the introduction of new asset classes and insurance products, including selling credit protection on single tranches referencing portfolios of MBS with various ratings, selling protection on single-name MBS (with various credit ratings), and executing credit swap transactions that reference the developing ABS indices.

Structured Credit Portfolio

The chart below shows the notional amounts of our insured Structured Credit portfolio as of the end of each quarter in 2006 and as of the end of each year since we closed our first Structured Credit transaction in 2002.

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Historical Notional Amount of Structured Credit Portfolio
(Dollars in billions)

We executed our first Structured Credit transaction in July of 2002. As of December 31, 2006, we had completed 157 transactions with 151 of these outstanding as of December 31, 2006 and our insured Structured Credit portfolio totaled $39.4 billion (in aggregate insured credit swap notional amount). One way in which we manage risk in our insured credit swap portfolio is by means of diversification based on a variety of criteria, including reference rating quality, industry type and geographic location. As of December 31, 2006, our insured credit swaps written on CSO tranches include well over 1,000 reference entities spread across numerous ratings (primarily investment grade) and a wide range of industries and countries. Reference entities domiciled in the United States and outside of the United States comprised 53.7% and 46.3%, respectively, of our aggregate single tranche corporate credit portfolio as of December 31, 2006; of those domiciled outside of the United States, 61.8% constituted European reference entities and 24.6% constituted Asian reference entities. All of our insured credit swaps are denominated in United States dollars except for seven transactions denominated in Euros.

The chart below shows our insured Structured Credit portfolio by deal type as of December 31, 2006:

Counterparties

As of December 31, 2006, we had 28 institutional counterparties in our Structured Credit business. Strengthening and expanding relationships with our counterparties is an important element of our business strategy. We enter into master agreements, standardized by the International Swaps and Derivatives Association, Inc. (ISDA) that govern the basic terms of our transactions with each of our counterparties,

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and a standard form financial guaranty insurance policy, which allows us to capitalize on market fluctuations and execute transactions in a timely and efficient manner.

Transaction Pricing and Loss Experience

The fixed payments that we receive in connection with our transactions are largely determined by the results of our quantitative modeling and credit swap market conditions, both generally and with respect to the particular reference entities included in a given portfolio. Our decision to enter into a particular transaction at a price is framed by our fundamental analysis of the underlying credits and by our proprietary model which considers numerous variables including the asset ratings and credit quality of the portfolio, portfolio industry and geographic concentrations, the explicit or implicit rating on the tranche, and the transaction terms and structural features, including the need for and terms of any potential collateral posting. We analyze our model’s output and the market context of the subject transaction in light of our risk and economic return parameters.

Since establishing our Structured Credit business, we have made no payments in respect of defaults under our insured credit swaps.

Credit Fund

ACA Capital Partners I Master Fund Ltd. and ACA Capital Partners I Ltd. are private investment funds organized under the laws of the Cayman Islands, and collectively, are referred to as the Credit-focused Absolute Return Fixed Income Fund. 100% of ACA Capital Partners I Ltd.’s investments are shares in ACA Capital Partners I Master Fund Ltd. The Credit Fund was created to leverage our expertise in the capital and credit markets and as an asset manager. The Credit Fund seeks to create value by investing in the structured finance, structured credit and corporate credit fixed income markets. As of December 31, 2006, ACA Capital Partners I Master Fund Ltd. had net assets under management of $25.6 million, of which ACA Financial Products, Inc., one of our wholly-owned indirect subsidiaries, owned $17.0 million. The balance of the $25.6 million was owned by outside investors through investments in ACA Capital Partners I Ltd. As of December 31, 2006, the Credit Fund had total assets under management of $264.6 million. The Credit Fund uses repurchase agreements to finance the acquisition of the majority of its assets. The Credit Fund is managed by ACA Management, which is paid a quarterly asset management fee for that portion of the assets managed for third parties. ACA Management is not paid a management fee for that portion of the Credit Fund’s assets managed on our subsidiary’s behalf. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Structured Credit.”

Public Finance

General

We provide financial guaranty insurance through our subsidiary ACA Financial Guaranty, focusing on underserved segments of the public finance market and specific credits which we believe represent strong risk-adjusted value to the Company. Our financial guaranty insurance policies guarantee to investors the payment of the principal and interest on the insured obligation in accordance with the original payment schedule. ACA Financial Guaranty is licensed to write financial guaranty insurance in all 50 states, the District of Columbia, Guam, Puerto Rico and the U.S. Virgin Islands. As of December 31, 2006, we had $6.1 billion gross par outstanding.

Consistent with general market practice, we are typically paid our insurance policy premiums up front. Our premiums are negotiated to capture a portion of the difference in the borrowing cost, or spread, between our insured obligations and the same obligations if issued uninsured. ACA Financial Guaranty is the sole “A” rated financial guarantor.

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From inception through December 31, 2006, we have paid $5.1 million of net losses and loss adjustment expenses which represent less than 1.7% of premiums written on our total Public Finance portfolio.

We generally execute our Public Finance transactions in the form of traditional financial guaranty insurance policies. In each of 2005 and 2006, however, we entered into an insured credit default swap referencing a single Public Finance obligation.

Target Public Finance Market

We target lower investment grade, high non-investment grade and non-rated transactions in the public finance market that we believe, by our analysis, have a strong credit profile and sufficient security to support our expectation of timely payment. Such additional security typically includes liens on the assets funded by the bond proceeds, mortgages on the underlying properties and revenue pledges amongst other forms of security as appropriate, all of which would be available to us in order to satisfy the principal and interest payments in the case of a default.

Our decision to insure a bond issue is only made following a detailed underwriting process. During this process, our underwriters perform quantitative and qualitative risk assessments that include stress testing the transaction to a remote-loss standard, a review of the economic rationale and the motivation of participants, an analysis of relative value and a legal review of the transaction structure. As part of the risk assessment process, the credit analysts also perform an economic analysis of each transaction, including a review of the proposed pricing relative to credit spreads for similar assets available in the market and the return on capital to us based on capital charges assessed by rating agencies. The ultimate decision to guarantee an issue is based upon such credit factors as the issuer’s ability to repay the bonds, the bond’s security features and the bond’s structure. Further, for issues involving substantial construction, we typically require enhanced security, usually through a combination of third-party guarantees such as payment and performance bonds and builder’s risk insurance, and liquidity reserve funds to cover completion and certain stabilization risks. As an “A” rated issuer we have greater flexibility from the rating agencies to select the credits we wish to insure as compared to other participants in the public finance market.

Prior to June 2004, we also participated in the secondary market for municipal bonds. In such cases, a holder of outstanding bonds in the secondary market will purchase financial guaranty insurance to facilitate the future sale of the bonds. Our current business strategy does not include any significant secondary market insurance participation; however, we do employ secondary market executions to supplement existing primary market exposures or in situations where we know the credit fundamentals of a particular issue of municipal bonds through primary underwriting. In the secondary market, the premium is generally payable in full at the time of policy issuance.

Public Finance Portfolio

We seek to maintain an insured portfolio that is designed to manage risk by means of diversification based on a variety of criteria including revenue source, issue size, type of asset, industry concentrations, type of bond and geographic area. As of December 31, 2006, we had 753 municipal policies outstanding relating to 379 unique obligors. Our insured portfolio of bonds is divided into the following major sector types:

Higher Education Bonds.   Higher education bonds include bonds that are secured by revenue collected by either public or private colleges and universities. Such revenue can encompass all of an institution’s revenue, including tuition and fees, or in other cases, can be specifically restricted to certain auxiliary sources of revenue. We also insure bonds issued for privatized student housing projects that benefit colleges and universities. These bonds are issued by not-for-profit entities that may or may not be affiliated with the college or university.

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Health Care Revenue Bonds.   Health care revenue bonds include bonds of healthcare facilities including community based hospitals and systems. To date, our primary focus in this area has been insuring bonds of acute care hospitals that are sole community providers in rural areas or specialty providers of essential services.

Tax-Backed (Non-General Obligation) Bonds.   Tax-backed bonds include a variety of bonds that are supported, not by a general obligation, but instead by a specific tax source, and include tax-backed revenue bonds and general fund obligations of the issuer, such as lease revenue bonds. Tax-backed bonds may be secured by a lien on pledged tax revenues, such as revenues from special taxes, including retail sales and gasoline taxes, or from tax increments (or tax allocations) generated by growth in property values within a district.

Long-Term Care Bonds.   Long-term care bonds that we insure consist primarily of long-term financings for capital construction or improvements of continuing care retirement communities, or CCRCs. CCRCs are organizations that offer a full range of housing, residential supportive services and healthcare to residents of retirement age. We typically insure the debt of CCRCs that have been operating with strong demand and stabilized occupancy or are being built to augment established operations.

General Obligation Bonds.   General obligation or full faith and credit bonds are issued by states, their political subdivisions and other municipal issuers and are supported by the general obligation of the issuer to pay the bonds from available funds and by a pledge of the issuer to levy sufficient taxes to provide for the full payment of the bonds.

Transportation Revenue Bonds.   Transportation revenue bonds include a wide variety of revenue-supported bonds, such as bonds for airports, ports, tunnels, municipal parking facilities, toll roads and toll bridges.

Housing Revenue Bonds.   Housing revenue bonds include affordable multi-family housing bonds, with varying security structures based on the presence of underlying mortgages, reserve funds, and various other features.

Not-For-Profit Bonds.   Not-for-profit bonds include bonds issued by not-for-profit organizations, including museums and other cultural institutions, the deal structures and security packages for which vary among transactions.

Municipal Utility Revenue Bonds.   Municipal utility revenue bonds include obligations of all forms of municipal utilities, including electric, water and sewer utilities and resource recovery revenue bonds. Insurable utilities may be organized as municipal enterprise systems, authorities or joint-action agencies.

Investor-Owned Utilities Bonds.   Pollution control bonds or industrial development bonds are issued to finance projects of investor-owned utilities. The bonds are secured by the senior credit or first mortgage obligations of an investor-owned utility, typically an electric distribution utility.

Other Public Bonds.   Other types of public bonds insured by ACA Financial Guaranty include financings for Native American tribes, stadiums, government office buildings, recreation facilities, prison facilities and mobile home parks. These bond types are typically secured by a combination of project-related fee revenue, lease payments or other support of state or local governmental entities.

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The following table shows the diversification by bond sector type of our gross par exposure insured for the year ended December 31, 2006 and our gross par exposure outstanding as of December 31, 2006:

Insured Public Finance Portfolio by Bond Type
(in millions)

(1)          Debt service balances for the years ended December 31, 2006 and 2005 are $10.9 billion and $11.3 billion, respectively.

The table below sets forth the geographic distribution, by location of the obligor, of our outstanding gross par exposure by the ten largest jurisdictions as of December 31, 2006.

Public Finance Insured Portfolio by State or Territory
(in millions)

As of December 31, 2006, the gross par amount outstanding for our ten largest Public Finance credits, totaling $705.3 million, was 11.5% of our total gross par amount outstanding, with no one credit representing more than 1.7% of our total gross par amount outstanding.

We underwrite financial guaranty insurance on the assumption that the insurance will remain in force until maturity of the insured obligations.

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CDO Asset Management

General

As an asset manager of CDOs we apply our core competencies in analyzing credit risk to construct and manage CDOs on behalf of third party investors for which we earn management fees. Increases in fee revenues generally correspond to increases in assets under management. To grow our assets under management, we sponsor CDOs that acquire pools of fixed income assets that we select and manage through our registered investment adviser subsidiary, ACA Management and, in the future, through ACA Capital Management (U.K.), our FSA regulated investment manager. We completed our first CDO in January 2002 and as of December 31, 2006, we had closed 22 CDO transactions and had grown our CDO assets under management from $2.4 billion as of year-end 2002 to $15.7 billion as of December 31, 2006. In the first quarter of 2007, ACA Capital Management (U.K.) obtained its license to manage CDOs in the United Kingdom and most of Europe. At December 31, 2006, our weighted average asset management fee was 0.23% on total CDO assets under our management. Based on our knowledge of the market, we believe that we are one of the largest global CDO managers as ranked by assets under management.

The chart below reflects assets under management as of December 31 of each year since we closed our first CDO in 2002.

CDO Assets Under Management
(in billions)

We receive multiple revenue streams in connection with our CDO products. We receive fees for structuring the CDOs, fees during the period the CDO assets are accumulated, which we call the warehouse phase, and fees for providing asset management services during the term of the CDO. In 2006, we invested in the equity of only four of our eight newly originated CDOs, ranging from 5% to 11% of the equity sold, which resulted in total equity investments of $8.6 million with respect to the $5.8 billion in CDO assets under management added. We view our equity investments as an opportunity to increase the marketability of our CDOs by aligning our interests as manager with those of our CDO investors. As an equity investor in our CDOs, we generally receive returns in respect of our equity investment from proceeds generated by the underlying collateral in excess of expenses and debt service, including principal payments currently payable on the liabilities issued by the CDO.

Each of our managed CDOs includes a diversified portfolio of financial obligations such as bonds, loans and/or credit swaps that reference individual bonds or loans. We currently sponsor and manage CDOs backed by non-investment grade and investment grade corporate financial obligations, ABS, MBS and other CDO securities, and non-investment grade leveraged loans and bonds. CDOs do not always own their underlying collateral outright but rather, in certain structures, achieve collateral exposure by entering into credit swaps, in which case we refer to the structures as synthetic CDOs. Our corporate credit CDOs and certain of our ABS CDOs are synthetic CDOs. In addition, many of our cash flow CDOs allow for some portion of the underlying exposures to be obtained synthetically through credit swaps.

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At December 31, 2006, we managed over 2,500 credit positions across 52 industries in our CDOs, which are actively monitored by our credit analysts. We have an experienced staff of professionals with backgrounds in insurance, credit analysis, capital markets and risk assessment that services our CDO Asset Management business as well as a strong infrastructure of legal, accounting, information technology and other professionals.

The following tables provide certain information on our CDO assets under management as of December 31 2006:

CDO Assets Under Management

(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.

(2)          Cash flow CDOs are generally callable once per quarter by a majority or greater vote of the equity holders beginning on a specific date as negotiated, which is referred to as the First Optional Call Date.

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(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.

(4)          Tribune is comprised of 13 distinct trades some of which are denominated in Euros or Yen. For purposes of this chart, we have converted the amounts to U.S. dollars at the prevailing currency exchange rates on December 31, 2006.

Origination and Structuring of CDOs

Structuring and Engagement.   We first determine the basic structure of a CDO, including the types of assets that may be included in the collateral acquired in the CDO, the minimum average rating of such assets, the financing costs to be paid to the investment bank for warehousing such assets during the warehousing phase, structuring and management fees to be paid to us and distribution fees for placement of the liabilities to be paid to the investment bank. These arrangements are approved by our internal Risk Management Committee. The Risk Management Committee defines our transactional underwriting guidelines and monitors compliance, reviews portfolio risk management policies and procedures, and approves any credit risk we assume during the warehousing phase and the appropriateness of all fees paid to us. Once we agree on a structure, we engage an investment bank to warehouse the assets and distribute the liabilities.

Warehousing and Credit Selection.   We enter into a warehousing agreement with the investment bank to provide financing for the accumulation of assets to be included in a particular CDO. During the warehousing period, at our direction, the investment bank acquires the securities that will constitute the assets of the CDO and continues to “warehouse” those assets until the transaction is closed and the assets are transferred to the CDO. If the credit quality of any of the selected assets deteriorates during the warehousing phase, we also advise the investment bank as to potential trading opportunities or strategies. The completion of the warehousing stage of a CDO typically takes approximately 30 days for a synthetic CDO and six to nine months for a cash flow CDO, though some asset classes may take a longer period. During this stage, in some transactions we take credit risk on the accumulating assets and therefore, are accountable to pay losses on assets in the portfolio in excess of earnings on the portfolio. The warehouse facility has been provided by a third party in all of our CDO transactions. We have not paid losses on any assets during the warehouse phase of any of our CDO transactions.

Pursuant to an established credit process that includes extensive analysis of the potential assets to be included in a CDO and formalized collateral committee approvals, our credit analysts identify a suitable group of the relevant fixed income securities to collateralize the CDO. For example, in evaluating an ABS for potential inclusion in an ABS CDO, our analysts first perform an extensive review of the credit and performance of the issuer and/or servicer of the ABS. They then prepare a comprehensive written analysis of each proposed ABS for the CDO that focuses on areas such as the underlying collateral, the structure of the ABS, any legal issues and the relative value of the ABS. Once the credit analysis is complete, our analysts make extensive presentations of the results of the analyses and reviews of the potential assets to the appropriate internal collateral committee for approval. See “—Underwriting and Risk Management - Underwriting Committee Process for CDO Asset Management Transactions.”

Obtaining asset allocations on credits approved by us in our targeted credit classes is highly competitive. Our ability to source such opportunities is important to our success. We have developed close relationships with numerous financial intermediaries, investment banks, commercial banks and brokerage firms which provide a source for many of the assets included in our CDOs. We also capitalize on the relationships developed by our senior management and portfolio managers, who have many years of experience in the market, to enhance our access to such assets.

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Placement of CDOs.   Once the warehousing of assets is completed, we work with the investment bank to determine the liability structure of the CDO given the actual portfolio of assets accumulated. The investment banks distribute these liabilities as well as the preferred shares or equity securities that we do not purchase to investors worldwide. The investor base for our CDOs is comprised largely of banks, money managers, hedge funds, non-bank financial institutions, pension funds and insurance companies. The liabilities sold to third party investors have recourse solely to the assets of the CDO; we do not credit enhance any portion of the CDO liabilities for third party investors.

Management of CDO Assets

Investment Strategy.   In structuring and managing our CDO portfolios we seek to diversify among industries, issuers, credit quality, types of instruments and other parameters as required to meet certain tests developed by the rating agencies and necessary to achieve and maintain the desired ratings on the various classes of CDO liabilities. Depending on the size of a CDO, it will typically own or reference in excess of 100 individual assets or reference entities.

As an asset manager, we are responsible for monitoring credits in our CDOs, and, in certain structures, reinvesting principal proceeds received by the CDO from the prepayment of underlying collateral. In constructing and managing our portfolios we generally follow a buy and hold strategy. However, we retain the ability to limit losses in our CDOs by trading deteriorating credits in a timely manner or hedging potential losses. We have adopted a defensive trading strategy and therefore trade primarily to offset deteriorating credit exposures as opposed to trying to improve yield.

Typical Asset Management Agreement Terms.   Under our asset management agreements with each of our CDOs, we are paid management fees quarterly for managing the selection, acquisition and disposition of the underlying collateral and for monitoring the underlying collateral. Our fees are typically divided into a senior fee and a subordinated fee and are paid out of cash flow from the underlying assets to the extent available. The senior fee is payable after certain expenses of the CDO but prior to payment on the CDO liabilities, whereas the subordinated fee is payable after payment of debt service on the CDO liabilities. As of December 31, 2006, we received all contractually agreed-upon senior and subordinated fees. In certain transactions we are also paid an incentive fee to the extent returns on the equity of the CDO exceed an agreed-upon annual rate of return. Generally, our services as asset manager may be terminated without cause by a vote of a majority of the holders of each class of debt securities and the equity tranche. We may also be removed “for cause” upon the occurrence of certain events on the affirmative vote of a majority of the holders of the senior CDO liabilities or a majority vote of the holders of the equity.

Equity Investment

In order to better align the interests of the asset manager with those of the CDO investors, CDO investors typically require that asset managers purchase a portion of the equity, or first loss position, in their CDOs. We do not view these investments as a revenue strategy but rather as an opportunity to increase the marketability of our CDOs and thereby maximize our CDO assets under management. In such circumstances, we purchase a portion of the preferred shares, or, in respect of our synthetic CDOs, enter into insured credit swaps requiring payment (pro rata with other equity holders) up to a certain amount on a first loss basis should defaults occur in the underlying referenced portfolio. While currently we are purchasing our equity positions with cash, in the past we have financed our equity investments, through either the investment bank participating with us in the CDO or other corporate borrowings, and may elect to finance some or all of our equity positions again in the future. Our equity investments, and financing terms, if any, are subject to the approval of our internal Investment Committee.

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While in our early transactions we invested in 100% of the equity tranches of our CDOs, since 2004, our growth in assets under management and historical asset management performance have allowed us to reduce the level of equity investments to between 5% and 25% of the total equity sold in a CDO. As of December 31, 2006, we had completed 22 CDOs, representing $15.7 billion in outstanding CDO assets under management. In 2006, we retained economic exposure through the purchase of equity in four of our eight newly originated CDOs of $8.6 million relative to $5.8 billion CDO assets under management added, which represented 5% to 11% of the equity sold. As of December 31, 2006, our total original equity investment in our CDOs was $209.1 million.

Conflict Resolution

In addition to providing management services to CDOs we originate and structure, we also provide management services to portfolios structured by third parties and provide investment advice to the Credit Fund. We may also enter into new lines of business. We may encounter conflicts of interest in these various roles and interests and between these roles and interests and our proprietary investment interests. We intend to act in a manner which is fair and equitable in allocating business opportunities and have established an allocation and conflict resolution process should conflicts occur; however, because of these potential conflicts, we may not be able to participate in certain opportunities which otherwise meet our business objectives.

Other

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 business line 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. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Other.”

Insured Risk Portfolio

ACA Financial Guaranty assumes credit risk through the issuance of financial guaranty insurance policies across all of our business lines. While we are subject to S&P guidelines and capital adequacy tests which we must meet in order to maintain our “A” rating, as well as internal risk management parameters, our insured risk portfolio contains exposures of various credit qualities.

The tables below set forth ACA Financial Guaranty’s gross par exposure by business line and, within each business line, ACA Financial Guaranty’s gross par exposure by credit quality as of December 31, 2006.

Gross Par Exposure by Business Line

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Gross Par Exposure by Credit Quality

(1)          Ratings assigned are internal credit ratings.

(2)          Exposure percentages do not reflect applicable reinsurance or any collateral posted for the benefit of the insured party.

Underwriting and Risk Management Processes

As a part of our credit analysis fundamental to each of our lines of business, we have adopted formalized underwriting and risk management policies and procedures. These policies and procedures are designed to ensure that the risk profile of a given credit is consistent with our credit standards and that the related transaction affords us adequate profitability and is otherwise appropriate for our portfolio. Our credit assessment, underwriting, risk management and surveillance processes across all of our business lines are designed to limit loss frequency and severity, though we do anticipate some cyclical and idiosyncratic credit event loss activity across our portfolio of credit exposures. Consequently, we place significant emphasis on managing loss severity should losses occur. In our Public Finance line of business, we assume credit risk to the scheduled maturity of the underlying bonds, which are typically long tenure. Our decision to assume credit risk in a particular transaction is based on a rigorous quantitative and qualitative analysis of such transaction and its incremental effect on our existing risk portfolio.

We have a Senior Credit Committee mandated to create and support a rigorous credit culture throughout our company, establish underwriting policies and procedures, define underwriting guidelines and monitor compliance, require appropriate portfolio risk management and approve the assumption of risk and related pricing, including commitments to insure. The Senior Credit Committee consists of seven members, including, among others, our Chief Executive Officer, Chief Financial Officer, General Counsel and Executive Vice President-Head of Institutional Risk Management. An approval by the Senior Credit Committee requires the affirmative vote of the Chief Executive Officer.

Additionally, we have established an internal Risk Management Committee that monitors and seeks to limit our exposure to any one credit on an aggregate basis across our business and our ACA Financial Guaranty investment portfolio. We also employ hedging strategies, which are directed by our Risk Management Committee. The Risk Management Committee is overseen by the Risk Oversight Committee of our Board of Directors. We are also subject to certain regulatory limits and rating agency guidelines on our exposure to a single risk.

Underwriting Committee Process for Structured Credit Transactions

The Senior Credit Committee serves as the principal underwriting committee for Structured Credit. Structured Credit transactions are brought to the Senior Credit Committee by the applicable internal underwriter and reviewed in context of numerous variables, including the credit quality of the portfolio, tranche ratings, transaction terms and structural features, such as the need for and terms of any potential collateral posting. The authority to approve certain transactions with standard pre-approved transactional and counterparty characteristics has been delegated to the Structured Credit Committee. Any member of

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the Senior Credit Committee or the Structured Credit Committee may require that a particular transaction delegated to the Structured Credit Committee be approved by the Senior Credit Committee.

Underwriting Committee Process for Public Finance Transactions

Public Finance transactions are subject to the approval of either the Public Finance Underwriting Committee, which includes, among others, our Chief Executive Officer, our Executive Vice President-Head of Public Finance, our Executive Vice President-Head of Institutional Risk Management and an attorney from the General Counsel’s office, or the Senior Credit Committee. The primary objective of the Public Finance Underwriting Committee is to approve routine Public Finance transactions, whereas approval of the Senior Credit Committee is required for larger transactions or those with non-routine collateral packages or transaction terms.

The Public Finance Underwriting Committee or the Senior Credit Committee, as the case may be, reviews the transaction terms, security package and credit, as well as proposed pricing relative to market spreads and returns on capital based on S&P’s capital charges.

Underwriting Committee Process for CDO Asset Management Transactions

In the case of CDO Asset Management transactions, the applicable portfolio manager seeks approval from our Risk Management Committee for the asset class being managed on behalf of ACA and other third party investors and for the general terms of such management, including the applicable management fees. The acquisition of equity in our CDOs must be approved by the our internal Investment Committee, which is chaired by our Chief Financial Officer, together with the related financing terms, if any. The decision to acquire securities for our CDOs is made by the relevant portfolio manager, however, such acquisitions may only be made from securities that are approved by the related Collateral Committee.

We have three different Collateral Committees. Each of the Collateral Committees is chaired by either the Managing Director - Head of Corporate Credit or the Managing Director—Head of ABS Credit, as applicable.

·       Our ABS Collateral Committee approves assets for all cash flow and synthetic ABS CDO transactions.

·       Our Corporate Credit Committee approves exposure to corporate reference entities for our synthetic corporate CDOs.

·       Our Leveraged Loan Committee approves loans which may be included in our leveraged loan CDOs, or CLOs.

The chairpersons of these committees report to our Chief Financial Officer. The relevant Collateral Committees may elect to approve securities categorically based on specific credit characteristics. Any such categorical approval will require approval of the Risk Management Committee.

Surveillance

Structured Credit and CDO Asset Management Surveillance

We have a dedicated team of credit analysts with, as of December 31, 2006, an average of over 11.5 years of experience in fixed income and corporate credit analysis. We actively monitor the performance of the underlying assets included in our Structured Credit and CDO portfolios. As a part of the monitoring process, we review credit ratings and periodic financial reporting, and track current news, research and monthly asset performance reports, in addition to rating agency reports and actions, among other available sources of information on individual credits. The extent to which we monitor a particular credit is generally determined by the degree of stress that credit is experiencing, and the potential impact

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that a particular credit may have on a given transaction or across transactions and in our ACA Financial Guaranty investment portfolio. We also continually assess and update our systems and the models we employ to analyze the overall impact of credit migrations and actual versus expected cash flow on our portfolios, as well as on our aggregate exposure across our operating business lines and in our investment portfolio.

Structured Credit.   Our proprietary software applications, SARA and ACA Wizard, are the primary applications we use for screening, surveilling and reporting on our Structured Credit transactions. The internal underwriter of a transaction retains primary responsibility for monitoring the performance of that transaction, including available subordination to our tranche of exposure, cash flows, conformance with projections and, in partnership with our credit analysts, the performance of the underlying credits. For our ongoing surveillance, we have established a five-point classification system into which all of our Structured Credit transactions are classified, as follows:

·       Category 1—performing;

·       Category 2—underperforming (the credit is deviating from expected performance, but no default is anticipated; more in depth, and potentially more frequent, review is required);

·       Category 3—continued deterioration (the credit is experiencing recurring and material violations of surveillance and/or covenants and a ratings downgrade has occurred or is expected; these credits are included on our credit monitor list and an action plan is devised and presented to the internal Risk Management Committee);

·       Category 4—potential impairment of principal (the credit is experiencing continued deterioration, operating results and/or enhancement are significantly below projections and a payment default may occur; these credits are presented to the Senior Credit Committee to formulate and approve an appropriate loss mitigation strategy, which is updated quarterly and more frequently as required to the internal Risk Management Committee); and

·       Category 5—impairment of principal (the credit has experienced or is expected to experience a default that will not be cured, resulting in an impairment of principal; a loss mitigation plan is put in place with respect to these credits and reported and updated quarterly and more frequently as required to the internal Risk Management Committee).

All Structured Credit transactions which are classified in Categories 3 through 5 are also reported on a quarterly basis to the Risk Oversight Committee of our Board of Directors.

Our credit analysts and risk management team also specifically review our credit swap portfolios to determine the risk of a default or other credit event of any reference entity included in our portfolios and the impact on the available subordination to our tranche of exposure. If we believe this risk exceeds acceptable levels, depending on the likely impact on our subordination and the overall performance of the relevant portfolio to date, we may seek to reduce or eliminate this credit exposure by removing and substituting reference entities within the relevant portfolio, or hedging our exposure outside of the particular transaction. From time to time, in order to manage our Structured Credit portfolio, we enter into transactions that either unwind prior transactions or assign our position to a third party.

CDO Asset Management.   Our proprietary software applications, SARA and ACA Wizard, are also the primary applications we use for screening, trading, surveilling and reporting on our CDOs. The CDO Asset Management group has adopted the same ratings system with respect to the individual credits in the CDO portfolio as the Structured Credit group applies to its transactions as a whole. Generally, credits are subject to monthly review by the monthly surveillance committee. If certain material events occur concerning the credit, such as a report of negative performance and financial results, a decrease in value of credit enhancement, announced litigation or adverse litigation results, or the occurrence of unexpected

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rating actions, the committee will recommend a reclassification of such credit to the appropriate category as reflected by its then current state of deterioration. Each of the individual credits held in our CDOs in Category 3 through 5 are also reviewed and an investment decision, such as to continue to hold, to sell, or to hedge the exposure, is made. Prior to execution of a trade with respect to any such credit, we perform an evaluation of the relevant CDO portfolio. All credits on the credit monitor list of Category 3 through 5 that are included in CDOs in which we own equity are reported on a quarterly basis to the Risk Oversight Committee of our Board of Directors.

Public Finance Surveillance

Our Public Finance surveillance group is responsible for monitoring outstanding issues of municipal bonds that we insure. The group reviews each credit for relevant changes in the economic or political environment and other criteria that could interrupt the timely payment of debt service on an insured issue of municipal bonds. Additionally, our surveillance group and risk management professionals review our Public Finance portfolio for concentration of risk by (i) specific bond types; (ii) geographic location; and (iii) size of issue. Our surveillance group is also responsible for portfolio analysis, which entails a broader examination of trends in specific asset classes and bond types.

Once an obligation is insured, the surveillance group periodically reviews information relating to each obligor, including audited and interim financial statements. Potential problems uncovered through this review, such as poor financial results, low fund balances, covenant or other trigger violations, trustee or servicer problems, or excessive litigation, could result in an immediate in-depth surveillance review and an evaluation of possible remedial actions. The surveillance group also monitors state and municipal finances and budget developments, and evaluates their impact on issuers of municipal bonds.

We have also established a five-point classification system into which all of our Public Finance credits are classified, as follows:

·       Category 1—performing;

·       Category 2—underperforming (the credit is deviating from expected performance but no default or claim payment by us is anticipated; more in depth review and potentially more frequent review is required);

·       Category 3—declining (the credit is experiencing recurring and material covenant violations and material deviation from operating and cash flow projections, and we may be required to make a claim payment in the long term; these credits are referred to our director of recovery management and an attorney in our legal department for continued monitoring who, together with surveillance and underwriting personnel, develop an action plan that is then reported to the managing director of surveillance and periodically updated to the loss mitigation committee);

·       Category 4—deteriorating (the credit is experiencing a material decline in creditworthiness and ability to pay, and draws upon debt service reserve funds indicate that we may be required to make payment of a claim in the foreseeable future; heightened involvement/review by the director of recovery management is required as are more frequent updates of loss mitigation strategies to the loss mitigation committee); and

·       Category 5—claim(s) paid or imminent (claims have been or will be paid pursuant to a payment default of the underlying obligor on the municipal bond; the director of recovery management has continued responsibility for implementing loss mitigation strategies and frequent reporting, and these credits are subject to write-offs and case basis reserves as determined to be appropriate).

Generally, Category 1 credits are reviewed annually and Category 2 credits are reviewed semi-annually. Category 3 credits are reviewed quarterly, except that negatively trending Category 3 credits and

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all Category 4 and 5 credits are reviewed monthly or more frequently consistent with any related action plan. All credits classified as Categories 3 through 5 are also reported on a quarterly basis to the Risk Oversight Committee of our Board of Directors. In the event a periodic review of a given credit reflects that the credit is not performing as expected, or if an unexpected material event occurs that may adversely affect the related obligor’s ability to pay debt service, such as damages pursuant to natural disasters, adverse litigation, the loss of tax revenues due to voter initiatives, or unexpected rating actions, surveillance will recommend a reclassification of such credit to the appropriate category as reflected by its then-current state of deterioration. Our loss mitigation committee, which includes our Chief Executive Officer, Executive Vice President-Head of  Public Finance, Managing Director-Head of Public Finance Surveillance, Executive Vice President-Head of  Institutional Risk Management and Senior Managing Director and Chief Accounting Officer, among others, oversees the loss mitigation efforts of the director of recovery management and the Public Finance surveillance group and periodically reviews and confirms the recommended classifications of our Public Finance credits.

ACA Financial Guaranty’s Rating

Our insurance subsidiary’s financial strength rating is an important factor in establishing our competitive position in the public finance and structured credit market. The value of ACA Financial Guaranty’s financial guaranty insurance policy is a function of the “rating” applied to the obligations insured. The rating also provides necessary credit support to our counterparties in our Structured Credit business who, in entering into the credit swaps, rely on the insurance provided in these transactions by ACA Financial Guaranty. From time to time, we also employ the rating to support our general corporate financing activities, including our outstanding medium-term note obligations and certain outstanding notes issued in connection with the financing of certain CDO equity investments. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Indebtedness.” ACA Financial Guaranty’s financial strength is rated “A” (“strong,” the sixth highest of twenty-one rating levels) by S&P.

This rating reflects only the views of S&P and is subject to revision or withdrawal at any time. A financial strength rating is an opinion regarding the financial security characteristics of an insurance or reinsurance organization with respect to an insurer’s ability to pay under its insurance policies and contracts in accordance with their terms. The opinion is not specific to any particular policy or contract. Financial strength ratings do not refer to an insurer’s ability to meet non-insurance or non-reinsurance obligations and are not a recommendation to purchase or discontinue any policy or contract issued by an insurer or to buy, hold, or sell any security issued by an insurer or any parent company of any insurer or reinsurer.

S&P has developed and published rating guidelines for rating financial guaranty insurers and reinsurers. The financial strength rating assigned by S&P is based upon factors relevant to policyholders and is not directed towards the protection of investors in our common stock. The rating criteria used by S&P in establishing its ratings include consideration of the sufficiency of capital resources to meet projected growth (as well as access to such additional capital as may be necessary to continue to meet applicable capital adequacy standards), a company’s overall financial strength, business plan and strategy, and demonstrated management expertise in financial guaranty and traditional reinsurance, credit analysis, systems development, marketing, capital markets and investment operations.

Reinsurance

State insurance laws and regulations (as well as the rating agencies) impose minimum capital requirements and single risk limits on financial guaranty insurance companies, limiting the aggregate amount of insurance which may be written and the maximum size of any single risk exposure which may be assumed. Financial guaranty insurance companies can use reinsurance to diversify risk, increase

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underwriting capacity, reduce capital needs and strengthen financial ratios. Although our use of reinsurance has been limited, from time to time, ACA Financial Guaranty may employ a variety of reinsurance structures to help manage risk or to comply with single risk or other regulatory requirements. As of December 31, 2006, we had ceded an aggregate of $53.7 million of facultative reinsurance in respect of Public Finance bond insurance policies we issued in order to reduce our single risk exposure to those credits, and additionally have obtained catastrophic coverage through an excess of loss reinsurance policy.

Investment Portfolio

Our investment portfolio primarily consists of the assets of ACA Financial Guaranty and the assets of our consolidated transactions, including our CDOs and the Credit Fund. The following discussion relates to the assets in ACA Financial Guaranty’s investment portfolio. Our principal objective in managing such investment portfolio is to generate an optimal level of after-tax investment income while preserving ACA Financial Guaranty’s “A” financial strength rating, to maintain adequate liquidity and to minimize the correlation with insurance risk. The investment policy is set by the Audit and Investment Committee of our Board of Directors, and ACA Financial Guaranty’s investment portfolio is managed by outside professional money managers. To accomplish our objectives, we have established guidelines for building a portfolio of high-quality fixed income investments, requiring that such investments be rated at least “BBB-” at acquisition and the overall portfolio be rated “A+” on average. The portfolio may continue to hold fixed income investments falling below the minimum quality level with approval of our internal Investment Committee. Eligible fixed income investments include, but are not limited to, U.S. Treasury and agency obligations, corporate bonds, municipal bonds and asset and mortgage backed securities. The following tables set forth certain information concerning our fixed maturity securities investment portfolio.

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The following table reflects the composition of our non-Variable Interest Entity (“VIE”) investment portfolio, by security type:

Non-VIE Investment Portfolio by Security Type(1)

(1)          Excludes assets related to our consolidated CDOs.

The following table reflects our non-VIE investment portfolio results for each year in the three-year period ended December 31, 2006:

Non-VIE Investment Results(1)(2)

(1)          Excludes assets and results related to our consolidated CDOs.

(2)          Includes cash and short-term investments.

(3)          Excluding investment expenses and realized investment gains (losses).

(4)          Investment income for the period divided by average invested assets for the same period.

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ACA Financial Guaranty’s investment portfolio is invested primarily in fixed income securities. The following table shows our non-VIE investment portfolio by comparable rating as of December 31, 2006:

Non-VIE Investment Portfolio by Rating(1)(2)(3)

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

(2)          Excludes assets related to our consolidated CDOs.

(3)          Includes cash and short-term investments.

The following table indicates the composition of our non-VIE fixed income security portfolio by time to maturity as of December 31, 2006:

Distribution of Non-VIE Investments by Maturity(1)(2)(3)

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

(2)          Excludes assets related to our consolidated CDOs.

(3)          Includes cash and short-term investments.

Additionally, we have proceeds from our initial public offering (the “IPO”) that we currently invest in short-term investments.

Regulation

The following summary is based upon current law and is provided for general information only.

ACA Financial Guaranty Corporation

ACA Financial Guaranty is licensed to provide financial guaranty insurance in the State of Maryland (its state of incorporation), as well as in each of the other 49 states, the District of Columbia, Guam, Puerto Rico and the U.S. Virgin Islands. The operations of ACA Financial Guaranty are subject to

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regulation by the departments of insurance in all of those jurisdictions. The extent of state insurance regulation and supervision varies by jurisdiction, but Maryland, New York and most other jurisdictions have laws and regulations prescribing minimum standards of solvency, including minimum capital requirements and business conduct that must be maintained by licensed insurance companies. These laws prescribe permitted classes of risks which may be written and limitations on the size of risks which may be insured. In addition, some state laws and regulations require the approval or filing of policy forms and rates. ACA Financial Guaranty is required to file detailed annual and quarterly financial statements with the Maryland Insurance Administration and similar supervisory agencies in each of the other jurisdictions in which it is licensed. These financial statements are prepared in accordance with Statutory Accounting Principles, or SAP, and procedures prescribed or permitted by the insurance departments in the jurisdictions in which ACA Financial Guaranty is licensed to do business. The operations and accounts of ACA Financial Guaranty are subject to examination by these regulatory agencies at regular intervals. The Maryland Insurance Administration conducts an examination of insurance companies domiciled in Maryland every five years. On January 19, 2007, the Maryland Insurance Administration issued its final report in respect of its examination of ACA Financial Guaranty for the period 1998 through 2003.

Maryland Financial Guaranty Insurance Law.   Title 31 of the Code of Maryland Regulations establishes, with respect to the transaction of financial guaranty insurance, single and aggregate risk limits, limits on the types of debt instruments and monetary obligations which may be insured, and contingency reserve funding requirements. These limits and reserve requirements are similar to those contained under Article 69 of the New York Insurance Law as described below, which also applies to our financial guaranty insurance policies by virtue of our doing business as a foreign insurer in New York. ACA Financial Guaranty is also subject to the laws and regulations governing financial guaranty in the jurisdictions other than Maryland and New York in which it transacts the business of financial guaranty insurance. The laws and regulations of these other jurisdictions governing financial guaranty insurance are generally not more stringent in any material respect than Article 69 of the New York Insurance Law.

New York Financial Guaranty Insurance Law.   Article 69 of the New York Insurance Law, or Article 69, is a comprehensive financial guaranty insurance statute that governs all financial guaranty insurers licensed to do business in New York, including ACA Financial Guaranty. This statute limits the business of financial guaranty insurers to financial guaranty insurance and related lines, such as certain types of surety.

Article 69 requires that financial guaranty insurers maintain a special statutory accounting reserve called the contingency reserve to protect policyholders against the impact of excessive losses occurring during adverse economic cycles. Article 69 requires ACA Financial Guaranty to provide a contingency reserve quarterly on a pro rata basis over a period of 20 years for municipal bonds, special revenue bonds and industrial development bonds, and 15 years for all other obligations in an amount equal to the greater of 50% of premiums written for the relevant category of insurance or a percentage of the principal guaranteed (varying from 0.55% to 2.50%, depending upon the type of obligation guaranteed), until the contingency reserve amount for the category equals the applicable percentage of net unpaid principal. Under statutory accounting policies, this reserve must be maintained for the periods specified above, except that reductions by the insurer may be permitted under specified circumstances if actual incurred losses exceed certain thresholds or if the reserve accumulated is deemed excessive in relation to the insurer’s outstanding insured obligations. Financial guaranty insurers also are required to maintain an unearned premium reserve as well as reserves for losses and loss adjustment expenses for insured obligations that have already defaulted.

Article 69 establishes single risk limits for financial guaranty insurers applicable to all obligations issued by a single entity and backed by a single revenue source. For example, under the limit applicable to each qualifying issue of ABS issued by a single entity and for each pool of consumer debt obligations, the lesser of (1) the insured average annual debt service for a single risk or (2) the insured unpaid principal

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(reduced by the extent to which the unpaid principal of the supporting assets and, provided the insured risk is investment grade, the excess spread, exceed the insured unpaid principal), divided by nine, net of qualifying reinsurance and collateral, may not exceed 10% of the sum of the insurer’s policyholders’ surplus and contingency reserve, subject to certain conditions. Under the single risk limit applicable to municipal obligations, the insured average annual debt service with respect to a single issuer, net of qualifying reinsurance and collateral, may not exceed 10% of the sum of the insurer’s policyholders’ surplus and contingency reserve. In addition, insured principal of municipal obligations attributable to any single issuer, net of qualifying reinsurance and collateral, is limited to 75% of the insurer’s policyholders’ surplus and contingency reserve. Single risk limits also are specified for other categories of insured obligations and generally are more restrictive than those listed for asset-backed or municipal obligations.

Article 69 also establishes aggregate risk limits on the basis of aggregate net liability insured as compared to policyholders’ surplus and contingency reserves. Aggregate net liability is defined as outstanding principal and interest of guaranteed obligations insured, net of qualifying reinsurance and collateral. Under these limits, policyholders’ surplus and contingency reserves must not be less than a percentage of aggregate net liability equal to the sum of various percentages of aggregate net liability for various categories of specified obligations. The percentage varies from 0.33% for certain municipal obligations to 4.00% for certain non-investment grade obligations.

In addition, Article 69 requires 95% of ACA Financial Guaranty’s outstanding total liability on municipal bonds, special revenue bonds and industrial development bonds, net of reinsurance and collateral, to be investment grade.

Maryland Insurance Holding Company Law.   ACA Financial Guaranty is subject to regulation under Maryland’s insurance holding company statute. The holding company statute requires ACA Financial Guaranty to register and file certain reports describing, among other information, our capital structure, ownership, financial condition and transactions with affiliates. The holding company statute also generally requires prior approval of changes in control, the payment of certain dividends and other inter-company transfers of assets, and of certain transactions between ACA Financial Guaranty and its affiliates, including us. The holding company statute imposes standards on certain transactions between ACA Financial Guaranty and related companies that include that all transactions be fair and reasonable, be appropriately recorded in the books of both parties and be appropriately accounted for, and requires prior regulatory approval for transactions not in the ordinary course of business that exceed specified limits.

The holding company statute prohibits any person from acquiring control of us or ACA Financial Guaranty unless that person has filed a notification with specified information with the Maryland Insurance Commissioner and has obtained the Commissioner’s prior approval. Under the Maryland statute, acquiring ten percent or more of the voting stock of an insurance company or its parent company is presumptively considered a change of control, although such presumption may be rebutted. Accordingly, any person who acquires, directly or indirectly, ten percent or more of our voting securities without either the prior approval of the Maryland Insurance Commissioner or a filed and approved disclaimer of control will be in violation of this law and may be subject to injunctive action. In addition, many U.S. state insurance laws require prior notification of state insurance departments of a change in control of a non-domiciliary insurance company doing business in that state. While these pre-notification statutes do not authorize the state insurance departments to disapprove the change in control, they authorize regulatory action in the affected state if particular conditions exist, such as undue market concentration. Any future transactions that would constitute a change in control of ACA may require prior notification in those states that have adopted pre-acquisition notification laws.

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These laws may discourage potential acquisition proposals and may delay, deter or prevent a change in control of ACA, including through transactions, and in particular unsolicited transactions, that some or all of our stockholders might consider to be desirable.

·       Dividends.   ACA Financial Guaranty must give ten days’ prior notice to the Maryland Insurance Commissioner of its intention to pay any ordinary dividend or make any ordinary distribution. Ordinary dividends and ordinary distributions refer to any dividend or distribution other than an extraordinary dividend or extraordinary distribution (as defined below). The Maryland Insurance Commissioner has the right to prevent such an ordinary dividend or distribution if he determines, in his discretion, that after the payment thereof, ACA Financial Guaranty’s policyholders’ surplus would be inadequate or could cause ACA Financial Guaranty to be in a hazardous financial condition. In the past, the Maryland Insurance Commissioner has consented to the payment of dividends by ACA Financial Guaranty sufficient to make interest payments on the debt service of $40 million of our indebtedness, the proceeds of which were contributed to ACA Financial Guaranty.

Under Maryland insurance law, ACA Financial Guaranty must provide the Maryland Insurance Commissioner with at least 30 days’ prior notice before paying an “extraordinary dividend” or making an “extraordinary distribution.” Extraordinary dividends and extraordinary distributions are dividends or distributions that, together with any other dividends and distributions paid during the immediately preceding 12-month period, would exceed the lesser of:

ten percent of ACA Financial Guaranty’s statutory policyholders’ surplus (as determined under SAP as of December 31 of the prior year); and

ACA Financial Guaranty’s net investment income excluding realized capital gains (as determined under SAP) for the 12-month period ending on December 31 of the prior year and pro rata distributions of any class of ACA Financial Guaranty’s own securities, but including any amounts of net investment income (excluding realized capital gains) in the three calendar years prior to the preceding calendar year that have not already been paid out as dividends.

These statutory limitations are subject to change. ACA Financial Guaranty may not pay extraordinary dividends or make extraordinary distributions until either the 30-day notice period has expired (without the Maryland Insurance Commissioner disapproving such payment) or the Maryland Insurance Commissioner has approved the payment within that period.

ACA Financial Guaranty may pay extraordinary dividends only out of positive earned surplus. “Earned surplus” is defined as that part of surplus that, after deduction of all losses, represents the net earnings, gains, or profits that have not been distributed to stockholders as dividends, transferred to stated capital or to capital surplus or applied to other permissible purposes, but does not include unrealized capital gains or reevaluation of assets. At December 31, 2006, ACA Financial Guaranty had a negative earned surplus of $109.7 million primarily due to the formula-driven calculations which assign surplus to contingency reserves based on our portfolio of insurance exposures. As a result, ACA Financial Guaranty is currently unable to pay extraordinary dividends until it has a positive earned surplus calculated on a SAP basis. Further, due to the nature of the calculation as applied to our business, increases in U.S. GAAP income will not necessarily result in positive earned surplus.

A surplus note is a subordinated debt instrument issued by an insurer, with the approval of the Maryland Insurance Commissioner, which, for regulatory purposes, is treated as policyholders’ surplus. The claims of the holder of a surplus note are subordinate to the claims of policyholders, insurance claimants and beneficiaries and to all other classes of creditors other than surplus note holders. In the case of a Maryland domestic insurer, payment of principal and interest on any surplus note is subject to the prior approval of the Maryland Insurance Commissioner. The Maryland Insurance Commissioner has in

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the past approved interest payments on a $10 million surplus note ACA Financial Guaranty issued to us in December 2004.

The foregoing dividend limitations are determined in accordance with SAP, which generally produce statutory earnings in amounts less than earnings computed in accordance with U.S. GAAP. Similarly, policyholders’ surplus, computed on a SAP basis, will normally be less than net worth computed on a U.S. GAAP basis.

·       Guaranty Funds.   Guaranty fund laws in most states require insurers transacting business in the state to participate in guaranty associations, which pay claims of policyholders and third-party claimants against impaired or insolvent insurance companies doing business in the state. In most states, insurers licensed to write only municipal bond insurance, financial guaranty insurance and other forms of surety insurance, such as ACA Financial Guaranty, are exempt from assessment by these funds and their policyholders are prohibited from making claims on these funds.

·       Credit Risk Exposure Limits.   Under Maryland insurance law, “A” rated financial guaranty insurance companies total liability, net of qualifying reinsurance and collateral, for municipal bonds, special revenue bonds and industrial development bonds must be 70% investment grade unless otherwise approved by the Maryland Insurance Commissioner. The Maryland Insurance Commissioner has approved an order permitting ACA Financial Guaranty to maintain 60% of its total liability of municipal bond, special revenue bond and industrial development bond exposure, net of qualifying reinsurance and collateral, in investment grade credits.

Other Applicable Insurance Regulatory Laws

·       Premium Rates and Policy Forms.   ACA Financial Guaranty’s premium rates and policy forms are subject to regulation in every state in which it is licensed to transact business in order to protect policyholders against the adverse effects of excessive, inadequate or unfairly discriminatory rates and to encourage competition in the insurance marketplace. In most states, premium rates and policy forms must be filed either prior to or shortly after their use. In some states, such rates and forms also must be approved prior to use. Changes in premium rates are subject to justification, generally on the basis of the insurer’s loss experience, expenses and future trend analysis.

·       Reinsurance.   Certain restrictions apply under the laws of several states to any licensed company ceding business to an unlicensed reinsurer. Under such laws, if a reinsurer is not admitted or approved in such states, the company ceding business to the reinsurer cannot take credit in its statutory statements for the risk ceded to such reinsurer absent compliance with certain reinsurance security requirements. These security requirements apply to any reinsurance agreements between ACA Financial Guaranty and an unlicensed reinsurer.

·       Investment.   Under Maryland insurance law, ACA Financial Guaranty may invest in only certain permitted investments and only up to specified amounts. Failure to comply with these investment limitations would cause investments exceeding regulatory limitations to be treated as non-admitted assets for purposes of measuring surplus in accordance with SAP, and in some instances, could require divestiture of such non-qualifying assets. In addition, pursuant to Maryland insurance law, ACA Financial Guaranty may make an investment only if it is approved (or made pursuant to approved guidelines) by ACA Financial Guaranty’s board of directors or the committee of ACA Financial Guaranty’s board of directors that is responsible for supervising or making such investment. Although it is not domiciled in New York, ACA Financial Guaranty must remain in substantial compliance with New York insurance law limitations on investments in order to retain its license there.

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Bermuda Insurance Subsidiaries

ACA Assurance Ltd. and ACA Solutions Ltd. are licensed in Bermuda to write insurance and reinsurance, respectively, and are not admitted to do business in any jurisdiction other than Bermuda. ACA Assurance’s activities are limited to certain discontinued lines of business and ACA Solutions has no current activities. The insurance laws of each state of the United States and of many other jurisdictions regulate the sale of insurance within their jurisdictions by alien insurers, such as ACA Assurance and ACA Solutions. ACA Assurance and ACA Solutions intend to conduct their business so as not to be subject to the licensing requirements of insurance regulators in the United States or elsewhere (other than Bermuda).

ACA Assurance and ACA Solutions are subject to regulations under the Bermuda Insurance Act of 1978, or Insurance Act, and are registered as insurers by the Bermuda Monetary Authority, or the BMA. The Insurance Act imposes on Bermuda insurance companies solvency and liquidity standards and auditing and reporting requirements as well as certain restrictions on the payment of dividends. The Insurance Act also grants to the BMA powers to supervise, investigate and intervene in the affairs of insurance companies.

ACA Management, L.L.C.

Our asset management subsidiary, ACA Management, is registered with the SEC as an investment adviser under the Investment Advisers Act and is subject to the provisions of the Investment Advisers Act of 1940, or the Investment Advisers Act, and the SEC’s regulations promulgated thereunder. The Investment Advisers Act imposes numerous obligations on registered investment advisers relating to, among other things, fiduciary duties to clients, engaging in transactions with clients, maintaining an effective compliance program with respect to its personnel, performance fees, solicitation arrangements, conflicts of interest, allocations of assets, best execution on pricing, advertising, and recordkeeping, reporting and disclosure requirements. The SEC is authorized to institute proceedings and impose sanctions for violations of the Investment Advisers Act, ranging from fines and censure to termination of an investment adviser’s registration.

ACA Capital Management (U.K.) Pte. Limited

ACA Capital Management (U.K.) provides investment management services in and from the United Kingdom under the regulation of the FSA. In addition to monitoring and regulating ACA Capital Management (U.K.) to ensure it is complying with the regulatory requirements of the Financial Services and Markets Act 2000 (“FSMA”) and certain other European Union directives, the FSA, among other things, approves the individuals who carry out particular “controlled” functions on behalf of ACA Capital Management (U.K.) and regulates the acquisition of “control” of ACA Capital Management (U.K.). Under the FSMA, any person proposing to acquire “control” (i.e., any company or individual directly or indirectly acquiring 10% or more of the shares of, or having the right to exercise or control the exercise of 10% or more of the voting power in ACA Capital Management (U.K.)) must give prior notification to the FSA of its intention to do so. The FSA has extensive powers to intervene in the affairs of an authorized person, culminating in the ultimate sanction of the removal of authorization to carry on a regulated activity. The FSMA imposes on the FSA statutory obligations to monitor compliance with the requirements imposed by FSMA, and to enforce the provisions of FSMA related rules made by the FSA. The FSA also has the power to prosecute criminal offenses arising under FSMA, and to prosecute insider dealing and breaches of money laundering regulations. The FSA’s stated policy is to pursue criminal prosecution in all appropriate cases.

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In addition, ACA Capital Management (U.K.) has obtained the right to operate on a passport basis allowing it to conduct its asset management business in European Union states in addition to the United Kingdom without the necessity of additional licensing or authorization in such other European Union jurisdictions. Although ACA Capital Management (U.K.) is principally regulated by the FSA, should it elect to conduct business in other European Union jurisdictions pursuant to its passport, it may have to comply with certain local rules in those jurisdictions.

Competition

All of our business lines are highly competitive, although each line has a different competitive dynamic.

Structured Credit Business.   The business of selling credit protection in the form of credit swaps is a quickly evolving and highly competitive market. Competition is based on many factors, including the general reputation of a counterparty, execution quality and efficiency, perceived financial strength of the protection seller and willingness to post collateral under certain circumstances, pricing and other terms and conditions of the transaction. We compete with hedge funds, insurance companies including financial guarantors that, like ACA Financial Guaranty, insure the obligations of subsidiaries providing credit protection through swaps, banks, derivative products companies such as Athilon Capital Corp. and non-bank financial institutions.

Public Finance Business.   As the sole “A” rated financial guarantor, our target market in our Public Finance line of business is different than that of other financial guarantors. We do not compete directly with “AAA” rated financial guarantors. Radian Group Inc., as the only “AA” rated financial guarantor, is able to participate in our target market, although to a lesser degree than we are. Our strongest competition in our target market is from letter of credit banks and high-yield municipal mutual funds that purchase uninsured non-investment grade municipal obligations. We also compete with structural alternatives to third-party credit enhancement, including senior-subordinated structures. These structural alternatives compete on price, quality of execution, reputation and structural advantages.

CDO Asset Management Business.   The financial services industry, and in particular, the market for CDO Asset Management services, is highly competitive with low barriers to entry. The key competitive factors are the historical performance of our portfolios, our underwriting processes for the acquisition of credits and the quality of our portfolio management and credit analyst teams. Our competitors include The TCW Group, Inc., Vanderbilt Capital Advisors, LLC, Blackrock Financial Management, Inc. and GSC Partners, among many financial institutions. Many of these companies have greater financial resources and are more established and well known in the CDO market than us.

Employees

As of December 31, 2006, we had 115 full-time employees. None of our employees are covered by collective bargaining agreements. We consider our employee relations to be good.

The data included in this Item 1 and elsewhere in this report regarding markets and product categories, including, but not limited to, the size of certain markets and product categories, are based on our estimates and definitions, which have been derived from third party sources and management’s knowledge and experience in the areas in which the relevant businesses operate. We have given market data for which the most recent information is available, which may be a different time period for different markets. We believe that these sources, in each case, provide reasonable estimates. However, market data is subject to change and cannot be verified with certainty due to limit, on the availability and reliability of raw data, the voluntary nature of the data gathering process and other limitations and uncertainties inherent in any statistical survey of market shares. In addition, we may define our markets in a way that may be different from how third parties, including our competitors, define various markets in which we participate.

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Item 1A.                Risk Factors.

You should carefully consider the following information, together with the other information contained in this Annual Report on Form 10-K. The risks and uncertainties described below are not the only ones we face. Additional risks that we currently do not know about or deem to be immaterial may also impair our business or results of operations. Any of the risks described below could result in a significant or material adverse effect on our results of operations or financial condition.

Risks Related to Our Business

Our failure to effectively analyze and monitor credit and other risks could have a material adverse effect on our financial condition, results of operations and capital adequacy.

Our ability to analyze, monitor and manage credit risk is at the core of each of our business lines. All of our business lines will be materially impacted if we fail to do this effectively.

In our Structured Credit business, if we fail to accurately analyze the credit and other risks associated with selling credit protection through our financial guaranty insurance products in our Structured Credit line of business, we may suffer unexpected losses, which could materially and adversely affect our results of operations and financial condition.

Our Public Finance business also depends significantly on our ability to effectively analyze and monitor credit risks. We guarantee obligations over an extended period of time, typically up to 30 years, and in riskier credit rating categories and sectors than the other financial guaranty insurance companies. As of December 31, 2006, based on our risk management internal rating systems, 35.2% of our outstanding Public Finance net par exposure was rated non-investment grade. We have also targeted certain industry sectors, such as health care and long-term care, which are higher risk credits than those exposures typically taken by other financial guaranty insurers. We have in the past, and expect in the future to, incur losses in our Public Finance portfolio. If we do not accurately assess the credit risk and the related security and structural protections in these transactions and effectively monitor and manage these risks on an ongoing basis, we may incur significant losses in excess of our expectations.

Our future success in structuring and managing CDOs will depend on our ability to accurately analyze the financial assets that comprise the CDOs. We manage our CDO portfolio by attempting to sell deteriorating credits in a timely manner in order to mitigate losses as they develop; however, we may not be able to do so or we may not be able to do so without incurring losses. If we do not effectively manage our CDOs, our reputation as a CDO asset manager could be negatively affected, which could materially and adversely affect our ability to originate future CDOs. In some cases, we also bear a portion of the risk associated with credit losses if there are defaults or assets otherwise become ineligible for inclusion in a CDO during the warehousing phase. See “Business—CDO Asset Management—Origination and Structuring of CDOs.” Furthermore, since we also own at least some portion, or in our earlier CDOs, all or most, of the first loss or equity tranche in our CDOs, if we experience losses in excess of our modeled expectations we could experience returns below our expectations or lose a portion or all of our equity interests in those CDOs. Our original aggregate first loss, or equity, position in our CDOs was $209.1 million as of December 31, 2006.

We face risks from the concentration of our liabilities and investments.

We face concentration risks in all of our businesses. While we seek diversification across our businesses, in each of our business lines and in ACA Financial Guaranty’s investment portfolio, we face risks to the extent that our aggregate exposure to losses is concentrated geographically, by industry, sector, obligor or type of credit or investment.

A large portion of the financial assets included in our CDOs are residential MBS, or RMBS, which present concentration risk to the national housing market. As of December 31, 2006, there was

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$10.4 billion of RMBS in our CDO assets under management. Current market trends indicate higher delinquency and foreclosure rates in the 2006 vintage of sub-prime residential mortgages. As of December 31, 2006, six of our 22 CDOs in which we owned equity had material exposure to the 2006 sub-prime vintage. Four of these CDOs assume exposure to RMBS below the A-/A3 level and ACA has an aggregate exposure to them of approximately $55.7 million, and two of these CDOs assume exposure to RMBS at or above the A-/A3 level ACA has an aggregate exposure to them of approximately $35.5 million. Depending on the severity of actual defaults on the 2006 vintage subprime mortgages underlying these RMBS, we may experience substantially reduced returns on our equity investments in these CDOs. Further, we cannot be certain that actual defaults will not exceed our expectations based on our modeled scenarios and that we will not sustain actual losses in respect of some or all of our equity in these six CDOs. In addition, poor performance in our CDOs relating to this issue could also hurt out reputation as an asset manager making it difficult for us to continue to originate CDOs in the future. As well, to the extent our CDOs continue to acquire RMBS, there is no certainty as to how future vintages of residential mortgages will perform. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—CDO Asset Management.”

Additionally, some of the mortgages underlying our other CDO exposures include interest only payments which are due to reset in the coming years. The reset of these mortgages to include interest plus principal payments may also cause an increase in obligor defaults of these mortgages. In addition, a significant portion of the assets securing the RMBS that we buy are secured by mortgages on properties in California and to a lesser extent in New York and Florida. Should one of those states specifically experience an economic downturn or natural disaster resulting in significant defaults on mortgages issued in that state, certain RMBS purchased into our CDOs may also experience defaults or lower market values. The occurrence of defaults in RMBS, could materially negatively impact the performance of our CDOs generally, making it difficult for us to continue to sponsor CDOs, and cause us to experience returns below our expectations on, or lose a portion or all of, our equity investment in our CDOs. A lower rate of appreciation of home values, or depreciation of home prices, either nationally or regionally, particularly in areas where we have concentrated exposure, may increase the severity of the economic impact of this risk. We also have exposure to RMBS underlying our insured credit swaps in our Structured Credit business. Should there be significant defaults on mortgages underlying RMBS in such insured credit swaps, we could also experience an increased number of credit events in our synthetic ABS structured credit transactions.

Our corporate synthetic CDOs, CLOs and Structured Credit transactions may include concentrations in particular industries or in geographical regions or in highly correlated industries and geographical regions. In the event that a particular industry or region experiences an economic downturn or natural disaster, the performance of our synthetic CDOs or CLOs may be materially negatively impacted. We may also experience significant numbers of credit events in relation to the reference entities included in the portfolios against which we sell protection in our Structured Credit transactions. Should such events occur, we could experience returns below our expectations on, or lose a portion or all of our equity investments in, our CDOs. Such an occurrence could harm our ability to continue to originate CDOs. Each of these events could materially and adversely impact our liquidity position as well as the adequacy of our capital.

In our Public Finance business we face default risk from the concentration of our exposure in certain states and in certain industries. As of December 31, 2006, $1,020.2 million, or 16.6%, of our outstanding gross par exposure was concentrated in California, and $2,659.2 million, or 43.4%, of our outstanding gross par exposure was concentrated in nine additional states. This concentration increases our vulnerability to economic downturns, natural disasters, or terrorist attacks in those states. In addition, as of December 31, 2006, $1,504.2 million, or 24.5% of our outstanding gross par exposure, was related to higher education and $1,545.2 million, or 25.2%, of our outstanding gross par exposure was in the healthcare and long-term care sectors. Both the health care and long-term care sectors are facing rising costs and revenue constraints. As a result, health care and long-term care are perceived to be higher risks than other

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segments of the public finance market. These factors could undermine the assumptions we made in our credit analysis of the issuers in those sectors and cause actual losses to exceed estimated losses.

General economic and market factors may materially adversely affect our loss experience, the demand for our products and our financial results.

Our business is impacted by general economic and market conditions. We could experience decreased demand for our products or incur losses due to extended economic recessions, business failures, interest rate changes or volatility, credit spread volatility, capital markets volatility, or changes in investor perceptions about the value of CDO securities or financial guaranty insurance products, or combinations of such factors. Additionally, terrorist attacks of significant scale could cause volatility in the financial markets, particularly in the credit markets, and uncertainty in the economies of the areas in which they occur and in the global economy.

The market for the sale of credit protection under insured credit swaps and, consequently, related premiums are affected by a number of economic and market factors not within our control. The occurrence of credit events with respect to reference entities, for instance, such as bankruptcy or the failure to pay indebtedness, may be caused by cyclicality of the economy in general, industry cyclicality or credit events within the industry and capital market volatility generally, which may impact the supply and demand conditions in the credit swap market. Our financial results depend to a significant degree upon the premiums that we receive for the sale of our insurance products through our credit swaps. These premiums are established at origination of the transaction and are generally a function of both absolute credit spreads and the level of correlation among credit portfolios and the movement of related spreads, each of which change over time as a result of changes in the overall economy, supply and demand conditions in the credit swap market and other factors affecting the corporate credit market in general. If a low credit swap premium environment persists, we may not be able to achieve profitable growth or profits or growth at all, which may have a material adverse effect on our financial condition and our results of operations. We can give no assurance that the credit swap market will continue to grow as it has in recent periods or at all or that it will not decline. Any such decline could have a material adverse effect on our financial condition and results of operations.

Prevailing interest rates affect demand for financial guaranty insurance in the public finance market. Higher interest rates may result in declines in new bond issuances and refunding volumes which may reduce demand for our financial guaranty products. Lower interest rates generally are accompanied by narrower interest rate spreads between insured and uninsured obligations resulting in lower cost savings to issuers from the use of financial guaranty insurance than is the case during periods of higher interest rates. These lower cost savings could be accompanied by a corresponding decrease in demand for financial guaranty insurance or lower pricing for our products.

The performance of our CDOs and our ability to originate future CDOs may be materially adversely affected by any of these factors or by a combination of these factors. Changes in the level of credit spreads (i.e., the difference in rates between risky securities and risk remote securities, such as U.S. Treasury securities) can affect our ability to acquire financial assets for our CDOs that create sufficient spread in the transaction to pay the CDO liabilities and the fees and expenses of the CDO, including our asset management fees. If we are unable to acquire assets with sufficient spread, we may not be able to be paid all or any portion of our asset management fees on our existing CDOs and we may not be able to continue to originate additional CDOs of the size of our current CDOs or at all. Also, the CDOs may pay returns below our expectations or not pay returns at all which could negatively impact our equity returns and the overall performance of our CDOs. Poor performance in our CDOs could also hurt our reputation as an asset manager.

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If S&P lowers the financial strength rating that it has assigned to ACA Financial Guaranty, our ability to generate new business in our Structured Credit and Public Finance business lines, as well as our results of operations and liquidity would be materially adversely affected.

ACA Financial Guaranty, our insurance subsidiary, has an “A” financial strength rating from S&P with a “stable” outlook. This rating is crucial to our Structured Credit and Public Finance businesses as well as our ongoing business strategy. This rating is subject to periodic review by S&P, and S&P may revise or withdraw its rating at any time at its sole discretion. Such an action may be based on factors which are entirely outside of our control, such as changes in the views or the policies of the rating agencies in relation to the financial guaranty industry, changes to the risk profile of ACA Financial Guaranty’s insurance portfolio or to other factors considered by S&P in providing such rating, or adverse developments in general economic conditions or the financial condition or results of operations of ACA Financial Guaranty.

In addition, the financial strength rating of financial guaranty companies is based in part on the maintenance of specified amounts of resources available to pay claims. As our business grows, we may need additional capital and we may not be able to raise such capital. S&P’s stable ratings outlook on ACA Financial Guaranty assumes that our insurance subsidiaries will continue to satisfy S&P’s current minimum capital requirement of $300 million. As of December 31, 2006, ACA Financial Guaranty met this capital requirement with statutory capital of $387.1 million. Further, S&P may revise its capital requirements for A-rated financial guarantor insurance companies at any time.  A change in applicable capital requirements or the incurrence of losses in excess of our expectations could diminish our capital below required rating agency levels. For instance, in 2004, we had to raise capital in response to an increase in S&P capital requirements. It may be difficult or costly for us to raise the additional capital necessary to satisfy the rating agency levels. Although we currently intend to operate our business in a manner that maintains our “A” rating, we are under no obligation to do so and we may not be able to do so.

If S&P were to downgrade our financial strength rating, put us on its CreditWatch negative list or change its outlook for us to negative, our reputation and financial performance in the structured credit and public finance industries could be materially adversely affected, which in turn could materially adversely impact our financial performance. CreditWatch highlights the potential direction of a rating, focusing on identifiable events and short-term trends that cause ratings to be placed under special surveillance by S&P. Ratings appear on CreditWatch negative when such an event or a deviation from an expected trend occurs and S&P needs additional information to evaluate the rating.

Our Structured Credit business would also be negatively affected by a downgrade of ACA Financial Guaranty’s financial strength rating to below “A” or a withdrawal of our rating. Since ACA Financial Guaranty insures our credit swaps and our counterparties rely on ACA Financial Guaranty’s financial strength rating when entering into transaction with us, we might be unable to enter into any new insured credit swap transactions and we could be required to provide collateral in the form of cash or securities securing our obligations under most of our existing insured credit swaps and any new credit swaps that we may enter.

In addition, under the terms of our credit agreement, to the extent we had outstanding borrowings under this facility, these borrowings would become due immediately, and we would be unable to make future borrowings, if our financial strength rating falls below “A-.”  Such collateral posting requirements and acceleration of our existing line of credit could severely disrupt our business and materially negatively impact our liquidity and reputation. It could also severely strain our capital resources thereby putting us at a competitive disadvantage.

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In our Structured Credit business we have contingent collateral posting requirements that in adverse circumstances may severely strain our liquidity and capital resources.

If ACA Financial Guaranty’s financial strength rating is downgraded below “A-,” we are required to post collateral in excess of negotiated threshold amounts with respect to most of our existing insured credit swaps in the amount of any negative mark to market fair value of the credit swap. Additionally, should credit events or, in some circumstances, negative credit migration occur with respect to the reference entities included in our various Structured Credit transaction portfolios resulting in losses above pre-agreed-upon levels or, in some circumstances, a downgrade of our position to below a pre-set level, we are generally required to post collateral in an amount that is the lesser of the amount by which actual losses exceed this pre-agreed point and the amount of any negative mark to market fair value of the credit swap. Posting collateral could materially and adversely impact our liquidity and our ability to enter into future insured credit swaps. We may not have sufficient liquidity to meet any posting requirements depending on the size of the negative mark and/or the level of losses at the time we are required to post collateral. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.”

In our Structured Credit business we are dependent on counterparties’ perception of our creditworthiness.

Before counterparties in our Structured Credit business enter into insured credit swaps with us, they analyze our financial condition, particularly the financial condition of ACA Financial Guaranty. They establish credit exposure limits to us based on their assessment of our financial condition, and monitor the appropriateness of these limits on an ongoing basis to limit the amount of risk they take should we be financially unable to make any payments we owe them. Once a counterparty reaches its credit exposure limit to us, the counterparty generally will not enter into any additional transactions with us until such counterparty’s credit limit with us is increased. In the event these counterparty credit limits are not increased as our insured credit swap portfolio expands, or if limits are reduced due to changes in our financial position or general economic conditions, prevailing levels of credit spread or other reasons, our financial performance would suffer. The growth of our Structured Credit business, in particular, will be materially impacted if we cannot maintain and increase the lines of credit with our existing counterparties and increase the number of counterparties willing to transact with us. We can give no assurance that additional financial institutions will become our counterparties or that existing counterparties will not reduce their exposure to us.

We may need to refinance our existing debt and otherwise require additional capital in the future, which may not be available or may only be available on unfavorable terms.

To the extent that our existing capital or the funds generated from our operations are insufficient to meet our future requirements, we may need to raise additional funds through financings. If additional funds are unavailable, we may need to curtail our growth, change our business strategy or sell assets. In addition, we will have to refinance our medium-term note program, which matures in 2010 and which date is in advance of the maturity date of many of the assets acquired with the proceeds of such issuance. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Indebtedness.”  Any equity or debt financing, if available at all, may be on terms that are not favorable to us. Equity or debt we may issue in the future may have rights, preferences and privileges that are senior to those of the current common stock and may contain covenants or restrictions that hamper our ability to operate our business. In the case of equity financings, our stockholders could experience material dilution.

We may also need to obtain reinsurance in order to comply with state insurance regulatory and rating agency capital requirements and single risk limits as our business grows. If we need to seek additional reinsurance, such reinsurance may not be available at acceptable terms or at all. This could have a material adverse impact on our ability to grow our insurance business and could materially adversely affect our “A” rating and future results of operations. See “Business—Reinsurance” and “Business—Regulation.”

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We assume construction and completion risk in our Public Finance transactions.

In underwriting Public Finance transactions, we sometimes assume exposure to the credit during construction or otherwise prior to completion of the related project. In these projects, the risk of loss on a Public Finance transaction is typically most significant during the construction and completion phases. Construction costs may exceed expectations and available funding, and timing delays, which may be caused by construction delays, natural disasters or economic downturns that diminish demand for a project, will delay the production of revenue necessary to pay debt service on the insured bonds. Delays in revenue production may also be caused post construction by delays in the commencement of operations. These delays can be caused by a variety of factors including industry-specific concerns such as obtaining all required regulatory approvals. Such delays in the production of revenue may result in our payment of claims until the project is completed and revenue generated. In the event a project is not completed, a default of the guaranteed bonds may occur resulting in the payment of claims by us. Depending on the status of the construction, our recoveries may be materially less than our claims paid as we rely on our security interest in the land and project itself for recoveries. Such an occurrence could negatively impact our results of operations. Also, should we experience a high level of defaults on these credits, the losses incurred could materially adversely impact our capital adequacy as well as our financial strength rating.

Our failure to accurately set our loss reserves may result in having to increase our loss reserves or make payments in excess of our loss reserves, which could materially and adversely impact our financial condition.

We establish loss reserves on our non-derivative financial guaranty insurance exposures. Setting our loss reserves involves significant reliance upon estimates with regard to the probability, magnitude and timing of losses. Our reserves may prove to be inaccurate in material amounts, especially during an extended economic downturn. As of December 31, 2006, we had non-specific loss reserves of $21.9 million and gross case specific loss reserves of $20.2 million net of estimated recoveries. If our loss reserves are determined to be inadequate, we will be required to increase our loss reserves which would result in a corresponding reduction in our net income and stockholders’ equity in the period in which the deficiency is recognized. Sizable losses could have a material impact on our capital adequacy and, ultimately, S&P financial strength rating. In addition, the Financial Accounting Standards Board, or FASB, is considering whether additional accounting guidance is necessary regarding methods of determining non-specific reserves. We may be required to significantly increase our loss reserves or restate our current reserve allocations as a result of FASB’s review. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates.”

We have legacy exposure on manufactured housing bonds we insured.

In 1999, we insured 12 securitized manufactured housing bonds with a collective notional balance of $213.3 million. As of December 31, 2006, four of those bonds, with an aggregate notional balance of $63.7 million, are underperforming and have either been partially written down or are at risk of being written down. As of December 31, 2006, we had a reserve of $23.4 million to cover potential claims on these four bonds. We are currently paying claims on one bond and expect to begin paying claims on the other three in 2007 or 2008. Our reserve represents the present value of expected losses, discounted at the applicable treasury rate. This reserve may not prove to be adequate because the underlying losses may not be accurately predicted or our discount may be lower than the actual discount rate and therefore we may have to pay significantly more in claims than we have reserved. This could have a material adverse impact on our results of operations and financial condition.

We are also currently paying periodic claims in respect of interest on one of the 12 insured bonds; however, as we expect to receive full recovery of such claims from payments on the underlying loans, we have not taken loss reserves in connection with this exposure. As of December 31, 2006, total claims paid,

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net of recoveries, on this bond was $5.5 million. If, however, loss rates on the underlying portfolio of loans are materially higher than we expect, we may not receive some portion or any of the recoveries as we currently anticipate.

Based on our analysis, as of December 31, 2006, we believe that a reserve is not currently required for any of the other manufactured housing bonds insured in 1999. Nonetheless, the current ratings on all but one of the 12 manufactured housing bonds have been materially downgraded from their initial ratings of “AA” and/or “Aa” by S&P, Moody’s Investor Services or Fitch Ratings Inc. and we cannot be certain that these bonds will not continue to deteriorate. We may be required to post additional reserves and we may have to pay claims with respect to such bonds. We may not be able to recover the amount of such payments.

Changes in accounting rules relating to the financial guaranty industry could have a material adverse effect on the perception of our results of operations and that of other industry participants.

In June 2005, the SEC asked the FASB to consider the accounting by financial guaranty insurers for claims liability recognition, premium recognition and deferred policy acquisition costs in addition to a then-existing request to review loss reserving accounting policies for the financial guaranty industry. The proposed guidance from this review is expected to be issued during 2007. When the FASB reaches a conclusion, it is possible that we and the financial guaranty insurance industry may be required to change some aspects of our and the industry’s relevant accounting policies. Changes in our accounting policies relating to the timing of premium and expense recognition could have a material effect on the perception of our results or operations and that of others in our industry. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates—FASB Financial Guaranty Insurance Project.”

Certain of our CDOs must be consolidated in accordance with applicable accounting rules which introduces volatility into our balance sheet and statement of operations which may result in negative investor perception of us.

Pursuant to FASB Financial Interpretation No. 46(R) (“FIN 46(R)”), we are required to consolidate into our balance sheet, assets and liabilities related to certain of our CDOs when we are deemed to be the primary beneficiary of the CDO vehicle. In general, this occurs when we own more than 35% of the equity of the vehicle. CDO assets are reflected on our balance sheet as fixed-maturity securities available for sale, at fair value. Although these CDOs are consolidated, we do not have the right to use the assets of the CDOs for general operations or in satisfaction of our corporate debt obligations. Similarly, the liabilities issued by the CDO are reflected on our balance sheet as debt. The consolidation of seven of our CDOs makes it more difficult for us to communicate economic trends and factors underlying our business. Additionally, losses in the asset portfolios that are consolidated could exceed our true economic risk. Our true economic risk is the amount of our equity investment in these CDOs. To the extent losses in the CDO asset portfolios exceed our associated equity investment, the financial statement impact is offset at CDO maturity, when the associated liabilities are written off; however, the potential interim mismatch may be significant and vary from period to period, which may not be understood by the market. This volatility could cause a negative investor perception of us and negatively impact our stock price. Pursuant to FIN 46(R), we are also required to consolidate the total assets of our Credit Fund. This consolidation presents the same issues in terms of an investor’s ability to understand our financial statements and financial condition and their potential perception of us. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates—Consolidation of Variable Interest Entities (VIE) and Other Restricted Investments.”

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Our net income may be volatile from reporting period to reporting period because a portion of the credit risk we assume is in the form of insured credit swaps and a number of our consolidated CDOs utilize interest rate swaps, both of which are derivatives and are accounted for under FAS 133/149, requiring that these instruments be marked to market.

As credit spreads increase or decrease, the spreads on the underlying assets included in our portfolios referenced by our insured credit swaps in our Structured Credit and synthetic CDO transactions will also increase or decrease, which will result in changes to the fair value of the credit swaps. Furthermore, changes in demand for such products, changes in the applicable legal and regulatory environments and overall growth in this sector can also affect the fair value of our credit swaps. Our insured credit swaps meet the definition of derivatives under Statement of Financial Accounting Standards Nos. 133 and 149 (“FAS 133/149”). Derivatives must be accounted for either as assets or liabilities on the balance sheet and measured at fair mark to market value. Since market prices are generally not available on our insured credit swaps we estimate the fair value of these swaps by using modeling methodologies which may be less precise than using quoted market price. Although there is no cash flow effect from this “marking to market” as we enter into these insured credit swaps with an intent that they remain outstanding to maturity, changes in the fair value of the derivative are reported in our consolidated statement of operations, together with the fixed premiums payable to us under the contract, in net insured credit swap revenue and other net credit swap revenue and therefore will affect our reported earnings. The impact from this marking to market on our reported earnings could vary significantly from period to period. Volatility in our reported earnings, even if there is no ultimate cash impact, could cause a negative investor perception of us and negatively impact our stock price.

Common events that may cause credit spreads to fluctuate on the underlying assets included in the portfolios referenced by our credit swaps include changes in the state of national or regional economic conditions, industry cyclicality, changes in the business or financial assets of a specific issuer of the underlying assets included in a referenced portfolio, such as the issuer’s competitive position within an industry, management changes, changes in the ratings of the underlying security, movements in interest rates, default or failure to pay interest, or any other factor leading investors to revise expectations about such issuer’s ability to pay principal and interest on its debt obligations. These events are outside of our control. Similarly, common events that may cause credit spreads on an underlying structured security referenced by a credit swap to fluctuate may include the occurrence and severity of collateral defaults, changes in demographic trends impacting the levels of credit enhancement, rating changes, changes in interest rates or prepayment speeds, or any other factor leading investors to revise expectations about the risk of the collateral or the ability of the servicer to collect payments on the underlying assets sufficient to pay principal and interest.

In addition, our net income may be volatile due to the inclusion of interest rate swaps in certain of our CDO transactions, which must be marked to market under FAS 133/149. We use interest rate swaps to hedge the exposure to variable interest rates within our CDOs. These interest rate swaps also provide a cost effective form of financing for the placement fees and other initial costs of those CDOs. Interest rate swaps are derivatives under FAS 133/149 and are required to be marked to market; however, that portion of the mark to market associated with the financing of placement fees and other initial costs are required to flow through the consolidated statement of operations, and are recorded in net realized and unrealized gains (losses) on derivative instruments rather than being recorded directly in stockholders’ equity on our balance sheet where standard interest rate hedges would be recorded. This increases the volatility in our reported earnings which may be confusing to stockholders or, in the case of negative marks, materially adversely impact investors’ perception of us which could negatively impact our stock price.

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We operate in competitive environments.

The credit swap market is large, quickly evolving and highly competitive. Most of our competitors are more established, have long-term relationships with market participants and have substantially greater financial resources than we have. Additionally, no significant regulatory impediments necessarily exist for new participants entering the credit swap market under different business models, such as non-insurance business models. To the extent that new participants enter the credit swap market, competition may intensify further. We cannot assure you that increased competition will not materially and adversely affect the volume, pricing and the profitability of this business.

The competitive environment for our Public Finance business principally comes from other forms of credit enhancement and the high yield municipal funds that are purchasing an increasing amount of high non-investment grade and unrated municipal debt. Continued growth by such competitors may reduce the demand for our financial guaranty insurance product. Currently no other “A” rated entities provide financial guaranty insurance. That could change, which could negatively impact our competitive standing.

The market for CDO Asset Management services is highly competitive with low barriers to entry. We compete for assets with other managers with greater resources. Competition for assets of the types and classes in which our CDOs invest may lead to increasing asset prices which may further limit our ability to generate our desired returns. Also, as spreads tighten, the competition to acquire financial assets with sufficient spreads to generate the returns required by our CDO investors will increase, limiting our ability to originate profitable CDOs and to reinvest our current CDOs so as to sustain our historical performance. In addition, some of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of transactions and establish more relationships than we can. If we are unable to acquire enough assets with sufficient spreads, our performance may suffer compared to our competitors. Should this occur, even for a short period, our financial results may be significantly and quickly negatively impacted.

Further, increasing competition in the origination of CDOs generally could negatively impact our ability to attract investors in our CDOs and therefore our ability to continue to generate CDOs and increase our assets under management. In addition, new entrants into the CDO asset management realm may cause a decrease in the rate of fees paid to asset managers and therefore also negatively impact our profitability.

Additionally, in our Structured Credit business, we are seeing the introduction of derivative products companies, or DPCs, which are will be competing with us in this sector. This increased competition could result in spread compression and make it more difficult for us to price our deals to achieve our minimum risk-adjusted returns.

See “Business - Competition.”

We may experience fluctuations in quarterly and annual results due to the limited number of transactions we enter into in a given period.

During any given quarter or year we enter into a limited number of transactions in each of our lines of business and we do not set performance targets based on closing a specified number of transactions or writing or insuring a specific notional or par amount in any particular quarter or year. Our targets are based on other metrics, such as aggregate fixed premiums, earned or written premiums or assets under management, as appropriate to our different business lines. This permits us to select only those opportunities, if any, that meet our risk-adjusted expectations, thereby maximizing our profitability. The transactions in which we participate are often highly negotiated and often take significant time to analyze, underwrite and close. Our Structured Credit and Public Finance businesses may elect to not transact if attractive opportunities are unavailable. In addition, while we intend to grow our CDO assets under management, we may not be able to sponsor a significantly increasing number of CDOs from year to year

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due to investor demand, marketing considerations, asset availability and pricing considerations. Accordingly, we can provide no assurance that we will enter into a minimum level of transactions in any given period. As a result, our financial performance and growth will vary significantly depending on market conditions and the timing and closing of opportunities available to our business lines. As a result, our financial performance will likely vary significantly from quarter to quarter and the operating results for any quarter should not be deemed indicative of results for any future period. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Overview.”

We have a limited operating history.

We and our subsidiaries are relatively new entities with narrow business focuses and limited operating histories. As a result, there is limited historical financial and operating information available to help you evaluate our past performance. We have not operated our business in a long-term significantly recessionary environment or a long-term inflationary environment. As a result, there is limited historical information available to help you evaluate what our track record may be during such economic cycles.

Future growth into international markets is subject to additional risks that are beyond our control.

Our business strategy contemplates expanding portions of our business into foreign markets. For example, we have formed a subsidiary in Singapore through which we have entered the Asian structured credit markets, and have also formed another subsidiary that recently obtained a license as an investment manager in the United Kingdom through which we will participate in the European CDO asset management markets. We may not be successful in developing the necessary business relationships to grow our activities in these jurisdictions. If we are able to implement these strategies, we will be subject to the significant additional risks associated with doing business abroad, including, without limitation: currency exchange fluctuations; the imposition of new laws and regulations; financial reporting according to the standards of non-U.S. jurisdictions; restrictions on the transfer of funds; changes in local economic conditions; and the ability to integrate our international business and employees separated by large distances and different time zones effectively and efficiently into our overall operations and control systems. Our inability to effectively manage these risks and other factors that may be beyond our control could have a material adverse effect on our business, financial condition and operations.

Our continued growth into additional product areas and markets could strain our resources.

Since 2001, we have significantly increased the scope of our financial guaranty operations, including expanding into insuring credit swaps, and have entered into markets in which we previously did not conduct business, including the origination, structuring and management of our CDOs. We continue to focus on growing our business lines and building new products, which could place a strain on our management, other personnel, resources and financial reporting systems in future periods. To implement our business strategy, we will need to evaluate continually and, where necessary, upgrade our operating and financial systems, procedures and controls, as well as personnel resources. In addition, as part of our business strategy, we plan on entering into new product areas and markets and we may not effectively anticipate the required resources, relevant risks and management challenges to sustaining these operations. We may not be able to effectively manage new operations or successfully integrate them into our existing operations. If we do not accurately anticipate required improvements in controls or systems and necessarily increases in personnel, our business and results of operations could be materially and adversely affected.

We are a holding company and our cash flow is dependent on payments by our subsidiaries, which are subject to significant limitations.

We are a holding company and, as such, conduct our operations primarily through our subsidiaries. A significant portion of our cash flow consists primarily of dividends and other permissible payments from

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our subsidiaries, plus income on any proceeds of potential financings that we retain at the holding company level. We depend on such payments to meet our obligations, including the payment of interest and principal on our debt. The majority of such dividend payments are subject to ACA Financial Guaranty’s ability to pay dividends, since we operate most of our lines of business through ACA Financial Guaranty or its subsidiaries. For more information regarding these restrictions, see “Business—Regulation.”  Our cash flow is further constrained because funds available to us from four of our CDOs are pledged as collateral or are used to make required payments in connection with our equity financing on those CDOs. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.”

While in the past the Commissioner of the Maryland Insurance Administration has consented to the payment of certain dividends, we cannot be certain that the Maryland Insurance Commissioner will continue to consent to such payments or other similar payments in the future. The inability of ACA Financial Guaranty to pay sufficient dividends and to make other permitted payments to us could have a material adverse effect on our ability to satisfy our ongoing operating expenses, debt service and other cash requirements, as well as our ability to pay dividends on our common stock in the future.

Our level of indebtedness could adversely affect our operations and growth and could limit our ability to react to changes in the economy or the markets in which we compete.

As of December 31, 2006, we had approximately $4,903.7 million of short-term debt, long-term debt and related party debt outstanding, of which approximately $4,732 million related to the liabilities of our consolidated CDOs, $100 million related to the investment agreement of our special purpose subsidiary ACA Parliament Funding, L.L.C., $79.9 million related to our obligations under certain trust preferred securities and $12 million related to other corporate debt outstanding. In addition, we have entered into a $75 million unfunded line of credit. We may also incur additional indebtedness in the future to fund acquisitions, working capital and growth in our business or for other general corporate purposes. Our level of corporate debt increases our vulnerability to competitive pressures and to general adverse economic, market or industry conditions and reduces the availability of cash flow for working capital and other general corporate purposes. This could limit our ability to compete and our flexibility in planning for, or reacting to, changing business, industry or economic conditions. See “Financial Statements and Supplementary Data—Note 10.”

We may incur liabilities because of the unconditional nature of our financial guaranty insurance policies.

Issuers whose obligations we insure may default on those obligations because of fraudulent or other intentional misconduct. Financial guaranty insurance is unconditional and does not provide for any exclusion of liability based on fraud or other misconduct. Despite any risk analysis we conduct, it is impossible to predict fraud or other intentional misconduct, or whether or to what extent we will have any remedy against any party in connection with such conduct. Payment of any such claims could have a material adverse effect on our financial condition and results of operations.

If our investments perform poorly, our financial results and ability to conduct business could be harmed.

Our operating results are affected by the performance of our and ACA Financial Guaranty’s investment portfolios.

Our and ACA Financial Guaranty’s investment portfolios are subject to:

·       market value risk, which may be due to a change in the yields realized on the investment portfolios and prevailing market yields for similar assets, an unfavorable change in the liquidity of the investments or an unfavorable change in the financial prospects or a downgrade in the credit rating of the issuers of the securities in the investment portfolios;

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·       default risk, which is the risk that some of the investments will not pay principal or interest owed to us when due; and

·       reinvestment risk, which is the risk that interest rates and credit spreads will decline and funds reinvested will earn less than expected.

Interest rates and credit spreads are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control. We may not be able to mitigate these risks effectively.

Hedging transactions may limit our income or result in losses.

We have and may in the future engage in hedging transactions to manage our credit risk exposure across our business lines and in our and ACA Financial Guaranty’s investment portfolios. We have and may also in the future engage in certain hedging transactions to limit our exposure to changes in interest rates, currency exchange rates and other financial market changes. Hedging does not prevent losses or eliminate the possibility of fluctuations or prevent losses, and could result in additional losses. Also, certain hedging transactions may limit the opportunity for income or gain if rates change favorably. Moreover, it may not be possible to hedge against potential risk of loss or expected rate fluctuations at an acceptable price. Additionally, ACA Financial Guaranty would have to obtain regulatory approval before entering into such transactions in relation to its investment portfolio and we may not be able to obtain such approval.

We are highly dependent on information systems and third parties, and systems failures could significantly disrupt our business.

Our businesses are highly dependent on communications and information systems. Any failure or interruption of our systems could cause delays or other problems in our trading activities and our ongoing credit analysis and risk management assessments. This could have a material adverse effect on our operating results.

We are dependent on key executives.

Our future success depends to a significant extent on the efforts of our executive management. We have one key man insurance policy in effect, which is for our President and Chief Executive Officer, Alan S. Roseman. We do not have key man insurance policies in effect for other members of senior management. We currently have employment agreements with these individuals, but employment agreements do not assure retention. We believe that there are a limited number of available, qualified executives with relevant experience in the insurance, capital markets and credit swap industries, and our inability to hire additional senior executives or the loss of the services of any of these individuals could adversely affect our business. Failure to retain or attract key personnel could have a material adverse effect on us.

In our Public Finance business we insure low investment grade and high non-investment grade credit risks which may require significant loss mitigation efforts.

Given the nature of our Public Finance portfolio, which is predominantly comprised of low investment grade and high non-investment grade credits, at any given time we are engaged in work-out strategies with a number of our credits to minimize or eliminate the potential for future losses. Such activities may result in increased loss adjustment expense, or LAE, reserves which could materially and adversely impact our results of operations in the periods such reserves are recorded. In addition, our work-outs may not be successful, which could result in our paying claims which could be significant. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates—Loss and Loss Adjustment Expenses.”

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In our CDO Asset Management business we are subject to termination under the provisions of our investment advisory agreements.

Generally, our services as asset manager may be terminated without cause by a vote of a majority of each class of debt securities and the equity tranche of a CDO. We may also be removed “for cause” upon the occurrence of certain events on the affirmative vote of a majority of the senior debt or a majority vote of the equity. In certain of our investment management agreements, substantial employee departures amongst CDO Asset Management and certain other key personnel within, most typically, a 12-month period constitutes a basis for our removal as asset manager. If we are removed as asset manager from one or more of our CDOs, it could have a significant negative impact on our reputation in the market and could have a material adverse effect on our results of operations, our ability to do new CDOs and our ability to be retained as an asset manager for our other CDOs.

We may be precluded from participating in certain opportunities that we otherwise would participate in due to our role as a CDO asset manager and potential conflicts of interest.

In addition to providing management services to CDOs originated and structured by us, we also provide management services to the Credit Fund, portfolios structured by third parties and take credit risk directly. Conflicts may exist for us in addressing these various roles and interests. We have developed an allocation policy and intend to act in a manner that is fair and equitable in allocating business opportunities and to follow our conflict resolution process should conflicts occur; however, because of these potential conflicts, we may not be able to participate in certain opportunities on a proprietary basis which opportunities otherwise meet our business objectives. Our inability to pursue certain opportunities due to conflicts of interest could have an adverse impact on our future results of operations.

Risks Related to the Regulation of Our Businesses

The regulatory systems under which we operate, and potential changes in regulation, could significantly and adversely affect our business.

We operate in a highly regulated industry, and these regulations can restrict our ability to take actions or conduct our business for the ultimate benefit of our stockholders. Our operations may become subject to increased regulation, and applicable federal and state law or existing regulations may change, which may result in administrative burdens, increased costs or other adverse consequences to us. For example, proposals have been made in Congress to enact legislation that would increase regulation of the credit swap market. We cannot predict what restrictions any such legislation, if adopted, would impose and the effect those restrictions would have on our businesses. In addition, we may not accurately predict the effects of regulation that will be imposed on our business as we continue to enter into and expand our operations in international markets. Furthermore, regulatory changes can also impact our counterparties or other persons we do business with and may make our products less attractive to third parties.

We are subject to the insurance holding company law of the State of Maryland, where ACA Financial Guaranty is organized and domiciled. This law generally requires each domestic insurance company directly or indirectly owned by a holding company to register with the Maryland Insurance Commissioner and to furnish financial and other information annually and periodically upon the occurrence of material events. Generally, all inter-company transactions between us or any affiliate and ACA Financial Guaranty in the holding company system must be fair and, if material, require prior notice to and approval by the Maryland Insurance Commissioner.

ACA Financial Guaranty is licensed to write financial guaranty insurance in all 50 states of the United States, the District of Columbia, Guam, Puerto Rico and the U.S. Virgin Islands. State insurance laws regulate many aspects of ACA Financial Guaranty’s insurance business and state insurance departments supervise its insurance operations. The purpose of the state insurance regulatory statutes is to protect

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policyholders, not stockholders. Among other things, Maryland insurance regulation requires ACA Financial Guaranty to maintain minimum levels of capital, surplus and liquidity, and imposes restrictions on the payment of dividends and distributions. These statutes and regulations may, in effect, restrict the ability of ACA Financial Guaranty to write new business or, as discussed under “Business—Regulation,” distribute funds to us. Also, because ACA Financial Guaranty is authorized to act as a foreign insurer in New York, it is also required to comply substantially with any requirement or limitation specified in the New York Insurance Law that is applicable to similar domestic insurers in New York. In recent years, the state insurance regulatory framework has come under increased federal scrutiny, and some state legislatures have considered or enacted laws that may alter or increase state authority to regulate insurance companies and insurance holding companies. Although not located or domiciled in the other jurisdictions in which ACA Financial Guaranty writes business, in order to maintain its licenses in those jurisdictions it is also subject to regulation in those states and territories as well. If ACA Financial Guaranty fail to comply with the various state insurance regulations applicable to it, it could experience material fines and potentially have its license withdrawn in the relevant jurisdiction, which could materially interfere with its ability to write insurance policies in the future.