10-Q 1 a07-25958_110q.htm 10-Q

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

Form 10-Q

 

x

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

 

 

 

For the Quarter Ended September 30, 2007

 

 

 

 

 

or

 

 

 

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                  to

 

Commission file number 1-33111

 

ACA Capital Holdings, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware

 

75-3170112

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer
Identification Number)

 

140 Broadway

New York, New York 10005

(212) 375-2000

(Address, including zip code, and telephone number, including

area code, of registrant’s principal executive offices)

 

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 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 Exchange Act).  Yes  o   No  x

 

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

 

 



 

INDEX

 

 

 

 

 

 

 

 

 

 

 

PART I - FINANCIAL INFORMATION

 

 

 

 

 

 

 

Item 1.

 

Financial Statements of ACA Capital Holdings, Inc. and Subsidiaries (Unaudited)

 

3

 

 

 

 

 

 

 

Report of Independent Registered Public Accounting Firm

 

3

 

 

 

 

 

 

 

Condensed Consolidated Balance Sheets (Unaudited) — September 30, 2007 and December 31, 2006

 

5

 

 

 

 

 

 

 

Condensed Consolidated Statements of Operations (Unaudited) — Three and nine months ended September 30, 2007 and 2006

 

6

 

 

 

 

 

 

 

Condensed Consolidated Statements of Stockholders’ Equity (Unaudited) — Nine months ended September 30, 2007 and 2006

 

7

 

 

 

 

 

 

 

Condensed Consolidated Statements of Cash Flows (Unaudited) — Nine months ended September 30, 2007 and 2006

 

8

 

 

 

 

 

 

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

9

 

 

 

 

 

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

23

 

 

 

 

 

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

 

53

 

 

 

 

 

Item 4.

 

Controls and Procedures

 

55

 

 

 

 

 

PART II - OTHER INFORMATION

 

 

 

 

 

 

 

Item 1.

 

Legal Proceedings

 

55

 

 

 

 

 

Item 1A.

 

Risk Factors

 

56

 

 

 

 

 

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

 

58

 

 

 

 

 

Item 3.

 

Defaults Upon Senior Securities

 

59

 

 

 

 

 

Item 4.

 

Submission of Matters to a Vote of Security Holders

 

59

 

 

 

 

 

Item 5.

 

Other Information

 

59

 

 

 

 

 

Item 6.

 

Exhibits

 

59

 

 

 

 

 

 

 

 

 

 

SIGNATURES

 

60

 

2



 

PART I — FINANCIAL INFORMATION

 

Item 1.        Financial Statements of ACA Capital Holdings, Inc. and Subsidiaries (Unaudited)

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders of

ACA Capital Holdings, Inc.

New York, New York

 

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

 

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

 

Based on our review, we are not aware of any material modifications that should be made to such condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

 

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

 

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

 

3



 

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

 

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

 

/s/ Deloitte Touche LLP

New York, New York

November 19, 2007

 

4



 

ACA CAPITAL HOLDINGS, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

 

AS OF SEPTEMBER 30, 2007 AND DECEMBER 31, 2006

 

(Dollars in thousands)

 

 

 

September 30,

 

December 31,

 

 

 

2007

 

2006

 

ASSETS

 

 

 

 

 

Investments:

 

 

 

 

 

Fixed-maturity securities available for sale at fair value, amortized cost of $3,808,777 and $5,043,239, respectively

 

$

3,373,228

 

$

5,026,276

 

Fixed-maturity securities trading at fair value, amortized cost of $133,333 and $251,884, respectively

 

125,176

 

251,825

 

Securities purchased under agreements to resell

 

1,000

 

10,248

 

Guaranteed investment contract

 

 

119,340

 

Total investments

 

3,499,404

 

5,407,689

 

Cash:

 

 

 

 

 

Cash and cash equivalents

 

283,240

 

379,905

 

Restricted cash

 

51,488

 

67,061

 

Total cash

 

334,728

 

446,966

 

Accrued investment income

 

15,805

 

21,222

 

Derivative assets

 

152,382

 

19,730

 

Deferred policy acquisition costs, net

 

50,839

 

48,810

 

Deferred debt issuance costs, net

 

17,477

 

34,104

 

Receivable for securities sold

 

4,339

 

824

 

Prepaid reinsurance premiums

 

464

 

528

 

Deferred income taxes

 

781,668

 

 

Other assets

 

95,558

 

58,321

 

Total assets

 

$

4,952,664

 

$

6,038,194

 

 

 

 

 

 

 

LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

LIABILITIES

 

 

 

 

 

Unearned premiums

 

$

196,842

 

$

189,537

 

Reserve for losses and loss adjustment expenses

 

42,878

 

42,113

 

Short-term debt

 

2,675,308

 

2,677,828

 

Long-term debt

 

672,140

 

2,125,914

 

Related party debt

 

100,000

 

100,000

 

Securities sold under agreements to repurchase

 

104,124

 

232,227

 

Derivative liabilities

 

1,897,207

 

33,874

 

Accrued interest payable

 

7,584

 

17,900

 

Accrued expenses and other liabilities

 

82,816

 

61,855

 

Payable for securities purchased

 

37,457

 

9,628

 

Current income tax payable

 

10,080

 

7,056

 

Deferred income taxes

 

 

258

 

Total liabilities

 

5,826,436

 

5,498,190

 

MINORITY INTEREST

 

9,520

 

30,190

 

 

 

 

 

 

 

COMMITMENTS AND CONTINGENCIES

 

 

 

 

 

 

 

 

 

 

 

STOCKHOLDERS’ EQUITY

 

 

 

 

 

Common stock of 100,000,000 shares authorized at September 30, 2007 and December 31, 2006; 37,444,873 and 37,375,123 shares issued at September 30, 2007 and December 31, 2006, respectively; and 34,505,126 and 36,523,276 shares outstanding at September 30, 2007 and December 31, 2006, respectively; par value of $0.10

 

3,744

 

3,737

 

Gross paid-in and contributed capital

 

442,299

 

438,935

 

Treasury stock at cost —2,939,747 and 851,847 shares at September 30, 2007 and December 31, 2006, respectively

 

(27,084

)

(12,088

)

Notes receivable from stockholders

 

(3,121

)

(3,121

)

Deferred compensation

 

 

(870

)

Accumulated other comprehensive loss — net of deferred income tax of $(140,737) and $(1,760) at September 30, 2007 and December 31, 2006, respectively

 

(261,216

)

(3,308

)

Retained earnings (deficit)

 

(1,037,914

)

86,529

 

Total stockholders’ equity

 

(883,292

)

509,814

 

Total liabilities, minority interest and stockholders’ equity

 

$

4,952,664

 

$

6,038,194

 

 

See notes to unaudited condensed consolidated financial statements.

 

5



 

ACA CAPITAL HOLDINGS, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

 

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006

 

(Dollars and shares in thousands, except per share amounts)

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

REVENUES:

 

 

 

 

 

 

 

 

 

Gross premiums written

 

$

7,113

 

$

5,570

 

$

27,632

 

$

26,085

 

Less premiums ceded

 

(380

)

(189

)

(1,141

)

(375

)

Net premiums written

 

6,733

 

5,381

 

26,491

 

25,710

 

Increase in unearned premium reserve - net

 

(1,205

)

3,213

 

(7,369

)

(3,759

)

Premiums earned

 

5,528

 

8,594

 

19,122

 

21,951

 

Net insured credit swap revenue

 

(1,627,460

)

17,079

 

(1,667,944

)

39,190

 

Net investment income

 

87,471

 

87,888

 

268,018

 

248,052

 

Net realized and unrealized gains (losses) on investments

 

19,514

 

(752

)

(94,336

)

(3,975

)

Net realized and unrealized gains (losses) on derivative instruments

 

(2,397

)

755

 

2,939

 

6,894

 

Other net credit swap revenue

 

2,794

 

2,090

 

18,951

 

7,634

 

Fee income

 

9,562

 

6,516

 

23,490

 

17,589

 

Other income

 

57

 

342

 

412

 

446

 

Total revenues

 

(1,504,931

)

122,512

 

(1,429,348

)

337,781

 

 

 

 

 

 

 

 

 

 

 

EXPENSES:

 

 

 

 

 

 

 

 

 

Loss and loss adjustment expenses

 

7,254

 

2,576

 

10,486

 

6,258

 

Policy acquisition costs

 

1,515

 

2,638

 

6,034

 

6,798

 

Other operating expenses

 

14,553

 

11,999

 

46,270

 

35,293

 

Interest expense

 

70,943

 

76,095

 

223,688

 

213,478

 

Depreciation and amortization

 

2,103

 

2,456

 

6,640

 

7,173

 

Total expenses

 

96,368

 

95,764

 

293,118

 

269,000

 

(Income) loss of minority interest

 

1,590

 

(897

)

(554

)

(3,126

)

Income (loss) before income taxes

 

(1,599,709

)

25,851

 

(1,723,020

)

65,655

 

Provision for income tax expense (benefit)

 

(558,685

)

9,790

 

(600,077

)

23,405

 

Net income (loss)

 

$

(1,041,024

)

$

16,061

 

$

(1,122,943

)

$

42,250

 

 

 

 

 

 

 

 

 

 

 

Share and Per Share Data

 

 

 

 

 

 

 

 

 

Earnings (loss) per share

 

 

 

 

 

 

 

 

 

Basic

 

$

(29.42

)

$

0.70

 

$

(31.05

)

$

1.85

 

Diluted

 

$

(29.42

)

$

0.53

 

$

(31.05

)

$

1.40

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding

 

 

 

 

 

 

 

 

 

Basic

 

35,390

 

23,028

 

36,165

 

22,897

 

Diluted

 

35,390

 

30,236

 

36,165

 

30,129

 

 

See notes to unaudited condensed consolidated financial statements.

 

6



 

ACA CAPITAL HOLDINGS, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (UNAUDITED)

 

 FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006

 

(Dollars in thousands, except for share amounts)

 

 

 

 

 

 

 

 

 

 

 

Gross

 

 

 

Notes

 

 

 

Accumulated

 

 

 

 

 

 

 

Preferred Stock

 

Common Stock

 

Paid in and

 

 

 

Receivable

 

 

 

Other

 

Retained

 

Total

 

 

 

 

 

 

 

 

 

Par

 

Contributed

 

Treasury

 

from

 

Deferred

 

Comprehensive

 

Earnings

 

Stockholders’

 

 

 

Shares

 

Amount

 

Shares

 

Value

 

Capital

 

Stock

 

Stockholders

 

Compensation

 

Income (Loss)

 

(Deficit)

 

Equity

 

BALANCE—January 1, 2006

 

2,786,857

 

$

226,460

 

6,442,950

 

$

644

 

$

125,184

 

$

(5,500

)

$

(1,355

)

$

(2,030

)

$

11,132

 

$

29,778

 

$

384,313

 

Comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

 

 

 

 

 

42,250

 

42,250

 

Change in unrealized gain on investments, net of change in deferred income tax of $1,904

 

 

 

 

 

 

 

 

 

2,670

 

 

2,670

 

Change in derivative hedges, net of change in deferred income tax of $(15)

 

 

 

 

 

 

 

 

 

(27

)

 

(27

)

Foreign exchange unrealized loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(18

)

 

 

(18

)

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

44,875

 

Vesting of Series B senior convertible preferred stock to CEO

 

 

 

 

 

 

 

 

870

 

 

 

870

 

Exercise of stock options by former executives

 

 

 

663,540

 

66

 

8,024

 

 

 

 

 

 

8,090

 

Common stock purchased from former executive

 

 

 

 

 

 

(6,588

)

 

 

 

 

(6,588

)

Stock based compensation-stock options

 

 

 

 

 

578

 

 

 

 

 

 

578

 

Issuance of note receivable from stockholder

 

 

 

 

 

 

 

(2,262

)

 

 

 

(2,262

)

Discharge of note receivable from stockholders

 

 

 

 

 

 

 

496

 

 

 

 

496

 

Senior convertible preferred stock dividend

 

25

 

1,957

 

 

 

 

 

 

 

 

(1,957

)

 

BALANCE—September 30, 2006

 

2,786,882

 

$

228,417

 

7,106,490

 

$

710

 

$

133,786

 

$

(12,088

)

$

(3,121

)

$

(1,160

)

$

13,757

 

$

70,071

 

$

430,372

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

BALANCE—January 1, 2007

 

 

$

 

37,375,123

 

$

3,737

 

$

438,935

 

$

(12,088

)

$

(3,121

)

$

(870

)

$

(3,308

)

$

86,529

 

$

509,814

 

Effect of adoption of FIN 48

 

 

 

 

 

 

 

 

 

 

(1,500

)

(1,500

)

Comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

 

 

 

 

 

 

(1,122,943

)

(1,122,943

)

Change in unrealized loss on investments, net of change in deferred income tax of $(135,070)

 

 

 

 

 

 

 

 

 

(250,844

)

 

(250,844

)

Change in derivative hedges, net of change in deferred income tax of $(3,907)

 

 

 

 

 

 

 

 

 

(7,256

)

 

(7,256

)

Foreign exchange unrealized gain

 

 

 

 

 

 

 

 

 

192

 

 

192

 

Total comprehensive loss

 

 

 

 

 

 

 

 

 

 

 

(1,380,851

)

Vesting of CEO restricted common stock

 

 

 

 

 

 

 

 

870

 

 

 

870

 

Stock repurchases

 

 

 

 

 

 

(14,996

)

 

 

 

 

(14,996

)

Offering costs

 

 

 

 

 

63

 

 

 

 

 

 

63

 

Stock based compensation—restricted stock

 

 

 

 

 

734

 

 

 

 

 

 

734

 

Stock based compensation—stock options

 

 

 

 

 

1,845

 

 

 

 

 

 

1,845

 

Exercise of common stock options

 

 

 

69,750

 

7

 

722

 

 

 

 

 

 

729

 

BALANCE—September 30, 2007

 

 

$

 

37,444,873

 

$

3,744

 

$

442,299

 

$

(27,084

)

$

(3,121

)

$

 

$

(261,216

)

$

(1,037,914

)

$

(883,292

)

 

See notes to unaudited condensed consolidated financial statements.

 

7



 

ACA CAPITAL HOLDINGS, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

 

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006

 

(Dollars in thousands)

 

 

 

2007

 

2006

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income (loss)

 

$

(1,122,943

)

$

42,250

 

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

 

 

 

 

 

Depreciation and amortization

 

6,640

 

7,173

 

Accrual of discount and amortization of premium on investment—net

 

504

 

(171

)

Income of minority interest

 

554

 

3,126

 

Net realized gain on sale of CDO equity investment

 

(39,577

)

 

Net realized losses on fixed-maturity securities-available-for-sale

 

124,062

 

3,857

 

Net realized and unrealized losses on fixed-maturity securities- trading

 

9,301

 

118

 

Net realized loss on other invested assets

 

550

 

 

Net realized and unrealized gains on derivative instruments

 

(2,939

)

(6,894

)

Net realized and unrealized (gains) losses on net insured credit swap revenue

 

1,738,453

 

(4,167

)

Net realized and unrealized (gains) losses on other net credit swap revenue

 

(15,536

)

149

 

Net foreign exchange loss

 

152

 

 

Share based compensation expense

 

2,579

 

578

 

Discharge of note receivable from shareholders

 

 

496

 

Deferred compensation

 

870

 

870

 

Securities purchased under agreements to resell -net

 

9,248

 

(32,066

)

Purchases of fixed-maturity securities-trading

 

(227,186

)

(82,792

)

Proceeds from sales of fixed-maturity securities- trading

 

245,460

 

(145,118

)

Proceeds from maturities of fixed-maturity securities- trading

 

89,285

 

 

Securities sold under agreements to repurchase - net

 

(128,103

)

235,679

 

 

 

 

 

 

 

Changes in assets and liabilities:

 

 

 

 

 

Income taxes payable

 

3,024

 

82

 

Deferred income tax expense

 

(631,361

)

3,219

 

Prepaid reinsurance premiums

 

64

 

249

 

Derivative liabilities

 

14,631

 

(2,871

)

Accrued expenses and other liabilities

 

(5,532

)

(6,785

)

Deferred policy acquisition costs

 

(2,029

)

(420

)

Unearned premium reserve

 

7,305

 

3,511

 

Loss and loss adjustment expenses

 

765

 

5,072

 

Interest payable

 

(4,560

)

1,583

 

Interest receivable

 

1,315

 

(4,373

)

Other

 

(12,585

)

(1,193

)

Net cash provided by operating activities

 

62,411

 

21,162

 

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Net release (deposit) of restricted cash

 

15,573

 

(7,334

)

Purchases of fixed maturity securities available for sale

 

(694,504

)

(786,738

)

Redemption of guaranteed investment contract

 

119,340

 

 

Proceeds from sales of fixed maturity securities available for sale

 

86,109

 

89,843

 

Proceeds from maturities of fixed maturity securities available for sale

 

730,888

 

827,751

 

Deconsolidation of CDOs, net of equity sale proceeds

 

(34,336

)

 

Net purchase of property and equipment

 

(4,360

)

(298

)

Net cash provided by investing activities

 

218,710

 

123,224

 

 

 

 

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Paydown of commercial paper—net

 

(2,520

)

5,228

 

Paydown on long-term debt

 

(364,062

)

(107,014

)

Purchase of treasury stock

 

(14,996

)

(760

)

Proceeds from issuance of equity in Credit Fund

 

3,000

 

8,600

 

Proceeds from exercise of stock options

 

729

 

 

Offering costs

 

63

 

 

Net cash used in financing activities

 

(377,786

)

(93,946

)

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS

 

(96,665

)

50,440

 

 

 

 

 

 

 

CASH AND CASH EQUIVALENTS—beginning of period

 

379,905

 

174,420

 

CASH AND CASH EQUIVALENTS—end of period

 

$

283,240

 

$

224,860

 

 

 

 

 

 

 

SUPPLEMENTAL CASH FLOW DISCLOSURES:

 

 

 

 

 

Federal and local income taxes paid

 

$

28,601

 

$

20,236

 

Interest paid

 

$

222,375

 

$

211,894

 

 

 

 

 

 

 

SUPPLEMENTAL DISCLOSURES OF NON-CASH OPERATING ACTIVITIES:

 

 

 

 

 

Impact on assets and liabilities due to CDO deconsolidation

 

 

 

 

 

Cash and cash equivalents

 

$

(34,336

)

$

 

Interest receivable

 

$

(4,102

)

$

 

Derivative assets

 

$

(792

)

$

 

Deferred debt issuance costs

 

$

(11,905

)

$

 

Receivable for securities sold

 

$

(72

)

$

 

Other assets

 

$

431

 

$

 

Derivative liabilities

 

$

16,320

 

$

 

Interest payable

 

$

5,756

 

$

 

 

 

 

 

 

 

SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING ACTIVITIES:

 

 

 

 

 

Impact on assets and liabilities due to CDO deconsolidation

 

 

 

 

 

 

 

Fixed maturity securities available for sale

 

$

(1,021,435

)

$

 

 

 

 

 

 

 

SUPPLEMENTAL DISCLOSURES OF NON-CASH FINANCING ACTIVITIES:

 

 

 

 

 

Common stock acquired in exchange for note receivable

 

$

 

$

2,262

 

Impact on assets and liabilities due to CDO deconsolidation

 

 

 

 

 

 

 

Long-term debt

 

$

1,089,712

 

$

 

 

See notes to unaudited condensed consolidated financial statements.

 

8



 

ACA CAPITAL HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

SEPTEMBER 30, 2007

 

1.  BUSINESS, ORGANIZATION AND OPERATIONS

 

ACA Capital Holdings, Inc. (“ACA” or the “Company”), is a Delaware domiciled holding company that provides financial guaranty insurance products to participants in the global credit derivatives markets, structured finance capital markets and public finance capital markets, as well as asset management services.  The Company’s principal activities include financial guaranty insurance of public finance obligations, structured credit risk assumption through insured credit derivatives and collateralized debt obligation asset management.  ACA conducts its business through three principal wholly-owned indirect subsidiaries.  Its financial guaranty insurance business is conducted through ACA Financial Guaranty Corporation (“ACA Financial Guaranty”), a Maryland domiciled insurance company.  ACA Financial Guaranty is licensed to conduct financial guaranty insurance business, which provides credit enhancement on public finance and other debt obligations, in all 50 states, the District of Columbia, Guam, the U.S. Virgin Islands and Puerto Rico.  ACA Financial Guaranty also provides the credit support for the Company’s Structured Credit business activities.  The Company conducts its U.S.-based CDO Asset Management business primarily through ACA Service L.L.C. and ACA Management, L.L.C.  This business encompasses the origination (in collaboration with investment banks), structuring and management of collateralized debt obligations (including collateralized loan obligations and other similarly securitized asset classes, collectively “CDOs”).  In January 2007, the Company’s wholly-owned indirect subsidiary, ACA Capital Management (U.K.) Pte. Limited, became authorized and regulated by the Financial Services Authority as an investment manager to manage CDOs in the United Kingdom and most of Europe.

 

The Company’s business is composed of three distinct continuing lines of business or segments.  They are Public Finance, Structured Credit and CDO Asset Management.  A fourth line of business, Other, includes business in areas and markets in which the Company is no longer active.  Although the Public Finance and Structured Credit businesses are reported in separate segments, together they form the Company’s financial guaranty insurance business.  Public Finance primarily provides financial guaranty insurance policies guaranteeing the timely payment of scheduled principal and interest on public finance and other debt obligations.  Structured Credit structures and sells credit protection, principally in the form of insured credit default swaps (“CDS” or “credit swaps”), against a variety of asset classes in the institutional fixed income markets.  CDO Asset Management focuses on CDO origination, structuring and management.  The Company will at times assume risk in the CDOs it manages through investment in some portion of the capital structure.

 

ACA was originally incorporated in Delaware on January 3, 1997.  On November 22, 2002, ACA changed its jurisdiction of incorporation from Delaware to Bermuda.  During 2004, the Board of Directors determined that re-domesticating to Delaware would eliminate certain adverse consequences of remaining in Bermuda, facilitate ACA’s access to U.S. capital markets, simplify its tax filings, accounting and operations, and reduce the costs of compliance with two sets of filing obligations and laws (as ACA stockholders are U.S. entities and individuals).  On September 15, 2004, therefore, ACA re-domesticated from Bermuda to Delaware through a process called a “discontinuation” under Bermuda law and “domestication” under Delaware law. As a result, it became a Delaware domiciled holding company and changed its name from American Capital Access Holdings, Ltd. to its current name.

 

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

 

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

 

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

These unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting.  Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America (“GAAP”) for complete financial statements and should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 (“Form 10-K”), filed with the SEC on April 2, 2007.  These unaudited condensed consolidated financial statements include all adjustments, consisting only of normal recurring adjustments, that we consider necessary for the fair presentation of our financial position and results of operations for these periods.  The preparation of financial statements in conformity

 

9



 

with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods.  Actual results could differ from those estimates.  Operating results for the three and nine months ended September 30, 2007 are not necessarily indicative of the results that may be expected for the year ended December 31, 2007.

 

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

 

Valuation of Insured Credit Swap Transactions — The Company values its insured credit swap transactions either by obtaining market quotes from dealers or through the application of the Company’s valuation model.  During the quarter ended June 30, 2007, the Company refined its valuation model to estimate fair value of its insured credit swap transactions.  The change was implemented to be more consistent with models that the Company understands other market participants utilize, including many of ACA’s insured credit swap counterparties.  The relatively young market for credit swaps has continued to evolve over time and, while there is still substantial variance in valuation models among market participants, the trend is toward increasing convergence in this area.  Under its refined model, the Company fully uses market spread data as a proxy for default probabilities in the determination of fair value.  For transactions in which the underlying exposure is to corporate credits, the Company uses individual market spreads as proxies for defaults as they are readily available. Historically, for synthetic asset-backed transactions individual spread data has not been as readily available and the Company used current weighted average portfolio spreads as a proxy for individual spreads where necessary. However, in the third quarter of 2007, individual spreads were obtained for all transactions, including synthetic asset-backed transactions. The Company will continue to use individual market spread data when available. The Company believes that its refined model will inherently increase the volatility of these valuations, but provide a better estimate of the cost or benefit of unwinding the related transaction.

 

3.  RELEVANT RECENT ACCOUNTING PRONOUNCEMENTS

 

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

 

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

 

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

 

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

 

In September 2006, the FASB issued FAS 157, “Fair Value Measurements” (“FAS 157”).  FAS 157 enhances existing guidance for measuring assets and liabilities using fair value, such as emphasizing that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the highest priority being quoted prices in active markets.  FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years.  Management does not expect the adoption of FAS 157 to have a material impact on the Company’s financial statements.

 

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

 

10



 

Misstatements when Quantifying Misstatements in Current Year Financial Statements”, which provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement.  The provisions of SAB 108 were put in effect at December 31, 2006.  The adoption of this statement did not have a material impact on the Company’s financial statements.

 

In April 2006, the FASB issued Staff Position (“FSP”) FIN 46(R)-6, “Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)” (“FSP FIN 46(R)-6”).  FSP FIN 46(R)-6 addresses whether certain arrangements associated with variable interest entities (VIEs) should be treated as variable interests or considered as creators of variability, and indicates that the variability to be considered shall be on based on an analysis of the design of the entity.  FSP FIN 46(R)-6 was adopted on June 15, 2006.  The adoption of this statement did not have a material impact on the Company’s financial statements.

 

In March 2006, the FASB issued FAS 156, “Accounting for Servicing of Financial Assets” (“FAS 156”), an amendment of FAS 140.  FAS 156 requires that all separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable, and permits for subsequent measurement using either fair value measurement with changes in fair value reflected in earnings or the amortization and impairment requirements of FAS 140.  The subsequent measurement of separately recognized servicing assets and servicing liabilities at fair value eliminates the necessity for entities that manage the risks inherent in servicing assets and servicing liabilities with derivatives to qualify for hedge accounting treatment and eliminates the characterization of declines in fair value as impairments or direct write-downs.  FAS 156 is effective for an entity’s first fiscal year beginning after September 15, 2006.  The implementation of this statement did not have a material impact on the Company’s financial statements.

 

In September 2005, Statement of Position (“SOP”) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts”, (“SOP 05-1”), was issued.  This SOP provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacement of insurance and investment contracts other than those specifically described in FAS No. 97, “ Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments “.  SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006.  The adoption of this SOP did not have a material impact on the Company’s financial statements.

 

4.  CDO ASSET MANAGEMENT BUSINESS

 

One of the ways the Company participates in the structured finance market is through structuring and managing CDOs originated in collaboration with investment banks.  CDOs can be issued in funded, unfunded or partially funded form.  Funded CDOs issue debt instruments and purchase investment assets, while unfunded CDOs synthetically acquire assets and issue liabilities (i.e., assets and liabilities are in derivative form). Partially funded CDOs are a combination of these two forms.  From an accounting perspective, funded and partially funded CDOs are determined to be VIEs.  Each time such CDOs are formed, the Company performs an analysis to determine whether it is the primary beneficiary and thus required to consolidate the CDO under the provisions of FSP FIN 46(R)-6. Upon the occurrence of a reconsideration event in accordance with FIN 46(R)-6, such as the sale or disposal of all or part of the Company’s equity investment, the Company re-performs its analysis to determine whether it is still the primary beneficiary.

 

The following table lists each of the Company’s CDOs outstanding as of September 30, 2007 (dollars in millions):

 

 

 

Year

 

 

 

 

 

 

 

 

 

Original

 

Original

 

First

 

 

 

 

 

Deal

 

Transaction

 

 

 

Notional

 

 

 

Investment in

 

Retained

 

Optional

 

Maturity

 

CDO name

 

Closed

 

Type

 

Collateral Type (1)

 

Deal Size (3)

 

Consolidated

 

Retained Equity

 

Equity %

 

Call Date(4)

 

Date

 

Asset-Backed CDOs:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ACA ABS 2002-1

 

2002

 

Funded

 

Investment Grade

 

$

404

 

No

 

$

18.0

 

100

 

8/2005

 

8/2037

 

ACA ABS 2003-1

 

2003

 

Funded

 

Investment Grade

 

400

 

No

 

18.0

 

100

 

6/2007

 

6/2038

 

Grenadier Funding

 

2003

 

Funded

 

High-Grade

 

1,500

 

Yes

 

22.5

 

100

 

8/2008

 

8/2038

 

ACA ABS 2003-2

 

2003

 

Funded

 

Investment Grade

 

725

 

No

 

33.5

 

100

 

12/2007

 

12/2038

 

ACA ABS 2004-1

 

2004

 

Funded

 

Investment Grade

 

450

 

Yes

 

10.0

 

61

 

7/2007

 

7/2039

 

Zenith Funding

 

2004

 

Funded

 

High-Grade

 

1,511

 

Yes

 

13.0

 

52

 

12/2009

 

12/2039

 

ACA ABS 2005-1

 

2005

 

Funded

 

Investment Grade

 

452

 

No

 

4.4

 

24

 

4/2008

 

4/2040

 

ACA ABS 2005-2

 

2005

 

Funded

 

Investment Grade

 

450

 

No

 

2.1

 

10

 

9/2009

 

12/2044

 

Khaleej II

 

2005

 

Partially funded

 

Investment Grade

 

750

 

No

 

4.5

 

14

 

9/2009

 

9/2040

 

Lancer Funding

 

2006

 

Funded

 

High-Grade

 

1,500

 

No

 

1.5

 

10

 

7/2010

 

4/2046

 

ACA Aquarius 2006-1

 

2006

 

Partially funded

 

Investment Grade

 

2,000

 

No

 

 

 

9/2010

 

9/2046

 

ACA ABS 2006-1

 

2006

 

Funded

 

Investment Grade

 

750

 

No

 

1.4

 

5

 

12/2009

 

6/2041

 

ACA ABS 2006-2

 

2006

 

Funded

 

Investment Grade

 

750

 

No

 

3.5

 

11

 

1/2011

 

1/2047

 

ACA ABS 2007-1

 

2007

 

Partially funded

 

Investment Grade

 

1,500

 

No

 

1.4

 

5

 

3/2010

 

5/2047

 

Millbrook

 

2007

 

Unfunded

 

Investment Grade

 

62

 

No

 

 

 

3/2010

 

10/2052

 

Abacus 2007-AC1

 

2007

 

Unfunded

 

Investment Grade

 

192

 

No

 

 

 

6/2010

 

3/2038

 

ACA ABS 2007-2

 

2007

 

Partially funded

 

Investment Grade

 

750

 

No

 

 

 

7/2011

 

7/2045

 

Lancer II

 

2007

 

Partially funded

 

High-Grade

 

1,000

 

No

 

 

 

7/2011

 

7/2047

 

ACA ABS 2007-3

 

2007

 

Partially funded

 

Investment Grade

 

350

 

No

 

 

 

8/2013

 

5/2047

 

Total Asset-Backed CDOs

 

 

 

 

 

 

 

15,496

 

 

 

 

 

133.8

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate Credit CDOs:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ACA CDS 2002-2

 

2003

 

Unfunded

 

Investment Grade

 

1,000

 

No

 

25.0

 

100

 

N/A

 

3/2008

 

Argon 49

 

2005

 

Funded

 

Investment Grade

 

71

(2)

No

 

 

 

N/A

 

6/2015

 

Argon 57

 

2006

 

Funded

 

Investment Grade

 

71

(2)

No

 

 

 

N/A

 

6/2013

 

Tribune

 

2006

 

Unfunded

 

Investment Grade

 

217

(5)

No

 

 

 

N/A

 

9/2016

 

Dolomite

 

2007

 

Unfunded

 

Investment Grade

 

71

(2)

No

 

 

 

N/A

 

7/2014

 

Total Corporate Credit CDOs

 

 

 

 

 

 

 

1,430

 

 

 

 

 

25.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Leveraged Loan CDOs:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ACA CLO 2005-1

 

2005

 

Funded

 

Non-Investment Grade

 

300

 

No

 

5.0

 

21

 

10/2009

 

10/2017

 

ACA CLO 2006-1

 

2006

 

Funded

 

Non-Investment Grade

 

350

 

No

 

 

 

7/2009

 

7/2018

 

ACA CLO 2006-2

 

2006

 

Funded

 

Non-Investment Grade

 

300

 

No

 

2.2

 

10

 

1/2011

 

1/2021

 

ACA CLO Euro 2007-1

 

2007

 

Funded

 

Non-Investment Grade

 

571

(2)

No

 

5.5

 

10

 

6/2010

 

6/2024

 

ACA CLO 2007-1

 

2007

 

Funded

 

Non-Investment Grade

 

350

 

No

 

2.7

 

10

 

6/2011

 

6/2022

 

Total Leveraged Loan CDOs

 

 

 

 

 

 

 

1,871

 

 

 

15.4

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

 

 

 

 

$

18,797

 

 

 

$

174.2

 

 

 

 

 

 

 

 

11



 


(1)             Based on original rating, investment grade collateral is rated “BBB-” or better; however certain of our investment grade CDOs include the ability to invest a minority portion (20% or less) in non-investment grade assets. High-grade is “A-” or better.

 

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

 

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

 

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

 

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

 

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

 

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

 

Beginning in 2005, the Company has retained a lesser share of the equity position of newly issued CDOs.  Based on analyses under FIN 46(R), the Company is not deemed to be the primary beneficiary of these VIEs.  As a result, these CDOs are not consolidated in the financial statements.  Rather, the non-majority investment is recorded as an investment in a single fixed maturity security under the provisions of FAS 115 and Emerging Issues Task Force (“EITF”) Issue No. 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets” (“EITF 99-20”).  The deconsolidated CDOs described in the paragraph above are also accounted for under this principle. During the first nine months of 2007, the Company closed nine CDOs and purchased an equity interest in three.  During 2006, the Company closed eight CDOs and purchased an equity interest in four.  During 2005, the Company closed five CDOs and purchased an equity interest in four.  The Company was not determined to be the primary beneficiary in any of these CDOs and therefore did not consolidate them.

 

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

 

Net insured credit swap revenue includes insured credit swap premiums received for credit protection the Company has sold under its insured credit swaps as well as realized and unrealized gains and losses related to those transactions.  Realized losses arise upon the occurrence of credit events requiring payment by the Company under the related credit swap and, additionally, realized gains or losses could occur if a transaction is terminated in advance of its scheduled termination date.  Unrealized gains and losses represent the adjustments for changes in fair value that are recorded in each reporting period, under FAS 133.  The fair value of the Company’s insured credit swaps are recorded as either a derivative liability or derivative asset in the consolidated balance sheets.

 

The following table disaggregates net insured credit swap revenue into its component parts for the three months and nine months ended September 30, 2007 and 2006:

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

(in thousands)

 

Net insured credit swap revenue

 

 

 

 

 

 

 

 

 

Insured credit swap premiums earned

 

$

28,147

 

$

13,742

 

$

70,509

 

$

35,023

 

Unrealized gains (losses) on insured credit swaps

 

(1,655,607

)

3,337

 

(1,738,453

)

2,158

 

Realized gains on insured credit swaps

 

 

 

 

2,009

 

Total net insured credit swap revenue

 

$

(1,627,460

)

$

17,079

 

$

(1,667,944

)

$

39,190

 

 

12



 

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

 

Other net credit swap revenue includes revenues received from a partially funded CDS CDO, which sells credit protection under credit swaps for which it receives fixed quarterly fees, the residual returns on two synthetic equity participations and the cost of credit protection purchased in the form of a credit default swap.  This credit protection was purchased to hedge against our exposure to RMBS in our CDO Asset Management line of business. It also includes trading activity in credit default swaps by the Credit Fund. Other net credit swap revenue also includes net realized and unrealized gains and losses associated with these transactions, if any.  As of June 30, 2007, the Company’s risk to the partially funded CDS CDO and one of the synthetic equity participations had expired.  These revenues were included in the Company’s consolidated statement of operations for periods prior to that date. The following table disaggregates other net credit swap revenue into its component parts for the three months and nine months ended September 30, 2007 and 2006:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

(in thousands)

 

Other net credit swap revenue

 

 

 

 

 

 

 

 

 

Credit swap fees earned

 

$

(2,395

)

$

2,530

 

$

3,415

 

$

7,783

 

Unrealized gain on credit protection purchased

 

3,242

 

 

14,816

 

 

Unrealized gains on credit swaps - credit fund

 

1,947

 

 

1,667

 

 

Unrealized losses on credit swaps - CDOs

 

 

(440

)

(947

)

(149

)

Total other net credit swap revenue

 

$

2,794

 

$

2,090

 

$

18,951

 

$

7,634

 

 

6.  INCOME TAXES

 

Effective January 1, 2007, the Company adopted the provisions of FIN 48. As a result, the Company recorded a $1.5 million reserve for uncertain tax positions and a corresponding decrease to the 2007 opening retained earnings. The Company’s effective tax rate would have increased if this amount was recognized as a tax expense. It is unlikely that the unrecognized tax expense will significantly change in the next 12 months.

 

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

 

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

 

Our tax provision for interim periods is determined using an estimate of our annual effective tax rate. The 2007 effective tax rate is estimated to be equal to the 35% statutory rate.

 

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

 

13



 

payments. The total T&L bonds recorded in current federal income tax payable as of September 30, 2007 is $18.3 million.

 

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

 

7.  LITIGATION

 

In May 2006, the Company paid a judgment in the amount of $3.7 million in satisfaction of a damages award in connection with an employment contract dispute with a former executive of the Company plus accrued interest through the date of payment.  Also in May 2006, the Company settled the former executive’s attorney’s fees at an additional amount of $0.6 million.  The Company had recorded a reserve of $4.2 million to cover these costs in December 2005.  A judicial satisfaction of the judgment has been filed and the Company has no additional liability with respect to this matter.

 

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

 

8.  SEGMENT INFORMATION

 

The Company’s reportable segments are as follows:

 

(1)           Structured Credit, which structures and sells credit protection, principally in the form of insured credit swaps, against a variety of asset classes in the institutional fixed income markets;

 

(2)           Public Finance, which provides insurance guaranteeing the timely payment of principal and interest on public finance and other debt obligations;

 

(3)           CDO Asset Management, which originates, structures and manages assets, primarily corporate obligations or asset-backed securities, in funded, partially funded or synthetic CDOs; and

 

(4)           Other, which primarily includes trade credit insurance business and financial guaranty insurance on certain other sectors, each of which the Company is no longer engaged in.

 

The Company’s first three reportable segments are strategic business units that offer different products and services.  They are managed separately since each business requires different marketing strategies, personnel skill sets and technology.

 

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

 

The accounting policies of the segments are the same as those described in the summary of significant accounting policies.  The Company evaluates segment performance based on its income (loss) before income taxes.  Reportable segment results are presented net of material inter-segment transactions.  The following tables summarize the Company’s operations and allocation of assets as of and for the three months and nine months ended September 30, 2007 and 2006 (dollars in thousands):

 

14



 

 

 

Three Months Ended September 30, 2007

 

 

 

Structured

 

Public

 

CDO Asset

 

 

 

Consolidated

 

 

 

Credit

 

Finance

 

Management

 

Other

 

Totals

 

REVENUES:

 

 

 

 

 

 

 

 

 

 

 

Gross premiums written

 

$

36

 

$

6,997

 

$

 

$

80

 

$

7,113

 

 

 

 

 

 

 

 

 

 

 

 

 

Premiums earned

 

$

36

 

$

5,302

 

$

 

$

190

 

$

5,528

 

Net insured credit swap revenue

 

(1,624,766

)

(520

)

(2,174

)

 

(1,627,460

)

Net investment income

 

4,722

 

4,576

 

74,964

 

3,209

 

87,471

 

Net realized and unrealized gains (losses) on investments

 

(7,142

)

(209

)

26,916

 

(51

)

19,514

 

Net realized and unrealized losses on derivative instruments

 

(33

)

 

(2,364

)

 

(2,397

)

Other net credit swap revenue

 

(496

)

 

3,290

 

 

2,794

 

Fee and other income

 

180

 

58

 

9,381

 

 

9,619

 

Total revenues

 

(1,627,499

)

9,207

 

110,013

 

3,348