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 quarterly period ended September 30, 2000.March 31, 2001.
OR
OR
¨o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period fromtofrom_________________ to________________ .
Commission File Number: 001-13533

Commission File Number: 001-13533

NovaStar Financial, Inc.
(Exact name of registrant as specified in its charter)

Maryland
74-2830661
(State or other jurisdiction of
of incorporation or organization)
74-2830661
(I.R.S. Employer
Identification NumberNo.)
1901 W. 47th Place, Suite 105, Westwood, KS 66205
(Address of principal executive offices)
(Zip Code)

1901 W. 47th Place, Suite 105, Westwood, KS 66205

(Address of principal executive offices)
(Zip Code)
(913) 362-1090
(Registrant’sRegistrant's telephone number, including area code)

______________________________________________
(Former name, former address and former fiscal year, if changed since last report)

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.
Yesx Noo¨

The number of shares of the registrant’sregistrant's common stock outstanding as of November 10, 2000May 11, 2001 was 6,163,741.

5,715,116.

NOVASTAR FINANCIAL, INC.

FORM 10-Q

QUARTER ENDED SEPTEMBER 30, 2000
MARCH, 31, 2001
INDEX

Page
PART IFINANCIAL INFORMATION 
 
Item 1.Consolidated Financial Statements: 
   Balance Sheets1
   Statements of Operations2
   Statements of Cash Flows3
   Notes4
 
Item 2.Management’sManagement's Discussion and Analysis of Financial
Condition and Results of Operations		6
 
Item 3.3.Quantitative and Qualitative Disclosures about Market Risk4429
 
PART IIOTHER INFORMATION
 
Item 1.Legal Proceedings4933
  
Item 2.Changes in Securities4933
  

Item 3.

Defaults Upon Senior Securities4933
  
Item 4.Submission of Matters to a Vote of Security Holders4933
  
Item 5.Other Information4933
  
Item 6.Exhibits and Reports on Form 8-K5033
  
 Signatures5435

NOVASTAR FINANCIAL, INC.
CONSOLIDATED BALANCE SHEETS

(dollars in thousands, except share amounts) (unaudited)
 

March 31, 2001

 

December 31, 2000

 
Assets      
   Cash and cash equivalents$10,533 $2,518 
   Mortgage loans — held-for-sale 99,219  — 
   Mortgage loans — held-in-portfolio 332,766  375,927 
   Mortgage securities — available-for-sale 76,207  46,650 
   Accrued interest receivable 8,187  9,151 
   Advances to and investment in NFI Holding
         Corporation		 —  45,415 
   Assets acquired through foreclosure 12,835  13,054 
   Other assets 12,438  1,767 
 
 
 
            Total assets$552,185 $494,482 
 
 
 
       
Liabilities and Stockholders' Equity      
   Liabilities:      
     Warehouse borrowings$68,266 $— 
     Asset-backed bonds 318,189  357,437 
     Mortgage securities repurchase agreements 25,000  25,000 
     Accounts payable and other liabilities 23,043  3,601 
     Dividends payable 525  525 
 
 
 
            Total liabilities 435,023  386,563 
       
   Stockholders' equity:      
   Capital stock, $0.01 par value, 50,000,000 shares
         authorized:		      
   Class B, convertible preferred stock, 4,285,714
         shares issued and outstanding, respectively		 43  43 
     Common stock, 5,716,316 and 6,094,595 shares
         issued and outstanding, respectively		 57  61 
   Additional paid-in capital 137,325  141,997 
   Accumulated deficit (35,488) (37,976)
   Accumulated other comprehensive income 16,583  10,168 
   Notes receivable from founders (1,358) (6,374)
 
 
 
            Total stockholders' equity 117,162  107,919 
 
 
 
      Total liabilities and stockholders' equity$552,185 $494,482 
 
 
 

     September 30,2000
    December 31, 1999
   (unaudited)    
Assets        
  Cash and cash equivalents    $    2,767     $    2,395 
  Mortgage loans    424,547     620,406 
  Mortgage-backed securities—available-for-sale    41,784     6,775 
  Accrued interest receivable    9,782     12,452 
  Advances to and investment in NFI Holding Corporation    20,617     29,208 
  Assets acquired through foreclosure    15,315     16,891 
  Other assets    1,905     2,383 
  
  
 
          Total assets    $516,717     $690,510 
  
 
Liabilities and Stockholders’ Equity        
  Liabilities:
    Borrowings    $413,156     $586,868 
    Dividends payable    525     525 
    Accounts payable and other liabilities    2,173     1,803 
  
  
 
          Total liabilities    415,854     589,196 
 
  Stockholders’ equity:
    Capital stock, $0.01 par value, 50,000,000 shares authorized:        
      Class B, convertible preferred stock, 4,285,714
        shares issued and outstanding		    43     43 
      Common stock, 8,143,407 and 8,130,069 shares issued;
        6,206,441 and 7,460,523 shares outstanding, respectively		    81     81 
    Additional paid-in capital    151,197     151,173 
    Accumulated deficit    (39,742)    (41,502)
    Accumulated other comprehensive income    3,283     242 
    Cost of treasury stock, 1,936,966 and 673,400 shares, respectively    (7,153)    (1,877)
    Notes receivable from founders    (6,846)    (6,846)
  
  
 
          Total stockholders’ equity    100,863     101,314 
  
  
 
      Total liabilities and stockholders’ equity    $516,717     $690,510 
  
  
 

See accompanying notes to consolidated financial statements.

NOVASTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited; in thousands except per share amounts)
 
For the Three Months
Ended March 31,
2001
2000
Interest income:
   Mortgage loans$12,740$12,812
   Mortgage securities1,350266
 
 
 
Total interest income14,09013,078
Interest expense:
   Financing on mortgage loans8,0369,636
   Financing on mortgage securities48062
 
 
 
Interest expense8,5169,698
 
 
 
Net interest income before provision for credit losses5,5743,380
Provision for credit losses(519)(1,579)
 
 
 
Net interest income5,0551,801
Prepayment penalty income250489
Premiums for mortgage loan insurance(437)(365)
Loan servicing income (fees)6,204(696)
Gain on sale of mortgage assets5,023—
Other income (loss)447(2)
Equity in net income of NFI Holding Corporation—699
General and administrative expenses:
   Net fees for other services provided by NovaStar
   Mortgage, Inc.		—3
   Compensation and benefits6,685384
   Travel and public relations1,897—
   Office administration1,790171
   Loan expense519—
   Professional and outside services414130
   Other51826
 
 
 
   Total general and administrative expenses11,823714
 
 
 
Net income before cumulative effect of a change in accounting
   principle		4,7191,212
Cumulative effect of a change in accounting principle(1,706)— 
 
 
 
Net income3,0131,212
Dividends on preferred shares(525)(525)
 
 
 
Net income available to common shareholders$2,488$687
 
 
 
Basic earnings per share — before cumulative effect of a change in
   accounting principle		$0.47$0.09
 
 
 
Diluted earnings per share — before cumulative effect of a change in
   accounting principle		$0.47$0.09
 
 
 
Basic loss per share due to the cumulative effect of a change in
   accounting principle		$(0.17)$—
 
 
Diluted loss per share due to the cumulative effect of a change in
   accounting principle		$(0.17)$—
 
 
Basic earnings per share$0.30$0.09
 
 
Diluted earnings per share$0.30$0.09
 
 
Weighted average basic shares outstanding5,7227,342
 
 
Weighted average diluted shares outstanding10,1627,352
 
 
Dividends declared per common share$—$—
 
 
 

See accompanying notes to consolidated financial statements.

NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited; in thousands)

      For the Nine Months
Ended September 30,
     For the Three Months
Ended September 30,
 
  2000
  1999
  2000
 1999
 
Interest income on mortgage loans $   34,981  $   52,236  $   10,391  $   15,595 
Interest expense on mortgage loans     26,881      36,059      8,240      11,206 
   
   
   
   
  
Net interest income     8,100      16,177      2,151      4,389 
Prepayment penalty income     1,431      2,385      448      769 
Provision for credit losses     (4,004)      (11,499)     (1,212)     (5,634)
Premiums for mortgage loan insurance     (1,009)     (1,339)     (302)     (427)
Loan servicing fees paid to NovaStar Mortgage, Inc.     (1,982)     (3,056)     (599)     (936)
   
   
   
   
  
Net portfolio income (loss)     2,536      2,668      486      (1,839)
                 
Net interest income on mortgage-backed securities     1,329      100      602      100 
                 
Other income (loss)     (453)     706      (591)     322 
                 
Equity in net income of NFI Holding Corporation     646      1,518      787      576 
                 
General and administrative expenses:                            
     Net fees for other services provided by (to) NovaStar Mortgage, Inc.  (1,460)  287   (1,458)  (169)
     Compensation and benefits.     1,042      1,358      325      421 
     Professional and outside services     467      546      210      181 
     Office administration     607      611      206      203 
     Other     66      156      23      60 
   
   
   
   
  
     Total general and administrative expenses     722      2,958      (694)     696 
   
   
   
   
  
                
Net income (loss) $  3,336  $  2,034  $ 1,978  $ (1,537)
  
  
 
  
 
Dividends on preferred shares $  (1,575) $  (1,081) $   (525) $   (525)
   
   
   
   
  
Net income (loss) available to common shareholders $  1,761  $   953  $  1,453  $  (2,062)
   
   
   
   
  
                 
Basic earnings (loss) per share $    0.25  $    0.12  $    0.21  $   (0.25)
   
   
   
   
  
Diluted earnings (loss) per share $  0.25  $0.11  $ 0.18  $ (0.25)
   
   
   
   
  
                 
Weighted average basic shares outstanding     7,087      8,130      6,900      8,130 
Weighted average diluted shares outstanding     7,094      8,326      11,192      8,130 
                 
Dividends declared per common share $—  $ —  $ —  $— 
   
   
   
   
  
 

For the Three Months
Ended March 31,

 
 
 
 

2001

 

2000

 
Net cash provided by (used in) operating activities:$(29,100)$5,486 
       
Cash flow from investing activities:      
   Mortgage loan repayments 32,399  59,770 
   Sales of assets acquired through foreclosure 8,692  6,697 
   Proceeds from paydowns on available-for-sale securities 3,557  661 
   Net assets acquired during acquisition of NFI Holding Corporation 1,242  — 
   Net change in advance to NFI Holding Corporation —  (4,936)
 
 
 
   Net cash provided by investing activities 45,890  62,192 
       

Cash flow from financing activities:

      
   Payments on asset-backed bonds (39,546) (66,265)
   Change in short-term borrowings 31,366  — 
   Proceeds from issuance of capital stock and exercise of equity instruments,
      net of offering costs		 —  14 
   Dividends paid on preferred stock (525) (525)
   Common stock repurchases (70) (952)
 
 
 
   Net cash used in financing activities (8,775) (67,728)
 
 
 
       
   Net increase (decrease) in cash and cash equivalents 8,015  (50)
   Cash and cash equivalents, beginning of period 2,518  2,395 
 
 
 
   Cash and cash equivalents, end of period$10,533 $2,345 
 
 
 

Supplemental disclosure of cash flow information:

      
   Transfer of available-for-sale securities$25,108 $— 
 
 
 
   Cash paid for interest$8,529 $9,801 
 
 
 
   Dividends payable$525 $525 
 
 
 
   Non-cash activities related to purchase of NFI Holding Corporation:      
      Operating activities:      
         Increase in real estate owned$(892)$— 
 
 
 
         Increase in other assets$(11,132)$— 
 
 
 
         Decrease in other liabilities$(9,422)$— 
 
 
 
      Investing activities:      
         Cash received in purchase$(872)$— 
 
 
 
         Increase in mortgage loans$(81,733)$— 
 
 
 
         Decrease in investment in/advances to NFI Holding Corp.$48,307 $— 
 
 
 
      Investing activities:     
         Increase in borrowings$36,900 $— 
 
 
 
         Decrease in founders' notes receivable$(370)$— 
 
 
 
      
      Non-cash financing activities related to founders' notes receivable:     
         Decrease in founders' notes receivable$(4,611)$— 
 
 
 
         Increase in additional paid-in capital$4,611 $— 
 
 
 

See accompanying notes to consolidated financial statements.

NOVASTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited; in thousands)
     For the Ninth Months
Ended September 30,
     2000    1999
Net cash provided by operating activities    $  13,945     $  23,504 
 
Cash flow from investing activities:        
     Mortgage loan repayments    176,799     201,034 
     Sales of assets acquired through foreclosure    15,295     17,542 
     Mortgage loans sold to others    —     4,900 
     Proceeds from paydowns on mortgage-backed securities    2,161     — 
     Net change in advances to NFI Holding Corporation    7,309     (15,360)
     Purchase of mortgage-backed securities from NFI Holding Corporation    (33,767)    — 
    
    
  
     Net cash provided by investing activities    167,797     208,116 
 
Cash flow from financing activities:        
     Payments on collateralized mortgage obligations    (185,502)    (236,872)
     Change in short-term borrowings    10,960     (18,029)
     Net proceeds from issuance of capital stock and exercise of equity instruments    23     29,029 
     Dividends paid on preferred stock    (1,575)    (556)
     Dividends paid on common stock    —     (2,845)
     Treasury stock purchases ��  (5,276)    — 
    
    
  
     Net cash used in financing activities    (181,370)    (229,273)
    
    
  
     Net increase in cash and cash equivalents    372     2,347 
     Cash and cash equivalents, beginning of period    2,395     — 
    
    
  
     Cash and cash equivalents, end of period    $    2,767     $    2,347 
    
    
  
 
Supplemental disclosure of cash flow information:        
     Cash paid for interest    $  27,048     $  36,567 
    
    
  
     Assets acquired through foreclosure    $  12,136     $  22,570 
    
    
  
     Dividends payable    $       525     $       525 
    
    
  
     Issuance of warrants    $         —     $       350 
    
    
  
See notes to consolidated financial statements.
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2000March 31, 2001 (Unaudited)

Note 1. Financial Statement Presentation

        The consolidated financial statements as of and for the periods ended September 30,March 31, 2001 and 2000 and 1999 are unaudited. In the opinion of management, all necessary adjustments have been made, which were of a normal and recurring nature, necessary for a fair presentation of the balance sheets and results of operations. The consolidated financial statements should be read in conjunction with Management’sManagement's Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements of NovaStar Financial and the notes thereto, included in NovaStar Financial’sFinancial's annual report to shareholders and annual report on Form 10-K for the fiscal year ended December 31, 1999.

2000.

        NovaStar Financial, Inc. owns 100 percent of the common stock of three special purpose entities — NovaStar Assets Corporation, NovaStar Certificates Financing Corporation and NovaStar Mortgage Funding Corporation. NovaStar Financial formed these entities in connection with the issuance of collateralized mortgage obligations.asset-backed bonds.

        The consolidated financial statements of NovaStar Financial include the accounts of these entities. Significant intercompany accounts and transactions have been eliminated in consolidation.

        On January 1, 2001, NovaStar Financial ownspurchased 100 percent of the non-voting preferred stock of NFI Holding Corporation (Holding) for which it receives 99 percent of any dividends paid by NFI Holding. The founders of NovaStar Financial own the voting common stock of NFI Holding Corporation (Holding). Prior to January 1, 2001 the Chief Executive Officer and receive 1%Chief Operating Officer of any dividends paid by NFI Holding.NovaStar Financial each owned one-half of these shares. NovaStar Mortgage, Inc., NovaStar Capital,Home Mortgage, Inc., and NovaStar Home Mortgage,Capital, Inc. are wholly owned subsidiaries of NFI Holding. NovaStar Mortgage Funding Corporation II, NovaStar Mortgage Funding Corporation III and NovaStar REMIC Financing Corporation are subsidiaries of NovaStar Mortgage. Prior to January 1, 2001, NovaStar Financial, accounts forInc. owned all of the preferred shares of Holding, which were non-voting and retired on January 1, 2001. Prior to January 1, 2001, NovaStar Financial, Inc. recorded its investment in Holding using the equity method.

Beginning January 1, 2001, the financial condition and results of operations of Holding and NovaStar Financial, Inc. are consolidated.

      NewNote 2. Implementation of Accounting Pronouncements.

        During 1998, the Financial Accounting Standards Board (FASB) issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". As amended by SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of FASB Statement No. 133" and SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment of FASB Statement No. 133," SFAS No. 133 standardizes the accounting for derivative instruments, including certain instruments embedded in other contracts, by requiring that an entity recognize those items as assets or liabilities in the balance sheet and measure them at fair value. If certain conditions are met, an entity may elect to designate a derivative instrument either as a cash flow hedge, a fair value hedge or a hedge of foreign currency exposure. Generally, SFAS No. 133 provides for matching the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in therequires derivative instruments to be recorded at their fair value with hedge ineffectiveness recognized in earnings. In addition, the pronouncement requires that the time value of hedge asset or liability that is attributablepurchased options be recorded at fair value as an adjustment directly to the hedge risk or the earnings effect of the hedge forecasted transaction. SFAS No. 137,Accounting for Derivative Instruments and Hedging Activities—Deferral of the Effective Date of FASB Statement No. 133 an amendment of FASB Statement No. 133 was issued in June 1999 and postponed the effective date ofearnings. The Company adopted SFAS No. 133 on January 1, 2001 and recorded a charge to fiscal years beginning after June 15, 2000. Management has reviewed all financial instrumentsearnings of NovaStar Financial and has determined that NovaStar Financial’s$1.7 million. The transition adjustment resulted from adjusting the carrying value of certain interest rate cap agreements areto their face value.

        The Company uses derivative instruments under SFAS No. 133. These derivatives are used to hedgewith the objective of hedging interest rate riskrisk. Interest rates on variableliabilities of the Company adjust daily or annually, while interest rates on the Company's assets adjust annually, or not at all. The Company has determined that all of our derivative instruments ( interest rate debtcaps & swaps qualify as cashflow hedges and will be accountedaccounts for as cash flow hedges under SFAS No. 133. Management does not expectthese instruments accordingly. As discussed above, a $1.7 million transition adjustment resulting from the adoption of SFAS No. 133 to have a material impactwas recorded on the financial statementsincome statement as a separate line item. In addition, the Company recorded as additional derivatives loss of $243,000 during the quarter. This amount is included in the amount reported as ""Financing on mortgage loans" on the income statement. The amount of the NovaStar Financial, Inc.

           In September 2000, the Financial Accounting Standards Board (FASB) issued SFAS No. 140,Accounting for Transfers and Servicingcash flow hedges' ineffectiveness was immaterial as of Financial Assets and Extinguishments of Liabilities—a replacement of FASB Statement No. 125.SFAS 125 was issued in June 1996 to revise the standards for accounting for securitization and other transfers of financial assets and requires certain disclosures regarding those transfers. SFAS 140 replaces SFAS 125 in its entirety. However, it carries over most of the provisions of SFAS 125. SFAS 140 also formalizes guidance provided by the FASB in various committee publications and technical bulletins. This Statement is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001. This Statement is effective for recognition and reclassification of collateral and for disclosures relating to securitization transactions and collateral for fiscal years ending after December 15, 2000. Disclosures about securitization and collateral accepted need not be reported for periods ending on or before December 15, 2000, for which financial statements are presented for comparative purposes. Management does not expect the adoption of SFAS No. 140 to have a material impact on the financial statements of NovaStar Financial.
          In addition, Note 1 of the consolidated financial statements contained in the annual report on Form 10-K for the fiscal year ended December 31, 1999 describes certain recently issued accounting pronouncements. Management believes the implementation of these pronouncements and others that have gone into effect since the date of these reports will not have a material impact on the consolidated financial statements.

Note 2.3. NovaStar Mortgage Funding Trust Series 2000-1 and 2000-22001-1

        On March 31, 2000 and September 28, 2000,29, 2001, NovaStar Mortgage executed a securitization transactionstransaction that, for financial reporting and tax purposes, was treated as a sale. As part of this transaction, NovaStar Mortgage sold $408 million in loans, of which $207 million will settle in the second quarter of 2001. The loans were sold to NovaStar Mortgage Funding Trust Series (NMFT) 2001-1, which issued asset-backed bonds of $415 million. NovaStar Mortgage retained the AAA-rated interest only and subordinated securities that were constructed to allow for accountingissued by NMFT 2001-1, with a carrying value of $25.1 million as sales of loans. DetailsMarch 31, 2001. A gain of these transactions are as follows:

     Value of
Asset-Backed
Bonds Issued
    Economic Residual Value
as of September 30, 2000
    Value of
Collateral Sold
    Gain
Recognized
NMFT 2000-1    $226 million    $13,750,000    $229,846,000    $2,936,000
NMFT 2000-2 (A)    $334 million    $20,534,000    $188,734,000    $3,584,000

$5.0 million was recognized on this transaction.

(A)       A second closing for NMFT 2000-2 is scheduled for December 26, 2000 in which $151.3 million of loans will be added.

Item 2. Management’sManagement's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the preceding consolidated financial statements of NovaStar Financial and the notes thereto as well as NovaStar Financial’sFinancial's annual report to shareholders and annual report on Form 10-K for the fiscal year ended December 31, 1999.2000.

Safe Harbor Statement

          “Safe Harbor”

            "Safe Harbor" statement under the Private Securities Litigation Reform Act of 1995: Statements in this discussion regarding NovaStar Financial, Inc. and its business, which are not historical facts, are “forward-looking statements”"forward-looking statements" that involve risks and uncertainties. Certain matters discussed in this quarterlyannual report may constitute forward-looking statements within the meaning of the federal securities laws that inherently include certain risks and uncertainties. Actual results and the time of certain events could differ materially from those projected in or contemplated by the forward-looking statements due to a number of factors, including general economic conditions, fluctuations in interest rates, fluctuations in prepayment speeds, fluctuations in losses due to defaults on mortgage loans, the availability of non-conforming residential mortgage loans, the availability and access to financing and liquidity resources, and other risk factors outlined in the annual report on Form 10-K for the fiscal year ended December 31, 1999.2000. Other factors not presently identified may also cause actual results to differ. Management continuously updates and revises these estimates and assumptions based on actual conditions experienced. It is not practicable to publish all revisions and, as a result, no one should assume that results projected in or contemplated by the forward-looking statements will continue to be accurate in the future. Risks and uncertainties, which could cause results to differ from those discussed in the forward-looking statements herein, are listed in the “ Risk Management”"Risk Management" section of the annual report on Form 10-K for the fiscal year ended December 31, 1999.

2000.

Basis of Presentation

          NovaStar Financial owns 100% of the common stock of NovaStar Assets Corporation, NovaStar Certificates Financing Corporation and NovaStar Mortgage Funding Corporation. These entities were established as special purpose entities used in issuance of collateralized mortgage obligations.

        The consolidated financial statementssubsidiaries of NovaStar Financial, include the financial condition and results of operations of these entities.

          NovaStar Financial also owns 100% of the non-voting preferred stock of NFI Holding Corporation for which it receives 99% of any dividends paid by NFI Holding. Scott Hartman and Lance Anderson, the founders of NovaStar Financial, own the voting common stock of NFI Holding and receive 1% of any dividends paid by NFI Holding. NovaStar Mortgage, Inc., NovaStar Capital and NovaStar Home Mortgage, Inc. are wholly owned subsidiaries of NFI Holding. NovaStar Mortgage Funding Corporation II, NovaStar Mortgage Funding Corporation III and NovaStar REMIC Financing Corporation are subsidiaries of NovaStar Mortgage. The business of NovaStar Mortgage is discussedpresented in “Description of Business—Business of NovaStar Mortgage.” NovaStar Capital was formedNote 1 to focus on acquiring non-conforming residential mortgage loans from banks, thrifts and credit unions. In February 2000, NovaStar Capital discontinued operations. NovaStar Home Mortgage was created in May 1999 to operate a network of mortgage brokers. Currently, NovaStar Home Mortgage operates 48 branches in 24 states.
           A significant component of the consolidated financial results of NovaStar Financial are derived from the operations of NovaStar Mortgage, Inc. Key officers of NovaStar Financial also serve as officers of NFI Holding, NovaStar Mortgage, NovaStar Capital, Inc and NovaStar Home Mortgage, Inc. The founders are the only members of the Board of Directors of NFI Holding, NovaStar Mortgage, NovaStar Capital and NovaStar Home Mortgage, Inc. NovaStar Mortgage owns 100% of NovaStar Mortgage Funding Corporation II, NovaStar Mortgage Funding Corporation III and NovaStar REMIC Financing Corporation. These special purpose entities were created for the issuance of interests in real estate mortgage investment conduits commonly known as REMICs. NovaStar Financial accounts for its investment in NFI Holding using the equity method, meaning the operations of NFI Holding are not consolidated with NovaStar Financial.
statements.

Recent Developments

        Federal Tax LegislationLegislation.. REITs will be allowed Recently adopted legislation allows a real estate investment trust (REIT) to own directly all of the stock of taxable subsidiaries beginning in the tax year 2001. The value of all taxable subsidiaries of a REIT will be limited to 20% of the total value of the REIT’sREIT's assets. Accordingly, NovaStar Financial expects to acquireacquired all of the common stock of NFI Holding Corporation from Scott Hartman and Lance Anderson inon January 1, 2001. As a result, NFI Holding will become a wholly-owned consolidated subsidiary of NovaStar Financial.

        Also, effective beginning with the 2001 tax year, the minimum dividend distributions of a REIT will have to equal 90% of taxable income, down from 95% of taxable income under current law. This provision will also first be effective beginning with the 2001 tax year. These and other federal tax legislation changes and proposals are discussed further in NovaStar Financial’sFinancial's Annual Report on Form 10K under “Federal"Federal Income Tax Consequences”Consequences".

Description of BusinessBusinesses

Business of NovaStar Financial:Investment Portfolio

  • ·
    		FoundedInvest in 1996 as a specialty finance lender to invest in mortgage assets;
    ·
    		Assets haveassets generated primarily come from theour wholesale origination of nonconforming, single-family, residential mortgage loans of its affiliate, NovaStar Mortgage;loans;
    ·
  		• Operates as a long-term portfolio investor;
  • ·
    		Loans are financed on a short-term basis through various warehouse facilities. Long-term financingFinancing is provided through securitization whereby issuing asset-backed bonds are issued in financing-structured transactions;and entering into reverse repurchase agreements;
    ·
  		• Earnings are generated from return on mortgage securities and spread income on the mortgage loan and securities portfolio and indirectly by gains associated with the sale of loans to outside parties or through securitization transactions of NovaStar Mortgage.portfolio;

    Business of NovaStar Mortgage:Residential Mortgage Lending

    ·
  		• Primary customer is the retail mortgage broker who deals with the borrower. NovaStar Mortgage’sMortgage's account executives work with more than 4,5005,800 brokers to solicit loans.
    ·
  		• Borrowers generally are individuals or families who do not qualify for agency/conventional lending programs because of a lack of available documentation or previous credit difficulties. Often, these borrowers have built up high-rate consumer debt and are attempting to use equity in their home to consolidate debt and lower their total monthly payments.
    ·
  		• Loans are financed on athrough short-term basis through warehouse facilities. Long-term financing is provided through securitization where asset-backed bonds are issued in transactions that are structured as a sale.
    ·
  		• Loans are held for sale—sale in either to affiliates, third partiesoutright sales for cash or subsidiariesin securitization transactions accounted for as collateralsales.

    Branch Operations

  		• Retail mortgage brokers and their staffs operate under the NovaStar Home Mortgage name and are employees of NovaStar Home Mortgage.
  		• Branches operate under a strict set of established policies.
  		• Branch can broker loans to any approved investor, including NovaStar Mortgage, Inc.
  		• Net operating income for securitization.the branch is returned as compensation to the branch "owner/manager."
  		• As of March 31, 2001, there were 76 active branches in 31 states operating under the NovaStar Home Mortgage name.

    Financial Condition of NovaStar Financial, Inc. as of September 30, 2000March 31, 2001 and December 31, 19992000

              NovaStar Financial’s

            Mortgage Loans. Our balance sheets consistsheet consists primarily of securitized mortgage loans originated bywe have originated. We classify our mortgage loans into two categories: "held-for-sale" and purchased from NovaStar Mortgage, which"held-in-portfolio." A majority of our loans serve as collateral for its collateralized mortgage obligations.asset-backed bonds we have issued and are classified as "held-in-portfolio." The carrying value of "held-in-portfolio" mortgage loans as of September 30, 2000March 31, 2001 was $425$333 million versus $620compared to $376 million as of December 31, 1999. The carrying value2000.

            Loans we have originated, but have not yet securitized, are classified as "held-for-sale." We expect to sell these loans outright in third party transactions or in securitization transactions that will be, for tax and accounting purposes, recorded as sales. We use warehouse lines of collateralizedcredit and mortgage obligationsrepurchase agreements to finance our held-for-sale loans.

            Premiums are paid on substantially all mortgage loans. Premiums are amortized as a reduction of September 30, 2000 was $402 million compared with $587 million asinterest income over the estimated lives of December 31, 1999. The decline in both balance sheet items is primarily a resultthe assets. Tables 3 and 6 provide information to analyze

    the impact of principal paydowns that occurred duringpayments on amortization. To mitigate the first nine monthseffect of 2000.prepayments on interest income from mortgage loans, we generally strive to originate mortgage loans with prepayment penalties.

            In periods of decreasing interest rates, borrowers are more likely to refinance their mortgages to obtain a better interest rate. Even though NovaStar Financialin rising rate environments, borrowers tend to repay their mortgage principal balances earlier than is no longer purchasingrequired by the terms of their mortgages. Non-conforming borrowers, as they update their credit rating, are more likely to refinance their mortgage loan to obtain a lower interest rate.

            Prepayment rates in Table 6 represent the annualized principal prepayment rate in the most recent one, three and twelve month periods and over the life of the pool of loans. This information has not been presented for held-for-sale loans as we do not expect to own the loans originated from NovaStar Mortgage, NovaStar Financial has been ablefor a period long enough to grow its mortgage asset portfolio by purchasing the residual assets of all NovaStar Mortgage’s securitization transactions. The carrying valueexperience material repayments.

            Characteristics of the residual assetsmortgage loans we own are provided in Tables 1 through 8. The operating performance of NovaStar Financial was $42 million asour mortgage loan portfolio, including net interest income, allowances for credit losses and effects of September 30, 2000 compared with $7 million ashedging are discussed under "Results of December 31, 1999. Mortgage loans collateralizing residual assets totaled $526 million as of September 30, 2000 compared with $143 million as of December 31, 2000 bringingOperations" and "Interest Rate/Market Risk." Gains on the total carrying valuesales of mortgage assets managed by NovaStar Financial to nearly $1 billionloans, including impact of securitizations treated as sales, is also discussed under "Results of September 30, 2000 compared with $770 million as of December 31, 1999.

    Operations."

    Mortgage Loans.    Table 1 is a presentation of loans as of September 30, 2000 and December 31, 1999 and their credit grades. Table 2 is a summary of all mortgage loans owned by NovaStar Financial as of September 30, 2000 and December 31, 1999 by state. These tables also provide details regarding the collateral outstanding on NovaStar Mortgage’s REMIC transactions, which NovaStar Financial owns the residual interests. The REMIC transactions are discussed further in the “Mortgage Loans—Available for Sale” and “Mortgage Loans Sales” sections of this document.

    Table 1
    —Mortgage Loans by Credit Grade
    (dollars in thousands)
       
    March 31, 2001
    		 
    December 31, 2000
    Credit
    Grade
    Allowed
    Mortgage
    Lates (A)
    Maximum
    Loan-
    to-value
    Current
    Principal
    Weighted
    Average
    Coupon
    Weighted
    Average
    Loan-to-
    Value
    		 
    Current
    Principal
    Weighted
    Average
    Coupon
    Weighted
    Average
    Loan-to-
    Value
     
    Held-for-sale:
    AAA0 x 30          97(B)$16,88710.03%75.8% $15,6969.83%73.8%
    AA0 x 30          9527,66510.4183.1 25,33510.0781.4
    A1 x 30          9015,40310.4078.8 15,20910.3580.3
    A-2 x 30          9011,75311.0275.4 6,81210.2780.4
    B3 x 30, 1x 60,5 x 30, 2 x 60          858,77911.2177.9 5,71910.5478.0
    C1 x 90          751,72111.6369.5 74010.7769.7
    D6 x 30, 3 x 60,2 x 90          65——— ———
    OtherVaries          9716,10611.9593.8 7,82311.9593.8
    		      
    		  
      $98,31410.7681.3 $77,334    10.2780.5
    Held-in-portfolio:
    AA0 x 30          95$50,68710.09%82.5%$56,46310.17%82.6%
    A1 x 30          90134,06910.5779.5 152,62110.6679.4
    A-2 x 30          9078,19711.2881.7 88,61711.3081.7
    B3 x 30, 1x 605 x 30, 2 x 60          8544,91911.8178.2 51,00111.8078.1
    C1 x 90          7520,69512.2573.0 22,90212.3072.8
    D6 x 30, 3 x 60, 2 x 90          653,99913.0663.9 4,26813.1363.8
    		  
    		  
      $332,56610.9779.7 $375,87211.0279.7
    (A)Represents the number of times a prospective borrower is allowed to be late more than 30, 60 or 90 days. For instance, a 3x30, 1x60 category would afford the prospective borrower to be more than 30 days late on three separate occasions and 60 days late no more than one time.
    (B)97% on fixed-rate purchases; all other maximum of 95%.

    Table 2—Mortgage Loans
    Geographic Concentration
    Percent Current Principal as of March 31, 2001

     

    Held-for-sale

    		 

    Held-in-portfolio

    		 

    Collateral Location

    		    

    California

    16

    		 

    13

    		 

    Florida

    15

    		 %

    16

    		%

    Michigan

    7

    		 

    3

    		 

    Nevada

    6

    		 

    4

    		 

    Ohio

    6

    		 

    3

    		 

    Tennessee

    4

    		 

    4

    		 

    Oregon

    3

    		 

    5

    		 

    Washington

    3

    		 

    6

    		 

    Texas

    2

    		 

    5

    		 

    All other states

    38

    		 

    41

    		 
     
    		 
    		 

    Total

    100

    		  %

    100

    		%
     
    		 
    		 

    Table 3 — Carrying Value of Mortgage Loans by Product/Type
    (in thousands)

    Product/Type

    March, 31, 2001

    		 

    December 31, 2000

    		 
           

    Held-in-portfolio:

    		      

    Two and three-year fixed

    		$

    139,198

    		 $

    $166,627

    		 

    Six-month LIBOR and one-year CMT

    		 

    20,244

    		  

    23,428

    		 

    30/15-year fixed and balloon

    		 

    173,124

    		  

    185,817

    		 
     
    		 
    		 

    Outstanding principal

    		 

    332,566

    		  

    375,872

    		 

    Premium

    		 

    6,832

    		  

    7,745

    		 

    Allowance for credit losses

    		 

    (6,632

    		) 

    (7,690

    		)
     
    		 
    		 

    Carrying Value

    		$

    $332,766

    		 $

    $375,927

    		 
     
    		 
    		 

    Carrying value as a percent of principal

    		 

    100.06

    		% 

    100.01

    		%
     
    		 
    		 
           

    Held-for-sale:

    		      

    Two and three-year fixed

    		$

    $72,309

    		 $

    $ 54,500

    		 

    Six-month LIBOR and one-year CMT

    		 

    —

    		  

    —

    		 

    30/15-year fixed and balloon

    		 

    26,005

    		  

    22,834

    		 
     
    		 
    		 

    Outstanding principal

    		 

    98,314

    		  

    77,334

    		 

    Premium

    		 

    1,098

    		  

    997

    		 

    Allowance for credit losses

    		 

    (193

    		) 

    (254

    		)
     
    		 
    		 

    Carrying Value

    		$

    99,219

    		 $

    78,077

    		 
     
    		 
    		 

    Carrying value as a percent of principal

    		 

    100.92

    		% 

    100.96

    		%
     
    		 
    		 

    Table 4—Mortgage Credit Analysis - Held-in-portfolio Loans
    March 31, 2001
    (dollars in thousands)

    Credit
    Grade
    		    Original
    Balance
    		    Current
    Principal
    		    Weighted Average Loan-
    to-Value Ratio
    		    Defaults as Percent
    of Original Principal
        60-89
    days
    		    90 days
    and greater
    		    Foreclosure
    and REO
    		    Total
    Novastar Home Equity Series 1997-1:                
    A $   117,904 $20,212 75.6—2.05.67.6
    A–    73,499    13,841    77.8    —    5.1    9.0    14.1
    B    53,812    8,459    73.0    1.33    —    10.8    12.1
    C    23,065    3,364    71.0    0.86    22.9    11.4    35.2
    D    9,021    1,315    69.4    —    —    20.7    20.7
    NovaStar Home Equity Series 1997-2:                
    AA    $        3,153    $      378    86.5    —    —    —    —
    A    104,582    21,378    78.2    0.73    0.7    10.0    11.4
    A–    63,660    11,979    82.2    4.29    4.1    6.1    14.5
    B    36,727    6,914    78.5    1.74    0.7    16.2    18.7
    C    11,354    2,973    69.9    —    2.1    5.1    7.2
    D    1,529    512    59.7    8.86    —    7.0    15.9
    NovaStar Home Equity Series 1998-1:                
    AA    $     59,213    19,213    83.4    4.06    1.5    8.6    14.2
    A    113,457    39,033    80.7    0.94    0.5    9.2    10.6
    A–    63,100    21,753    81.8    1.74    4.1    9.8    15.7
    B    38,249    11,374    78.3    0.67    0.6    13.1    14.4
    C    22,908    6,501    75.5    —    2.1    13.9    16.0
    C–    123    121    80.0    —    —    —    —
    D    5,493    1,193    64.0    —    17.2    10.9    28.0
    NovaStar Home Equity Series 1998-2:                
    AA    $     64,851    30,315    81.9    0.68    1.1    4.5    6.3
    A    113,557    54,006    83.2    1.75    3.0    10.5    15.2
    A–    70,399    30,360    80.7    0.47    0.6    8.4    9.5
    B    40,818    18,431    80.1    1.26    6.0    17.0    24.2
    C    22,335    7,922    72.8    0.32    1.8    14.8    16.9
    D    2,951    1,019    63.6    —    —    23.9    23.9
                
    Total    $1,115,760    $332,566                    
      
    		 
    		     

    Table 5 — Loss Analysis — Held-in-portfolio Loans
    March 31, 2001
    (dollars in thousands)
              Loans Repurchased From Trusts
    		     
         Cumulative Losses As Reported
    		    Loss Amount
    		    As a % of Original Balance
    		    Total Losses
    NHES 1997-1    1.69%    $3,503    1.27%    2.96%
    NHES 1997-2    1.91       6,068    2.73     4.63 
    NHES 1998-1    1.54       7,255    2.40     3.94 
    NHES 1998-2    1.34       1,807    0.57     1.92 

    Table 6 — Mortgage Loan Coupon and Prepayment Analysis
    (dollars in thousands)
         Issue Date      Original
    Principal    		    Current
    Principal    		    Premium    Percent with
    Prepayment
    Penalty    		    Coupon    Remaining
    Prepayment
    Penalty
    Period (in years)
    for Loans with
    Penalty    		    Constant Prepayment Rate
    (Annual Percent)
          Three-
    month    		    Twelve-
    Month    		    Life
     
    As of March 31, 2001
    Held-in-portfolio — serving as collateral for NovaStar Home Equity Series asset backed bonds:
    Series 1997-1 October 1, 1997  $    277,301  $    47,191  $ 2,173 26%    11.51%    0.25            
    Series 1997-2    December 11, 1997  221,005  44,134  891    19  11.32  0.28 40 39 40
    Series 1998-1 April 30, 1998  302,543  99,188  1,620 22  10.87  0.40 46 45 37
    Series 1998-2 August 18, 1998  314,911  142,053  2,148 52  10.50  0.69 41 41 31
       
    		  
    		  
    		                
    Total   $1,115,760  $  332,566  $  6,832 35% 10.86% 0.48 0.49  
       
    		 
    		 
    		 
    		   
    		   
    		   
    Held-for-sale:       $98,314  $1,098 79%   10.76%  3.01 Not meaningful
          
    		 
    		 
    		   
    		   
    		   
    As of December 31, 2000
    Held-in-portfolio — serving as collateral for NovaStar Home Equity Series asset backed bonds:
    Series 1997-1 October 1, 1997  $    277,301  $  52,282  $2,494 25% 11.80% 0.30 40 39 40
    Series 1997-2 December 11, 1997  221,005  53,727  1,040 16  11.55  0.28 46 45 37
    Series 1998-1 April 30, 1998  302,543  114,367  1,877 33  11.03  0.46 41 41 31
    Series 1998-2 August 18, 1998  314,911  155,596  2,334 60  10.57  0.85 33 35 25
       
    		  
    		  
    		                
    Total   $1,115,760  $375,972  $7,745 40% 11.02% 0.57    
       
    		 
    		 
    		 
    		   
    		   
    		   
    Held-for-sale:     $77,334  $997 81% 10.27% 3.19 Not meaningful
           
    		  
    		 
    		   
    		   
    		   

    Mortgage Securitiesavailable-for-sale. During 2001, 2000 and 1999, $211 million, $570 million, and $165 million in loans were pooled in securitization transactions. These transactions were treated as sales for accounting and tax purposes. We service the loans sold in these securitizations and we retained the AAA-rated, interest-only and other subordinated securities issued in the securitizations. Under the section “Mortgage Loan Sales” we discuss the details of the loan securitization transactions.
              As of March 31, 2001 and December 31, 2000, the carrying value of mortgage securities was $76.2 million and $46.6 million, respectively. This value represents the present value of the securities’ cash flows that we expect to receive over their lives, considering estimated prepayment speeds and credit losses of the underlying loans, discounted at an appropriate risk-adjusted market rate of return. The cash flows are realized over the life of the loan collateral as cash distributions are received from the trust that manages the collateral. In estimating the fair value of our mortgage securities, management must make assumptions regarding the future performance and cash flow of the mortgage loans collateralizing the securities. These estimates are based on management’s judgements about the nature of the loans. We believe the value of the securities is fair, but can provide no assurance that future prepayment and loss experience or changes in the required market discount rate will not require write-downs of the residual asset. Write-downs would reduce income of future periods. Table 7 summarizes our mortgage securities and the underlying collateral and senior asset-backed bonds. Table 8 provides a summary of the critical assumptions used in estimating the cash flows of the collateral and the resulting estimated fair value of the mortgage securities.

    Table 7 — Mortgage Securities
    March, 31, 2001 and December 31, 2000
    (dollars in thousands)
          Estimated
    Fair
    Value of
    Mortgage
    Securities
    		    Asset-Backed Bonds
    		    Mortgage Loans
             Remaining
    Principal
    		    Interest
    Rate
    		    Remaining
    Principal
    		    Weighted Average
         Coupon
    		    Estimated
    Months to Call
    March, 31, 2001                    
    NMFT 1999-1    $  5,900    $      85,291    5.66    $  88,360    10.60    54
    NMFT 2000-1    16,500    198,199    4.63    202,017    10.20    61
    NMFT 2000-2    28,700    317,685    4.76    323,603    10.60    62
    NMFT 2001-1    25,107    413,082    5.31    209,502    10.54    69
        
    		  
    		    
    		     
    Total    $76,207    $1,014,257        $823,482        
        
    		  
    		    
    		     
    December 31, 2000                    
    NMFT 1999-1    $  6,900    $      96,521    6.23    $103,968    10.67    57
    NMFT 2000-1    14,950    210,261    6.11    216,216    10.21    64
    NMFT 2000-2    24,800    328,025    6.12    333,865    10.61    65
        
    		  
    		    
    		     
    Total    $46,650    $    634,807        $654,049        
        
    		  
    		    
    		     
     
         September 30, 2000
    		 December 31, 1999
    Credit
    Grade
    		 Allowed
    Mortgage
    Lates (A)
    		 Maximum
    Loan-to-
    value
    		 Current
    Principal
    		 Weighted
    Average
    Coupon
    		 Weighted
    Average
    Loan-to-
    value
    		 Current
    Principal
    		 Weighted
    Average
    Coupon
    		 Weighted
    Average
    Loan-to-
    value
    Retained loans collateralizing
    asset-backed bonds:    		                                   
    AA     0 x 30     95 $ 62,099     10.11%     82.8% $ 85,476     9.50%     83.2%
    A     1 x 30     90     170,903     10.61      79.3      244,187     10.06      80.1 
    A-     2 x 30     90     100,568     11.18      81.8      149,248     10.45      81.8 
    B     3 x 30, 1 x 60     85     59,056     11.68      78.0      89,477     10.86      78.4 
          5 x 30, 2 x 60                                   
    C     1 x 90     75     26,353     12.11      72.8      42,766     11.35      72.5 
    D     6 x 30, 3 x 60,     65     5,004     12.95      63.4      7,668     12.16      62.1 
             
    		       
    		      
          2 x 90                                   
    Total on balance sheet      $   423,983     10.94%     79.6% $   618,822     10.31%     80.0%
             
    		 
    		   
    		   
    		 
    		   
    		  
    Table 8 — Characteristics of Loan Collateral and Valuation Assumptions
         March 31, 2001    December 31, 2000
    NovaStar Mortgage Funding Trust Series:    1999-1    2000-1    2000-2    2001-1    1999-1    2000-1    2000-2
    Constant prepayment rate (%).    29    30    30    29    32    32    32
    Discount rate    16.5    14.8    15.0    20.0    16.5    14.8    15.0
    As a percent of mortgage loan principal:                            
         Delinquent loans (30 days and greater)    17.1    5.8    2.5    —    17.0    5.7    1.1
         Loans in foreclosure    5.3    1.8    1.0    —    5.5    1.6    0.3
         Real Estate Owned    5.6    1.3    0.1    —    4.2    0.1    —
         Cumulative losses    1.2    —    —    —    1.0    —    —
     
                  September 30, 2000
    		    December 31, 1999
    Credit
    Grade
    		     Allowed
    Mortgage
    Lates (A)
    		     Maximum
    Loan-to-
    value
    		    Current
    Principal
    		    Weighted
    Average
    Coupon
    		    Weighted
    Average
    Loan-to-
    value
    		    Current
    Principal
    		    Weighted
    Average
    Coupon
    		    Weighted
    Average
    Loan-to-
    value
    Sold loans collateralizing asset-
    backed bonds:    		                         
    AAA     0 x 30     97(B)    $115,453    9.69%    80.8%    $    3,474    9.18%    80.7%
    AA     0 x 30     95     136,895    10.17     83.6     27,236    9.47     84.8 
    A     1 x 30     90     106,876    10.39     81.2     43,119    9.86     83.1 
    A-     2 x 30     90     75,505    10.49     81.4     35,311    10.09     83.1 
    B     3 x 30, 1x 60     85    39,052    10.97     79.3     19,612    10.59     79.7 
          5 x 30, 2 x 60                          
    C     1 x 90     75     16,180    11.50     70.4     11,405    11.09     71.9 
    D     6 x 30, 3 x 60,     65     2,071    12.29     70.0     3,171    12.16     62.1 
          2 x 90                             
    Other     Varies     97     36,525    11.42     92.6     —    —     — 
                
    		          
    		        
    Total off balance sheet         $528,557    10.35%    82.0%    $143,328    10.08%    81.5%
                
    		  
    		    
    		    
    		  
    		    
    		  
              The performance of the loans serving as collateral for our mortgage securities is critical to the return our mortgage securities will generate. Credit quality and prepayment experience characteristics of the loan collateral, among others, are important to properly analyze the performance of our mortgage securities. We have presented characteristics of the loans collateralizing our mortgage securities in Tables 8 through 14. The operating performance of our mortgage securities portfolio, including net interest income and effects of hedging are discussed under “Results of Operations” and “Interest Rate/Market Risk.”
    Table 9 — Loans Collateralizing Mortgage Securities
    Credit Grade (dollars in thousands)
                   March 31, 2001
    		    December 31, 2000
    Credit
    Grade    		    Allowed
    Mortgage
    Lates (A)    		    Maximum
    Loan-
    to-value    		    Current
    Principal    		    Weighted
    Average
    Coupon    		    Weighted
    Average
    Loan-to-
    Value    		    Current
    Principal    		    Weighted
    Average
    Coupon    		    Weighted
    Average
    Loan-to-
    Valu e
    AAA    0 x 30    97(B)    $165,688    9.74%    80.9%    $143,673    9.71%    80.9%
    AA    0 x 30    95     231,580    10.26     83.6     175,068    10.25     83.5 
    A    1 x 30    90     153,662    10.53     81.3     130,027    10.54     81.2 
    A–    2 x 30    90     102,547    10.70     78.1     86,660    10.65     81.3 
    B    3 x 30, 1x 60 5 x 30, 2 x 60    85     61,713    11.05     69.7     44,487    11.16     79.3 
    C    1 x 90    75     18,708    11.71     69.7     18,398    11.69     70.1 
    D    6 x 30, 3 x 60, 2 x 90    65     1,336    12.67     61.6     1,568    12.69     61.6 
    Other    Varies    97     88,248    11.57     93.0     54,168    11.44     92.7 
                  
    		  
    		          
    		            
                 $823,482    10.50         $654,049        
                  
    		  
    		          
    		            
    (A)Represents the number of times a prospective borrower is allowed to be late more than 30, 60 or 90 days. For instance, a 3x30, 1x60 category would afford the prospective borrower to be more than 30 days late on three separate occasions and 60 days late no more than one time.
    (B)97% on fixed-rate purchases; all other maximum of 95%.
     
    Table 2
    10 — Loans Collateralizing Mortgage Loans by StateSecurities
    Percent of Portfolio
    (based on current principal balance)
         Retained loans collateralizing asset-
    backed bonds—on balance sheet
    		    Sold loans collateralizing asset-backed
    bonds—off balance sheet
        September 30, 2000
    		    December 31, 1999
    		    September 30, 2000
    		    December 31, 1999
    Collateral Location
    		                
    Florida    15%    14%    16%    21%
    California    14     16     10     7 
    Washington    6     7     4     4 
    Texas    5     5     3     6 
    Nevada    4     4     6     4 
    Oregon    4     5     2     1 
    Tennessee    4     3     6     5 
    Michigan    3     3     8     5 
    Ohio    3     3     6     4 
    All other states    42     40     39     43 
        
    		    
    		    
    		    
    		  
    Total    100%    100%    100%    100%
        
    		    
    		    
    		    
    		  
              Table 3 provides a summary of NovaStar Financial’s mortgage loans by type and carrying valueCurrent Principal as of September 30, 2000 and DecemberMarch 31, 1999.2001
    Collateral Location
    Florida14%
    California11
    Michigan9
    Nevada6
    Ohio6
    Tennessee5
    Washington5
    Texas3
    Oregon3
    All other states38
    Total100%
     
    Table 311 — Loans Collateralizing Mortgage Securities
    Carrying Value of Loans by Product/Type
    September 30, 2000 and December 31, 1999
    (in (in thousands)
    Product/Type
    		    September 30, 2000
    		    December 31, 1999
     
         Retained loans collateralizing asset-backed bonds—
             on balance sheet:    		        
                   Two and three-year fixed.    $201,440     $343,193 
                   Six-month LIBOR and one-year CMT    27,164     43,178 
                   30/15-year fixed and other    195,379     232,451 
        
    		    
    		  
                   Outstanding principal    423,983     618,822 
                   Premium    8,696     12,689 
                   Allowance for credit losses    (8,132)    (11,105)
        
    		    
    		  
                   Carrying Value    $424,547     $620,406 
        
    		    
    		  
                   Carrying value as a percent of principal    100.13%    100.26%
        
    		    
    		  
     
         Sold loans collateralizing asset-backed bonds—
             off balance sheet:    		        
                   Two and three-year fixed.    $357,210     $  78,238 
                   Six-month LIBOR and one-year CMT    2,864     5,052 
                   30/15-year fixed and other    168,483     60,038 
        
    		    
    		  
                   Outstanding principal    $528,557     $143,328 
        
    		    
    		  
                   Mortgage securities retained.    $  41,784     $    6,775 
        
    		    
    		  
              Substantially all mortgage loans are acquired at a premium. Premiums are amortized as a reduction of interest income over the lives of the assets. See Tables 4, 5, and 6 for the impact of principal payments on amortization. To mitigate the effect of prepayments on interest income from mortgage loans, NovaStar Financial generally strives to acquire mortgage loans that have prepayment penalties. During the nine months ended September 30, 2000, prepayment penalties collected from borrowers totaled $1.4 million in comparison with $2.4 million for the same period of 1999. Table 4 is an analysis of mortgage loans and prepayment penalties.
    Product/Type    March, 31, 2001    December 31, 2000
    Two and three-year fixed    $595,077    $465,976
    Six-month LIBOR and one-year CMT    2,876    2,492
    30/15-year fixed and balloon    225,529    185,581
        
    		  
    Outstanding principal    $823,482    $654,049
        
    		  
    Mortgage securities retained    $  76,207    $  46,650
        
    		  
     
    Table 412 — Loans Collateralizing Mortgage Securities
    Mortgage Loan Coupon and Prepayment Penalties (dollars in thousands)
    Issue DateOriginal
    Principal    		Current
    Principal    		Percent with
    Prepayment
    Penalty    		CouponRemaining
    Prepayment
    Penalty Period (in
    years) for Loans
    with Penalty    		Constant Prepayment Rate
    (Annual Percent)
    Three-
    month    		Twelve-
    Month    		Life
    March 31, 2001
    NovaStar Mortgage Funding Trust Series:
    1999-1    January 29, 1999    $164,995    $  88,360    64     10.61%    1.11    37    33    24
    2000-1    March, 31, 2000    230,138    202,017    94     10.21     2.20      20    12    11
    2000-2    September 28, 2000    339,688    323,603    91     10.60     2.28    11    —    8
    2001-1    March 29, 2001    209,502    209,502    87     10.57     2.50    —    —    8
            
    		  
    		                            
    Total        $944,323    $823,482    88%    10.50%    2.19            
            
    		  
    		  
    		    
    		    
    		            
     
    December 31, 2000
    NovaStar Mortgage Funding Trust Series:
    1999-1    January 29, 1999    $164,995    $103,968    60     10.66     1.23    38    28    21
    2000-1    March, 31, 2000    230,138    216,216    94     10.03     2.43    10    —    8
    2000-2    September 28, 2000    339,502    333,865    90     10.57     2.49    5    —    5
            
    		  
    		                            
    Total        $734,635    $654,049    70%    10.66%    1.65            
            
    		  
    		  
    		    
    		    
    		            
    Table 13 — Loans Collateralizing Mortgage Securities
    September 30, 2000 and DecemberMortgage Credit Analysis
    March 31, 19992001
    Credit
    Grade
    		    Original
    Balance
    		    Current
    Principal
    		    Weighted Average Loan-
    to-Value Ratio
    		    Defaults as Percent
    of Original Principal
        60–89
    days
    		    90 days and
    greater
    		    Foreclosure
    and REO
    		    Total
    Total NovaStar Mortgage Funding Trust Series 1999-1:   
    AAA    $      4,024    $      2,746    80.0    —    —    2.3    2.3
    AA    30,772    17,175    85.1    —    —    5.8    5.8
    A    50,693    27,383    82.3    0.7    0.62    10.9    12.2
    A–    38,953    20,739    82.8    1.6    2.53    11.6    15.8
    B    23,135    12,078    79.7    2.3    6.27    15.0    23.6
    C    12,959    6,931    71.9    1.2    3.99    22.6    27.7
    C–    47    46    49.0    —    —    —    —
    D    4,412    1,262    61.6    —    —    32.5    32.5
    NovaStar Mortgage Funding Trust Series 2000-1:   
    AAA    $    85,222    $    73,377    80.6    0.2    0.31    2.8    3.2
    AA    55,874    49,834    82.9    0.6    0.34    2.2    3.1
    A    36,422    32,781    80.2    0.2    0.77    3.2    4.1
    A–    23,329    21,101    80.6    3.0    —    6.4    9.4
    B    13,089    10,950    80.4    0.8    —    11.2    12.0
    C    5,922    4,733    68.9    0.9    —    7.0    7.9
    C–    335    238    51.7    —    —    —    —
    D    51    50    58.0    —    —    —    —
    Other    9,894    8,968    91.9    —    —    4.1    4.1
    NovaStar Mortgage Funding Trust Series 2000-2:   
    AAA    $    57,846    $    54,117    81.6    0.3    —    0.1    0.4
    AA    103,454    100,014    83.3    0.4    0.08    1.2    1.7
    A    60,735    56,857    81.4    0.1    —    1.8    1.9
    A–    39,939    38,547    81.1    —    0.43    1.9    2.3
    B    19,843    19,286    76.6    —    —    1.1    1.1
    C    4,275    3,610    67.4    1.4    —    —    1.4
    C–    388    387    64.4    —    —    —    —
    Other    53,208    50,784    92.9    —    —    1.0    1.0
    NovaStar Mortgage Funding Trust Series 2001-1:   
    AAA    $    34,480    $    34,480    80.5    —    —    —    —
    AA    64,807    64,807    84.1    —    —    —    —
    A    36,217    36,217    81.4    —    —    —    —
    A–    22,869    22,869    79.7    —    —    —    —
    B    20,058    20,058    77.5    0.3    —    —    0.3
    C    3,003    3,003    68.3    —    —    1.0    1.0
    C–    134    134    85.1    —    —    —    —
    Other    28,002    28,002    93.5    —    —    —    0.3
    Table 14 — Mortgage Loss Analysis — Loans Collateralizing Mortgage Securities
    March 31, 2001
    (dollars in thousands)
         Current
    Principal
    		    Premium
    		    Percent with
    Prepayment
    Penalty
    		    Weighted Average
         Coupon
    		    Loan-to-
    value
    		 Remaining
    Prepayment Penalty
    Period (in years) -
    Loans with Penalty
    As of September 30, 2000                      
    Retained loans collateralizing asset-backed bonds:                       
              NHES 1997-1    $  58,054    $2,679    23%    11.61%    74.9% 0.33
              NHES 1997-2    63,337    1,269    22     11.34     79.1    0.31
              NHES 1998-1    127,936    2,126    48     10.96     80.6  0.57
              NHES 1998-2    174,393    2,609    58     10.54     81.0    0.98
              All other loans    263    13    —     12.86     76.0    —
        
    		  
    		            
              Total on balance sheet    $423,983    $8,696    45%    10.94%    79.6%   0.67
        
    		  
    		  
    		    
    		    
    		  
    Sold loans collateralizing asset-backed bonds (A):                 
              NMFT 1999-1    $119,327    $     —    66%    10.43%    81.7%   1.36
              NMFT 2000-1 (B)    221,963    —    93     10.15     81.1    2.63
              NMFT 2000-2 (C)    187,267    —    90     10.54     83.3     2.62
        
    		  
    		            
              Total off balance sheet    $528,557    $     —    86%    10.35%    82.0%   2.34
        
    		  
    		  
    		    
    		    
    		  
         Current
    Principal
    		    Premium
    		    Percent with
    Prepayment
    Penalty
    		    Weighted Average
         Coupon
    		    Loan-to-
    value
    		 Remaining
    Prepayment Penalty
    Period (in years) -
    Loans with Penalty
    As of December 31, 1999                        
    Retained loans collateralizing asset-backed bonds:                        
              NHES 1997-1    $  85,015    $  3,942    32%     11.04 %    75.5 %    0.51
              NHES 1997-2    101,031    1,917    35     10.90     79.3     0.55
              NHES 1998-1    195,170    3,205    63     10.08     81.1     0.93
              NHES 1998-2    237,223    3,606    74     9.97     81.1     1.51
              All other loans    383    19    6     11.96     77.6     0.10
        
    		  
    		              
                        Total on balance sheet    $618,822    $12,689    58%    10.31%    80.0%    1.03
        
    		  
    		  
    		    
    		    
    		  
    Sold loans collateralizing asset-backed bonds (A):                        
              Off balance sheet NMFT 1999-1    $143,328    $       —    84%    10.08%    81.5%    2.03
        
    		  
    		  
    		    
    		    
    		  
    (A)NovaStar Financial owns economic residual interests. The mortgage loans are not retained on the balance sheet of NovaStar Financial.
    (B)The economic residual interests in NMFT 2000-1 were purchased by NovaStar Financial April 1, 2000.
    (C)The economic residual interests in NMFT 2000-2 were purchased by NovaStar Financial September 29, 2000.
               In periods of decreasing interest rates, borrowers are more likely to refinance their mortgages to obtain a better interest rate. Even in rising rate environments, borrowers tend to repay their mortgage principal balances earlier than is required by the terms of their mortgages. Non-conforming borrowers, as they update their credit rating, are more likely to refinance their mortgage loan to obtain a lower interest rate.
              Prepayment rates in the table below represent the annualized principal prepayment rate in the most recent one, three and twelve month periods and over the life of the pool of loans.
    Table 5
    Prepayment Speeds
    (dollars in thousands)
         Issue Date
    		    Current
    Principal
    Balance
    		    Weighted
    Average Age
    of Loans at
    Inception
    (in months)
    		    Constant Prepayment Rate
    (Annual Percent)
         One-
    month
    		    Three-
    month
    		    Twelve-
    month
    		    Life
    September 30, 2000                            
    Retained loans
    collateralizing asset-
    backed bonds:    		                            
              NHES 1997-1    October 1, 1997    $  58,054    7    44    41    41    40
              NHES 1997-2    December 11, 1997    63,337    3    33    38    47    35
              NHES 1998-1    April 30, 1998    127,936    3    38    45    41    29
              NHES 1998-2    August 18, 1998    174,393    3    39    43    30    23
            
    Sold loans collateralizing
    asset—backed bonds:    		                            
              NMFT 1999-1    January 29, 1999    $119,327    5    36    31    23    18
              NMFT 2000-1    March 31, 2000    221,963    2    8    9    —    7
              NMFT 2000-2    September 28, 2000    187,267    1    —    —    —    —
         Issue Date
    		    Current
    Principal
    Balance
    		    Weighted
    Average Age
    of Loans at
    Inception
    (in months)
    		    Constant Prepayment Rate
    (Annual Percent)
         One-
    month
    		    Three-
    month
    		    Twelve-
    month
    		    Life
    December 31, 1999                            
    Retained loans
    collateralizing asset-
    backed bonds:    		                            
              NHES 1997-1    October 1, 1997    $  85,015    7    44    42    50    40
              NHES 1997-2    December 11, 1997    101,031    3    64    58    42    32
              NHES 1998-1    April 30, 1998    195,170    3    47    36    29    23
              NHES 1998-2    August 18, 1998    237,223    3    26    21    21    18
            
    Sold loans collateralizing
    asset—backed bonds:    		                            
              NMFT 1999-1    January 29, 1999    $143,328    5    14    20    14    14
    Table 6 details the amount of premium as a percent of principal at quarter end for 2000 and 1999.
    Table 6
    Premium as a Percent of Principal
    Mortgage
    Loans
    September 30, 20002.05%
    June 30, 20002.03
    March 31, 20002.05
    December 31, 19992.05
    September 30, 19992.09
    June 30, 19992.15
    March 31, 19992.22
    Mortgage-Backed Securities –Available-For-Sale.    NovaStar Financial owns the economic residual certificates in NovaStar Mortgage Funding Trust Series 1999-1, 2000-1 and 2000-2. As the owner of the residual certificates, NovaStar Financial receives the net cash flow of the NovaStar Mortgage Funding Trust Series asset-backed bonds, which represent the right to receive, over the life of the securitizations, the excess of the weighted average coupon on the mortgage loan collateral over the sum of the interest rate on the bonds, a normal servicing fee, a trustee fee, insurance premiums and the credit losses relating to the securitized loans. As of September 30, 2000 and December 31, 1999, the carrying value of the residual interests was $41.8 million and $6.8 million. These values represent the present value of the residual cashflows that NovaStar Financial expects to receive over the life of the securitizations, taking into consideration estimated prepayment speeds and credit losses, and is discounted at a rate which management believes is an appropriate risk-adjusted market rate of return for the residual asset. The residual cashflows are realized over the life of the securitizations as cash distributions are received from the trusts. NovaStar Financial believes its residual assets are fairly valued as of September 30, 2000, but can provide no assurance that future prepayment and loss experience or changes in the required market discount rate will not require write-downs of the residual asset. Write-downs would reduce the income of future periods and could cause NovaStar Financial to report net losses.
              Key statistics, assumptions and characteristics of the NovaStar Mortgage Funding Trust Series mortgage loan collateral and bonds as of September 30, 2000 and December 31, 1999 are included in the table below and in Tables 4, 5 and 8 of this document.
              NovaStar Mortgage originated and securitized the loans serving as collateral in NMFT 1999-1, 2000-1 and 2000-2. Upon securitization, NovaStar Mortgage recognized gains on the transfer of the loans. Details of these transactions are provided in “Mortgage Loan Sales.”
    Table 7
    Residual Assets’ Key Statistics, Assumptions and Characteristics
    September 30, 2000 and December 31, 1999
    (dollars in thousands)
         September 30, 2000
    		  December 31, 1999
    		 
      1999-1  2000-1  2000-2  1999-1 
      Estimated Fair Value $7,500  $13,750  $20,534  $6,775 
       
    		   
    		   
    		   
    		 
      Constant Prepayment Rate (weighted average life)  37   29   28   31 
       
    		   
    		   
    		   
    		 
      Static loss, net of mortgage insurance  2.5%  1.0%  1.0%  2.5%
     
    		 
    		 
    		 
      Discount Rate  17%  15%  15%  17%
     
    		 
    		 
    		 
    As a percent of mortgage loan principal:    
      Delinquent loans (30 days and greater)  9.05%  2.59%  0.21%  7.03%
     
    		 
    		 
    		 
      Loans in foreclosure  4.16   0.13   —   3.22 
     
    		 
    		 
    		 
      Real Estate Owned  1.92   —   —   1.26 
     
    		 
    		 
    		 
      Cumulative losses $969  $       —  $       —  $ — 
     
    		 
    		 
    		 
              Loans Repurchased From Trusts
    		     
         Cumulative Losses As Reported
    		    
    Loss Amount
    		    As a % of Original Balance
    		    Total Losses
    NMFT 1999-1    0.91%    $423    0.26%    1.17%
    NMFT 2000-1    0.01     2    0.00     0.01 
    NMFT 2000-2    0.01     16    0.00     0.01 
    NMFT 2001-1    —     —    —     — 
              Assets Acquired through Foreclosure. As of September 30, 2000, NovaStar FinancialMarch 31, 2001, we had 174 loans171 properties in real estate owned with a carrying value of $15.3$12.8 million (principal of $16.7$14.8 million) compared to 192 loansproperties with a carrying value of $16.9 million (principal of $24.4 million) as of December 31, 1999.2000.
     
              Short-term and Long-term Financing Arrangements. Mortgage loan originations are funded with various financing facilities prior to securitization. Loans originated are funded initially usingthrough one of two committed warehouse lines with First Union National Bank or Residential Funding Corporation (RFC) under which NovaStar Financialof credit. Amounts outstanding and NovaStar Mortgageavailable for borrowing are co-borrowers. NovaStar Financial and NovaStar Mortgage can borrow up to $75 million from First Union and $50 million from RFC under these warehouse agreements. NovaStar Financial and NovaStar Mortgage also use repurchase agreements as a means of warehousing loans prior to securitization. First Union provides a $175 million committed facility for this purpose. These First Union and RFC facilities are committed through July 27, 2001 and December 27, 2000, respectively.listed below.
     
              First Union also provides a $25 million committed facility secured by residual interests Table 15 — Short-term Financing Resources
    March, 31, 2001
    (in asset-backed bonds that is committed through December 2001. Amounts outstanding as of September 30, 2000 under this financing arrangement were $11.0 million.thousands)
         Expiration
    		    Maximum
    Borrowing
    Limit
    		    Lending
    Value of
    Collateral
    		    Borrowings
    		    Availability
    Cash                    $10,533
    First Union National Bank:               
         Mortgage loan warehouse line of credit    July 2001    $  75,000    $  66,718    $48,100    21,618
         Mortgage loan repurchase agreement    July 2001    175,000    2,481    2,481    —
         Mortgage securities repurchase
              agreement    		    April 2003    25,000    25,000    —    25,000
    GMAC/Residential Funding Corporation —
         Mortgage loan warehouse line of credit    		    December 2001    60,000    23,984    17,685    6,298
    Morgan Stanley Dean Witter    March 2002    100,000    25,000    25,000    —
            
    		  
    		  
    		  
     
    Total        $435,000    $146,183    $93,266    $63,449
            
    		  
    		  
    		  
     
              Amounts outstanding under short-term financing arrangements as of September 30, 2000 are detailed in Table 25 of this document.
    Long-term Financing ArrangementsOn a long-term basis, NovaStar Financial has financed itswe finance mortgage loans using collateralized mortgage obligations commonly called CMOs.by issuing asset-backed bonds. Investors in CMOsasset-backed bonds are repaid based on the performance of the mortgage loans collateralizing the CMOs.bonds. These non-recourse financing arrangements match the loans with the financing arrangement for long periods of time, as compared to lines of credit and repurchase agreements that mature frequently with interest rates that reset frequently and have liquidity risk in the form of margin calls. Under the terms of its CMOs, NovaStar Financial isour asset-backed bonds we are entitled to repurchase the mortgage loan collateral and repay the remaining CMObond obligations when theirthe aggregate collateral principal balance falls below 35% of their original balance for issuethe loans in NHES 97-01 and 25% for issuesthe loans in NHES 97-02, 98-01 and 98-02. Non-conforming mortgage loans are not readily
    obtainable financial assets. As a result, NovaStar Financial retains effective control over the transferred assets as defined in paragraph 9c. of Statement of Financial Accounting Standards (SFAS) No. 125,Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilitiesand further clarified by paragraph 30 of SFAS No. 125. Accordingly, NovaStar Financial records its CMO transactions as secured borrowings, rather than sales of the transferred loans. The securitization transactions executed by NovaStar Mortgage have been structured as sales for financial reporting and tax purposes. NovaStar Financial as the residual owner does not have an option to call these bonds in the future. However, NovaStar Mortgage, as servicer of the collateral of these transactions, holds a small clean up call.
     
              Under its CMOs, NovaStar Financial retains the mortgage loans and incurs the obligation to pay the CMO bondholders. NovaStar Financial earns the net spread between the interest income on the loansTable 16 provides details for all asset-backed bonds, and the interest expense on the bonds. The spread earned also is reduced by credit losses on the portfolio. Prepayments on the mortgage loans serve to reduce the term over which interest spread is earned. The longer the mortgagerelated collateral is outstanding, the longer the period of cash flow. To the extent the borrowers prepay, it shortens the life of the CMO and the period over which cash flow is received. The cash flow will change when interest rates on the bonds fluctuate at amounts or times that are different from the mortgage loan collateral, thereby subjecting NovaStar Financial to interest rate risk. The carrying value of CMOs as of September 30, 2000 was $402 million compared with $587 million as of December 31, 1999. The decline in carrying value is primarily a result of principal paydowns.
              The following table provides details regarding NovaStar Financial’s CMOs as of September 30, 2000 and December 31, 1999. This table also provides details regarding the bonds and collateral outstanding underlying NovaStar Financial’s economic residual interests.we have issued.
     
    Table 816 — Asset-backed Bonds
    Collateralized Mortgage Obligations
    September 30, 2000March, 31, 2001 and December 31, 19992000
    (dollars in thousands)
        Asset-Backed Bonds
    		    Mortgage Loans
              Weighted Average
       Remaining
    Principal
    		    Interest
    Rate
    		    Remaining
    Principal (A)
    		    Coupon
    		    Estimated
    Months to Call
    March, 31, 2001             
    NHES 1997-1    $  43,617     5.53%    $    47943    11.52    0
    NHES 1997-2    42,091     5.57     45,850    11.39    0
    NHES 1998-1    92,877     5.33     102,527    10.92    6
    NHES 1998-2    140,392     5.26     148,599    10.52    19
    Unamortized debt issuance costs, net    (788)                
        
    		                    
    Total    $318,189                 
        
    		                    
    December 31, 2000             
    NHES 1997-2    $  48,121     7.13%    5,2910    11.66    0
    NHES 1998-1    51,114     6.91     5,5736    11.54    0
    NHES 1998-1    105,780     6.92     117,121    11.05    9
    NHES 1998-2    153,508     6.86     163,039    10.55    22
    Unamortized debt issuance costs, net    (1,086)                
        
    		                    
    Total    $357,437                 
        
    		                    
     
         Collateralized
    Mortgage Obligation
    		    Mortgage Loans
         Remaining
    Principal
    		    
    Current
    Interest
    Rate
    		    
    Remaining
    Principal
    (A)
    		    
    Weighted
    Average
    Coupon
    		    Estimated
    Weighted
    Average
    Months to Call
    As of September 30, 2000:                    
    Retained loans collateralizing asset-backed bonds:                    
         NHES 1997-1    $  54,325     7.13%    $59,297    11.61%    —
         NHES 1997-2    59,453     6.88     65,061    11.34      4
         NHES 1998-1    116,152     6.90     130,671    10.96     13
         NHES 1998-2    173,663     6.84     183,913    10.54     25
         Unamortized debt issuance costs, net    (1,397)                
        
    		                      
              Total on balance sheet    $402,196 
        
         Collateralized
    Mortgage
    Obligation
    		    Mortgage Loans
         Remaining
    Principal
    		    
    Current
    Interest
    Rate
    		    
    Remaining
    Principal
    (A)
    		    
    Weighted
    Average
    Coupon
    		    Estimated
    Weighted
    Average
    Months
    to Call
    Sold loans collateralizing asset-backed bonds:             
                  
         NMFT 1999-1    $116,659     7.14%    $119,327    10.43%    50
         NMFT 2000-1 (B)    218,166     7.02     221,963    10.15     63
         NMFT 2000-2 (C)    334,220     6.95     187,267    10.54     66
        
    		                      
              Total off balance sheet    $669,045                 
        
    		  
      As of December 31, 1999:                    
    Retained loans collateralizing asset-backed bonds:                    
         NHES 1997-1    $  75,580     6.94     $  87,534    11.04     —
         NHES 1997-2    95,053     6.72     104,851    10.90     12
         NHES 1998-1    186,493     6.55     200,625    10.08     22
         NHES 1998-2    231,969     6.71     244,109    9.97     29
         Unamortized debt issuance costs, net    (2,227)                
        
    		                      
              Total on balance sheet    $586,868                 
        
    		                      
    Sold loans collateralizing asset-backed bonds:                    
         Off balance sheet NMFT 1999-1    $140,710     6.67%    $143,328    10.08%    55
        
    		              
    (A) Includes assets acquired through foreclosure.
    (B) NovaStar Financial purchased the residual interests in NMFT 2000-1 on April 1, 2000.
    (C) NovaStar Financial purchased the residual interests in NMFT 2000-2 on September 29, 2000.
    (A)Including assets acquired through foreclosure.
     
              Stockholders’ Equity.The decreaseincrease in NovaStar Financial’sour stockholders’ equity as of September 30, 2000March 31, 2001 compared withto December 31, 19992000 is a result of the following:
     
    ·
    		$3.33.0 million increase due to net income recognized for the ninethree months ended September 30, 2000.March 31, 2001.
     
    ·
    $5.3300,000 net increase due to the restructuring of founders notes receivable and purchase of NFI Holding Corporation on January 1, 2001. This transaction resulted in a $5 million increase in equity due to a decrease in founders notes receivable with a corresponding $4.7 million decrease in equity as a result of common stock repurchases.NovaStar Financial’s Board of Directors amended its stock repurchase program to increase the amount of common stock authorized.Refer to be acquired up to an aggregate purchase price of $9 million. Stock repurchases may be made in the open market, in block purchase transactions, through put options or through privately negotiated transactions. The timing of repurchases and the number of shares ultimately repurchased will depend upon market conditions and corporate requirements.December 31, 2000 Form 10-K for more detail regarding this transaction. As of September 30, 2000, NovaStar Financial had repurchased 1,936,966March 31, 2001, we have purchased 2,428,445 shares of itsour common stock. The number of shares repurchased by NovaStar Financial has increased to 1,979,666 through November 10, 2000 for an aggregate purchase price of $7.3 million.
     
    ·
    		$3.06.4 million increase in the unrealized gaingains on the economic residual interests in NovaStar Mortgage’s asset backed bond transactions that for tax and accounting purposes were treated by NovaStar Mortgage as sales. The residual interests in those transactions have beenmortgage securities classified as available-for-sale securities and the unrealized gain is recognized as a component of accumulated other comprehensive income.available-for-sale.
     
    ·
    		$1.6 million525,000 decrease due to dividends on Class B 7% cumulative convertible preferred stock in 2000.stock.
     
    Notes Receivable from Founders.The founders of NovaStar Financial purchased 216,666 units in the 1996 private placement in exchange for forgivable promissory notes. A unit consisted of one share of convertible preferred stock and one common stock warrant. Principal on these notes is divided into three equal parts, called “tranches”, and is forgiven if certain incentive performance targets are achieved. The incentive tests relate to the return generated to investors in the private placement, including the appreciation in stock price, the value of the warrants, and dividends paid. One tranche will be forgiven for each fiscal year NovaStar Financial generates a return of 15% to investors in the private placement. All three tranches will be forgiven if a return of 100% is generated within five years.Mortgage Loan Production
     
              DuringOur non-conforming loans are originated through a network of mortgage brokers throughout the periodUnited States. Approximately 1,000 brokers are active customers and approximately 5,800 are approved. Loans are underwritten and funded in a centralized facility by our employees. We increased our sales force from 85 on January 1, 2001 to 91 on March 31, 2001. The increase has contributed to our significant increase in mortgage loan originations. Our sales force operates in 35 states, which allows us to mitigate the closingrisk of geographical concentrations of credit risk.
    Table 17 — Wholesale Loan Originations
    (dollars in thousands, except for average loan balance)
                             Weighted Average
         Number
    		    Principal
    		    Average
    Loan
    Balance
    		    Price Paid to
    Broker
    		    Loan to
    Value
    		    Credit
    Rating (A)
    		    Coupon
    		    Percent with
    Prepayment
    Penalty
    2001:                    
    First quarter    2,087     $244,639    $117,220    101.1%    82%    5.25    10.4%    82%
    2000:                   
    Fourth quarter    1,768     $208,232    $117,778    101.1%    82%    5.12    10.7%    86%
    Third quarter    1,793     207,662    115,818    101.1     84     5.20    10.7     90 
    Second quarter    1,473     171,375    116,344    101.0     82     5.32    10.5     91 
    First quarter    1,232     132,072    107,201    101.1     80     5.45    10.2     93 
        
    		    
    		  
    		  
    		    
    		    
    		  
    		    
    		  
    Total    6,266     $719,341    $114,801    101.1     82     5.28    10.5     90 
        
    		    
    		  
    		                            
    (A)AAA=7, AA=6, A=5, A-=4, B=3, C=2, D=1
    Table 18 — Quarterly Mortgage Loan
    Originations by State (based on original principal)
        2001
    		    2000
    Collateral Location    First    Fourth    Third    Second    First
    California    17%    11%    11%    10%    10%
    Florida    15     14     12     13     14 
    Michigan    8     9     10     11     11 
    Arizona    6     4     5     5     5 
    Ohio    5     6     7     8     7 
    Tennessee    4     4     4     6     7 
    Washington    3     3     5     5     5 
    All other states    42     40     35     30     30 
              The following table presents a summary of our mortgage loan during 2001 and 2000 as a percent of the private placement through December 31, 1997, NovaStar Financial’s stock price averaged $17.08 per share, dividendsrespective quarter’s beginning principal of $0.28 were declaredmortgage loans held in warehouse and the value of each warrant was $2.08. The combination of these produced a return to investors in the private placement exceeding 15%. As a result, the first tranche of these notes was forgiven resulting in a non-cash charge of $1,083,000 during the fourth quarter of 1997. NovaStar Financial has not recognized any further forgiveness of the notes since 1997, as incentive performance targets have not been met.loan origination principal.
     
              In March 1998, the founders exercised options to acquire 289,332 shares of common stock by executing notes payable to NovaStar Financial. The notes bear interest at one month LIBOR plus 1%, are collateralized by the common stock issued, and are non-recourse in nature which means that NovaStar Financial’s recourse is limited to the collateral. These notes and accrued interest are classified as part of the contra-equity account, notes receivable from founders. Unpaid principal on the notes was $4,340,000 as of September 30, 2000 and December 31, 1999. Accrued interest on these notes was $339,000 as of September 30, 2000 and December 31, 1999.Table 19 — Mortgage Loan Activity
         Sold to Third
    Parties    		    Sold in
    Securitizations    		    Held in
    Warehouse    		    Payments    Total
    2001          
    First quarter    3%    66%    30%    1%    100%
          
    2000          
    Fourth quarter    9     55     34     2     100 
    Third quarter    9     60     30     1     100 
    Second quarter    12     44     43     1     100 
    First quarter    20     53     26     1     100 
     
    Results of Operations
    Presentation
    On January 1, 2001, we purchased the voting common shares of NFI Holding Corporation. Previously, two members of NovaStar management owned these securities. The assets and liabilities and operating results of NFI Holding Corporation were not consolidated with that of NovaStar Financial. Beginning January 1, 2001, the financial statements of NFI Holding Corporation are consolidated with those of NovaStar Financial. For comparative purposes, we have presented prior period information as if the financial results of NFI Holding had been consolidated with those of NovaStar Financial Inc.—Nine Months Ended September 30, 2000 Comparedin relevant analyses that follow. In these cases, we have marked the proforma information accordingly. Table 20 is a presentation of proforma consolidated operating results.
    Table 20—NOVASTAR FINANCIAL, INC.
    PROFORMA CONSOLIDATED STATEMENTS OF OPERATIONS
    (dollars in thousands except per share amounts)
         For the Three Months
    Ended March 31,
         2001    Pro Forma
    2000
    Interest income:
         Mortgage loans    $12,740     $16,203 
         Mortgage securities    1,350     266 
        
    		    
    		  
    Total interest income    14,090     16,469 
    Interest expense    8,516     11,735 
        
    		    
    		  
    Net interest income before provision for credit losses    5,574     4,734 
    Provision for credit losses    (519)    (1,430)
        
    		    
    		  
    Net interest income    5,055     3,304 
    Prepayment penalty income    250     494 
    Premiums for mortgage loan insurance    (437)    (365)
    Loan servicing income    6,204     667 
    Gain on sale of mortgage assets    5,023     2,666 
    Other income    447     364 
    General and administrative expenses:
         Compensation and benefits    6,685     3,288 
         Travel and public relations    1,897     276 
         Office administration    1,790     1,521 
         Loan expense    519     189 
         Professional and outside services    414     526 
         Other    518     118 
        
    		    
    		  
         Total general and administrative expenses    11,823     5,918 
        
    		    
    		  
    Net income before cumulative effect of change in accounting principle    4,719     1,212 
    Cumulative effect of change in accounting principle    (1,706)    — 
        
    		    
    		  
    Net income    3,013     1,212 
    Dividends on preferred shares    (525)    (525)
        
    		    
    		  
    Net income available to common shareholders    $  2,488     $    687 
        
    		    
    		  
              Table 21 is a summary of income by our primary operating units. Mortgage portfolio operating results are driven from the income generated on the assets we manage less associated management costs. Mortgage lending and servicing operations include the marketing, underwriting and funding of loan production. Servicing operations represent the income and costs to service our on and off-balance sheet loans. Branch operations include the Nine Months Ended September 30, 1999collective income generated by NovaStar Home Mortgage brokers and the associated operating costs. Branch management costs include the corporate-level income and costs to support branch operations. Each of these operations is discussed below.
     
    Net IncomeTable 21 — Divisional Operations
    Three Months Ended March 31, 2001
         Mortgage
    Portfolio
    		    Mortgage Lending
    and Servicing
    		    Branch
    Operations
    		    Branch
    Management
    		    
    Total
    Net interest income    $3,511     $2,063     —     —     $  5,574 
    Provision for losses    (480)    (39)    —     —     (519)
    Prepayment penalty income    250     —     —     —     250 
    Mortgage insurance    (240)    (197)    —     —     (437)
    Gains (loss) on sales of loans    (22)    5,045     —     —     5,023 
    Fee income (expense)    (479)    1,393     4,840     450     6,204 
    Other income (expense)    51     (1,310)                (1,259)
    General and administrative expenses    (760)    (5,729)    (4,840)    (494)    (11,823)
        
    		    
    		    
    		    
    		    
    		  
    Net income    $1,831     $1,226     $    —     ($44)    $  3,013 
        
    		    
    		    
    		    
    		    
    		  
     
              During the ninethree months ended September 30, 2000, NovaStar Financial recordedMarch, 31, 2001, we earned net income of $3.3$3.0 million, $0.25$0.30 per diluted common share, compared with net income of $2.0$1.2 million, $0.11$0.09 per diluted common share, for the ninethree months ended September 30, 1999.March 31, 2000.
     
              NovaStar Financial’sOur primary sources of revenue are interest earned on its securitizedour mortgage loan portfolio and securities, prepayment penalty income. In addition, results indirectly reflectincome and gains from the salesales and securitizations of whole loans to third parties and securitization transactions executed by NovaStar Mortgage.mortgage loans.
     
    Net Interest Income
     
              Table 922 presents a summary of the average interest-earning assets, average interest-bearing liabilities and the related yields and rates thereon for the ninethree months ended September 30, 2000March 31, 2001 and 1999.2000.
    Table 9
    Interest Analysis
    (dollars in thousands)
       Mortgage Loans
    		 Mortgage-Backed Securities
    		 Total
      Average
    Balance
    		 Interest
    Income/
    Expense
    		  Annual
    Yield/
    Rate
    		  Average
    Balance
    		 Interest
    Income/
    Expense
    		 Annual
    Yield/
    Rate
    		 Average
    Balance
    		 Interest
    Income/
    Expense
    		 Annual
    Yield/
    Rate
    Nine months ended September 30, 2000           
    Interest-earning mortgage assets $475,419  $34,981 9.81% $13,648 $1,611  15.74% $489,067 $36,592 9.98%
       
    		 
    		    
    		 
    		    
    		 
    		   
    Interest-bearing liabilities         
            Collateralized mortgage obligations $499,805  $26,721 7.13% — — —  $499,805 $26,721 7.13%
            Other borrowings — — —  5,228 282 7.19% 5,228 282 7.19 
       
    		     
    		     
    		    
            Cost of derivative financial                
            Instruments hedging liabilities  160   — —   160 
          
    		         
    		       
    		     
                    Total borrowings $499,805 $26,881 7.17% $  5,228 $  282  7.19% $505,033  $27,163 7.17%
       
    		 
    		 
    		   
    		 
    		 
    		   
    		 
    		 
    		  
            Net interest income  $  8,100   $1,329   $  9,429 
          
    		         
    		         
    		     
            Net interest spread   2.64%   8.55%   2.81%
             
    		         
    		         
    		  
            Net yield   2.27%   12.98%   2.57%
             
    		         
    		         
    		  
      Mortgage Loans
    		 Mortgage-Backed Securities
    		 Total
      Average
    Balance
    		 Interest
    Income/
    Expense
    		  Annual
    Yield/
    Rate
    		 Average
    Balance
    		  Interest
    Income/
    Expense
    		 Annual
    Yield/
    Rate
    		 Average
    Balance
    		 Interest
    Income/
    Expense
    		 Annual
    Yield/
    Rate
    Nine months ended September 30, 1999                 
    Interest-earning mortgage assets  $765,073  $52,236  9.10% $808 $100 16.50% $765,845 $52,336 9.11%
       
    		 
    		    
    		 
    		 
    		   
    		 
    		   
    Interest-bearing liabilities                
            Collateralized mortgage obligations $785,547 $33,782  5.73% $  — $  — —% $785,547 $33,782 5.73%
            Other borrowings 5,623 541  12.83  — — —  5,623 541 12.83 
       
    		     
    		     
    		    
            Cost of derivative financial                
            Instruments hedging liabilities  1,736    —   1,736 
          
    		         
    		         
    		     
                    Total borrowings $791,170 $36,059  6.08% $  — — —% $791,170 $36,059 6.08%
       
    		 
    		 
    		   
    		 
    		 
    		   
    		 
    		 
    		  
            Net interest income  $16,177    $100   $16,277 
          
    		         
    		         
    		     
            Net interest spread    3.02%   16.50%   3.03%
             
    		         
    		         
    		  
            Net yield    2.82%   16.50%   2.83%
             
    		         
    		         
    		  
     
              Interest Income.During 2000,the three months ended March 31, 2001, mortgage loans earned $35.0$12.7 million, or a yield of 9.8%10.32%, compared with $52.2$16.2 million, or a yield of 9.1%9.7% for the same period of 1999. Mortgage-backed2000. Mortgage securities income for 20002001 consists of earnings on economic residual interestsmortgage securities that NovaStar Financial purchased from NovaStar Mortgage startingwe retained in September 1999.our securitizations of mortgage loans as discussed above. In total, assets earned $36.6$14.1 million or a yield of 10.0%9.80% for the ninethree months ended September 30, 2000.March 31, 2001. During the same period of 1999,2000, assets earned $52.3$16.5 million or a 9.1%10.6% yield. As noted in Table 9,22, interest income is a function of volume and rates. Increasing the volume of assets will cause future increases in interest income, while declining balances will reduce interest income. Market interest rates will also affect future interest income.income on adjustable-rate mortgages.
     
              Interest Expense.The cost of borrowed funds for mortgage loans was $26.9$8.5 million for the ninethree months ended September 30, 2000,March 31, 2001, or 7.2%6.8% of average borrowings compared with $36.1$11.7 million, or 6.1%7.0% for the same period of 1999. Mortgage-backed securities’ cost of borrowed funds for the nine months
    ended September 30, 2000 includes repurchase agreements secured by economic residual interests executed during the second and third quarters of 2000. Average interest-bearing liabilities for the ninethree months ended September 30, 2000 alsoMarch, 31, 2001 consisted primarily of financing costs on collateralized mortgage obligations compared with the same period of 1999, which also included a short-term financing arrangement with GMAC/RFC secured by residual interests in NovaStar Financial’s CMOs. In 1998, NovaStar Financial borrowed $15 million from GMAC/RFC, which included a $3 million financing fee. In February 1999, NovaStar Financial used the First Union residual facility to pay this debt in full. In March 1999, proceeds from the convertible preferred stock offering repaid all the outstanding debt on the residual facility.our asset-backed bonds.
     
              NovaStar Financial’s collateralized mortgage obligationsOur asset-backed bonds are indexed to LIBOR. During the ninethree months ended September 30, 2000,March 31, 2001, one-month LIBOR averaged 6.33%5.51% compared with 5.07%5.92% for same period of 1999. Because the Federal Reserve Board increased the targeted federal funds interest rate in the latter part of 1999, effective borrowing costs have been higher in 2000. As with interest income, the cost of funds in the future will largely depend on market conditions, most notably levels of short-term interest rates. Rates on other borrowings generally fluctuate with short-term market interest rates, such as LIBOR or the federal funds rate.
     
    Table 22 — Interest Analysis
    (dollars in thousands)
       Mortgage Loans
    		  Mortgage Securities
    		  Total
       Average
    Balance
    		  Interest
    Income/
    Expense
    		  Annual
    Yield/
    Rate
    		  Average
    Balance
    		  Interest
    Income/
    Expense
    		  Annual
    Yield/
    Rate
    		  Average
    Balance
    		  Interest
    Income/
    Expense
    		  Annual
    Yield/
    Rate
    Three months ended March 31, 2001
    Interest-earning mortgage assets  $493,852  $12,740  10.32%  $35,613  $1,350   15.15%  $529,966  $14,090  10.63%
       
    		 
    		 
    		   
    		 
    		   
    		   
    		 
    		 
    		  
    Interest-bearing liabilities:
         Asset-backed bonds  $341,598  5,763  6.75%        341,598  5,763  6.75%
         Other borrowings  135,113  2,406  7.12   25,000  481   7.69   160,113  2,887  7.24 
       
    		            
    		                  
         Cost of derivative financial
         instruments hedging
         liabilities    		    (133)            (133)  
          
    		                      
    		     
    Total borrowings  $476,711  8,036  6.74   25,000  480   7.69   501,711  8,516  6.79 
       
    		 
    		 
    		      
    		   
    		   
    		 
    		 
    		  
    Net interest income    $  4,704      $  870       $  5,574  
          
    		         
    		           
    		     
    Net interest spread      3.58       7.46       2.26 
             
    		           
    		         
    		  
    Net yield      3.81       9.76       4.21 
             
    		           
    		         
    		  
    Three months ended March 31, 2000 (proforma)
    Interest-earning mortgage assets  $669,053  $16,203  9.70%  $  6,375  $  266   16.50%  $675,429  $16,409  9.77%
       
    		 
    		 
    		   
    		 
    		   
    		   
    		 
    		 
    		  
    Interest-bearing liabilities:
         Asset-backed bonds  $557,238  $  9,334  6.63%  $      —  $   —
    		  — %  $557,238  $  9,334  6.63%
         Other borrowings  109,560  2,099  7.58   —  —   —   109,560  2,099  7.58 
       
    		         
    		           
    		        
    Cost of derivative financial
    instruments hedging liabilities    		     302       —   —      302  
          
    		         
    		           
    		     
    Total borrowings  $666,799  11,735  6.96   $      —  —   —   $666,799  11,735  6.96 
       
    		 
    		 
    		   
    		 
    		   
    		   
    		 
    		 
    		  
    Net interest income    $  4,468      $  266       $  4,734  
          
    		         
    		           
    		     
    Net interest spread      2.74       16.50       2.81 
             
    		           
    		         
    		  
    Net yield      2.64       16.50       2.77 
             
    		           
    		         
    		  
              Net Interest Income and Spread.Net interest income on mortgage loans for the ninethree months ended September 30, 2000March 31, 2001 was $9.4$4.7 million or 2.6% of average interest-earning mortgage loans, compared with $16.3$4.5 million or 2.8% for the same period of 1999.in 2000. Net interest spread on mortgage loans was 2.8%3.6% and 3.0%2.7%, respectively, for the ninethree months ended September 30, 2000March 31, 2001 and 1999.2000. Net interest income on mortgage-backedmortgage securities (economic residual interests) during the ninethree months ended September 30, 2000March, 31, 2001 was $1.3 million,$870,000, or 13.0%7.5% of average interest-earning mortgage securities compared with a net interest spread$266,000 and 16.5% for the same period of 8.6%.2000. The volume of assets and liabilities and how well the spread between earnings on assets and the cost of funds is managed will dictate future net interest income.
              Impact of Interest Rate Agreements.NovaStar Financial has entered intoWe have executed interest rate agreements designed to mitigate exposure to interest rate risk. Interest rate cap agreements require NovaStar Financialus to pay either a monthly fixedone-time “up front” premium or a quarterly premium, while allowing it to receive a rate that adjusts with LIBOR when rates rise above a certain agreed-upon rate. Interest rate swap agreements to which we are a party allow us to pay a fixed rate of interest while receiving a rate that adjusts with one-month LIBOR. These agreements are used to alter, in effect, the interest rates on funding costs to more closely match the yield on interest-earning assets.
     
              As part of the NMFT 2000-1 asset-backed bond transaction discussed under “Mortgage Securities— Available-For-Sale” and “Mortgage Loan Sales” sections of this document, NovaStar Financial sold a cap with a carrying value of $480,000 to NovaStar Mortgage recognizing a deferred gain of $880,000. The cap was hedging liabilities incurred to fund the mortgage loans sold to NMFT 2000-1 and the deferred gain will be amortized over the remaining cap term. This cap had a carrying value of $545,000 as of September 30, 2000. During the nine months ended September 30, 2000 and 1999, net interest expense incurred on hedging agreements was $160,000 and $1.7 million, respectively, which is included as a component of interest expense. The significant decline in this expense in 2000 compared with the same period of 1999 is a result of the majority of the caps’ quarterly LIBOR resets in 2000 were greater than their strike rates.
    Prepayment Penalty Income
              NovaStar Financial strives to purchase loans that have some form of prepayment penalty fee to mitigate exposure to prepayment risk. During the nine months ended September 30, 2000 and 1999, 91% of the mortgage loans originated by NovaStar Mortgage had prepayment penalties. As of September 30, 2000, 45% of NovaStar Financial’s mortgage loan portfolio had prepayment penalties compared with 58% as of December 31, 1999. Prepayment penalties totaled $1.4 million during the nine months ended September 30, 2000 compared with $2.4 million for the same period of 1999. The decrease is due to NovaStar Financial no longer purchasing loans from NovaStar Mortgage, seasoning of the portfolio and prepayment penalty windows expiring in 2000 compared with 1999.
    Premiums for Mortgage Loan Insurance
              NovaStar Financial and NovaStar Mortgage have executed agreements whereby lender-paid mortgage insurance coverage is purchased on selected mortgage loans. The use of mortgage insurance is one method of managing the credit risk in the mortgage asset portfolio.
              As of September 30, 2000 and December 31, 1999, approximately 66% and 39% of the loans owned by NovaStar Financial are covered under this agreement, including loans serving as collateral for the REMIC deals. The loans collateralizing REMIC deals are not recorded as loans of NovaStar Financial, but the performance of NovaStar’s investment in the residual interests of the REMIC deals is dependent on the credit losses of the underlying collateral.
              Premiums for mortgage insurance on loans maintained on the balance sheet of NovaStar Financial are recorded as a portfolio cost and included in the income statement under the caption “Premiums for Mortgage Loan Insurance.” During the nine months ended September 30, 2000, total premiums paid by NovaStar Financial totaled $1.0 million compared with $1.3 million for the same period of 1999. Premiums for mortgage insurance on loans serving as collateral for the residual interests owned by NovaStar Financial is paid from the loan collateral proceeds, and therefore are not included in the amount of total premiums paid as shown above.
    Provisions for Credit Losses
     
              NovaStar Financial ownsWe originate and own loans wherein which the borrower possesses credit risk higher than that of conforming borrowers. Delinquent loans and losses are expected to occur. Most Provisions for credit losses are made in amounts considered necessary to maintain an allowance at a level sufficient to cover probable losses inherent in the loan portfolio. Charge-offs are recognized at the time of foreclosure by recording the value of real estate owned property at its estimated realizable value. One
    of the loans owned by NovaStar Financial were underwrittenprincipal methods used to estimate expected losses is a delinquency migration analysis. This analysis takes into consideration historical information regarding foreclosure and funded by NovaStar Mortgage. All loans owned by NovaStar Financial are serviced by NovaStar Mortgage. NovaStar Mortgage usesloss severity experience and applies that information to the portfolio at the reporting date.
              We use several techniques to mitigate credit losses, including pre-funding audits by quality control personnel and in-depth appraisal reviews. Another loss mitigation technique allows a borrower to sell their property for less than the outstanding loan balance prior to foreclosure in transactions known as short sales, when it is believed that the resulting loss is less than what would be realized through foreclosure. While short sales serve to reduce the overall severity of losses incurred, they also accelerate the timing of losses. Loans are charged off in full when the cost of pursuing foreclosure and liquidation exceed recorded balances. ManagementWhile short sales have served to reduce the overall severity of losses incurred, they also believes aggressive servicing is an important element to managing credit risk.
    accelerate the timing of losses. As discussed further under the caption “Premiums for Mortgage Loan Insurance”, lender paid mortgage insurance is also used as a means of managing credit risk exposure. Generally, the exposure to credit loss on insured loans is considered minimal.
              Provisions for Management also believes aggressive servicing is an important element to managing credit losses are made in amounts considered necessary to maintain the allowance at a level sufficient to cover probable losses inherent in the loan portfolio. Charge-offs are recognized at the time of foreclosure by recording the value of real estate owned property at its estimated realizable value. Subsequent gains or losses on dispositions, if any, are recorded in operations. The net gains or (losses) recognized on real estate owned properties are discussed further under “Other Income”. One of the principal methods used to estimate expected losses is a delinquency migration analysis. This analysis takes into consideration historical information regarding foreclosure and loss severity experience and applies that information to the portfolio at the reporting date.risk.
     
              During the ninethree months ended September 30, 2000, NovaStar FinancialMarch 31, 2001, we made provisions for losses of $4.0 million$519,000 and incurred net charge-offs of $7.0$1.6 million, compared to $11.5$1.6 million and $9.7$2.9 million during the same period of 1999.2000. Charge-offs during the nine monthsfirst quarter of 20002001 include $586,000$114,000 resulting from short sale transactions and loans charged off in full compared with $879,000$191,000 during the same period of 1999.
              In the opinion of management, the allowance for credit losses as of September 30, 2000 is adequate to cover losses inherent in the portfolio at that date. If losses do not develop in accordance with current expectations, future provisions will be increased or decreased as necessary. Management also believes that internal processes involving quality control, appraisal review and servicing that have been made as a result of experience to-date will result in lower losses being incurred on loans currently being originated.
              Table 10 is a rollforward of the activity in the allowance for credit losses during 2000 and 1999.2000.
     
    Table 10
    Rollforward of 23 — Quarterly Activity—Allowance for Credit Losses
    (in thousands)
     
      2000
    		  1999
    		 
      September 30
    		  June 30
    		  March 31
    		  December 31
    		  September 30
    		  June 30
    		  March 31
    		 
    Beginning balance    $  8,993  $  9,763  $11,105  $  5,370  $  3,573  $  3,492  $  3,573 
    Provision for credit losses 1,212  1,213  1,579  10,579  5,634  3,566  2,299 
    Amounts charged off, net
    of recoveries    		  (2,073)  (1,983)  (2,921)  (4,844)  (3,837)  (3,485)  (2,380)
       
    		  
    		  
    		  
    		  
    		  
    		  
    		 
    Ending Balance $  8,132  $  8,993  $  9,763  $11,105  $  5,370  $  3,573  $  3,492 
       
    		  
    		  
    		  
    		  
    		  
    		  
    		 
         2001
    		    2000
         March 31
    		    December 31
    		    September 30
    		    June 30
    		    March 31
    Beginning balance    $7,944     $8,701     $9,770     $10,230     $11,817 
    Provision for credit losses    519     1,460     1,252     1,336     1,430 
    Amounts charged off, net of recoveries    (1,638)    (2,217)    (2,321)    (1,796)    (3,017)
        
    		    
    		    
    		    
    		    
    		  
    Ending balance    $6,825     $7,944     $8,701     $  9,770     $10,230 
        
    		    
    		    
    		    
    		    
    		  
    Prepayment Penalty Income
     
              A large percentage of the loans we originate require the borrower to pay a cash penalty if they pay off their loan early in the loan’s life, generally within two years of origination. This income serves to mitigate and offset prepayment risk and the amortization expense of premiums we paid to loan brokers. The following tables provide details regardingpenalty is generally six months of interest on 80% of the delinquencies, defaults, and loss statisticsunpaid principal at prepayment. During the three months ended March, 31, 2001, 93% of NovaStar Financial’sthe mortgage loans we originated had prepayment penalties, as compared to 93% during the same period of 2000. As of March, 31, 2001, 54% our mortgage loan portfolio.portfolio had prepayment penalties. Prepayment penalty income was $250,000 and $489,000 during the three months ended March, 31, 2001 and 2000, respectively. The decrease is due to the seasoning of the portfolio and the expiration of prepayment penalties.
    Premiums for Mortgage Loan Insurance
              We purchase mortgage insurance on substantially all of the loans we originate. The use of mortgage insurance is one method of managing the credit risk in the mortgage asset portfolio. As of March 31, 2001, approximately 73% of the loans we service are covered by mortgage insurance. By the end of April 2001, this number increased to 93%.
              Premiums for mortgage insurance on loans maintained on our balance sheet are recorded as a portfolio cost and included in the income statement under the caption “Premiums for Mortgage Loan Insurance.”
              It is important to note that substantially all of the mortgage loans that serve as collateral for our mortgage securities carry mortgage insurance. This serves to reduce credit loss exposure in those mortgage pools. Insurance premiums on these loans are paid from the collateral proceeds and, therefore, are not included in the amount of total premium expense in our statement of operations.
    Sales of Mortgage Loans
              During 1999, 2000 and 2001, we executed securitization transactions in which we transferred mortgage loan collateral to an independent trust. In those transactions, we retained the interest-only and subordinated securities. In addition, we continue to service the loan collateral. Accounting principles require us to record these transactions as loan sales. Whole loan sales have also been executed whereby we sell loans outright.
     
    Table 11
    24 — Quarterly Mortgage Loan Delinquencies (90 days and greater) (A)
    2000 and 1999
    (in thousands)
         2000
    		  1999
         September 30
    		  June 30
    		  March 31
    		  December 31
    		  September 30
    		  June 30
    		  March 31
    Mortgage loans Collateralizing
    NovaStar Home Equity Series
    (CMO):    		                
    1997-1 Issued October 1, 1997    $3,410  $4,039  $3,434  $4,726  $6,093  $6,087  $6,454
    1997-2 Issued December 11, 1997    5,222  6,336  6,311  6,047  5,934  5,671  8,388
    1998-1 Issued April 30, 1998    8,131  6,455  5,987  8,467  11,411  9,687  11,818
    1998-2 Issued August 18, 1998    10,621  11,159  11,433  12,754  10,247  10,808  10,832
    (A)Includes loans in foreclosure or bankruptcy.
    Table 12
    Loan Delinquencies (90 days and greater) as a Percent of Total Loan Principal(A)
    2000 and 1999
         2000
    		  1999
         September 30
    		  June 30
    		  March 31
    		  December 31
    		  September 30
    		  June 30
    		  March 31
    Mortgage loans Collateralizing
    NovaStar Home Equity Series
    (CMO):    		                
    1997-1 Issued October 1, 1997    6.01%  6.21%  4.59%  5.63%  6.32%  5.13%  4.37%
    1997-2 Issued December 11, 1997    8.23   8.88   7.66   6.24   4.92   4.03   5.38 
    1998-1 Issued April 30, 1998    6.44   4.40   3.58   4.42   5.32   4.13   4.64 
    1998-2 Issued August 18, 19986.035.485.105.384.063.943.72
    (A)Includes loans in foreclosure or bankruptcy.
    Table 13
    Delinquencies, Defaults and Losses
    September 30, 2000 and December 31, 1999Sales
    (dollars in thousands)
     
    NovaStar Home Equity Series
    September 30, 20001997-1
    		1997-2
    		1998-1
    		1998-2
    		All Loans
    Allowance for Credit Losses:
              Balance, January 1, 2000    $2,335     $  2,861     $4,214     $  1,685     $11,105 
              Provision for credit losses    532     815     1,419     1,235     4,004 
              Amounts charged off, net of Recoveries    (1,154)    (1,796)     (2,246)    (1,778)    (6,977)
        
    		    
    		    
    		    
    		    
    		  
              Balance, September 30, 2000    $1,713     $  1,880     $3,387     $  1,142     $  8,132 
        
    		    
    		    
    		    
    		    
    		  
    Defaults as a percent of loan balance                  
              Delinquent loans (A)  11.46%    9.09%    8.81%    12.49%    10.78%
         
    		    
    		    
    		    
    		    
    		  
              Loans in foreclosure    3.99     6.71     4.80     4.53     4.86 
        
    		    
    		    
    		    
    		    
    		  
              Real estate owned    4.34     3.70     3.88     3.82     3.90 
        
    		    
    		    
    		    
    		    
    		  
    Cumulative losses    $4,102     $  4,272     $4,015     $  2,345     
        
    		    
    		    
    		    
    		      
    NovaStar Home Equity Series
    December 31, 19991997-1
    		1997-2
    		1998-1
    		1998-2
    		All Loans
    Allowance for Credit Losses:
              Balance, January 1, 1999    $  816     $  1,049     $1,163     $  346     $  3,573 
              Provision for credit losses    4,317     5,436     8,194     4,065     22,078 
              Amounts charged off, net of Recoveries    (2,798)     (3,624)     (5,143)     (2,726)     (14,546) 
        
    		    
    		    
    		    
    		    
    		  
    Balance, December 31, 1999    $2,335     $  2,861     $4,214     $1,685     $11,105 
        
    		    
    		    
    		    
    		    
    		  
    Defaults as a percent of loan balance
              Delinquent loans (A)    8.03%    9.89%    6.38%    7.50%    7.63%
        
    		    
    		    
    		    
    		    
    		  
              Loans in foreclosure    4.73     4.32     3.75     4.02     4.09 
        
    		    
    		    
    		    
    		    
    		  
              Real estate owned    3.85     4.88     3.61     2.62     3.51 
        
    		    
    		    
    		    
    		    
    		  
    Cumulative losses    $2,377     $  1,756     $  538     $  745     
        
    		    
    		    
    		    
    		      
         Outright Mortgage Loan Sales
    		    Mortgage Loans
    Transferred in
    Securitizations
         Principal
    Amount
    		    
    Net Gain
    Recognized
    		    Weighted
    Average
    Price To
    Par
    		    
    Principal
    Amount
    		    
    Net Gain
    Recognized
    2001:    
         First quarter    $  10,773    $  262    102.9(A)    $211,420    $4,944
        
    		  
    		  
    		    
    		  
    2000:
         Fourth quarter    $  46,158    $1,666    104.6     $151,277    $3,227
         Third quarter    50,334    1,552    104.4     188,734    3,584
         Second quarter    27,799    661    103.8     101,675    1,392
         First quarter    48,548    1,204    104.0     128,121    1,544
        
    		  
    		        
    		  
         Total    $172,839    $5,083    104.2     $569,857    $9,747
        
    		  
    		  
    		    
    		  
    (A)Includes sales of loans delinquent 30 days or greaterin our highest credit category, which have relatively low coupons. Average price of 102.9 represent market prices for similar loans, but are lower than market prices for high coupon loans such as those sold in prior quarters.
              In the outright sales of mortgage loans, we retain no assets or servicing rights. For mortgage loans transferred in securitizations, we allocate our basis in the mortgage loans between the portion of the mortgage loans sold and the retained assets, securities and servicing rights, based on the relative fair values of those portions at the time of sale. The values of these assets are determined by discounting
    estimated future cash flows using the cash out method. The following table details the significant assumptions used to determine the value of the resulting retained assets at the time of securitization.
    Table 25 —Mortgage Loans Transferred in Securitizations—Valuation Assumptions at Closing
         Constant Prepayment
    Rate
    		    Total Projected Default Rate (%
    of original principal) (A)
    		    Discount Rate
    NovaStar Mortgage Funding Trust Series:
    1999-01    25 to 30    2.5%    16.5%
    2000-01    25 to 30    1.0     14.8 
    2000-02    25 to 30    1.0     15.0 
    2001-01    25 to 30    1.2     20.0 
    (A)After the effect of mortgage insurance.
     
    Loan Servicing Fees Paid to NovaStar Mortgage, Inc.
              Loan servicing fees paid to NovaStar Mortgage, Inc. include the 50 basis point fee charged by NovaStar Mortgage for servicing the loans owned by NovaStar Financial serving as collateral on CMOs. The fee charged is based on the loan principal balance of the mortgage loans serviced. Loan servicing fees for the first nine months of 2000 were $2.0 million compared with $3.1 million for the same period of 1999. The reduction is due to principal paydowns between the two periods.
    OtherFee Income
     
              OtherFee income (loss) during the nine months ended September 30, 2000 primarily consists of net losses recognized onfees from two sources—servicing fees from investors and borrowers and broker fees from loan investors. As a loan servicer, we collect normal fees for servicing loans that collateralize asset-backed bonds. These fees are generated at the salerate of real estate owned properties50 basis points of $722,000 compared with net gains on the sale of real estate owned properties of $74,000 during the same period of 1999. The net losses recognized in 2000 resultedprincipal balance and are earned as interest is collected from borrowers. In addition, we collect fees directly from the liquidationborrower in the normal course of aged properties with slightly higher severities thanservicing loans for such items as late payment assessments and processing fees for special handling.
     
    Novastar Financial’s historical average severity. Other income          Loan investors who fund the loans we broker pay fees to our branches. These fees constitute standard broker “premiums” for the nine months ended September 30, 2000 also consiststypes of interest earned on securitization funds held in trustloans we broker. As discussed below under Branch Operations, the net income of $169,000 and interest earned on money market funds of $101,000. Other income for the same period of 1999 also included interest earned on notes receivable from founders of $368,000 and interest earned on securitization funds held in trust of $173,000.branches accrues to the branch manager.
     
    General and Administrative Expenses
     
              General and administrative expenses for the nine months ended September 30, 2000 and 1999 are provided in Table 14. Table 15 displays the relationship of portfolio expenses to stockholders’ equity during 2000 and 1999 by quarter.
    Table 14
    26 — General and Administrative Expenses
    (dollars in thousands)
     
         Nine Months Ended September 30,
         2000
    		    1999
              Percent of
    Stockholders’
    Equity
    (Annualized)
    		         Percent of
    Stockholders’
    Equity
    (Annualized)
    Compensation and benefits    $1,042     1.38%    $1,358    1.61%
    Professional and outside services    467     0.62     546    0.65 
    Office administration    607     0.80     611    0.72 
    Other    66     0.09     156    0.18 
        
    		    
    		    
    		  
    		  
    Total general and administrative expenses before Intercompany fees    2,182     2.89%    2,671    3.16%
         
    		   
    Net fees for other services provided by (to) NovaStar Mortgage, Inc.    (1,460)        287    
        
    		          
    		      
    Total general and administrative expenses.    $  722         $2,958    
        
    		          
    		      
     
    Table 15
    Portfolio Related Expenses as a
    Percent of Stockholders’ Equity
    2000 and 1999
    Percent of
    Stockholders’
    Equity
    2000:
    Third quarter3.05%
    Second quarter2.80
    First quarter2.80
    1999:
    Fourth quarter3.63
    Third quarter3.06
    Second quarter2.07
    First quarter3.94
         Quarter Ended March 31,
         2001
    		    2000
              (Pro forma)
    Quarter ended March 31, 2001
       Compensation and benefits    $  6,685    $3,288
       Travel and entertainment    1,897    276
       Office administration    1,790    1,521
       Loan expense    519    189
       Other    518    118
       Professional and outside services    414    526
        
    		    
       Total general and administrative expenses    $11,823    $5,918
        
    		    
     
              Compensation and benefits includes employee base salaries, benefit costs and incentive compensation awards. The decrease in compensation and benefits for the nine months ended September 30, 2000 compared with the same period of 1999 is due to staff reductions and employee cost allocations to NovaStar Mortgage.
     
              Professional and outside services include fees for legal and accounting services. In the normal course of business, fees are incurred for professional services related to general corporate matters and specific transactions. The 2000 decline is a result of legal fees incurred on the structuring of various financing arrangements and general company growth experienced during the first nine months of 1999. Office administration includes items such as rent, depreciation, telephone, office supplies, postage, delivery, maintenance and repairs.
     
              The following is a summary of the fees, in thousands, paid to (received from) NovaStar Mortgage for the nine months ended September 30, 2000 and 1999.
         Nine Months Ended
    September 30,
    		 
         2000
    		      1999
    		 
    Amounts paid to NovaStar Mortgage:    
            
              Loan servicing fees$    1,982  $   3,056 
     
    		  
    		 
              Administrative fees    126      1,263 
    Amounts received from NovaStar Mortgage:
              Guaranty, commitment, loan sale and securitization fees    (1,246)     — 
              Interest income    (340)     (976)
     
    		  
    		 
     $   (1,460)  $      287 
     
    		  
    		 
              The decline in these fees for the nine months ended September 30, 2000 compared with 1999 is due to the cancellation of the administrative fees intercompany agreement on April 1, 1999, since NovaStar Financial is no longer purchasing loans from NovaStar Mortgage. This agreement was replaced with an intercompany loan and guarantee agreement with NovaStar Mortgage. Under the terms of this agreement,

    NovaStar Mortgage pays interest on amounts it borrows from NovaStar Financial. Interest on the borrowings accrues at the federal funds rate plus 1.75%. Under this agreement, NovaStar Mortgage is required to pay guaranty fees in the amount 0.25% of the loans sold by NovaStar Mortgage for which NovaStar Financial has guaranteed the performance of NovaStar Mortgage. In addition, beginning July 1, 2000, NovaStar Mortgage entered into the following intercompany agreements:

    ·Servicing support fee: NovaStar Mortgage pays NovaStar FinancialCost of production. Our quarter-to-quarter wholesale loan production costs steadily declined as a fee equalresult of
    increased efficiencies in the mortgage lending operation. During the third quarter of 1999, we introduced
    Internet Underwriter®:, “IU”, a web-based origination system that has allowed us to five basis pointsincrease production
    volumes without adding proportionate infrastructure. Account executive costs typically are higher in the first
    few months of employment and are expected to decline as the weighted average mortgagesales force becomes more productive with added
    experience and exposure to our loan servicing principal.
    ·Financing commitment fee: NovaStar Mortgage pays NovaStar Financial a fee equal to 25 basis points on a $150 million annual commitment
    ·Residual purchase commitment fee: NovaStar Mortgage pays NovaStar Financial a fee at each securitization close equal to 20 basis points of the collateral principal value.
    ·Securitization consulting fee: NovaStar Mortgage pays NovaStar Financial a fee at each securitization close equal to 12.5 basis points of the collateral principal value.
    ·Guaranty spread fee: NovaStar Mortgage pays NovaStar Financial a fee equal to one basis point of the weighted average mortgage loan warehouseproducts and repurchase borrowings.markets.
     
              NovaStar Financial provides liquidity resources for all operations and enhances the creditworthinessTable 27 — Wholesale Loan Costs of NovaStar Mortgage. In addition, Novastar Financial provides substantial expertise to NovaStar Mortgage in its execution of loan sales and securitizations. The fees charged to NovaStar Mortgage are designed to recognize this liquidity, credit and financial support.
    Equity in EarningsProduction, as a Percent of NFI Holding CorporationPrincipal
     
              For the nine months ended September 30, 2000, NFI Holding recorded net income of $652,000 compared with net income of $1.5 million for the same period of 1999. NovaStar Financial records its portion of the earnings as equity in net earnings of NFI Holding in its income statement. NFI Holding’s net earnings include the net earnings of NovaStar Mortgage, a subsidiary of NFI Holding as discussed under “Basis of Presentation”. NFI Holding’s financial position and results of operation for the nine months ended September 30, 2000 and 1999 are discussed further under the heading “NFI Holding Corporation”.
     
    Results of Operations of NovaStar Financial, Inc.—Three Months Ended September 30, 2000 Compared to the Three Months Ended September 30, 1999
    Net Income
              During the three months ended September 30, 2000, NovaStar Financial recorded net income of $2.0 million, $0.18 per diluted common share, compared with a net loss of $1.5 million, $0.25 per diluted common share, for the three months ended September 30, 1999.
    Net Interest Income
              Table 16 presents a summary of the average interest-earning assets, average interest-bearing liabilities and the related yields and rates thereon for the three months ended September 30, 2000 and 1999.
         Gross
    Loan
    Production
    		    Premium paid to
    broker, net of
    fees collected
    		    Total
    Acquisition
    Cost
    2001:
         First quarter    2.3    0.7    3.0
                 
    2000:
         Fourth quarter    2.8    0.5    3.3
         Third quarter    2.6    0.5    3.1
         Second quarter    3.0    0.5    3.5
         First quarter.    3.3    0.5    3.8
     
    Table 16
    Interest Analysis
    (dollars in thousands)
          Cost of derivative financial instruments hedging liabilities
         Mortgage Loans
    		    Mortgage-Backed Securities
    		    Average
    Balance
    		    Total
    		    Annual
    Yield/
    Rate
    Three months ended September 30, 2000
    		    Average
    Balance
    		    Interest
    Income/
    Expense
    		    Annual
    Yield/
    Rate
    		    Average
    Balance
    		    Interest
    Income/
    Expense
    		    Annual
    Yield/
    Rate
    		    Interest
    Income/
    Expense
    Interest-earning mortgage assets    $417,846    $10,391     9.95%    $18,701    $733    15.68%    $436,548    $11,124     10.19%
        
    		  
    		    
    		    
    		  
    		  
    		    
    		  
    		    
    		  
    Interest-bearing liabilities                       
          Collateralized mortgage obligations    $443,082    $  8,400     7.58%    —    —    —     $443,082    $  8,400     7.58%
          Other borrowings    —    —     —     6,787    131    7.72%    6,787    131     7.72%
        
    		              
    		            
    		            
         Cost of derivative financial instruments hedging liabilities        (160)            —            (160)    
            
    		              
    		            
    		        
              Total borrowings    $443,082    $  8,240     7.44%    $  6,787    $131    7.72%    $449,869    $  8,371     7.44%
        
    		  
    		    
    		    
    		  
    		        
    		  
    		    
    		  
          Net interest income        $  2,151             $602            $  2,753     
            
    		              
    		            
    		        
          Net interest spread            2.51%            7.96%            2.75%
                  
    		            
    		              
    		  
          Net yield            2.06%            12.88%            2.52%
                  
    		            
    		              
    		  
     
         Mortgage Loans
    		    Mortgage-Backed Securities
    		    Average
    Balance
    		    Total
    		    Annual
    Yield/
    Rate
    Three months ended September 30, 2000
    		    Average
    Balance
    		    Interest
    Income/
    Expense
    		    Annual
    Yield/
    Rate
    		    Average
    Balance
    		    Interest
    Income/
    Expense
    		    Annual
    Yield/
    Rate
    		    Interest
    Income/
    Expense
    Interest-earning mortgage assets    $690,323    $15,595     9.04%    $  2,424    $100    16.50%    $692,747    $15,695     9.06%
        
    		  
    		    
    		    
    		  
    		  
    		    
    		  
    		    
    		  
    Interest-bearing liabilities                       
          Collateralized mortgage obligations    $706,685    $10,626     6.01%    —    —    —     $706,685    $10,626     6.01%
          Other borrowings    —    —     —     —    —    —     —    —     — 
        
    		              
    		            
    		            
          Cost of derivative financial instruments hedging liabilities        580             —            580     
            
    		              
    		            
    		        
              Total borrowings    $706,685    $11,206     6.34%    $      —    —    —%    $706,685    $11,206     6.34%
        
    		  
    		    
    		    
    		  
    		        
    		  
    		    
    		  
          Net interest income        $  4,389             $100            $  4,489     
            
    		              
    		            
    		        
          Net interest spread            2.70%            16.50%            2.72%
                  
    		            
    		              
    		  
          Net yield            2.54%            16.50%            2.59%
                  
    		            
    		              
    		  
              Average interest-earning assets were $436.5 million during the three months ended September 30, 2000, which included in $18.7 million of residual assets classified as mortgage-backed securities, compared with average interest-earning assets of $692.7 million for the same period of 1999, comprised primarily of mortgage loans. Mortgage securities earned $733,000 for the three months ended September 30, 2000, or a yield of 15.7% compared with $100,000, or a yield of 16.5% for the same period of 1999. During the three months ended September 30, 2000, mortgage loans earned $10.4 million, or a yield of 10.0%, compared with $15.6 million, or a yield of 9.0% for the same period of 1999. In total, assets earned $11.1 million—a 10.2% yield for three months ended September 30, 2000 compared to $15.7 million, or a 9.1% yield for the same period ended September 30, 1999.
              During the three months ended September 30, 2000, borrowed funds for NovaStar Financial averaged $443.1 million on which interest was incurred of $8.2 million, or 7.4%. In comparison, for the three months ended September 30, 1999, borrowed funds for NovaStar Financial averaged $706.7 million on which interest was incurred of $11.2 million, or 6.3%.
              Net interest income during the three months ended September 30, 2000 was $2.8 million or 2.5% of average interest-earning assets, compared with $4.4 million, or 2.6% of average interest-earning assets during the same period of 1999. Net interest spread was 2.8% during the three months ended September 30, 2000 compared with 2.7% during the three months ended September 30, 1999.
               During the three months ended September 30, 2000 and 1999, net interest expense was incurred on hedging agreements of $(160,000) and $580,000, respectively, which is included as a component of interest expense. The decline in this expense for the third quarter of 2000 compared with the same period of 1999 is due to the fact that quarterly LIBOR reset rates were higher than the interest rate agreement strike rates on a majority of NovaStar Financial’s interest rate agreements during the third quarter of 2000. NovaStar Financial receives credits against the quarterly premium payments to counterparties whenever LIBOR reset rates are higher than the strike rates.
    Provisions for Credit Lossesand Premium for Mortgage Loan Insurance
              During the three months ended September 30, 2000, NovaStar Financial provided $1.2 million to the allowance for credit losses, compared with $5.6 million during the same period of 1999. Charge-offs during the three months ended September 30, 2000 were $2.1 million compared with $3.8 million during the same period of 1999. See “Mortgage Insurance” and Provisions for Credit Losses“ under ”Results of Operations of NovaStar Financial, Inc.28 —Nine Months Ended September 30, 2000 Compared to the Nine Months Ended September 30, 2000.“
              Premiums for mortgage loan insurance include the premiums paid to Radian Guaranty, Inc. and PMI, Inc. on certain loans held in NovaStar Financial’s portfolio.
    Loan Servicing Fees Paid to NovaStar Mortgage, Inc.
              Loan servicing fees paid to NovaStar Mortgage, Inc. include the 50 basis point fee that NovaStar Mortgage charges NovaStar Financial for the loans collateralizing the CMOs. This fee is based on the collected principal balance of the mortgage loans serviced. The decrease in loan servicing fees paid to NovaStar Mortgage during the three months ended September 30, 2000 compared with the same period of 1999 is due to principal paydowns in NovaStar Financial’s CMO collateral during the two periods.
    Other Income
              Other income during the three months ended September 30, 2000 primarily consists of prepayment penalties of $448,000, net loss recognized on the sale of real estate owned properties of $684,000, interest earned on securitization funds held in trust of $59,000 and interest earned on money market funds of $34,000. Other income for the same period of 1999 primarily consisted of prepayment penalties of $769,000, net gains on the sale of real estate owned properties of $91,000, interest earned on notes receivable from founders of $126,000 and interest earned on securitization funds held in trust of $62,000.
    General and Administrative Expenses
              General and administrative expenses for the three months ended September 30, 2000 and 1999 are provided in Table 17.
    Table 17
    Divisional Operations—General and Administrative Expenses
    (dollars in thousands)Three Months Ended March 31, 2001
     
         Three Months Ended September 30,
         2000
    		    1999
              Percent of
    Stockholders’
    Equity
    (Annualized)
    		         Percent of
    Stockholders’
    Equity
    (Annualized)
    Compensation and benefits $325     1.30%$  421    1.49%
    Professional and outside services    210     0.84     181    0.64 
    Office administration    206     0.82     203    0.72 
    Other    23     0.09     60    0.21 
      
    		    
    		  
    		  
    		  
    Total general and administrative expenses before Intercompany fees    764     3.05%    865    3.06%
                
    		 
    Net fees for other services provided by (to) NovaStar Mortgage, Inc.     (1,458)         (169)
      
    		        
    		      
         Total general and administrative expenses.$(694)    $   696    
      
    		        
    		      
     
              Compensation and benefits totaled $325,000 for the nine months ended September 30, 2000 compared with $421,000 for the same period of 1999. The decline is due to staff reductions and intercompany employee expense allocations to NovaStar Mortgage.
              Professional and outside services for the three months ended September 30, 2000 was $210,000 compared with $181,000 for the three months ended September 30, 1999. This line-item includes the cost of various accounting and legal services and varies based on the nature and timing of operational needs.
              The following is a summary of the fees, in thousands, paid to NovaStar Mortgage for the three months ended September 30, 2000 and 1999:
          Three Months
    Ended
    September 30,
      2000
    		     1999
    Amounts paid to NovaStar Mortgage:          
         Loan servicing fees $599  $ 936 
       
    		   
    		  
         Administrative fees, net of guaranty fees.     (111)     115 
    Amounts received from NovaStar Mortgage:      
         Guaranty, commitment, loan sale and securitization fees     (1,239)     — 
         Interest income     (108)     (284)
       
    		   
    		  
      $ (1,458)  $ (169)
       
    		   
    		  
              The decline in loan servicing fees paid to NovaStar Mortgage for the three months ended September 30, 2000 compared with the three months ended September 30, 1999 is due to a decline in NovaStar Financial’s mortgage loan portfolio serviced by NovaStar Mortgage.
               The guaranty, commitment, loan sale and securitization fees are a result of the intercompany agreements NovaStar Mortgage and NovaStar Financial entered July 1, 2000. These agreements are discussed further under the “Results of Operations of NovaStar Financial, Inc.—Nine Months Ended September 30, 2000 Compared to the Nine Months Ended September 30, 1999”.
              The decrease in the interest income paid to NovaStar Mortgage during these same periods is a result of the decline in average intercompany borrowings in 2000.
         Mortgage
    Portfolio
    		    Mortgage
    Lending and
    Servicing
    		    Branch
    Operations
    		    Branch
    Management
    		    
    Total
    Compensation and benefits    $442     $3,513    $2,475    $255    $6,685
    Office administration    123     1,165    413    89    1,790
    Professional and outside services    195     207    3    9    414
    Loan expense    —     461    58    —    519
    Travel and entertainment    11     310    1,549    27    1,897
    Other    (11)    73    342    114    518
        
    		    
    		  
    		  
    		  
    Total    760     5,729    4,840    494    11,823
        
    		    
    		  
    		  
    		  
     
    Equity in Earnings (Loss) of NFI Holding CorporationMortgage Loan Servicing
     
              For the three months ended September 30, 2000, NFI Holding recorded net income of $795,000 compared with net income of $583,000 for the same period of 1999. NFI Holding’s financial position and results of operation for the three month period ended September 30, 2000 and 1999 are discussed further under the heading “NFI Holding Corporation”.
    Estimated Taxable Income (Loss)
              Income reported for financial reporting purposes as calculated in accordance with generally accepted accounting principles (GAAP) differs from income computed for income tax purposes. This distinction is important as dividends paid are based on taxable income. Table 18 is a summary of the differences between net income or loss reported for GAAP and estimated taxable income for nine months ended September 30, 2000 and 1999.
    Table 18
    Estimated Taxable Income (Loss)
    Nine Months Ended September 30, 2000 and 1999
    (in thousands)
      September 30,
    		 
      2000
    		  1999
    		 
    Net income $3,336  $2,034 
    Use of net operating loss carryforward     (176)     (2,628)
    Results of NFI Holding and subsidiaries     (646)     (1,518)
    Provision for credit losses     4,004      11,499 
    Loans charged-off     (6,977)     (9,702)
    Other, net     459      1,175 
       
    		   
    		  
    Estimated taxable income (loss) $—  $860 
       
    		   
    		  
              NovaStar Financial has a net operating loss carryforward of approximately $2.3 million available to offset taxable income in 2000, and thereby reduce the amount of required distributions under REIT guidelines. In addition, dividends paid on convertible preferred stock serve to reduce the amount of required distributions to common shareholders.
    NFI Holding Corporation
              Since NovaStar Financial discontinued purchasing loans from NovaStar Mortgage and holding them in portfolio in the latter part of 1998, NovaStar Mortgage has had a larger impact on NovaStar Financial’s operational results. Instead of selling loans to NovaStar Financial, NovaStar Mortgage has sold loans to outside third parties. Through its indirect equity ownership of NFI Holding, NovaStar Financial has shared in the profits of NovaStar Mortgage’s loan sales.
              The following table presents NFI Holding’s consolidated financial statements as of September 30, 2000 and 1999, which consists primarily of the assets, liabilities, and operational results of NovaStar Mortgage.
    NFI Holding Corporation
    Condensed Consolidated Balance Sheets
    (unaudited, dollars in thousands)
          September 30,
    2000    		  December 31,
    1999
    Assets          
              Cash and cash equivalents $3,272 $1,466
              Mortgage loans     68,750     107,916
              Other assets     12,647     10,061
       
    		 
                                   Total assets $ 84,669 $119,443
       
    		 
    Liabilities and Stockholders’ Equity          
              Liabilities:
                        Borrowings $ 44,805 $    78,448
                        Due to NovaStar Financial, Inc.     12,918     22,161
                        Accounts payable and other liabilities     19,247     11,787
       
    		 
                                   Total liabilities     76,970     112,396
                        Stockholders’ equity     7,699     7,047
       
    		 
                                   Total liabilities and stockholders’ equity $84,669 $119,443
       
    		 
    NFI Holding Corporation
    Condensed Consolidated Statements of Operations
    (unaudited, dollars in thousands)
         Nine Months Ended
    September 30,
    		    Three Months Ended
    September 30,
         2000
    		    1999
    		    2000
    		    1999
    Interest income    $11,828    $  7,948     $ 4,723     $3,122 
    Interest expense.    7,034    3,764     3,007     1,544 
        
    		  
    		    
    		    
    		  
         Net interest income    4,794    4,184     1,716     1,578 
    Provision for credit losses    80    (284)    97     (168)
        
    		  
    		    
    		    
    		  
    Net interest income after provision for credit losses    4,714    4,468     1,619     1,746 
    Other income:                
         Fees from third parties    5,057    706     2,826     152 
         Fees received from, net of paid to, NovaStar Financial, Inc.    522    3,343     (859)    767 
                
         Net gain on sales of mortgage assets    9,909    9,189     5,075     3,101 
        
    		  
    		    
    		    
    		  
              Total other income    15,488    13,238     7,042     4,020 
    General and administrative expenses    19,550    16,172     7,866     5,183 
        
    		  
    		    
    		    
    		  
    Net income before taxes    652    1,534     795     583 
    Income tax expense    —    —     —     — 
        
    		  
    		    
    		    
    		  
    Net income    $     652    $  1,534     $    795     $   583 
        
    		  
    		    
    		    
    		  
    Financial Condition of NFI Holding Corporation as of September 30, 2000 and December 31, 1999
    Mortgage Loan Originations.    NFI Holding originated 4,498 non-conforming residential mortgage loans during the nine months ended September 30, 2000 with an aggregate principal amount of $511 million. Virtually all of NFI Holding’s mortgage assets as of September 30, 2000 and December 31, 1999 consist of non-conforming mortgage loans that will be sold directly to independent buyers of whole loans or through securitization transactions that are treated for tax and accounting purposes as sales.
              Table 19 is a summary of NFI Holding’s wholesale loan originations for 2000 and 1999. Table 20 presents a summary of mortgage loan transfers of NFI Holding during 2000 and 1999. Table 21 is a summary of wholesale loan origination costs of production.
    Table 19
    2000 and 1999 Quarterly Wholesale Loan Originations
    (dollars in thousands, except for average loan balance)
         Number
    of Loans
    		    Principal
    		    Average
    Loan
    Balance
    		        Weighted Average
    		    Percent with
    Prepayment
    Penalty
     Price Paid
    to
    Broker
    		    Loan to
    Value
    		    Credit
    Rating (A)
    		    Coupon
    2000:                                
              Third quarter    1,793    $207,662    $115,818    101.1    84%    5.20    10.72%    90%
              Second quarter    1,473    171,375    116,344    101.0    82     5.32    10.50     91 
              First quarter    1,232    132,072    107,201    101.1    80     5.45    10.16     93 
        
    		  
    		                        
    2000 total    4,498    $511,109    $113,630    101.1    82%    5.30    10.50%    91%
        
    		  
    		  
    		  
    		  
    		    
    		  
    		    
    		  
    1999:                                
              Fourth quarter    1,265    $130,288    $102,994    101.0    82%    5.30    10.04%    91%
              Third quarter    1,204    125,140    103,937    100.8    82     5.28    9.87     91 
              Second quarter    1,161    114,631    98,735    101.1    82     5.14    9.82     89 
              First quarter    865    82,495    95,370    100.5    80     4.95    9.85     89 
        
    		  
    		                        
    1999 total    4,495    $452,554    $100,679    100.9    82%    5.19    9.90%    90%
        
    		  
    		  
    		  
    		  
    		    
    		  
    		    
    		  
    (A)AAA=7, AA=6, A=5, A-=4, B=3, C=2, D=1
    Table 20
    Quarterly Mortgage Loan Transfers
    (dollars in thousands)
         Mortgage Loan Sales to Third
    Parties
    		    Mortgage Loans
    Transferred in
    Securitizations
         Principal
    Amount
    		    Net Gain
    Recognized
    		    Weighted
    Average
    Price To
    Par
    		    Principal
    Amount
    		    Net Gain
    Recognized
    2000:                    
              Third quarter    $  50,334    $  1,552    104.0     $188,734    $3,584
              Second quarter    27,799    661    104.0     101,675    1,392
              First quarter    48,548    1,204    104.0     128,171    1,544
        
    		  
    		      
    		  
              2000 total    $126,681    $  3,417    104.0     $418,580    $6,520
        
    		  
    		  
    		    
    		  
    1999:                    
              Fourth quarter    $109,443    $  2,583    104.1%    $        —    $    —
              Third quarter    110,512    3,075    104.2     —    —
              Second quarter    98,048    2,911    104.4     25,800    355
              First quarter    72,824    1,593    103.6     138,847    1,250
        
    		  
    		       
    		  
              1999 total    $390,827    $10,162    104.1     $164,647    $1,605
        
    		  
    		  
    		    
    		  
    Table 21
    Wholesale Loan Costs of Production
       Gross Loan
    Production
    		    Premium paid to
    broker, net of fees
    collected
    		    Total
    Acquisition
    Cost
    Costs as a percent of principal:
     
    2000:
              Third quarter    2.6%    0.5%    3.1%
        
    		    
    		    
    		  
              Second quarter    3.0%    0.5%    3.5%
        
    		    
    		    
    		  
              First quarter    3.3%    0.5%    3.8%
        
    		    
    		    
    		  
     
    1999:
              Fourth quarter    3.1%    0.5%    3.6%
        
    		    
    		    
    		  
              Third quarter    3.8%    0.4%    4.2%
        
    		    
    		    
    		  
              Second quarter    4.2%    0.5%    4.7%
        
    		    
    		    
    		  
              First quarter.    6.2%    0.2%    6.4%
        
    		    
    		    
    		  
              As noted in the table above, NovaStar Mortgage’s quarter-to-quarter 1999 wholesale loan production costs steadily declined as a result of increased efficiencies in the mortgage lending operation. During the third quarter of 1999, NovaStar Mortgage introduced Internet Underwriter®, “IU”, a web-based origination system that has allowed NovaStar Mortgage to increase production volumes without adding infrastructure. First quarter 2000 production costs were slightly higher than fourth quarter 1999 due in part to more expense allocations from NovaStar Financial. In addition, NovaStar Mortgage hired more account executives during the first three months of 2000. Account executive costs typically are higher in the first few months of employment and are expected to decline, as a percent of principal, as the sales force becomes more productive with added experience and exposure to NovaStar Mortgage’s whole loan origination products and markets.
              Table 22 is a summary of loans originated by state for 2000 and 1999 by quarter. As of September 30, 2000, NovaStar Mortgage had 78 account executives 46 covering states.
    Table 22
    Mortgage Loan Originations by State
    2000 and 1999
       Percent of Total Originations during Quarter
    (based on original principal balance)
    		 
      2000
    		     1999
    		 
    Collateral Location
    		  Third
    		  Second
    		  First
    		  Fourth
    		  Third
    		  Second
    		  First
    		 
    Florida  12% 13% 14% 12% 15% 12% 15%
    California  11  10  10  10  10  8  6 
    Ohio  7  8  7  8  12  10  8 
    Michigan  10  11  11  12  10  10  12 
    Nevada  6  7  7  5  4  4  3 
    Arizona  5  5  5  8  5  7  4 
    Colorado  5  5  4  2  1  1  2 
    Tennessee  5  6  7  6  4  6  9 
    Washington  5  5  5  4  4  5  3 
    All other states  34  30  30  33  35  37  38 
              NFI Holding’s loan originations are funded through warehouse and repurchase facilities at First Union and GMAC/RFC. Table 25 of the “Liquidity Resources and Capital” section of this document detail borrowings outstanding under these financing arrangements as of September 30, 2000.
    Mortgage Loan Sales.     NovaStar Mortgage executed two securitizations during the first nine months of 2000, combining $570 million in loans, which were sold to a Special Purpose Entity (SPE), of which $151 million will settle in December 2000. A gain of $6.5 million was recognized on these transactions. Bonds issued by the SPE were $560 million and proceeds received were used to pay down warehouse and mortgage loan repurchase facilities of NovaStar Mortgage. The loans were sold without recourse. NovaStar Mortgage retained residual certificates issued by the SPE, which NovaStar Financial subsequently purchased. NovaStar Mortgage also retained loan servicing rights for the loans sold. The values of the retained interests and the mortgage servicing rights have been recorded as an asset and the loans sold have been removed from the balance sheet of NovaStar Mortgage.
              NovaStar Mortgage allocated its basis in the mortgage loans between the portion of the mortgage loans sold and the retained assets based on the relative fair values of those portions at the time of sale. The values of these assets are determined by discounting estimated future cash flows using the cash out method. The following table details the significant assumptions used to determine the value of the resulting retained assets in NMFT 2000-1 and 2000-2.
     Constant
    prepayment rate
    (weighted average
    life)    		Static loss, net of
    mortgage insurance
    (basis points)    		Discount
    Rate
        2000-1271%15%
        2000-2281%15%
              Details regarding loan collateral as of September 30, 2000 and December 31, 1999 are included in Tables 4, 5 and 8 of this document.
               NFI Holding also sold $126.7 million of its whole loan portfolio to unrelated third parties for cash at a net gain of $3.4 million at an average price to par of 104.0 during 2000. Table 20 of “Financial Condition of NFI Holding Corporation as of September 30, 2000 and December 31, 1999” provides a quarterly analysis of NFI Holding’s mortgage loan sales to third parties.
    Mortgage Loan Servicing.    Loan servicing is a critical part of NovaStar Mortgage’ sour business. The majority of the loans serviced by NovaStar Mortgage are owned by NovaStar Financial. In the opinion of management, maintaining contact with borrowers is vital in managing credit risk and in borrower retention. Non-conforming borrowers are prone to late payments and are more likely to default on their obligations than conventional borrowers. NovaStar Mortgage strivesWe strive to identify issues and trends with borrowers early and take quick action to address such matters.
    Table 29 — Summary of Servicing Operations
     
              Table 23 provides summaries of delinquencies and default statistics of NovaStar Mortgage’s mortgage loan portfolio in 2000 and 1999 by quarter. The information presented in both tables includes mortgage loans owned by NovaStar Financial and its affiliates. Other information regarding the credit quality of NovaStar Financial’s mortgage loans is provided in Table 1.
       2001
    		  2000
       March 31
    		  December 31
    		  September 30
    		  June 30
    		  March 31
       Amount
    		  %
    		  Amount
    		  %
    		  Amount
    		  %
    		  Amount
    		  %
    		  Amount
    		  %
    Unpaid principal    $1,263,773         $1,112,615         $1,016,951         $970,026         $872,702     
        
    		      
    		      
    		      
    		      
    		    
    Units    11,999         10,774         10,041         9,683         8,919     
        
    		      
    		      
    		      
    		      
    		    
    Servicing
         income, net
         of amortization
         of mortgage
         servicing rights    		    $1,465    0.46    $ 1,473    0.53    $ 1,392    0.55    $ 1,321    0.54    $ 1,219    0.56
    Costs of servicing    1,238    0.39    1,185    0.43    1,095    0.43    1,015    0.42    1,064    0.49
        
    		  
    		  
    		  
    		  
    		  
    		  
    		  
    		  
    		  
    Net servicing
         income    		    $          227    0.07    $          288    0.10    $          297    0.12    $      306    0.12    $      155    0.07
        
    		  
    		  
    		  
    		  
    		  
    		  
    		  
    		  
    		  
    Annualized
         costs of
         servicing
         per unit    		    $      412.70         $      439.95         $      436.21         $  419.29         $  477.18     
        
    		      
    		      
    		      
    		      
    		    
     
    Branch Operations
      Table 23
    Delinquencies and Defaults
    (dollars in thousands)
     
         2000
    		    1999
       September 30
    		 June 30
    		 March 31
    		 December 31
    		  September 30
    		 June 30
    		 March 31
    Loan servicing
    portfolio    		    $1,016,952 $970,016 $872,693 $894,572 $969,343 $1,032,065 $1,072,393
      
    		 
    		 
    		 
    		 
    		 
    		 
    Total defaults:         
         Delinquent loans (A)       4.90%    4.82%     5.58%    6.28%    4.75%     5.21%     4.12%
      
    		 
    		 
    		 
    		 
    		 
    		 
         Loans in
              foreclosure    		    3.34  3.25  3.55 3.62 3.79 3.36 3.39
      
    		 
    		 
    		 
    		 
    		 
    		 
         Real estate owned    1.97   2.07  2.65 2.71 2.24 2.20 1.66
      
    		 
    		 
    		 
    		 
    		 
    		 

              
    (A)Includes loans delinquent 30 days or greater
              The following table presentsWe operate our mortgage brokerage unit under the name NovaStar Home Mortgage, Inc. Our first branch was
    opened in December 1999. Following is a summary of the mortgage loan activity of NFI Holding for 2000 and 1999 as a percent of the respective quarter’s beginning principal of mortgage loans held in portfolio and loan origination principal.operations.
     
    Table 2430 — Branch Operations
    Mortgage Loan Activity—NFI Holding Corporation(dollars in thousands)
     
         Percent Sold
    to NovaStar
    Financial, Inc.
    		    Percent Sold
    to Third
    Parties
    		    Percent Sold
    in
    Securitizations
    		    Percent
    Held in
    Portfolio
    		    Percent of
    Prepayments
    		    Total
    2000                            
    Third quarter    —    9%    60%    30%    1%    100%
    Second quarter    —    12     44     43     1     100 
    First quarter    —    20     53     26     1     100 
     
    1999                        
    Fourth quarter    —    52     —     46     2     100 
    Third quarter    —    54     —     44     2     100 
    Second quarter    —    32     13     54     1     100 
    First quarter    —    25     45     29     1     100 
         2001
    		    2000
         March 31
    		    December 31
    		    September 30
    		    June 30
    		    March 31
    Branches (end of quarter)    84    63    48    25    16
    Loans originated    1,126    867    533    272    103
    Fee income    $4,840    $3,955    $2,283    $1,093    $330
    General and administrative costs    $4,840    $3,662    $2,277    $1,093    $328
    Personnel    288    252    162    107    81
              Under our agreements with branch managers, fee income generated by the branches, excluding our management fee, is paid to the branch manager as compensation. Fees we retain are designed to cover our management costs and generate a profit. For the fees we retain, we provide administrative functions for the branches, including accounting, human resources, license/registration and loan investor management. The following table summarizes the branch management fee income and costs.
     
    Results of Operations of NFI Holding Corporation—Nine Months Ended September 30, 2000 Compared to the Nine Months Ended September 30, 1999Table 31 — Branch Management
    (dollars in thousands)
     
              For the nine months ended September 30, 2000, NFI Holding recorded net income of $652,000 compared with net income of $1.5 million during the same period of 1999. A summarized income statement of NFI Holding is presented in the “NFI Holding Corporation” section of this document.
     
              The following summarizes operating results of NFI Holding for the nine months ended September 30, 2000 compared with the same period of 1999:
    ·
    		Fees from third parties increased from $706,000 during the nine months ended September 30, 1999 to $5.1 million during the nine months ended September 30, 2000. The significant increase is due to broker fees received on loans originated through the mortgage brokers of NovaStar Home Mortgage. NovaStar Home Mortgage operates 48 mortgage broker offices in 24 states. The operations of NovaStar Home Mortgage began in November 1999.
    ·
    		Fees received from, net of paid to, Novastar Financial, Inc. declined from $3.3 million in 1999 to $522,000 in 2000, primarily due to the cancellation of the administrative fee agreement between NovaStar Financial and NovaStar Mortgage on April 1, 1999. A summary of the intercompany fees by type is included in the “Results of Operations of NovaStar Financial, Inc.—Nine Months Ended September 30, 2000 Compared to the Nine Months Ended September 30, 1999” section of this document.
    ·
    		During the nine months ended September 30, 2000, NovaStar Mortgage recognized net gains of $9.9 million on the sale of whole loans. Of that amount, $6.5 million was recognized in two securitization transactions that closed during the period. The remainder of the gain was primarily due to various whole loan sales to third parties for cash. During the same period of 1999,
    NovaStar Mortgage recognized gains of $9.2 million on the transfer of whole loans, including $1.6 million on the NMFT 1999-1 asset-backed bond transaction.
    ·
    		General and administrative expenses increased from $16.2 million during the first nine months of 1999 to $19.6 million during the same period of 2000. The increase is primarily attributable to various expenses incurred by the broker branches of NovaStar Home Mortgage, including the net income generated from the branches is expensed to the branch in the form of compensation. NovaStar Home Mortgage began providing various accounting and compensation services to mortgage brokerage companies during the fourth quarter of 1999.
    ·
    		No income tax expense has been recorded during the first nine months of 2000 because of the existence of substantial net operating loss carryforwards, which are expected to offset all of the pre-tax income in 2000.
    Results of Operations of NFI Holding Corporation—Three Months Ended September 30, 2000 Compared to the Three Months Ended September 30, 1999
                 For the three months ended September 30, 2000, NFI Holding recorded net income of $795,000 compared with net income of $583,000 for the same period of 1999. The following summarizes the explains the decline in net earnings for the three months ended September 30, 2000 compared with the same period of 1999:
    ·
    		Fees from third parties increased from $152,000 during the three months ended September 30, 1999 to $2.8 million during the three months ended September 30, 2000. The significant increase is due to broker fees received on loans originated through the mortgage brokers of NovaStar Home Mortgage.
    ·
    		Net gains on sales of mortgage assets increased from $3.1 million during the third quarter 1999 to $5.1 million during the third quarter 2000. During the three months ended September 30, 2000 NovaStar Mortgage recognized a gain of $3.6 million on the first close of the 2000-2 securitization transaction. The remainder of the gain recognized in the third quarter 2000 was primarily on mortgage loan sales to third parties. During the third quarter of 1999, all of NFI Holding’s net gain on sales of mortgage assets were on mortgage loan sales to third parties.
    ·
    		Fees received from, net of paid to, NovaStar Financial, Inc. decreased from $767,000 during the third quarter of 1999 to ($859,000) during the same period of 2000 as a result of the implementation of additional intercompany agreements July 1, 2000 as discussed under the “Results of Operations of NovaStar Financial, Inc.—Nine Months Ended September 30, 2000 Compared to the Nine Months Ended September 30, 1999”.
    ·
    		General and administrative expenses increased from $5.2 million during the third quarter 1999 to $7.9 million during the third quarter 2000. The increase is primarily attributable to various expenses incurred by the broker branches of NovaStar Home Mortgage, including the net income (loss) generated from the branches is expensed to the branch in the form of compensation paid to
    brokers. NovaStar Home Mortgage began providing various accounting and compensation services to mortgage brokerage companies during the fourth quarter of 1999.
    ·
    		No income tax expense has been recorded in the third quarter of 2000 because of the existence of substantial net operating loss carryforwards, which are expected to offset all of the pre-tax income in 2000.
         2001
    		    2000
         March 31
    		    December 31
    		    September 30
    		    June 30
    		    March 31
    Fee income    $450    $343    $210    $101    $31
    General and administrative costs    494    590    362    219    93
    Personnel    15    12    11    6    5

    Liquidity and Capital Resources

            Liquidity means the need for, access to and uses of cash. The primary needs for cash include the acquisition of mortgage loans, principal repayment and interest on borrowings, operating expenses and dividend payments. Substantial cash is required to support the operating activities of the business, especially the mortgage origination operation. Mortgage asset sales, principal, interest and fees collected on mortgage assets and residual interests on CMOs will serve to support cash needs. Drawing upon various borrowing arrangements typically satisfies major cash requirements.

              NovaStar

            Mortgage lending requires substantialsignificant cash to fund loan originations and for operating costs. As of September 30, 2000, NFI Holding owned $68.8 million of non-conformingOur warehouse lending arrangements, including repurchase agreements, are used to support the mortgage loans. NFI Holding provided financing for these loans through warehouse and repurchase credit facilities with First Union and GMAC/RFC.lending operation. Loans financed with warehouse and repurchase credit facilities are subject to changing market valuation and margin calls. Management expectsLoans we originate can be sold to continue selling loans originated by NovaStar Mortgage or securitizing those loansthird a party, which also generates cash to meet the significant cash needs of the wholesale loan operation. Management believes NovaStar Financialfund on-going operations. We believe we can operate indefinitely in this manner, provided that the level of loan originations is at or near the capacity of its production infrastructure.

              Table 25 Our liquidity position is a summary of cash, financing arrangements and available borrowing capacity for NovaStar Financial and NovaStar Mortgage, on a combined basis, as of September 30, 2000:
    Table 25
    Liquidity Resources
    September 30, 2000
    (in thousands)
        Maturity
    		 Maximum
    Borrowing
    Limit
    		 Lending
    Value of
    Collateral
    		 Borrowings
    		 Availability
    Resource  
    Cash                  $  6,039
    Committed facilities with First Union National Bank  (A):                
         Warehouse line of credit  7/27/01 $75,000 $43,950  $21,038 $22,912
          Secured whole loan repurchase agreement  7/27/01 $175,000 $224  $224 $—
          Residual financing available  12/17/01 $25,000 $(B) $10,960 $14,040
    Committed facility with GMAC/Residential Funding 
        Corporation (A):    		                
          Warehouse line of credit    12/27/00 $ 50,000 $ 23,543  $23,543 $—
         
    		 
    		   
    		 
                        Total    $335,961 $81,024  $55,765 $42,991
           
    		 
    		   
    		 
    (A)
    		Value of collateral and borrowings include amounts for NovaStar Financial and NovaStar Mortgage, as they are co-borrowers under the arrangements with First Union National Bank and GMAC/RFC.
    (B)
    		Management estimates the value of the residuals range from $55 to $70 million and does not include the value of mortgage servicing rights.
              The warehouse line of credit and whole loan repurchase agreements with First Union National Bank expire on July 27, 2001.
              In the opinion of management, the available liquidity resources are sufficient to cover expected future production of NovaStar Mortgage.
    shown under "Financial Condition - Short-term Financing Arrangements."

            Cash activity during the ninethree months ended September 30,March 31, 2001 and 2000 and 1999 are presented in the consolidated statement of cash flows.

              The

            Our capital of NovaStar Financial has come from

  • ·
    		a private placement offering of preferred stock, raising net proceeds of $47 million.
  • ·
    		an initial public offering of common stock, raising net proceeds of $67 million, and
  • ·
    		a private offering of convertible preferred stock, raising net proceeds of $29 million.
              NovaStar Financial uses

            We use capital when financing loans on a long-term basis. Under short-term financing arrangements, NovaStarwe can borrow up to the lessor of 98% of the face amount or 95% of the market value of the loans it owns.our loans. In long-term financing (i.e. in the form of asset-backed bonds) NovaStarwe can finance approximately 95% of the market value of the loans. NovaStar must use its own capital resourcesCapital is used to “finance”fund the difference between the financed portion and the full loan cost.

            During 19992000 and 2000, most2001, a portion of the loans we originated by NovaStar Mortgage were sold to third parties and in securitization transactions treated as sales for tax and financial reporting purposes. In

    doing so, NovaStar doeswe do not use capital. In fact, if the sales prices are above the full cost to originate loans, this method of operation will generate capital for NovaStar.
    capital.

            During 2000, management expects2001, we expect to finance half75% or more of the loans produced by NovaStar Mortgage.we produce. The remainder will be sold to third parties. NovaStarWe currently hashave excess capital available to support this mode ofoperation during 2000.of operation. When NovaStar Financialwe fully deploys itsdeploy our capital, management expectswe expect to either raise more equity from the capital markets or sell enough loans so that it operateswe operate without the need for additional capital.

    Inflation

            Virtually all of our assets and liabilities of NovaStar Financial are financial in nature. As a result, interest rates and other factors drive company performance far more than does inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. TheOur financial statements of NovaStar Financial are prepared in accordance with generally accepted accounting principles and the dividends are based on taxable income. In each case, financial activities and balance sheet are measured with reference to historical cost or fair market value without considering inflation.

    Impact of Recently Issued Accounting Pronouncements

              During 1998, the Financial Accounting Standards Board (FASB) issued SFAS No. 133,Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 standardizes the accounting for derivative instruments, including certain instruments embedded in other contracts, by requiring that an entity recognize those items as assets or liabilities in the balance sheet and measure them at fair value. If certain conditions are met, an entity may elect to designate a derivative instrument either as a cash flow hedge, a fair value hedge or a hedge of foreign currency exposure. Generally, SFAS No. 133 provides for matching the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of hedge asset or liability that is attributable to the hedge risk or the earnings effect of the hedge forecasted transaction. SFAS No. 137,Accounting for Derivative Instruments and Hedging Activities—Deferral of the Effective Date of FASB Statement No. 133 an amendment of FASB Statement No. 133 was issued in June 1999 and postponed the effective date of SFAS No. 133 to fiscal years beginning after June 15, 2000. Management has reviewed all financial instruments of NovaStar Financial and has determined that NovaStar Financial’s interest rate cap agreements are derivative instruments under SFAS No. 133. These derivatives are used to hedge the interest rate risk on variable rate debt and will be accounted for as cash flow hedges under SFAS No. 133. Management does not expect the adoption of SFAS No. 133 to have a material impact on the financial statements of the NovaStar Financial, Inc.
              In September 2000, the Financial Accounting Standards Board (FASB) issued SFAS No. 140,Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities—a replacement of FASB Statement No. 125.SFAS 125 was issued in June 1996 to revise the standards for accounting for securitization and other transfers of financial assets and requires certain disclosures regarding those transfers. SFAS 140 replaces SFAS 125 in its entirety. However, it carries over most of the provisions of SFAS 125. SFAS 140 also formalizes guidance provided by the FASB in various committee publications and technical bulletins. This Statement is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001. This Statement is

    effective for recognition and reclassification of collateral and for disclosures relating to securitization transactions and collateral for fiscal years ending after December 15, 2000. Disclosures about securitization and collateral accepted need not be reported for periods ending on or before December 15, 2000, for which financial statements are presented for comparative purposes. Management does not expect the adoption of SFAS No. 140 to have a material impact on the financial statements of NovaStar Financial.

            In addition,        Note 1 of the consolidated financial statements contained in the annual report on Form 10-K for the fiscal year ended December 31, 19992000 describes certain recently issued accounting pronouncements. Management believes the implementation of these pronouncements and others that have gone into effect since the date of these reports will not have a material impact on the consolidated financial statements.

    Item 3. Quantitative and Qualitative Disclosures About Market Risk

    Interest Rate/Market Risk

              The

            Our investment policy for NovaStar Financial sets the following general goals:

    (1)Maintain the net interest margin between assets and liabilities, and
    (2)Diminish the effect of changes in interest rate levels on the market value of NovaStar Financial.

    Loan Price Volatility. Under itsour current mode of operation, NovaStar Financial dependswe depend heavily on the market for wholesale non-conforming mortgage loans. To conserve capital, NovaStar Mortgagewe may sell loans itwe originates. The financialFinancial results of NovaStar Financial will depend, in part, on the ability to find purchasers for the loans at prices that cover origination expenses. Exposure to loan price volatility will beis reduced as NovaStar Financial resumeswe resume acquisition and retention of mortgage loans.

    Interest Rate Risk. Interest rate risk is the risk that the market value of assets will increase or decrease at different rates than that of the liabilities. Expressed another way, this is the risk that NovaStar Financial’s net asset value will experience an adverse change when interest rates change. When interest rates on the assets do not adjust at the same rates as the liabilities or when the assets are fixed rates and the liabilities are adjusting, future earnings potential is affected. Management primarily uses financing sources where the interest rate resets frequently. As of September 30, 2000March, 31, 2001 borrowings under all financing arrangements adjust daily, monthly, or quarterly. On the other hand, very few of the mortgage assets owned by NovaStar Financial, as of September 30, 2000,we own, adjust on a monthly or daily basis. Most of the mortgage loans contain features where their rates are fixed for some period of time and then adjust frequently thereafter. For example, one of our loan products is the “2/28”"2/28" loan. This loan is fixed for its first two years and then adjusts every six months thereafter.

    While short-term borrowing rates are low and long-term asset rates are high, this portfolio structure produces good results. However, if short-term interest rates rise rapidly, earning potential is significantly affected, as the asset rate resets would lag the borrowing rate resets. The converse can be true when sharp declines in short-term interest rates cause interest costs to fall faster than asset rate resets, thereby increasing earnings.

            In its assessment of the interest sensitivity and as an indication of exposure to interest rate risk, management relies on models of financial information in a variety of interest rate scenarios. Using these models, the fair value and interest rate sensitivity of each financial instrument, or groups of similar instruments is estimated, and then aggregated to form a comprehensive picture of the risk characteristics of the balance sheet. The risks are analyzed on both an income and market value basis.

            The following are summaries of the analysis as of September 30, 2000 and DecemberMarch 31, 1999.

    2001.

    Table 26

    32—Interest Rate Sensitivity-Income
    September 30, 2000 and DecemberMarch, 31, 19992001
    (dollars in thousands)
         Basis Point Increase
    (Decrease) in Interest
    Rate(A)
    		 
    As of September 30, 2000
    		    (100)
    		    Base
    		    100
    		 
    Income from:     
    Assets    $84,379     $86,755     $88,761 
    Liabilities (B)     64,589      72,375      80,318 
    Interest rate agreements     (1,882)     221      3,961 
        
    		    
    		    
    		  
    Net spread income    $17,908     $14,601     $12,404 
        
    		    
    		    
    		  
    Cumulative change in income from base (C)    $3,307      —     $(2,197)
        
    		    
    		    
    		  
    Percent change from base spread income (D)     22.6%     —      (15.0)%
        
    		    
    		    
    		  
    Percent change of capital(E)     3.3%     —      (2.2)%
        
    		    
    		    
    		  
     
    As of December 31, 1999
    		    (100)
    		    Base
    		    100
    		 
    Income from:     
    Assets    $61,610     $64,419     $66,954 
    Liabilities (B)     42,173      47,803      53,442 
    Interest rate agreements     (1,379)     (1,379)     1,122 
        
    		    
    		    
    		  
    Net spread income    $18,058     $5,237     $14,634 
        
    		    
    		    
    		  
    Cumulative change in income from base (C)    $2,821      —     $(603)
        
    		    
    		    
    		  
    Percent change from base spread income (D)     18.5%     —      (4.0)%
        
    		    
    		    
    		  
    Percent change of capital(E)     2.8%     —      (0.6)%
        
    		    
    		    
    		  

    Basis Point Increase (Decrease) in
    Interest Rate(A)

    		 
     
    		 
     

    (100) 

    		 

    Base

    		 

    100  

    		 

    Income from:

    		         

         Assets

    		$

    103,707

    		 $

    105,554

    		 $

    107,210

    		 

         Liabilities (B)

    		 

    57,107

    		  

    66,577

    		  

    76,309

    		 

         Interest rate agreements

    		 

    (1,299

    		) 

    ( 1,299

    		) 

    ( 1,291

    		)
     
    		 
    		 
    		 

    Net interest income

    		$

    45,301

    		 $

    37,678

    		 $

    29,610

    		 
     
    		 
    		 
    		 

    Cumulative change in net interest income from base

    		         

    Percent change in net interest income from base

    		 

    18.8

    		  

    —

    		  

    (21.3

    		)
     
    		 
    		 
    		 

    Percent change of capital (C)

    		 

    6.5

    		  

    —

    		  

    (6.9

    		)
     
    		 
    		 
    		 
                            
    (A)Income of asset, liability or interest rate agreement in a parallel shift in the yield curve, up and down 1%.
    (B)Includes deal expenses,debt issuance costs, amortization of loan premium amortization,premiums, mortgage insurance premiums and provisions for credit losses.
    (C)Total change in estimated spread income, in dollars, from “base.” “Base” is the estimated spread income as of September 30, 2000 and December 31, 1999.
    (D)Total change in estimated spread income, as a percent, from base.
    (E)Total change in estimated spread income as a percent of total stockholders’stockholders' equity as of September 30, 2000 and DecemberMarch 31, 1999.2001.

    Table 27

    33—Interest Rate Sensitivity—Sensitivity—Market Value
    September 30, 2000 and DecemberMarch 31, 19992001
    (dollars in thousands)
         Basis Point Increase
    (Decrease) in
    Interest Rate(A)
    As of September 30, 2000
    		    (100)
    		    100
    Change in market values of:        
              Assets    $12,254    $ (14,627)
              Liabilities    (1,820)    2,020 
              Interest rate agreements    (2,611)    5,522 
        
    		    
    		  
    Cumulative change in market value    $  7,823   $   (7,085)
        
    		    
    		  
    Percent change of market value portfolio equity (B)    8.4%    (7.6)%
        
    		    
    		  
     
    As of December 31, 1999        
    		            
    Change in market values of:        
              Assets   $   9,112   $  (11,340)
              Liabilities    (2,068)    2,376 
              Interest rate agreements    (2,809)    4,723 
        
    		    
    		  
    Cumulative change in market value  $   4,235   $    (4,241)
        
    		    
    		  
    Percent change of market value portfolio equity (B)    4.4%    (4.4)%
        
    		    
    		  
     
    Basis Point Increase (Decrease)in Interest Rate(A)
     
    		 
    (100)
    100
    Change in market values of:
         Assets$9,564$(12,220)
         Liabilities(1,876)2,176
         Interest rate agreements(3,825)5,677)
     
    		 
    		 
    Cumulative change in market value$3,863$(4,367)
     
    		 
    		 
    Percent change of market value portfolio equity (B)3.9%(4.4)%
     
    		 
    		 
                            
    (A)Change in market value of assets, liabilities or interest rate agreements in a parallel shift in the yield curve, up and down 1%.
    (B)Total change in estimated market value as a percent of market value portfolio equity as of September 30, 2000 and DecemberMarch 31, 1999.2001.

    Interest Rate Sensitivity Analysis.. The values under the heading “Base”"Base" are management’smanagement's estimates of spread income for assets, liabilities and interest rate agreements on September 30, 2000 and DecemberMarch 31, 1999.2001. The values under the headings “100”"100" and “(100)”"(100)" are management’smanagement's estimates of the income and change in market value of those same assets, liabilities and interest rate agreements assuming that interest rates were 100 basis points, or 1 percent higher and lower. The cumulative change in income or market value represents the change in income or market value of assets, net of the change in income or market value of liabilities and interest rate agreements.

            The interest sensitivity analysis is prepared monthly. If the analysis demonstrates that a 100 basis point shift, up or down, in interest rates would result in 25 percent or more cumulative decrease in income from base, or a 10% cumulative decrease in market value from base, policy requires management to adjust the portfolio by adding or removing interest rate cap or swap agreements. The Board of Directors reviews and approves NovaStar Financial’sour interest rate sensitivity and hedged position quarterly. Although management also evaluates the portfolio using interest rate increases and decreases less than and greater than one percent, management focuses on the one percent increase.

    Assumptions Used in Interest Rate Sensitivity Analysis..    Management uses a variety of estimates and assumptions in determining the income and market value of assets, liabilities and interest rate agreements. The estimates and assumptions have a significant impact on the results of the interest rate sensitivity analysis, the results of which are shown as of September 30, 2000 and DecemberMarch 31, 1999.2001.

              Management’s

            Management's analysis for assessing interest rate sensitivity on its mortgage loans relies significantly on estimates for prepayment speeds. TheA prepayment model used by management has been internally developed and is a function based on the borrowers’ payment change percentage. The factors affecting the size of the borrowers’ payment are as follows:

    upon four main factors:
  • ·
    		Refinancing incentives (the interest rate of the mortgage compared with the current mortgage rates available to the borrower)
  • ·
    		Program Type
    ·
    		Borrower credit grades
  • ·
    		Loan Term
    ·
    		Loan-to-value ratios
  • ·
    		Loan size
    ·
    		Prepayment penalties, (length and type)if any
    ·
    		Estimated closing costs

            Generally speaking, when market interest rates decline, borrowers are more likely to refinance their mortgages. The higher the interest rate a borrower currently has on his or her mortgage the more incentive he or she has to refinance the mortgage when rates decline. In addition, the higher the credit grade, the more incentive there is to refinance when credit ratings improve. When a borrower has a low loan-to-value ratio, he or she is more likely to do a “cash-out”"cash-out" refinance. When a borrower has a higher balance loan, as refinancing rates fall, the percent of potential payment decrease is greater than on a comparably smaller balance loan, thereby making higher balance loans prepay faster. Each of these factors increases the chance for higher prepayment speeds during the term of the loan. On the other hand, prepayment penalties serve to mitigate the risk that loans will prepay because the penalty is a deterrent to refinancing.

            These factors are weighted based on management’smanagement's experience and an evaluation of the important trends observed in the non-conforming mortgage origination industry and NovaStar Financial and NovaStar Mortgage’s mortgage loan portfolio.industry. Actual results may differ from the estimates and assumptions used in the model and the projected results as shown in the sensitivity analyses. Management evaluates and updates the model periodically as the market changes and new data is collected.

              NovaStar Financial’s projected

            Projected prepayment rates are based on a prepayment vector and in each interest rate scenario start at a prepayment speed less than 5% in month one and increase to a long-term prepayment speed in nine to 18 months, to account for the seasoning of the loans. The long-term

    prepayment speed ranges from 20% to 40% and depends on the characteristics of the loan which include type of product (ARM or fixed rate), note rate, credit grade, LTV, gross margin, weighted average maturity and lifetime and periodic caps and floors. This prepayment vectorcurve is also multiplied by a factor of 55% to 70% depending60% on the length and type of penaltyaverage for periods when a prepayment penalty is in effect on the loan. Prepayment assumptions are also multiplied by a factor of greater than 100% during periods around rate resets and prepayment penalty expirations. These assumptions change with levels of interest rates. The actual historical speeds experienced on NovaStar Financial’sFinancial's loans shown in Table 56 are weighted average speeds of all loans in each deal.

            As shown in Table 5,6, actual prepayment rates on loans that have been held in portfolio for shorter periods are slower than long term prepayment rates used in the interest rate sensitivity analysis. This table also indicates that as pools of loans held in portfolio season, the actual prepayment rates are more consistent with the long term prepayment rates used in the interest sensitivity analysis.

    Hedging with Off-Balance-Sheet Financial Instruments..    In order to address a mismatch of assets and liabilities, the hedging section of the investment policy is followed, as approved by the Board. Specifically, the interest rate risk management program is formulated with the intent to offset the potential adverse effects resulting from rate adjustment limitations on its mortgage assets and the differences between interest rate adjustment indices and interest rate adjustment periods of its adjustable-rate mortgage loans and related borrowings.

              NovaStar Financial uses

            We use interest rate cap and swap contracts to mitigate the risk of the cost of its variable rate liabilities increasing at a faster rate than the earnings on its assets during a period of rising rates. In this way, management intends generally to hedge as much of the interest rate risk as determined to be in the best interest of NovaStar Financial, given the cost of hedging transactions and the need to maintain REIT status.

              NovaStar Financial seeks

            We seek to build a balance sheet and undertake an interest rate risk management program that is likely, in management’smanagement's view, to enable NovaStar Financialus to maintain an equity liquidation value sufficient to maintain operations given a variety of potentially adverse circumstances. Accordingly, the hedging program addresses both income preservation, as discussed in the first part of this section, and capital preservation concerns.

            Interest rate cap agreements are legal contracts between NovaStar Financialus and a third party firm or “ counter-party”"counter-party". The counter-party agrees to make payments to NovaStar Financialus in the future should the one- or three-month LIBOR interest rate rise above the strike rate specified in the contract. NovaStar FinancialWe make either makes quarterly premium payments or hashave chosen to pay the premiums upfront to the counterparties under contract. Each contract has a fixed notional face amount on which the interest is computed, and a set term to maturity. When the referenced LIBOR interest rate rises above the contractual strike rate, NovaStar Financial earnswe earn cap income. Payments on an annualized basis equal the contractual notional face amount times the difference between actual LIBOR and the strike rate.

            Interest rate swaps have similar characteristics. However, interest rate swap agreements allow us to pay a fixed rate of interest while receiving a rate that adjusts with one-month LIBOR.

    PART II. OTHER INFORMATION

    Item 1.
    		Legal Proceedings
     
    		As of September 30, 2000,March, 31, 2001, there were no material legal proceedings pending to which NovaStar Financial waswe were a party or of which any of itsour property was subject.
    Item 2.Changes in Securities
       
     Not applicable
       
    Item 3.Defaults upon Senior Securities
       
     Not applicable
       
    Item 4.Submission of Matters of Vote of Security Holders
       
     Not applicable
       
    Item 5.Other Information
       
     None
    Item 6.  Exhibits and Reports on Form 8-K
    (a)  Exhibit Listing
    Exhibit No.
    		Description of Document
    None
     3.1*
    Item 6. Exhibits and Reports on Form 8-K

    (a) Exhibit Listing

    Exhibit No.

    Description of Document

       3.1*           

    Articles of Amendment and Restatement of the Registrant

      

       3.2*           

    Articles Supplementary of the Registrant 

      

       3.3*           

    		3.2*Articles Supplementary

    Bylaws of the Registrant

      
    3.3*Bylaws of the Registrant

    3.3a*****

    Amendment to Bylaws of the Registrant, adopted February 2, 2000

      

    3.4****

    Articles Supplementary of NovaStar Financial, Inc. dated as of March 24, 1999, as filed with the Maryland Department of Assessment and Taxation.

      

    10.10a    

    		4.1*Specimen Common Stock Certificate
    4.2*Specimen Warrant Certificate
    4.3****Specimen certificate for Preferred Stock
    10.1*Purchase Terms Agreement, dated December 6, 1996, between the Registrant and the Placement Agent.
    10.2*Registration Rights Agreement, dated December 9, 1996, between the Registrant and the Placement Agent.
    10.3*Warrant Agreement, dated December 9, 1996, between the Registrant and the Holders of the Warrants Acting Through the Registrant as the Initial Warrant Agent.
    10.4*Founders’ Registration Rights Agreement, dated December 9, 1996, between the Registrant and the original holders of Common Stock of the Registrant.
    10.5*Commitment Letter dated October 3, 1996 from General Electric Capital Group accepted by the Registrant.
    10.6*Form of Master Repurchase Agreement for mortgage loan financing

    10.7*Mortgage Loan Warehousing Agreement dated as of November 24, 1997 between First Union National Bank of North Carolina, NovaStar Mortgage, Inc. and the Registrant.
    10.7a***Amendment No. 6 dated as of February 12, 1999 to Mortgage Loan Warehousing Agreement dated as of February 20, 1997 between First Union National Bank and Registrant.
    10.7b*****Amendment No. 7 dated as of December 17, 1999 to Mortgage Loan Warehousing Agreement dated as of February 20, 1997 between First Union National Bank and Registrant.
    10.7cAmendment No. 10 dated as of July 28, 2000 to Mortgage Loan Warehousing Agreement dated as of February 20, 1997 between First Union National Bank and Registrant.
    10.8*Employment Agreement, dated September 30, 1996, between the Registrant and Scott F. Hartman.
    10.9*Employment Agreement, dated September 30, 1996, between the Registrant and W. Lance Anderson.
    10.10*

    Promissory Note by Scott F. Hartman to the Registrant, dated December 9, 1996.

    January 1, 2001.

      

    10.11a    

    		10.11*

    Promissory Note by W. Lance Anderson to the Registrant, dated December 9, 1996.

    January 1, 2001.

      

    11.1           

    		10.12*Stock Pledge Agreement between Scott F. Hartman and the Registrant, dated December 9, 1996.
    10.13*Stock Pledge Agreement between W. Lance Anderson and the Registrant, dated December 9, 1996.
    10.14*1996 Executive and Non-Employee Director Stock Option Plan, as last amended December 6, 1996.
    10.15*Administrative Services Outsourcing Agreement, dated June 30, 1997, between the Registrant and NovaStar Mortgage, Inc.
    10.16*Mortgage Loan Sale and Purchase Agreement, dated as of June 30, 1997, between the Registrant and NovaStar Mortgage, Inc.
    10.17*Flow Loan Subservicing Agreement, dated as of June 30, 1997, between the

    Registrant and NovaStar Mortgage, Inc.
    10.18*Certificate of Incorporation of NFI Holding Corporation.
    10.19*Agreement of Shareholders of Common Stock NFI Holding Corporation.
    10.20**Term Loan and Security Agreement between NovaStar Certificates Financing Corporation and Reliance Funding Corporation dated as of October 13, 1998 and related agreements including Guaranty of even date by Registrant.
    10.21***Addendum to Master Repurchase Agreement dated as of February 12, 1999 among NovaStar Financial, Inc., NovaStar Capital, Inc. and NovaStar Mortgage, Inc., as sellers, and First Union National Bank, as buyer.
    10.22***Form of Addendum to Master Repurchase Agreement dated as of February 12, 1999 between Registrant’s taxable affiliate, as seller, and First Union Bank, as buyer, with respect to the residual interest on certain asset-backed bonds.
    10.23***Warrant Agreement dated as of February 12, 1999 between the Registrant and First Union National Bank.
    10.24****Warrant Agreement, dated as of March 10, 1999, by and between NovaStar Financial, Inc. and Residential Funding Corporation , and related Guaranty Warrant, Tag Along Warrant and Registration Rights Agreement as filed with April 6, 1999 8-K of NovaStar Financial, Inc.
    10.25****Registration Rights Agreement, dated March 25, 1999 among NovaStar Financial and Stifel, Nicolaus & Company, Incorporated.
    10.26*****Warehousing Credit and Security Agreement, dated as of December 29, 1999, between NovaStar Financial, Inc., NovaStar Mortgage, Inc., NovaStar Capital, Inc. and Residential Funding Corporation.
    10.27Mortgage Loan Sale and Securitization Transaction Administration Personnel and Facilities Agreement, dated as of July 1, 2000 between the Registrant and NovaStar Mortgage, Inc.
    10.28Lending and Credit Support Agreement, dated as of July 1, 2000 between the Registrant and NovaStar Mortgage, Inc.
    10.29Software License Agreement, dated as of July 1, 2000 between the Registrant and

    NovaStar Mortgage, Inc.
    10.30Amendment dated as of July 28, 2000 to the Master Repurchase Agreement, dated as of February 12, 1999 between First Union National Bank and the Registrant.
    11.1Statement regarding computation of per share earnings.

      

    21.1           

    		21.1

    Subsidiaries of the Registrant

    __________
    27.1Financial Data Schedule
    * Incorporated by reference to the correspondingly numbered exhibit to the Registration Statement on Form S-11 (373-32327) filed by the Registrant with the SEC on July 29 1997, as amended.
    **Incorporated by reference to the correspondingly numbered exhibit to Form 8-K filed by the Registrant with the SEC on December 22, 1998.
    ***Incorporated by reference to the correspondingly numbered exhibit to Form 8-K filed by the Registrant with the SEC on February 23, 1999.
    ****Incorporated by reference to the correspondingly numbered exhibit to Form 8-K filed by the Registrant with the SEC on April 5, 1999.
    *****Incorporated by reference to the correspondingly numbered exhibit to Annual Report on Form 10K filed by the Registrant with the SEC on March 20, 2000.

     
    NovaStar Financial hasWe filed the following Form 8-K’s:
    ·NovaStar Financial filed a Form 8-K on September 29, 2000January 3, 2001 regarding NovaStar Financial, Inc.’s expansion's purchase of its stock repurchase programall the common shares of NFI Holding Corporation from the founders and the repurchasea restructure of 9.7% of its outstanding common stock from GE Capital Equity in a negotiated bulk transaction.
    founders' notes receivable.

    NOVASTAR FINANCIAL, INC.

    SIGNATURES

    Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

    NOVASTAR FINANCIAL, INC.

    DATE: November 13, 2000May 11, 2001/s/ Scott F. Hartman
    Scott F. Hartman

    Chairman of the Board, Secretary and

    Chief Executive Officer

    (Principal Executive Officer)
    DATE: November 13, 2000May 11, 2001/s/ Rodney E. Schwatken
    Rodney E. Schwatken

    Vice President, Treasurer and Controller (Principal
    (Principal Accounting Officer)