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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, 1998.March 31, 1999.
OR
[ ][_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _____________ to _____________..
Commission File Number: 001-13533
NovaStar Financial, Inc.
------------------------
(Exact name of registrant as specified in its charter)
----------------
Maryland 74-2830661
- ------------------------------- ------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
66205
1901 W. 47th Place, (Zip Code)
Suite 105, Westwood, KS 66205
-------------------------------------------------
(Address of principal executive
offices)
(Zip Code)
(913) 362-1090
--------------
(Registrant's telephone number, including area code)
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(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. Yes X[X] No --- ---[_]
The number of shares of the registrant's common stock outstanding as of NovemberMay
10, 19981999 was 8,127,314.8,130,069.
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NOVASTAR FINANCIAL, INC.
FORM 10-Q
QUARTER ENDED SEPTEMBER 30, 1998MARCH 31, 1999
INDEX
Page
----
PART I FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements:
Balance Sheets.................................................Sheets......................................................................... 1
Statements of Operations.......................................Operations............................................................... 2
Statements of Cash Flows.......................................Flows............................................................... 3
Notes..........................................................Notes.................................................................................. 4
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.............................Operations.. 6
Item 3. Quantitative and Qualitative Disclosures about Market Risk............................. 38
PART II OTHER INFORMATION
Item 1. Legal Proceedings............................................... 31Proceedings...................................................................... II-1
Item 2. Changes in Securities........................................... 31Securities.................................................................. II-1
Item 3. Defaults Upon Senior Securities................................. 31Securities........................................................ II-2
Item 4. Submission of Matters to a Vote of Security Holders............. 31Holders.................................... II-2
Item 5. Other Information............................................... 31Information...................................................................... II-2
Item 6. Exhibits and Reports on Form 8-K................................ 31
Signatures...................................................... 328-K....................................................... II-2
Signatures............................................................................. II-3
NOVASTAR FINANCIAL, INC.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share amounts)
- --------------------------------------------------------------------------------
September 30, 1998March 31, 1999 December 31, 19971998
-------------- -----------------
(unaudited)
Assets
Cash and cash equivalents......................................equivalents................... $ 2,403 $ --
$ --
Restricted cash................................................ 55,383 20,424
Mortgage loans................................................. 944,228 574,984
Available-for-sale securities:
Mortgage securities........................................... 390,276 517,246
Other......................................................... 18,000 --loans, net......................... 847,744 920,697
Accrued interest receivable.................................... 11,046 7,088receivable................. 9,357 9,702
Due from affiliates......................... 61,071 51,528
Investment in NFI Holding Corporation.......................... (409) 2,188
DueCorporation....... 2,147 13
Assets acquired through foreclosure......... 14,173 10,583
Amounts due from NFI Holding Corporation............................... 259,312 --founders................... 5,561 5,354
Other assets................................................... 15,489 4,322
----------assets................................ 1,867 4,359
-------- ----------
Total assets.............................................. $1,693,325 $1,126,252
==========assets.............................. $944,323 $1,002,236
======== ==========
Liabilities and Stockholders' Equity
Liabilities:
Collateralized mortgage obligations...........................obligations......... $819,899 $ 948,590 $ 408,867
Repurchase agreements......................................... 579,697 556,443
Warehouse line of credit...................................... 46,779 40,250891,944
Residual interest financing................. -- 18,000
Dividends payable........................... 2,876 2,845
Accounts payable and accrued expenses......................... 8,411 4,203
----------expenses....... 1,836 2,157
-------- ----------
Total liabilities......................................... 1,583,477 1,009,763liabilities......................... 824,611 914,946
Stockholders' equity:
Capital stock, $0.01 par value, 50,000,000
shares
authorized:
Preferred stock, 4,285,714 shares of Class B
7% cumulative convertible preferred
stock issued and outstanding as of
March 31, 1999 with a redemption and
liquidation value of $7 per share.......... 43 --
Common stock, 8,127,314 and 7,828,6658,130,069 shares issued and
outstanding, respectively................outstanding................................ 81 7881
Additional paid-in capital.................................... 121,358 117,084capital.................. 151,247 122,180
Accumulated deficit........................................... (5,416) (2,859)deficit......................... (31,108) (32,804)
Accumulated other comprehensive income (deficit).............. (4,777) 4,353income...... 1,616 --
Forgivable notes receivable from founders..................... (1,398)founders... ( 2,167) (2,167)
------------------ ----------
Total stockholders' equity............................... 109,848 116,489
----------equity................ 119,712 87,290
-------- ----------
Total liabilities and stockholders'
equity.................. $1,693,325 $1,126,252
==========equity................................... $944,323 $1,002,236
======== ==========
See notes to consolidated financial statements.
1
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited; in thousands)
- --------------------------------------------------------------------------------thousands, except per share amounts)
For the NineThree
Months Ended
For the Three Months
September 30, Ended September 30,
-------------------------- ---------------------------March 31,
----------------
1999 1998
1997 1998 1997------- -------
Interest income:
Mortgage loans.............................................. $56,274 $14,749 $22,312 $ 7,670$19,550 $14,550
Mortgage securities......................................... 22,881 6,796 6,485 4,555
------- --------- 9,364
------- -------
Total interest income........................................ 79,155 21,545 28,797 12,225income......................................... 19,550 23,914
Interest expense............................................. 60,948 16,224 22,088 9,786
------- -------expense.............................................. 13,209 18,442
------- -------
Net interest income.......................................... 18,207 5,321 6,709 2,439income........................................... 6,341 5,472
Provision for credit losses.................................. 3,400 1,444 1,179 726
------- -------losses................................... 2,299 1,076
------- -------
Net interest income after provision for credit losses........ 14,807 3,877 5,530 1,713
Fees from NovaStar Mortgage, Inc............................. 3,766 -- 3,349 --losses......... 4,042 4,396
Other income................................................. 2,012 326 919 259income.................................................. 935 364
Equity in earnings (loss) of NFI Holding Corporation......... (2,455) (141) (2,446) 290Corporation.......... 551 (271)
General and administrative expenses:
ServicesLoan servicing fees paid to NovaStar Mortgage, Inc.......... 1,115 630
Fees for other services provided by NovaStar Mortgage,
Inc................. 5,700 2,450 2,100 1,200
Loan servicing.............................................. 3,163 694 1,547 123Inc........................................................ 1,050 1,500
Compensation and benefits................................... 1,374 701 478585 436
Professional and outside services........................... 332 56
Other loan servicing expenses............................... 470 44
Forgiveness of notes receivable from founders............... 812 -- 270 --271
Office administration....................................... 681 201 276 89
Professional and outside services........................... 649 430 296208 181
Other....................................................... 184 288 (9) 160
------- -------42 92
------- -------
Total general and administrative expenses................. 12,563 4,764 4,958 2,085
------- -------3,802 3,210
------- -------
Net income (loss)............................................income.................................................... $ 5,5671,726 $ (702)1,279
======= =======
Preferred stock dividends..................................... (31) --
------- -------
Income available to common stockholders....................... $ 2,3941,695 $ 177
======= =======1,279
======= =======
Basic earnings per share.....................................common share............................... $ 0.690.21 $ (0.19) $ 0.29 $ 0.05
======= =======0.16
======= =======
Diluted earnings per share...................................common share............................. $ 0.640.20 $ (0.19) $ 0.29 $ 0.05
======= =======0.15
======= =======
Dividends declared per share.................................common share........................... $ 1.00-- $ 0.18 $ 0.35 $ 0.08
======= ======= ======= =======
Basic weighted average shares outstanding.................... 8,033 3,767 8,124 3,767
======= ======= ======= =======
Diluted weighted average shares outstanding.................. 8,639 3,767 8,157 3,804
======= =======0.30
======= =======
See notes to consolidated financial statements.
2
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited; in thousands)
- --------------------------------------------------------------------------------
For the NineThree
Months
Ended September 30,
-------------------------March 31,
------------------
1999 1998
1997------- ---------
Net cash provided by operating activities $ 4,1915,812 $ 3,2812,913
Cash flow from investing activities:
Mortgage loans purchased from NovaStar Mortgage, Inc............... (510,267) (229,364)Inc..... -- (208,632)
Mortgage loan repayments................................. 57,029 22,515
Mortgage loans sold to others...................................... 7,933others............................ 4,545 --
Mortgage loans purchased from others...............................Sales of assets acquired through foreclosure............. 3,757 -- (219,995)
Mortgage loan repayments........................................... 125,818 27,402
Purchases of available-for-sale securities......................... (375,051) (380,820)securities............... -- (293,992)
Proceeds from sales of available-for-sale securities............... 323,631 99,794securities..... -- 315,573
Proceeds from paydowns on and maturities of available-for-sale
securities....................................................... 150,018 22,506
Settlement of amounts payable to brokers...........................available-
for-sale securities..................................... -- (12,676)63,892
Net change in amounts due from NFI Holding Corporation............. (259,035) 5,861
Investment in NFI Holding Corporation.............................. -- (1,980)
---------affiliates................ (7,427) (3,570)
------- ---------
Net cash used inprovided by (used in) investing activities.............................. (536,953) (689,272)activities...... 57,904 (104,214)
Cash flow from financing activities:
Net change in restricted cash...................................... (34,959) --
Proceeds from issuing collateralized mortgage
obligations.......... 665,000obligations............................................. -- 50,000
Payments on collateralized mortgage obligations.................... (125,277)obligations.......... (72,395) (29,324)
Debt issuance costs paid on collateralized mortgage
obligations............................................. -- Net borrowings under repurchase agreements(367)
Change in short-term borrowings.......................... (18,029) 85,646
Proceeds from issuance of capital stock and warehouse line...... 29,783 644,195
Exerciseexercise of
stock options and warrants............................. 4,365 --
Registrationequity instruments,
net of offering costs of stock options and warrants................... (88)1,240.......................... 29,111 7
Dividends paid........................................... -- Additional private placement offering costs........................ -- (48)
Dividends paid..................................................... (6,062) (354)
---------(783)
------- ---------
Net cash provided by (used in) financing activities.......................... 532,762 643,793
---------activities...... (61,313) 105,179
------- ---------
Net increase (decrease) in cash and cash equivalents............... -- (42,198)equivalents................ 2,403 3,878
Cash and cash equivalents, beginning of period.....................period........... -- 46,434
--------- -----------
Cash and cash equivalents, end of period...........................period................. $ --2,403 $ 4,236
=========3,878
======= =========
Supplemental disclosure of cash flow information:
Note received in exchange for options exercised by
founders................................................ $ -- $ 4,340
======= =========
Cash paid for interest.............................................interest................................... $13,487 $ 60,312 $ 15,416
=========18,543
======= =========
Dividends payable..................................................payable........................................ $ 2,8452,876 $ 2842,436
======= =========
Assets acquired through foreclosure...................... $ 7,270 $ 1,524
======= =========
See notes to consolidated financial statements.
3
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 1998March 31, 1999 (Unaudited)
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Note 1. Financial Statement Presentation
The consolidated financial statements as of and for the periods ended September 30,March
31, 1999 and 1998 and 1997 are unaudited. In the opinion of management, all 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's Discussion and Analysis of Financial Condition and Results of
Operations and the Consolidatedconsolidated financial statements of NovaStar Financial Statements of the Company and
the Notesnotes thereto, included in the Company's Annual ReportNovaStar Financial's annual report to
Shareholdersshareholders and Annual Reportannual report on Form 10-K for the fiscal year ended December
31, 1997.
The Company1998.
NovaStar Financial owns 100 percent of the common stock of three special
purpose entities -- NovaStar Assets Corporation, NovaStar Certificates Financing
Corporation and NovaStar Mortgage Funding Corporation. The CompanyNovaStar Financial
formed these entities in connection with the issuance of collateralized
mortgage obligations. The consolidated financial statements of the CompanyNovaStar
Financial include the accounts of these entities. Significant intercompany
accounts and transactions have been eliminated in consolidation.
The CompanyNovaStar Financial owns 100 percent of the preferred stock of NFI Holding
Corporation (Holding) for which it receives 99 percent of any dividends paid by NFI
Holding. The founders of the CompanyNovaStar Financial own the voting common stock of NFI
Holding. NovaStar Mortgage, Inc. and NovaStar Capital, Inc. are wholly owned
subsidiaries of NFI Holding. Certain key officers of the Company serve as officers of Holding, NovaStar Mortgage Funding Corporation II and
NovaStar Capital. The CompanyREMIC Financing Corporation are subsidiaries of NovaStar Mortgage.
NovaStar Financial accounts for its investment in Holding using the equity
method.
Note 2. Subsequent Events
AsStockholders' Equity
In March 1999, NovaStar Financial issued 4,285,714 shares of Class B 7%
cumulative convertible preferred stock. The preferred shares have no voting
rights, are senior to any other class of NovaStar Financial capital stock and
have a resultstated and liquidation value of significant liquidity constraints imposed upon the Company by
certain key lenders subsequent to September 30, 1998, management took the
following actions in October 1998:
On October 11, 1998, the Board of Directors$7 per share. Each holder of the
Company agreedpreferred stock is entitled to defer
paymentquarterly dividends that accrue at 7% per annum
on the stated value. Holders of the dividend it declaredClass B preferred shares have the right, at
any time, to convert all or a portion of their preferred stock into an equal
number of shares of common stock. NovaStar Financial has the right to redeem
the Class B preferred stock at any time on September 22, 1998 ($0.35 per share, $2.8
million in total) until January 15, 1999.
On various dates during October 1998, the Company and NovaStar Mortgage
executed contracts for the sale of all securities owned by the Company and
NovaStar Mortgage. All securities sales settled during October at an aggregate
loss of $15.4 million.
On various dates during October 1998, the Company executed contracts for the
termination of interest rate swap agreements with a notional amount of $455
million, representing 42 percent of all interest rate agreements owned by the
Company. The terminations settled in October 1998 at an aggregate loss of $8.0
million. The Company continues to own interest rate cap agreements, but has
significantly reduced liquidity risk exposure relating to its interest rate
agreements.
On October 13, 1998, the Company executed a 90-day financing agreement with
GMAC/Residential Funding Corporation, secured by certain mortgage interests of
the Company. Under the terms of the agreement, the Company borrowed $15 million
to support immediate cash needs. In addition, the Company agreed to pay a $3
million commitment fee at maturity of the note. The resulting $18 million
obligation bears interest at one-month LIBOR plus five percent. Additionally,
GMAC/RFC acquired 812,731 warrants for the purchase of the Company's common
stockor after March 31, 2002 at a price
of $4.5625, the closing price of the common stock on October
12, 1998. The Company and GMAC/RFC are presently$7.00 per share, payable in negotiations regarding
terms to establish a long-term strategic alliance. However, no assurance can be
given that the alliance will be established. If a strategic alliance is
successfully negotiated, GMAC/RFC has the option to waive $2 million of the
commitment fees discussed above in exchange for an additional 811,919 warrants
for the purchase of the Company's stock at a price of $4.5625 per share.
Additional events, as described below, occurred subsequent to September 30,
1998. Although these events were not a direct result of the event discussed
above, they affect the Company's liquidity position.
On various dates during October 1998, NovaStar Mortgage accepted bids from
third parties for the sale of approximately $221 million, or 94 percent of loans
it owned as of September 30, 1998. Final terms of the sales will be determined
after due diligence is performed on subject loans. Closings on these sales are
expected to be prior to December 31, 1998. Management of NovaStar Mortgage
expects to continue marketing its originated loans for sale to third parties.
On October 21, 1998, the Company finalized the second closing on the
securitization of asset-backed bonds, the first closing of which was during the
third quarter. In the second closing, approximately $43 million of loans were
added to the trust assets of NovaStar Home Equity Series 1998-2.
4
Note 3. Related Party Receivable
Prior to July 1, 1998, the Company acquired all mortgage loans originated
by NovaStar Mortgage, Inc. These acquisitions were financed using warehouse and
repurchase lending arrangements with commercial and investment banks. During
the third quarter of 1998, NovaStar Mortgage discontinued virtually all its
sales of mortgage loans to the Company in order to market and sell these loans
to third parties. However, the Company continues to provide financing for these
loans on behalf NovaStar Mortgage. As a result, the Company has a receivable as
of September 30, 1998 of $259.3 million from NovaStar Mortgage. The receivable
represents its interest in mortgage loans, restricted cash and other assets
related to mortgage loans recorded on the balance sheet of NovaStar Mortgage,
Inc. These advances will be repaid when the loans are sold (see Note 2), and
the Company will, in turn, repay borrowings.
Note 4. Comprehensive Income
Effective January 1, 1998, the Company adopted the provisions of Statement
of Financial Accounting Standards No. 130, Reporting Comprehensive Income."cash.
Comprehensive income includes net income and revenues, expenses, gains and
losses that are not included in net income. Currently, the only componentscomponent of
comprehensive income for the Company areNovaStar Financial is the net change in the unrealized
gain (loss) on available-for-sale securities and net income. The adoption of SFAS
No. 130 did not result in an adjustment to assets, liabilities, stockholders'
equity or net income. The consolidated balance sheets of the Company as of and
for the year ended December 31, 1997 are comparable to those as of September 30,
1998. However, the caption for comprehensive income has appropriately been
identified.securities. Following is a summary of
comprehensive income for the three-three months ended March 31, 1999 and nine-
month periods ended September 30, 1998.
For the Nine Months For the Three Months
Ended September 30 Ended September 30
-------------------March, 31
--------------------
1999 1998
1997 1998 1997--------------------
Net income (loss).....................................income............................................. $ 5,5671,726 $ (702) $ 2,394 $ 1771,279
Other comprehensive income -- netincome--net change in unrealized
gain (loss) on available-for-sale securities......... (9,130) 2,255 (4,828) 872
------- ------ ------- ------securities.......... 1,616 (4,108)
--------- ----------
Comprehensive income (loss)........................... $(3,563) $1,553 $(2,434) $1,049
======= ====== ======= ======............................ $ 3,342 $ (2,829)
========= ==========
4
Note 3. Earnings Per Share
The computations of basic and diluted EPS computations for the three months
ended March 31, 1999 and 1998 are as follows (in thousands, except per share
amounts):
For the three months
ended March 31,
----------------------
1999 1998
---------- ----------
Numerator:
Net Income.............................................. $ 1,726 $ 1,279
Less: Preferred stock dividends......................... (31) --
---------- ----------
Income available to common
stockholders--basic ................................... $ 1,695 $ 1,279
========== ==========
Plus: Preferred stock dividends......................... 31 --
---------- ----------
Income available to common
stockholders--diluted.................................. $ 1,726 $ 1,279
========== ==========
Denominator:
Weighted average common
shares outstanding--basic.............................. 8,130 7,855
========== ==========
Warrants................................................ 232 708
Stock options........................................... 22 97
Convertible preferred stock............................. 254 --
---------- ----------
Weighted average common
shares outstanding--dilutive .......................... 8,638 8,660
========== ==========
Basic earnings per share................................ $ 0.21 $ 0.16
========== ==========
Diluted earnings per share.............................. $ 0.20 $ 0.15
========== ==========
The following stock options and warrants to purchase shares of common stock
were outstanding during each period presented, but were not included in the
computation of diluted earnings per share because the options' weighted-average
exercise price was greater than the average market price of the common shares
for the periods presented, therefore, the effect would be antidilutive (in
thousands, except per share amounts):
Three months ended
March 31,
--------------------
1999 1998
---------- ---------
Number of stock options and warrants........................ 4,417 --
Weighted average exercise price............................. $11.61 --
5
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion should be read in conjunction with the preceding
Consolidatedconsolidated financial statements of NovaStar Financial Statements of the Company and the Notes theretoaccompanying
notes as well as the Company's Annual ReportNovaStar Financial's annual report to Shareholdersshareholders and Annual Reportannual
report on Formform 10-K for the fiscal year ended December 31, 1997.1998.
Safe Harbor Statement
"Safe Harbor" statement under the Private Securities Litigation Reform Act
of 1995: Statements in this discussion regarding NovaStar Financial, Inc. (the
Company) and
its business, which are not historical facts, are "forward-looking statements"
that involve risks and uncertainties. Risks and uncertainties, which could
cause results to differ from those discussed in the forward-looking statements
herein, are listed in the Company's Annual Report filed on form 10K."Risk Management" section of this annual report. In
addition, there are many important factors that could cause NovaStar's actual results to
differ materially from those indicated in the forward-looking statements. These
factors include, but are not limited to, general economic conditions, interest
rate levels and risk, prepayment speeds, delinquency and loss rates, changes (legislative and otherwise) in
the asset securitization industry or the REIT provisions of the Internal
Revenue Code, demand for NovaStar's service,services and products offered by NovaStar, the impact
of certain covenants in loan agreements, of
NovaStar, the degree to which NovaStar Financial is
leveraged, itsthe needs for and availability of financing, its access to capital and
other risks identified in NovaStar'sNovaStar Financial's Securities and Exchange
Commission filings. In addition, it should be noted that past financial and
operational performance of the CompanyNovaStar Financial is not necessarily indicative of
future financial and operational performance.
Information
Management intends to provide extensive information about the financial
position and results of operations of NovaStar Financial in a format that is
clear and easy to understand. This report and other published documents are
designed to provide a framework for understanding NovaStar Financial's business
and the associated risks. The manner in which management conducts business and
assesses risks will determine future performance. By providing detailed
information to this extent, investors will be able to evaluate NovaStar
Financial as an investment option and to compare NovaStar Financial with its
competition.
Basis of Presentation
The CompanyNovaStar Financial owns 100 percent100% 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 the Company's issuance of collateralized mortgage obligations. The
consolidated financial statements of the CompanyNovaStar Financial include the financial
condition and results of operations of these entities.
The CompanyNovaStar Financial also owns 100 percent100% of the non-voting preferred stock of NFI
Holding Corporation (Holding) for which it receives 99 percent99% of any dividends paid by NFI
Holding. A significant component of the financial results of NovaStar Financial
are derived from the operations of NovaStar Mortgage, Inc. Scott Hartman and
Lance Anderson, the Company's 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. is a wholly owned subsidiary of NFI Holding. Certain keyKey officers of
the CompanyNovaStar Financial serve as officers of NFI Holding and NovaStar Mortgage and
the founders are the only members of the Board of Directors of NFI Holding and
NovaStar Mortgage. In June 1998, NFI Holding formed NovaStar Capital, Inc. to
purchase and sell mortgage loans. The CompanyNovaStar Mortgage owns 100% of NovaStar
Mortgage Funding Corporation II and NovaStar REMIC Financing Corporation. Both
of these special purpose entities were created in January 1999 for the issuance
of real estate mortgage investment conduits (REMICs). NovaStar Financial
accounts for its investment in NFI Holding using the equity method.
Events SubsequentA separate section of this MD&A discusses the financial results of NovaStar
Mortgage.
6
Description of Business
Business of NovaStar Financial:
. NovaStar Financial was founded in 1996 as a specialty finance lender to
September 30, 1998
Asinvest in mortgage assets;
. NovaStar Financial's assets have primarily come from the wholesale
origination of September 30, 1998,single-family nonconforming loans by its affiliate,
NovaStar Mortgage;
. NovaStar Financial operates as a long-term portfolio investor;
. NovaStar Financial's loans are financed on a short-term basis through a
mortgage loan repurchase facility. Long-term financing is provided
through securitization where asset-backed bonds are issued in financing-
structured transactions;
. Earnings are generated from spread income on the Company had an arrangementmortgage loan portfolio
and indirectly by gains associated with an lender
whereby the Company could borrow up to 50 percent of the value of the residual
interests in the Company's collateralized mortgage obligations. Borrowing
capacity under this arrangement was in excess of $30 million. However, the
lender restricted the Company's access to funds under this arrangement to $25
million as of September 30, 1998. In October, the lender withdrew its financing
under this arrangement. This event, combined with declining market prices for
its securities and off-balance-sheet financial instruments, caused management to
take several actions, as discussed in following paragraphs, to restore the
Company's liquidity and to reduce further exposure to liquidity risk. As a
result of these actions, the Company anticipates incurring a significant net
loss during the fourth quarter of 1998.
On October 11, 1998, the Board of Directors of the Company agreed to defer
payment of the third quarter dividend ($0.35 per share) until January 15, 1999.
On various dates during October 1998, the Company and NovaStar Mortgage
executed contracts for the sale of all securities owned by the Company andloans to outside
parties or through securitization transactions of NovaStar Mortgage.
All securities sales settled during October at an aggregated
lossBusiness of $15.4 million.
On various dates during October 1998,NovaStar Mortgage:
. NovaStar Mortgage's customer is the Company terminated interest rate
swap agreementsretail mortgage broker who deals
with a notional amount of $455 million, representing 42 percent
of all interest rate agreements owned by the Company. The terminations settled
in October 1998 at an aggregate loss of $8.0 million.
On October 13, 1998, the Company executed a 90-day financing agreementborrower. NovaStar Mortgage's account executives work with GMAC/Residential Funding Corporation, secured by certain mortgage interests of
the Company. Under the terms of the agreement, the Company received a $15
million loanover
3,000 brokers to support immediate cash needs. The loan bears interest at one-
month LIBOR plus five percent. The Company is required to pay a $3 million
commitment fee upon maturity of the note. Additionally, GMAC/RFC acquired
812,731 warrantssolicit loans.
. NovaStar Mortgage's borrowers generally are individuals or families who
do not qualify for the purchase of the Company's common stock at a price of
$4.5625, the closing price of the common stock on October 12, 1998. The Company
and GMAC/RFC are presently in negotiations regarding terms for a long-term
strategic alliance. However, no assurances can be given that an alliance will
in fact be executed. Upon executionagency/conventional lending programs because of a
strategic alliance, GMAC/RFC will
refund $2 millionlack of the commitment fees discussed aboveavailable 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.
. NovaStar will issue
additional 811,919 warrants for the purchase of the Company's stock atMortgage's loans are financed on a price
of $4.5625 per share.
Additional events, as described below, occurred subsequent to September 30,
1998. Although these events were not a direct result of the above-described
events, they affect the Company's liquidity position.
6
On various dates during October 1998, NovaStar Mortgage has accepted bids
for the sale of approximately $221 million, or 94 percent of loans it owned as
of September 30, 1998. However, final terms of these sales will be determined
after due diligenceshort-term basis through
warehouse facilities. Long-term financing is performed on subject loans. Closing on these sales is
expected to take place prior to December 31, 1998.
On October 21, 1998, the Company finalized the second closing on theprovided through
securitization ofwhere asset-backed bonds the first closing of which occurred during
the second quarter. In the second closing, approximately $43 million of loans
were added to the trust assets of NovaStar Home Equity Series 1998-2.
After completing the aboveare issued in transactions the Company's balance sheet will
consist primarily of subprime mortgage loans financed with non-recourse asset-
backed bonds. Table I is a condensed balance sheet as of September 30, 1998
with a comparative pro-forma balance sheet assuming the foregoing transactions
had been executed on that
date, excluding the sales of mortgage loans expected
to occur during the fourth quarter.
Table I
Condensed Balance Sheets
September 30, 1998
- --------------------------------------------------------------------------------
September 30, 1998
-------------------------
Actual Pro Forma
Assets
Cash and cash equivalents........................... $ -- $ 15,638
Restricted cash..................................... 55,383 12,683
Mortgage loans...................................... 944,228 987,781
Available-for-sale securities....................... 408,276 --
Due from NFI Holding Corporation.................... 259,312 215,758
Other assets........................................ 26,126 21,008
---------- ----------
Total assets...................................... $1,693,325 $1,252,868
========== ==========
Liabilities and Stockholders' Equity
Liabilities:
Collateralized mortgage obligations................ $ 948,590 $ 948,590
Repurchase agreements.............................. 579,697 151,521
Warehouse line of credit........................... 46,779 35,079
Short-term note payable............................ -- 18,000
Accounts payable and accrued expenses.............. 8,411 8,346
---------- ----------
Total liabilities................................. 1,583,477 1,161,536
Stockholders' equity................................ 109,848 91,332
---------- ----------
Total liabilities and stockholders' equity........ $1,693,325 $1,252,868
========== ==========
In the foreseeable future, the Company does not expect to purchase a
significant amount of loans originated by NovaStar Mortgage, and NovaStar
Mortgage is expected to sell a majority of the mortgage loans it originates to
unrelated entities for cash. Net income for the Company will be generated from
the spread on securitized loans, general and administrative expenses and equity
in earnings of NFI Holding Corporation. Earnings of NFI Holding Corporation
will primarily include gains on the sales of mortgage loans originated by
NovaStar Mortgage and general and administrative expenses.
Additional information regarding the Company's liquidity position and
events subsequent to September 30, 1998 are included in "Liquidity and Capital
Resources."
Liquidity and Capital Resources
Subsequent to September 30, 1998, access to a key financing source was
withdrawn, as discussed in "Events Subsequent to September 30, 1998." The
events and actions discussed therein are important to the discussion below
regarding the liquidity and capital resources of the Company.
Liquidity, as used herein, means the need for, access to and uses of cash.
The Company's primary needs for cash include the acquisition of mortgage loans,
principal repayment and interest on borrowings, operating expenses and dividend
payments. The Company's business requires substantial cash to support its
operating activities. The Company has a certain amount of cash on hand to fund
operations. Principal, interest and fees received on mortgage assets will
serve to support the cash needs of the Company. Drawing upon various borrowing
arrangements typically satisfies major cash requirements. Historically, the
Company demonstrated the ability to access public marketsstructured as a source of long-
term cash resources. The events in early October
7
1998 changed the liquidity position of the Company. Options available to the
Company for financing sources have been restricted.
Actions of the Company, during unfavorable market conditions as discussed
in "Events Subsequent to September 30, 1998" were taken to restore liquidity and
mitigate additional margin call risk. Although these actions will result in a
significant net loss for the fourth quarter of 1998, management believes they
were necessary under the circumstances.
In addition to the mortgage loans that have been securitized and are
reflected on the Company's balance sheet, NovaStar Mortgage continues to
originate subprime mortgage loans expected to be sold to third parties. As of
September 30, 1998, NovaStar Mortgage had $238 million of subprime mortgage
loans. The Company provides financing for these loans through its own warehouse
and repurchase credit facilities. Sales commitments have been accepted for $221
million of these loans. Management expects to continue selling loans originated
by NovaStar Mortgage during the fourth quarter of 1998 and into 1999. Loans
financed with warehouse and repurchase credit facilities are subject to changing
market valuation and margin calls.
Table II is a summary of financing arrangements and available borrowing
capacity under those arrangements as of November 9, 1998.
Table II
Liquidity Resources
November 9, 1998 (dollars in thousands)
- ------------------------------------------------------------------------------------------------------
Maximum
Borrowing Value of
Resource Limit Collateral Borrowings Availability
First Union National Bank:
Committed warehouse line of credit................. $ 75,000 $ 34,895 $ 16,913 $17,982
Committed secured whole loan repurchase agreement.. 100,000 85,816 85,816
Merrill Lynch Mortgage Capital, Inc. ................ 150,100 150,100 --
Residual financing available under CMOs.............. 18,000 (A) 18,000 --
-------- -------
Total............................................ $270,829 $17,982
======== =======
Total availability as percent of:
Total assets....................................... 1.06%
=====
Total stockholders' equity......................... 16.37%
=====
- --------------
(A) The Company's estimates of the value of the residuals range from $50 to $70
million.
During the nine months ended September 30, 1998, the Company's operating
and financing activities generated cash of $4 million and $533 million, while
investing activities used cash of $537 million.sale.
Forgivable Notes Receivable from Founders
The Company's 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 will be 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 the Company's stock price, the value of the
warrants, and dividends paid. One tranche will be forgiven for each fiscal year
the CompanyNovaStar Financial generates a return of 15 percent15% to investors in the private
placement. All three tranches will be forgiven if the Company generates
a 100 percent return of 100% is generated
within five years.
ForDuring the period from the closing of the private placement through December
31, 1997, NovaStar Financial's stock price averaged $17.08 per share, dividends
of $0.28 were declared and the Company generatedvalue of each warrant was $2.08. The combination
of these produced a return exceeding 15 percent to investors in the private placement investors andexceeding 15%.
As a result, the first tranche of these notes was forgiven resulting in a non-cashnon-
cash charge of $1,083,000 during the fourth quarter of 1997. Based on the Company's performance and stock priceNovaStar recorded
a non-cash charge of $271,000 to earnings during the first three quartersmonths ended March
31, 1998 in anticipation of the year, the Company's management anticipated forgiveness of the second tranche of these notes. Astranche. However, as
a result non-cash charges to earnings have
been recordedof NovaStar Financial's significant loss in the fourth quarter of 1998
and the market price of its stock during the first three quarters of 1998 in the amount of $812,000.
Based on actions taken by management as described in "Events Subsequent to
September 30, 1998" and the current value of Company's stock, it appears
unlikely thatsame period, the second tranche of
the notes receivable from founders will be
forgiven. Final determination regardingwas not forgiven in 1998. NovaStar Financial
has not recognized any forgiveness will be made during the
fourth quarter of 1998. If the second tranche in 1999 because
management is not forgiven, all amounts that
have been charged off during 1998uncertain of whether the incentive performance targets will be
reinstated.
8met.
7
Financial Condition During the nine months ended September 30,of NovaStar Financial, Inc. as of March 31, 1999 and
December 31, 1998
NovaStar Mortgage
originated approximately 8,000 subprime residential mortgage loans with an
aggregate principal amount of $735 million, of which $498 million was acquired
by the Company. However, unlike previous periods, the Company discontinued
virtually all its purchase of NovaStar Mortgage's loan originations during the
third quarter of 1998 as NovaStar Mortgage intends to sell the majority of its
third quarter production to independent third parties. The Company'sFinancial's balance sheet continues to become more heavily weighted toward subprime mortgage loans.
As of September 30, 1998, subprime mortgage loans comprise 71 percent of the
mortgage assets owned by the Company compared with 51 percentsheets at March 31, 1999 and December 31, 1997.
During the nine months ended September 30, 1998
the Company sold $7.5
millionprimarily consist of mortgage loans purchased from NovaStar Mortgage, to unrelated third parties for
cash, recognizing gainswhich
serve as collateral on these transactions of $315,000.its collateralized mortgage obligations. The Company also
completed two securitizations during the nine months ended September 30, 1998,
pooling $618 millioncarrying
value of mortgage loans as collateralat March 31, 1999 was $848 million versus $921 million
at December 31, 1998. The carrying value of which $43collateralized mortgage obligations
at March 31, 1999 was $820 million was
addedat March 31, 1999 compared with $892 million
at December 31, 1998. The decline in both balance sheet items is primarily a
result of principal paydowns that occurred during the fourthfirst quarter of 1998.1999.
Table III1 is a presentation of loans as of March 31, 1999 and December 31,
1998 and their credit grades. Table 2 is a summary of wholesale loan originationsall mortgage loans owned
by NovaStar Financial as of March 31, 1999 and bulk acquisitions
forDecember 31, 1998 and 1997.by state.
Table IV presents a more detailed analysis of wholesale loan
originations.
Table III
Wholesale Loan Originations (A) and Bulk Acquisitions (B)
Nine Months Ended September 30, 1998 and Year Ended December 31, 19971
Mortgage Loans by Credit Grade
(dollars in thousands)
- ----------------------------------------------------------------------------------------------
Wholesale Originations (A) Bulk Acquisitions (B) Total
--------------------------------------------------------------------------
Number Principal Number Principal Number Principal
of Loans Amount of Loans Amount of Loans Amount
1998:
Third quarter... 2,576 $232,333 79 $ 8,165 2,655 $240,498
Second quarter.. 3,133 294,303 -- -- 3,133 294,303
First quarter... 2,033 207,976 -- -- 2,033 207,976
----- -------- ----- ----------- ----- --------
1998 total...... 7,742 $734,612 79 $ 8,165 7,821 $742,777
===== ======== ===== ======== ===== ========
1997:
Fourth quarter.. 1,552 $183,012 -- $ -- 1,552 $183,012
Third quarter... 1,025 136,582 -- -- 1,025 136,582
Second quarter.. 509 77,692 530 49,808 1,039 127,500
First quarter... 68 12,688 1,422 157,432 1,490 170,120
----- -------- ----- -------- ----- --------
1997 total...... 3,154 $409,974 1,952 $207,240 5,106 $617,214
===== ======== ===== ======== ===== ========
- ----------------
(A) Loans originated by NovaStar Mortgage
(B) First two quarters of 1997 represent bulk acquisitions by NFI; third
quarter of 1998 represents bulk acquisitions by NovaStar Capital, Inc.
9
Table IVMarch 31, 1999 December 31, 1998
and 1997 Quarterly Wholesale Loan Originations (A)
(dollars in thousands)
- ----------------------------------------------------------------------------------------------------------------------------------------- ---------------------------
Weighted Weighted
Allowed Weighted Average -----------------------------Weighted Average
Mortgage Maximum Loan- Current Average Loan-to- Current Average Loan-to-
Credit Percent with
Number Loan Price Paid to Value Rating (B)Grade Lates (A) to-value Principal Coupon Prepayment
of Loansvalue Principal Balance Broker PenaltyCoupon value
------------ --------------- ------------- --------- -------- -------- --------- -------- --------
1998:
Third quarter... 2,576 $232,333AA...................... 0 x 30 95(B) $ 109,172 9.53% 83.5% $117,172 9.51% 83.4%
A....................... 1 x 30 90 101.4 81% 4.37 10.11% 79%
Second quarter.. 3,133 294,303 94 101.3 81 4.43 9.93 71
First quarter... 2,033 207,976 102 101.4 81 4.45 9.93330,437 9.86 79.7 356,994 9.84 79.7
A....................... 2 x 30 90 198,285 10.31 81.5 214,627 10.31 81.3
B....................... 3 x 30, 1x 60 85 124,250 10.66 78.1 138,497 10.62 77.9
5 x 30, 2 x 60,
C....................... 1 x 90 75 58,280 11.18 72.4 62,784 11.13 72.3
D....................... 6 x 30, 3 x 60, 65 -----11,853 12.09 62.0 13,328 12.14 62.2
2 x 90
--------- --------
Total................... $ 832,277 10.17% 79.6% $903,402 10.15% 79.5%
========= ===== ==== ======== ===== ====
- --------
A Represents the number of times NovaStar Financial allows a prospective
borrower 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 Fixed purchases; all other maximum of 90%.
Table 2
Mortgage Loans by State
Percent of Portfolio (based on current principal balance)
March 31, 1999 and
Collateral Location December 31, 1998
total........ 7,742 $734,612 95 101.4 81 4.42 9.99 72
=====- ------------------- ------------------
California................................................... 18%
Florida...................................................... 12
Washington................................................... 8
Oregon....................................................... 5
All other states............................................. 57
---
Total...................................................... 100%
===
8
Table 3 provides a summary of NovaStar Financial's mortgage loans by type
and carrying value as of March 31, 1999 and December 31, 1998.
Table 3
Carrying Value of Loans by Product/Type
March 31, 1999 and December 31, 1998 (in thousands)
March 31, December 31,
Product/Type 1999 1998
------------ --------- ------------
Two- and three-year fixed............................ $471,002 $511,824
Six-month LIBOR and one-year CMT..................... 75,201 88,958
30/15-year fixed and balloon......................... 286,074 302,620
-------- --------
Outstanding principal.............................. 832,277 903,402
Premium.............................................. 18,959 20,868
Allowance for credit losses.......................... (3,492) (3,573)
-------- --------
Carrying Value..................................... $847,744 $920,697
======== 1997:
Fourth quarter.. 1,552 $183,012 118 101.6 81 4.32 10.09 71
Third quarter... 1,025 136,582 133 101.6 79 4.21 10.12 66
Second quarter.. 509 77,692 153 102.1 77 4.23 10.17 84
First quarter... 68 12,688 187 102.3 75 4.22 9.64 78
----- --------
1997 total........ 3,154 $409,974 130 101.7 79 4.26 10.10 73
=============
Carrying value as a percent of principal............. 101.86% 101.91%
======== ========
- -----------------
(A) Loans originatedDuring the first half of 1998, NovaStar Financial purchased securities as a
temporary use of capital from its initial public offering. As NovaStar
Financial's capital was deployed for mortgage loan acquisition, NovaStar
Financial discontinued purchasing securities. In October 1998, NovaStar
Financial was forced to sell all of its securities due to the liquidity crisis
faced by the capital markets. Since that time, as indicated in the table below,
NovaStar Mortgage
(B) AAA=7, AA=6, A=5, A-=4, B=3, C=2, D=1
The Company's subprime borrowers generally include individuals that doFinancial has not qualify for agency/conventional lending programs because of a lack of available
documentation or previous credit difficulties, but have equity in their homes.
Often, they are individuals or families who have built up high-rate consumer
debt and are attempting to use the equity in their home to consolidate debt and
lower their monthly payments. The credit grade assignedpurchased any additional securities.
Table 4 is a functionsummary of the relative strength or weakness of the borrower's credit and/or the naturesecurities acquired during 1999 and extent of documents that can be provided to support income. NovaStar1998 by
quarter.
Table 4
Mortgage underwrites the loans acquired by the Company using guidelines that have been
approved by the Company.
Table V is a presentation of loans as of September 30, 1998Security Acquisitions
Three Months Ended March 31, 1999 and their
credit grades.
Table V
Mortgage Loans by Credit Grade
September 30, 1998 (dollars in thousands)
- ----------------------------------------------------------------------------------------
Maximum
Net Weighted
Weighted
Allowed Loan-to- CurrentPrice Average
Average
Credit Rating Mortgage Lates value Principal Premium Discount to Par Coupon
Loan-to-value--------- ------- -------- ------- --------
AA........... 0 x 30 95 $115,975 9.48 83.3%
A............ 1 x 30 90 367,921 9.82 79.6
A-........... 2 x 30 90 222,011 10.25 80.7
B............ 3 x 30, 1 x 60 85 141,165 10.52 77.5
5 x 30, 2 x 60,
C............ 1 x 90 80 62,965 11.09 72.3
D............ 6 x 30, 3 x 60,
2 x 90 65 14,398 11.97 62.2
--------
Total...... $924,435 10.11 79.2
========
Table VI is a summary of loans originated by NovaStar Mortgage by state.
Table VII is a summary of all mortgage loans owned by the Company as of
September 30, 1998 by state.
10
Table VI
Mortgage Loan Originations by State (A)
Nine Months Ended September 30, 1998 and Year Ended December 31, 1997
- ---------------------------------------------------------------------
Percent of Total Originations during Quarter
(based on original principal balance)
-----------------------------------------------------------------------------------
1998 1997
------------------------------- ----------------------------------------
Collateral Location Third Second1999:
First Fourth Third Second First
Florida.................. 17% 16% 12% 9% 10% 8% 1%
California............... 6 9 15 19 24 26 40
Washington............... 5 6 7 8 11 16 15
Michigan................. 5 5 5 5 3 -- --
Texas.................... 5 3 3 3 4 7 2
North Carolina........... 5 3 2 1 1 -- 1
Ohio..................... 4 5 2 2 2 2 --
Nevada................... 4 3 6 5 4 2 --
Oregon................... 3 4 5 6 6 9 7
Maryland................. 2 3 4 5 6 5 13
Utah..................... 2 3 3 6 6 9 13
Virginia................. 2 2 2 5 6 2 --
Oklahoma................. -- 1 1 1 1 2 5
All other states......... 40 40 35 26 17 12 4
- -------------------------
(A) Loans originated by NovaStar Mortgage, Inc.
Table VII
Mortgage Loans by State
As of September 30, 1998
- ------------------------
Percent of Portfolio (based on
original principal balance)
Collateral Location
Percent
California............... 19%
Florida.................. 12
Washington............... 8
Oregon................... 5
All other states......... 56
As of September 30, 1998, the carrying value of mortgage securities totaled
$390.3 million compared with $517.2 million as of December 31, 1997. As more of
the Company's capital is allocated to subprime mortgage loans, less is available
for mortgage securities. As a result, during the nine months ended September 30,
1998, the Company sold mortgage securities with an amortized cost of $323.3
million compared with $100.6 million for the period ended September 30, 1997.
The Company acquired mortgage securities with an aggregate cost of $354.9
million for the period ended September 30, 1998 compared with $376.0 million for
the same period of 1997. Tables VIII and XI are summaries of the securities
acquired during 1998 and 1997 by quarter and the portfolio as of September 30,
1998.
11
Table VIII
Mortgage Security Acquisitions
Nine Months Ended September 30, 1998 and Year Ended December 31, 1997 (dollars
in thousands)
- ------------------------------------------------------------------------------
Net Weighted
Price to Average
Principal Premium Discount Par Coupon
1998:
Third quarterquarter.................... $ -- $ -- $ -- -- -- %
1998:
Fourth quarter................... $ -- $ -- $ -- -- -- %
Third quarter ................... -- -- -- -- --
Second quarter - Federalquarter--Federal National
Mortgage.....Mortgage Association.......... 80,237 823 -- 101.0 6.40
Association.................................
First quarter:
Federal National Mortgage
Association.......Association................... 40,929 444 -- 101.1 6.12
Government National Mortgage
Association....Association................... 229,130 3,726 (364) 101.5 6.39
1997:
Fourth quarter:
Federal National Mortgage Association....... 46,779 1,856 -- 104.0 8.00
Government National Mortgage Association.... 233,546 2,649 (1,457) 100.5 5.74
Third quarter - Federal Home Loan Mortgage..... 2,202 87 -- 104.0 7.40
Corporation....................................
Second quarter:
Federal National Mortgage Association....... 247,219 5,174 -- 102.1 7.48
Federal Home Loan Mortgage Corporation...... 102,083 2,450 -- 102.4 6.90
First quarter:
Federal National Mortgage Association....... 7,491 231 -- 103.1 7.57
Government National Mortgage Association.... 8,931 174 -- 101.9 7.13
Table IX
Mortgage Security Portfolio
As of September 30, 1998 (dollars in thousands)
- --------------------------------------------------------------------------------
Gross
--------------------------- Weighted
Unamortized Unaccreted Carrying Average
Principal Premium Discount Value Coupon
Federal National Mortgage Association.......... $259,860 $5,565 $ -- $265,424 7.04%
Government National Mortgage Association....... 123,211 282 (225) 123,268 5.40
Federal Home Loan Mortgage Corporation......... 4,160 136 -- 4,296 7.54
-------- ------ ----- --------
$387,231 $5,983 $(225) 392,989 6.52%
======== ====== =====
Net unrealized loss (2,713)
--------
Carrying value $390,276
========
As described under the section labeled "Events Subsequent to September 30,
1998", all of the securities portfolio at September 30, 1998 was sold in October
1998 at losses aggregating $15.4 million.
Mortgage loan originations are fundedShort-term Financing Arrangements. NovaStar Financial is a co-borrower with various warehouse facilities
prior to securitization. Loans originated through the lending operations of
NovaStar Mortgage have typically been funded initially through a $75 millionunder warehouse linelending and master repurchase agreements with
First Union National Bank under which the Companyare scheduled to mature in February 2000. As of
March 31, 1999, NovaStar Financial and NovaStar Mortgage can borrow up to $75
million under the warehouse lending agreement and $300 million under the master
9
repurchase agreement. NovaStar Financial had no borrowings outstanding as of
March 31, 1999 and December 31, 1998, and NovaStar Mortgage had borrowings of
$65,155,000 and $203,341,000 outstanding, respectively under these
arrangements. Borrowings under these arrangements are co-borrowers.secured by mortgage
loans. The Company also uses repurchase agreementsinterest rate on borrowings under the warehouse lending arrangement
is indexed to finance mortgage loan purchases. Funds borrowed againstthe federal funds rate. Under the master repurchase agreement,
borrowings are indexed to one-month LIBOR.
On February 12, 1999, two additional one-year agreements are also used to acquire loans from NovaStar Mortgage. Residual
financing is another short-term borrowing instrument currently available to the
Company.
Using individual assets as collateral for repurchase agreements, the
Company has financed acquisitions of agency-issued mortgage securities. These
agreements have beenwere executed with
a number of reputable securities dealers.
Under the terms of all financingFirst Union whereby NovaStar Financial and/or NovaStar Mortgage can borrow up
to $20 million secured by residual interests in CMOs issued by NovaStar
Financial, its affiliates or subsidiaries. Borrowings under these arrangements
lending institutions require
"over-collateralization" from the Company. The value of the collateral generally
must exceed the allowable borrowing by two tobear interest at one-month LIBOR plus five percent. As of March 31, 1999,
NovaStar Financial had no borrowings under this financing arrangement. In
connection with executing the renewals and additional agreements, NovaStar
Financial issued warrants to First Union to acquire 350,000 shares of NovaStar
common stock for $6.94 per share. In exchange for the new warrants, First Union
returned 186,667 warrants that were purchased in NovaStar Financial's 1996
private placement. The new warrants expire on February 12, 2002.
All arrangements with First Union require NovaStar Financial and NovaStar
Mortgage to maintain minimum tangible net worth, meet equity ratio tests and
comply with other customary debt covenants.
As of December 31, 1998, NovaStar Financial also had a result,short-term financing
arrangement with GMAC/Residential Funding Corporation (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 connection with the Company must have capital availableagreement, NovaStar Financial issued 812,731 warrants to
cover this "haircut."
Table X displaysGMAC/RFC for the amountspurchase of NovaStar Financial's stock at $4.63 per share.
NovaStar Financial had no other short-term borrowings outstanding under borrowing arrangements as of
September 30,December 31, 1998. 12
Table X
Borrowings
September 30, 1998 (dollarsIn February of 1999, NovaStar Financial used financing
sources at First Union to pay this debt in thousands)
- --------------------------------------------------------------------------------
As of September 30, 1998
----------------------------------
Weighted Average Daily
Weighted Days to Balance During the
Average Reset or Nine Months Ended
Rate Maturity Balance September 30, 1998
Repurchase agreements secured by mortgage securities.......... 5.44% 4 $397,176 $511,460
Master repurchase agreement secured by mortgage loans......... 6.38 31 182,521 156,854
--------
Total repurchase agreements................................. 579,697
Warehouse line of credit...................................... Demand 46,779 20,043
--------
Total borrowings............................................ $626,476
========
full.
Collateralized mortgage obligations. On a long-term basis, the CompanyNovaStar
Financial finances its mortgage loans using collateralized mortgage obligations
(CMOs).commonly called CMOs. Investors in CMOs are repaid based on the performance of
the mortgage loans collateralizing the CMOs. CMOs are
outstanding as long as the mortgage loans are outstanding. However, under the
CMOs issued by NovaStar, the Company has the right to reacquire the mortgage
loans collateralizing the CMO when certain events occur. These non-recourse financing
arrangements match the loans with the financing arrangement for long periods of
time, as compared to repurchase agreements that mature frequently with interest
rates that reset frequently and have liquidity risk in the form of margin
calls. Table XI displaysUnder the terms of its CMOs, NovaStar Financial is entitled to
repurchase the mortgage loan collateral and, repay the remaining CMO, when
their aggregate principal balance falls below 35% for issue 97-01 and 25% for
issues 97-02, 98-01 and 98-02. Subprime 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 Liabilities and 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.
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 loans 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 mortgage 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.
10
Following is a summary of outstanding under collateralized
mortgage obligationsCMOs as of September 30, 1998.March 31, 1999 and December
31, 1998 (dollars in thousands):
Table XI5
Collateralized Mortgage Obligations
September 30,March 31, 1999 and December 31, 1998 (dollars in thousands)
- --------------------------------------------------------------------------------
Collateralized Mortgage Obligation Underlying Mortgage Loans
--------------------------- ------------------------------------------------------------------------------------ ------------------
Estimated Weighted Weighted
Remaining Interest Carrying Average Average Months Remaining Average
Principal Rate Valueto Call Principal Coupon
to Maturity--------- -------- ------------------ --------- --------
As of March 31, 1999:
NovaStar Home Equity
Series:
Issue 1997-1................... $181,770 5.97% $192,084 10.43% 241997-1.......... $141,994 5.19% 27 $146,350 10.64%
Issue 1997-2................... 179,371 5.84 184,013 10.45 261997-2.......... 147,394 5.19 29 153,355 10.36
Issue 1998-1................... 283,020 5.70 290,240 10.14 241998-1.......... 248,060 5.01 33 253,709 10.16
Issue 1998-2................... 308,986 5.70 273,308 (A) 9.991998-2.......... 286,384 5.05 37 Debt291,419 10.08
Unamortized debt
issuance costs, net....... (4,557) --net.. (3,933)
--------
$819,899
========
As of December 31, 1998:
NovaStar Home Equity
Series:
Issue 1997-1.......... $163,419 5.88% 29 $166,821 10.56%
Issue 1997-2.......... 164,496 5.88 31 166,544 10.37
Issue 1998-1.......... 268,152 5.69 35 272,742 10.01
Issue 1998-2.......... 300,161 5.74 38 301,749 9.95
Unamortized debt
issuance costs, net.. (4,284)
--------
$948,590 $939,645
========$891,944
========
------------------------------
(A) Does not include $43 millionNovaStar Financial acquires substantially all of its mortgage assets at a
premium. Premiums are amortized as a reduction of interest income over the
estimated lives of the assets. See Tables 6, 7, 8 and 9 for the impact of
principal payments on amortization. To mitigate the effect of prepayments on
interest income from mortgage loans, added as collateralNovaStar Financial generally strives to
acquire mortgage loans that have some form of prepayment penalty. During the
three months ended March 31, 1999, NovaStar Financial collected $656,000 in
prepayment penalties from borrowers compared with the $200,000 during Octoberthe same
period of 1998. Table 6 is an analysis of mortgage loans and prepayment
penalties. Prepayments on mortgage loans have generally been consistent with
management's expectations.
11
Table 6
Mortgage Loan Prepayment Penalties
March 31, 1999 and December 31, 1998 (dollars in thousands)
Weighted Average
-----------------------------------
Remaining
Prepayment Penalty
Percent with Period (in years)
Current Prepayment Loan-to- - Loans with
Principal Premium Penalty Coupon value Penalty
--------- ------- ------------ ------ -------- ------------------
As of March 31, 1999
Loans collateralizing
NovaStar Home Equity
Series (CMO):
1997-1................ $142,019 $ 6,972 63% 10.64% 75.1% 0.80
1997-2................ 149,392 3,118 73 10.36 78.6 0.94
1998-1................ 249,901 4,295 69 10.05 81.1 1.34
1998-2................ 289,815 4,524 72 9.95 81.1 1.93
All other loans......... 1,150 50 49 11.31 76.8 0.87
-------- -------
Total................... $832,277 $18,959 70% 10.17% 79.6% 1.38
======== =======
Weighted Average
-----------------------------------
Remaining
Prepayment Penalty
Percent with Period (in years)
Current Prepayment Loan-to- - Loans with
Principal Premium Penalty Coupon value Penalty
--------- ------- ------------ ------ -------- ------------------
As of December 31, 1998
Loans collateralizing
NovaStar Home Equity
Series (CMO):
1997-1................ $162,423 $ 7,975 65% 10.57% 75.1% 0.89
1997-2................ 163,049 3,403 72 10.37 78.5 1.10
1998-1................ 270,640 4,651 69 10.01 81.1 1.51
1998-2................ 301,527 4,703 71 9.95 81.1 2.09
All other loans......... 5,763 136 65 9.91 80.0 1.59
-------- -------
Total................... $903,402 $20,868 70% 10.15% 79.5% 1.52
======== =======
In periods of decreasing interest rates, borrowers are more likely to
refinance their mortgages to obtain a lowerbetter interest rate and monthly payment.rate. Even in rising rate
environments, borrowers tend to collectively repay their mortgage principal
balances earlier than is required by the terms of their mortgages. This is
particularly true for subprime borrowers who are seeking to upgrade their
credit rating to obtain a lower interest rate.
Table XII
displaysPrepayment rates in the historical prepayment speeds for mortgage loans collateralizingtable below represent the Company's CMOs. Table XVI provides an analysispercent of prepayment characteristicsloan principal
that pre-pays in the most recent one, three and twelve month periods and over
the life of the Company's mortgage loan portfolio.
13pool of loans. Percents are presented on an annual basis. For
instance, the CPR for 1998-1 in December 1998 was 20. This means that if you
ascribe the prepayment of loans for that month for one year, 20% of the loans
outstanding at the beginning of the year would prepay during the year.
Percentages for the life of the pool represent the percent that has paid off
since the loans were pooled as collateral for the CMO. Virtually all loans are
used as collateral for CMOs.
12
Table 7
Prepayment Speeds
Table XII
Prepayment Speed
- --------------------------------------------------------------------------------Weighted Constant Prepayment Rate
Average Age (Annual Percent)
------------------------------------------
One-month Three-month Twelve-monthCurrent of Loans at -------------------------
Principal Inception One- Three- Twelve-
Issue Date Balance (in months) month month month Life
----------------- --------- ----------- ----- ------ ------- ----
As of SeptemberMarch 31, 1999
NovaStar Home Equity
Series:
1997-1................ October 1, 1997 $142,019 7 45 40 37 33
1997-2................ December 11, 1997 149,392 3 25 27 26 22
1998-1................ April 30, 1998 249,901 3 26 24 -- 15
1998-2................ August 18, 1998 289,815 3 15 12 -- 10
As of December 31, 1998
NovaStar Home Equity
Series:
1997-1....................... 35.5 34.91997-1................ October 1, 1997 $162,423 7 44 36 33 31
1997-2................ December 11, 1997 163,049 3 42 32 22 21
1998-1................ April 30, 1998 270,640 3 20 17 -- 29.8
1997-2....................... 28.3 26.012
1998-2................ August 18, 1998 301,527 3 18 10 -- 17.7
1998-1....................... 13.3 12.8 -- 9.6
1998-2....................... 9.4 -- -- 7.8
As of December 31, 1997
NovaStar Home Equity Series:
1997-1....................... 18.6 15.7 -- 15.7
1997-2....................... 10.5 -- -- 10.59
To mitigate the Company's exposure to prepayment risk, and in order for the
CompanyNovaStar attempts to retain those
borrowers whose credit is considered desirable, the
Company created a portfolio retention department in the latter part of 1997 thatdesirable. NovaStar Financial encourages
borrowers who have satisfactorily met their obligations to refinance or rate
modify their loans with NovaStar.NovaStar Financial. Of the loans that prepaid during
the first nine monthsquarter of 1999, $783,000, or 2% of the loans were successfully
refinanced. No loans were rate-modified during the period. During the year
ended December 31, 1998, $11.5$13.1 million, or ten percent8% of the loans were successfully
refinanced and $1.9$2.0 million, or two percent of the loans, were
rate-modified. For the third quarter of 1998, $5.1 million, or eleven percent of
the loans were successfully refinanced and $1.2 million or three percent1% of the loans were rate-modified. Although
these loans are considered prepayments for the purposes of the information in
Table XII,7, they remain in the NovaStar Financial's loan portfolio.
13
Table XIII8 summarizes quarterly mortgage asset activity during 1999 and 1998 and 1997 and Table XIV9
details the amount of premium as a percent of principal at quarter end for 19981999
and 1997.
Table XIII1998.
Table 8
Mortgage Assets Activity
(thousands)
- ---------------------------------------------------------------------------------------------------------------
Mortgage
Mortgage Loans Mortgage Securities Total
------------------- ------------------------------------- ------------------ --------------------
Principal Premium Principal Premium Principal Premium
Balance, January 1, 1997................ $ -- $ -- $ 12,821 $ 434 $ 12,821 $ 434
Acquisitions............................ 170,120 10,530 16,422 405 186,542 10,935
Principal repayments and amortization... (338) (53) (977) (28) (1,315) (81)
--------- ------- --------- ------- ---------- -------
Balance, March 31, 1997................. 169,782 10,477 28,266 811 198,048 11,288
Acquisitions............................ 127,500 4,100 349,302 7,624 476,802 11,724
Principal repayments and amortization... (6,989) (420) (2,332) (133) (9,321) (553)
Dispositions............................ -- -- (98,267) (2,309) (98,267) (2,309)
--------- ------- --------- ------- ---------- -------
Balance, June 30, 1997.................. 290,293 14,157 276,969 5,993 567,262 20,150
Acquisitions............................ 136,582 2,449 2,202 87 138,784 2,536
Principal repayments and amortization... (22,227) (913) (19,291) (383) (41,518) (1,296)
--------- ------- --------- ------- ---------- -------
Balance, September 30, 1997............. 404,648 15,693 259,880 5,697 664,528 21,390
Acquisitions............................ 183,012 3,314 280,325 3,048 463,337 6,362
Principal repayments and amortization... (28,224) (1,146) (26,095) (363) (54,319) (1,509)
Dispositions............................ -- -- (9,263) (177) (9,263) (177)
--------- ------- --------- ------- ---------- -------
Balance, December 31,
1997..............1997................... 559,436 17,861 504,847 8,205 1,064,283 26,066
Acquisitions............................Acquisitions............ 207,976 3,758 270,059 3,806 478,035 7,564
Principal repayments and
amortization...amortization........... (27,224) (1,160) (63,892) (731) (91,116) (1,891)
Dispositions............................Dispositions............ -- -- (310,113) (5,294) (310,113) (5,294)
----------------- ------- --------- ------- ---------- -------
Balance, March 31,
1998.................1998................... 740,188 20,459 400,901 5,986 1,141,089 26,445
Acquisitions............................Acquisitions............ 290,350 5,148 80,237 823 370,587 5,971
Principal repayments and
amortization...amortization........... (43,849) (1,506) (47,201) (451) (91,050) (1,957)
Dispositions............................Dispositions............ (2,843) (53) -- -- (2,843) (53)
----------------- ------- --------- ------- ---------- -------
Balance, June 30, 1998..................1998.. 983,846 24,048 433,937 6,358 1,417,783 30,406
Acquisitions............................Acquisitions............ -- -- -- -- -- --
Principal repayments and
amortization...amortization........... (54,745) (1,442) (38,925) (493) (93,670) (1,935)
Dispositions............................Dispositions............ (4,666) (56) (7,781) (107) (12,447) (163)
----------------- ------- --------- ------- ---------- -------
Balance, September 30,
1998.............1998................... 924,435 22,550 387,231 5,758 1,311,666 28,308
Acquisitions............ 42,298 458 -- -- 42,298 458
Principal repayments and
amortization........... (62,953) (2,135) (15,215) (173) (78,168) (2,308)
Dispositions............ (378) (5) (372,016) (5,585) (372,394) (5,590)
-------- ------- --------- ------- ---------- -------
Balance, December 31,
1998................... $903,402 $20,868 $ 924,435 $22,550-- $ 387,231-- $ 5,758 $1,311,666 $28,308903,402 $20,868
======== ======= ========= ======= ========== =======
Acquisitions............ -- -- -- -- -- --
Principal repayments and
amortization........... (66,679) (1,830) -- -- (66,679) (1,830)
Dispositions............ (4,446) (79) -- -- (4,446) (79)
-------- ------- --------- ------- ---------- -------
Balance, March 31,
1999................... $832,277 $18,959 $ -- $ -- $ 832,277 $18,959
======== ======= ========= ======= ========== =======
14
Table XIVTable 9
Premium as a Percent of Principal
- --------------------------------------------------------------------------------
Total
Mortgage Mortgage Mortgage
Loans Securities Assets
-------- ---------- --------
As of:
March 31, 1999................................... 2.28% --% 2.28%
December 31, 1998................................ 2.31 -- 2.31
September 30, 1998....... 2.44% 1.49% 2.16%1998............................... 2.44 1.49 2.16
June 30, 1998............1998.................................... 2.44 1.47 2.14
March 31, 1998...........1998................................... 2.76 1.49 2.32
December 31, 1997........1997................................ 3.19 1.63 2.45
September 30, 1997....... 3.88 2.19 3.22
June 30, 1997............ 4.88 2.16 3.55
March 31, 1997........... 6.17 2.87 5.70
14
Stockholders' equity. During the first quarter of 1999, NovaStar Financial
increased its equity from $87 million at December 31, 1998 to $120 million at
March 31, 1999. This was primarily a result of the issuance of 4,285,714 shares
of Class B 7% cumulative convertible preferred stock in March 1999. Gross
proceeds on the issuance aggregated $30 million. The issuance of these
preferred shares will have an impact on future earnings per share as discussed
under "Net Income" below.
Also, included in the accumulated other comprehensive income component of
stockholders' equity as of March 31, 1999 is NovaStar Financial's portion of
the unrealized gain on available-for-sale securities held by NovaStar Mortgage.
NovaStar Mortgage sold its first asset backed bonds in January 1999, which for
accounting and tax purposes was treated as a sale. The residual interests in
those transactions have been classified as available-for-sale securities.
Residual interests are discussed further under "Financial Statement Condition
as of March 31, 1999 and December 31, 1998--NovaStar Mortgage, Inc."
Results of Operations -- Nineof NovaStar Financial, Inc.--Three Months Ended September 30, 1998March 31,
1999 Compared to Ninethe Three Months Ended September 30, 1997March 31, 1998
Net LossIncome
During the ninethree months ended September 30, 1998, the CompanyMarch 31, 1999, NovaStar Financial recorded
net income of $5,567,000, a$1.7 million, $0.20 per diluted $0.64 per share, compared with a net lossincome
of $702,000, a$1.3 million, $0.15 per diluted $0.19share, for the three months ended March 31,
1998. In computing earnings per share, shares issued during the period are
weighted for the portion of the period they are outstanding. If the preferred
shares would have been outstanding for the entire first quarter of 1999,
NovaStar Financial's pro forma diluted earnings per share for the ninethree months
ended September 30,
1997.March 31, 1999, would have been $0.14 per share.
NovaStar Financial's main sources of revenue are interest earned on its
securitized mortgage loan portfolio and prepayment penalty income. In addition,
results indirectly reflect gains from the sale of whole loan packages to third
parties and securitizations of NovaStar Mortgage.
15
Net Interest Income
Interest Income. The Company hadTable 10 presents a summary of the average interest-earning assets, of $1.3
billionaverage
interest-bearing liabilities and the related yields and rates thereon for the
three months ended March 31, 1999 and 1998.
Table 10
Interest Analysis
Three Months Ended March 31, 1999 and 1998
(dollars in thousands)
Mortgage Loans Mortgage Securities Total
------------------------ ------------------------ --------------------------
Interest Annual Interest Annual Interest Annual
Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/
March 31, 1999 Balance Expense Rate Balance Expense Rate Balance Expense Rate
- -------------- -------- -------- ------ -------- -------- ------ ---------- -------- ------
Interest-earning
mortgage assets........ $830,558 $19,550 9.42% $ -- $ -- --% $ 830,558 $19,550 9.42%
======== ======== ==========
Interest-bearing
liabilities
Repurchase
agreements............ $ -- $ -- --% $ -- $ -- --% $ -- $ -- --%
Collateralized
mortgage
obligations........... 862,559 12,139 5.63 -- -- -- 862,559 12,139 5.63
Other borrowings....... 17,051 490 11.47 -- -- -- 17,051 490 11.47
Cost of derivative
financial
Instruments hedging
liabilities........... 580 580
------- -------
Total borrowings..... $879,610 $13,209 6.01 $ -- $ 879,610 $13,209 6.01
======== ------- ----- ======== ========== ======= -----
Net interest income.... $ 6,341 $ -- $ 6,341
======= =======
Net interest spread.... 3.41% --% 3.41%
===== ==== =====
Net yield.............. 3.05% -- % 3.05%
===== ==== =====
Mortgage Loans Mortgage Securities Total
------------------------ ------------------------ --------------------------
Interest Annual Interest Annual Interest Annual
Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/
March 31, 1998 Balance Expense Rate Balance Expense Rate Balance Expense Rate
- -------------- -------- -------- ------ -------- -------- ------ ---------- -------- ------
Interest-earning
mortgage assets........ $619,666 $14,550 9.39% $582,264 $9,364 6.43% $1,201,930 $23,914 7.96%
======== ======== ==========
Interest-bearing
liabilities
Repurchase
agreements............ $136,145 $ 1,836 5.39% $589,267 8,421 5.72% $ 725,412 $10,257 5.66%
Collateralized
mortgage
obligations........... 435,940 7,214 6.62 -- -- -- 435,940 7,214 6.62
Other borrowings....... 27,173 324 4.77 -- -- -- 27,173 324 4.77
-------- -------- ----------
Cost of derivative
financial
Instruments hedging
liabilities........... 467 180 647
------- ------ -------
Total borrowings..... $599,258 $ 9,841 6.57 $589,267 8,601 5.84 $1,188,525 $18,422 6.21
======== ------- ----- ======== ------ ========== ======= -----
Net interest income.... $ 4,709 $ 763 $ 5,472
======= ====== =======
Net interest spread.... 2.82% 0.59% 1.75%
===== ==== =====
Net yield.............. 3.04% 0.52% 1.82%
===== ==== =====
16
Interest income. Average interest-earning assets were $830.6 million during
the ninethree months ended September 30, 1998, including $781.8
millionMarch 31, 1999, all of which were mortgage loans, and $478.1 million of mortgage securities
compared with average interest-earning assets of $351.6$1.2 billion for the same
period of 1998, which included $582.3 million of mortgage securities. As
mentioned earlier, NovaStar Financial sold all of its mortgage securities in
October 1998 to meet short-term liquidity needs faced in the fourth quarter of
1998. Accordingly, no interest income was recognized on mortgage securities
during the ninethree months ended September 30, 1997.March 31, 1999. Mortgage securities earned $9.4
million for the months ended March 31, 1998, or a yield of 6.4%. During the
ninethree months ended September 30, 1998,March 31, 1999, mortgage loans earned $56.3$19.6 million, or a
yield of 9.6 percent,9.4%, compared with $14.7$14.6 million, or a yield of 9.1 percent9.4% for the nine months ended September 30,
1997. Mortgage securities earned $22.9 million for the nine months ended
September 30, 1998, or a yieldsame
period of 6.4 percent, compared with $6.8 million, or a
yield of 6.7 percent for the nine months ended September 30, 1997.1998. In total, assets earned $79.2$19.6 million, or an 9.4% yield for
three months ended March 31, 1999. During the same period of 1998, assets
earned $23.9 million or a 8.4 percent yield for the nine months ended
September 30, 1998. During the nine months ended September 30, 1997, assets
earned $21.5 million or an 8.2 percent8.0% yield.
A substantial portion of the mortgage assets owned by the Company have interest rates that fluctuate
with short-term market interest rates. However, many of these assets have
initial coupons that are lower than current market rates ("teaser" rates).rates. Rates on the Company's assets
are expected to increase to their full potential as the assets "season". Table XV is a summary of the
Company's mortgage assets by type, presenting their current and fully indexed
weighted-average coupons.
Table XV
Mortgage Assets by Product/Type and Weighted Average Coupon
September 30, 1998 (dollars in thousands)
- --------------------------------------------------------------------------------
Weighted Average
Coupon
----------------
Outstanding Fully
Product/Type Principal Current Indexed
Mortgage loans:
Two and three year fixed/adjustable thereafter.. $ 521,535 10.15% 10.90%
Fixed rate (30 Yr, 15 Yr, 30/15)................ 301,087 10.02 --
Other (1 year CMT, 6 month LIBOR)............... 101,813 10.19 10.81
----------
Total mortgage loans........................ 924,435
Mortgage securities issued by:
Federal National Mortgage Association........... 259,860 7.04 6.64
Government National Mortgage Association........ 123,211 5.40 6.87
Federal Home Loan Mortgage Corporation.......... 4,160 7.54 6.81
----------
Total mortgage securities................... 387,231
----------
Total............................................. $1,311,666
==========
15
The Company acquires substantially all of its mortgage assets at a premium.
Premiums are amortized as a reduction of interest income over the estimated
lives of the assets. See Tables XII, XIII and XIV for the dollar impact of
principal payments on amortization. To mitigate the effect of prepayments on
interest income from mortgage loans, the Company generally strives to acquire
mortgage loans that have some form of prepayment penalty. During the nine
months ended September 30, 1998 and the third quarter of 1998, the Company
collected $1.3 million and $625,000, respectively, in prepayment penalties from
borrowers. Table XVI is an analysis of mortgage loans and prepayment penalties.
Prepayments on mortgage loans of the Company have been consistent with
management's expectations.
Table XVI
Mortgage Loan Prepayment Penalties
September 30, 1998 (dollars in thousands)
- ---------------------------------------------------------------------------------------------------------
Weighted Average
------------------------------------
Remaining
Percent with Prepayment Penalty
Current Prepayment Loan-to- Period (in years)
Principal Premium Penalty Coupon value Loans with Penalty
Loans collateralizing NovaStar
Home Equity Series (CMO):
1997-1....................... $183,760 $ 9,375 70.6% 10.45% 75.02% 1.44
1997-2....................... 181,329 3,049 70.8 10.31 78.14 1.77
1998-1....................... 286,746 4,306 68.7 9.99 81.04 2.43
1998-2....................... 268,312 5,266 69.6 9.90 80.88 3.13
All other loans................. 4,288 554 70.1 9.39 81.96 3.41
-------- -------
Total........................... $924,435 $22,550 69.8 10.11 79.24 2.31
======== =======
season.
As noted above,in Table 10, interest income is a function of volume and rates.
Management will continue to monitor the market for mortgage securities and whole
loan mortgage pools and will acquire mortgage assets that are appropriate for
its overall asset/liability strategy.
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.
Interest Expense.expense. The cost of borrowed funds for the Company was $60.9$13.2 million during the
ninethree months ended September 30, 1998,March 31, 1999, or 6.2 percent6.0% of average borrowings, compared with
$16.2$18.4 million for the ninesame period of 1998, or 6.2% of average borrowings. The
make up of interest expense is significantly different for the three months
ended September 30, 1997, or 6.4 percentMarch 31, 1999 compared with same period of average borrowings.1998. This is due to the
following factors:
. The majority of mortgage loans serve as collateral on collateralized
mortgage obligations at March 31, 1999. At March 31, 1998, 60% of
mortgage loans served as collateral on collateralized mortgage
obligations while the remaining loans served as collateral on higher-
rate warehouse and repurchase facility debt. The change in financing
composition is primarily due to the fact that NovaStar Financial
discontinued purchasing mortgage loans from NovaStar Mortgage during the
last half of 1998. Prior to that point in time, NovaStar Financial had
purchased 100% of NovaStar Mortgage's loan production. Loans held in
portfolio prior to securitization were financed by repurchase
facilities. Under agreements with NovaStar Mortgage, NovaStar Financial
reimbursed NovaStar Mortgage for its warehousing costs incurred prior to
sale. Repurchase and warehouse facility costs for the three months ended
March 31, 1998 are included under repurchase agreements and other
borrowings in Table 10.
. NovaStar sold all its mortgage securities in October 1998 and paid off
all related repurchase financing on these assets. No mortgage securities
have been purchased since that time.
. Due to the liquidity crisis faced in the last quarter of 1998,
GMAC/Residential Funding Corporation provided additional financing under
a residual line that was secured by mortgage interests in NovaStar's
asset-backed bonds. This debt was paid off in February 1999 with funds
from a similar facility provided by First Union National Bank. The
interest on this facility during the three months ended is included as a
component of other borrowings in Table 10.
Advances under the warehouse line of credit bear interest based on the
Federal Fundsfederal funds rate plus a spread. The Company receivesNovaStar Financial and NovaStar Mortgage
receive credits to warehouse line interest based on
restricted cash balances maintained
with First Union. Advances under the master repurchase agreement bear interest
at rates based on LIBOR, plus a spread. During the ninethree months ended September 30, 1998 and 1997,March 31,
1999, the one-month LIBOR averaged 5.6 percent.4.95 percent compared with 5.65 percent for
the three months ended March 31, 1998. As with interest income, the Company's 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 Fundsfederal
funds rate.
Table XVII presents a summary of the average interest-earning assets,
average interest-bearing liabilities and the related yields and rates thereon
for the nine months ended September 30, 1998.
Table XVII
Interest Analysis
Nine Months Ended September 30, 1998 (dollars in thousands)
- ----------------------------------------------------------------------------------------------------------------------------------
Mortgage Loans Mortgage Securities Total
-------------------------- --------------------------- ----------------------------
Interest Annual Interest Annual Interest Annual
Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/
Balance Expense Rate Balance Expense Rate Balance Expense Rate
Mortgage Assets......................... $781,786 $56,274 9.60% $478,125 $22,881 6.38% $1,259,911 $79,l55 8.38%
======== ======== ==========
Liabilities.............................
Repurchase agreements.................. $156,854 7,643 6.50% $511,460 20,785 5.42% $ 668,314 28,428 5.67%
Collateralized mortgage obligations.... 626,960 29,659 6.31 626,960 29,659 6.31
Other borrowings....................... 20,043 647 4.30 21,492 647 4.01
-------- ----------
Cost of derivative financial 577
Instruments hedging liabilities....... 1,637 ------- 2,214
------- -------
Total borrowings.................... $803,857 39,586 6.57 $511,460 21,362 5.57 $1,316,766 60,948 6.18
======== ------- ======== ------- ========== -------
Net interest income.................... $16,688 $ 1,519 $18,207
======= ======= =======
Net interest spread.................... 3.03% 0.81% 2.20%
==== ==== ====
Net yield.............................. 2.85% 0.42% 1.93%
==== ==== ====
1617
Net Interest Incomeinterest income and Spread.spread. Net interest income during the ninethree months
ended September 30, 1998March 31, 1999 was $18.2$6.3 million or 1.93 percent3.0% of average interest-
earninginterest-earning
assets, compared with 5.3$5.5 million, or 2.02 percent1.8% of average interest-
earninginterest-earning assets
during the nine months ended September 30, 1997.same period of 1998. Net interest spread was 3.4% during the three
months ended March 31, 1999 compared with 1.8% during the three months ended
March 31, 1998. The significant increase in net margin and spread for the Company was 2.20 percent during the ninethree
months ended September
30, 1998March 31, 1999 compared with 1.73 percent during the ninethree months ended September 30,
1997.March 31, 1998
is due to the change in NovaStar Financial's asset and liability composition.
During the latter part of 1998, NovaStar Financial sold all mortgage securities
and paid off related financing. NovaStar Financial has not purchased any more
of these lower-yielding mortgage assets. Net interest income and the spread are
functions of the yield of the
Company's assetsasset yields relative to its costs of funds. The Company's cost of funds
has remained relatively low and stable during 1998. This lower cost of funds
offsets, to some degree, the lower yield on "teased" assets discussed above. The volume of assets
and liabilities and how well the Company manages the spread between earnings on assets and the cost
of funds is managed will dictate future net interest income.
Impact of Interest Rate Agreements. The Companyinterest rate agreements. NovaStar Financial has entered into
certain
interest rate agreements and financial futures contracts designed to mitigate exposure to interest rate risk.
Interest rate cap agreements require the
CompanyNovaStar Financial to pay a monthly fixed
premium while allowing it to receive a rate that adjusts with LIBOR, when rates
rise above a certain agreed-upon rate. Other
agreements executed by the Company include simple fixed to floating interest
rate swaps. These agreements are used to alter, in
effect, the interest rates on funding costs to more closely match the yield on
interest-earning assets.
During the ninethree months ended September 30,March 31, 1999 and 1998, the Company incurred net interest expense
was incurred on thesehedging agreements of $2.2 million,$580,000 and $647,000, respectively,
which is included as a component of interest expense. The net interest expense forfollowing table
provides details of the same period
ending September 30, 1997 was $808,000. Table XVIII details the Company's interest rate agreements as of September 30, 1998 (dollars in thousands):March 31, 1999 and
December 31, 1998.
Table XVIII11
Interest Rate Agreements
As of September 30,March 31, 1999 and December 31, 1998
(dollars in thousands)
- ---------------------------------------------------------------------------------------------------------------------Unrealized
------------
Weighted
Average
Unrealized Weighted Interest Rate Accrued Interest
Notional -------------- Days to Cap ------------------- -------------------
Value Gains Losses Maturity Rate
Receivable Payable Receivable Payable-------- ----- ------ -------- ----
Interest rate swap agreements
-- fixed rate pay............ $ 455,000 $ -- $ 7,845 674 NA 5.64% 6.11% $2,671 $2,736As of March 31, 1999:
Interest rate cap agreements.. 625,000 -- 3,645 710agreements............... $625,000 $-- $1,914 644 6.27%
NA NA -- --
---------- ----- -------
$1,080,000 $ -- $11,490
========== ===== =============== ==== ======
As of December 31, 1998:
Interest rate cap agreements............... $625,000 $-- $2,483 734 6.27%
======== ==== ======
As discussed in the section, "Events Subsequent to September 30, 1998", the
Company terminated all swap agreements and paid off the liabilities pertaining
to these hedging instruments in October 1998, recognizing losses aggregating
$8.0 million.
Fees from NovaStar Mortgage, Inc.
The Company and NovaStar Mortgage are party to a Mortgage Loan Sale and
Purchase Agreement whereby the Company has committed to acquire the wholesale
loan originations of NovaStar Mortgage. Under the terms of the agreement, if
NovaStar Mortgage chooses to sell its loan originations to other parties, it
pays a fee to the Company for not delivering its production under the purchase
commitment. During the first two quarters of 1998, the Company acquired
virtually all of the mortgage loans originated by NovaStar Mortgage. As a
result, there were no significant fees paid to the Company during the first half
of 1998. During the 1998 third quarter, NovaStar Mortgage retained
substantially all of its production with the intent of selling loans to third
parties. Under the terms of the Mortgage Loan Sale and Purchase Agreement,
NovaStar Mortgage remitted fees aggregating $3.8 million to the Company during
the nine months ended September 30, 1998.
Other Income
The Company may deem it appropriate to sell securities and loans, from time
to time, to reallocate the Company's capital. During the nine months ended
September 30, 1998, the Company recognized $108,000 in net gains on sales of
mortgage securities with a principal balance of $318 million. Also, during this
same period, the company sold two separate pools of loans (principal of $7.5
million) recognizing gains of $315,000.
Additional components of otherOther income during the ninethree months ended September 30, 1998 areMarch 31, 1999 primarily consists
of prepayment penalties of $1.3 million$656,000, net gains recognized on the sale of real
estate owned properties of $77,000, interest earned on securitization funds
held in trust of $57,000, and interest earned on notes receivable from founders
of $300,000.
As discussed in "Events Subsequent to September 30, 1998"$120,000. Other income for the Companysame period of 1998 primarily consisted of
prepayment penalties of $200,000, net gains on mortgage security sales of
$92,000 and NovaStar Mortgage sold all mortgage securities at an aggregate lossinterest earned on notes receivable from founders of $15.4
million during October 1998.
17
$57,000.
Provisions for Credit Losses
The CompanyNovaStar Financial provides regular reservesallowances for credit losses including
principal and interest, on its
mortgage loans. Management continuously evaluates the potential for credit
losses for mortgage loans held in its portfolio. Since
the Company has limited actual performance history for its loan portfolio,
lossesProvisions have been provided for primarilymade based on
NovaStar Financial's historical experience, general industry trends and
on
the judgement of management. The Company believes that loanmanagement's judgement. Loan defaults occur throughout the life of a loan or group of
loans. As a result, provisions for credit losses are recorded against income
over the estimated life of the loans, rather than immediately upon acquisition
of the loan.loans. Provisions are based upon total expected losses and an estimated
loss curve. Losses are recognized and loans are charged off upon foreclosure.
Losses upon final liquidation are reflected in earnings. Foreclosed assets are
recorded at the lower of the remaining unpaid loan balance or the estimated net
realizable value of the foreclosed asset.
18
During the ninethree months ended September 30, 1998,March 31, 1999, NovaStar Financial provided
$2.3 million to the Company provided $3.4 millionallowance for credit losses, compared with $1.4$1.0 million
during the ninesame period of 1998. The increase is due partly to the increase in
NovaStar Financial's securitized mortgage loan portfolio, overall seasoning of
the portfolio and changes in the timing of foreclosures. Management has
accelerated provisions in 1999 in recognition of this trend to ensure the
credit allowance is maintained at an adequate level. Charge-offs during the
three months ended September 30, 1997.March 31, 1999 were $2.4 million compared with $518,000
during the same period of 1998. Management believes the increases in charge-
offs are principally for the same reasons as discussed for the loan loss
provision.
During the third quarter of 1998, the CompanyNovaStar Financial and NovaStar Mortgage
executed an agreement with Commonwealth Mortgage Acceptance Corporation (CMAC)
whereby CMAC will provide insurance coverage on certain mortgage loans owned by
the Company and NovaStar Mortgage.loans. As of September 30,March 31,
1999 and December 31, 1998, approximately 29
percent27% and 26% of the loans owned by
the CompanyNovaStar Financial and substantially all of the loans owned by NovaStar
Mortgage are covered under this agreement. During the third
quarter of 1998,three months ended March
31, 1999, total premiums paid to CMAC totaled $291,000, which$457,000 and are included as a
component of loan servicing expenses onexpense in the Company's financial statements. Management
believes that its exposure to credit loss on loans insured by CMAC is minimal and, therefore, has not included these loans in
determining its loan loss provision.minimal.
Management expects that a substantial portion of loans originated in future
periods will be covered under similar insurance arrangements.
The Company charges off a loan when in management's best judgment the loan
is uncollectable. In addition, the Company will charge off a loan to the lower
of cost or market when it takes title of the property collateralizing the loan.
As of September 30, 1998, the CompanyMarch 31, 1999, NovaStar Financial had 86149 loans in real estate owned
with a principal balancecarrying value of $9.6$14.2 million andcompared with 126 loans with a carrying
value of $7.3 million.
Charge-offs during the nine months ended September 30, 1998 were $3.0 million.
The Company had no charge-offs during the same period$10.6 million as of 1997. As the portfolio
continues to season, management expects that the actual loss rate may continue
to increase.December 31, 1998.
Table XIX12 is a rollforward of the reserveallowance for credit losses during 19981999 and
1997.1998.
Table 12
Rollforward of Allowance for Credit Losses
1999 and 1998
Table XIX
Rollforward1999 1998
-------- -----------------------------------------
June
March 31 December 31 September 30 30 March 31
-------- ----------- ------------ ------ --------
Beginning balance.......... $3,573 $2,757 $3,341 $2,871 $2,313
Provision for credit
losses.................... 2,299 4,030 1,179 1,145 1,076
Amounts charged off, net
of Reserve for Credit Losses
Ninerecoveries............. (2,380) (3,214) (1,763) (675) (518)
------ ------ ------ ------ ------
Ending Balance............. $3,492 $3,573 $2,757 $3,341 $2,871
====== ====== ====== ====== ======
Loans owned by NovaStar Financial are serviced by NovaStar Mortgage. Details
regarding the delinquencies, defaults, and loss statistics of the loan
servicing portfolio are presented in Tables 21 and 22, in "Financial Condition
of NovaStar Mortgage as of March 31, 1999 and December 31, 1998".
19
General and Administrative Expenses
General and administrative expenses for the three months ended March 31,
1999 and 1998 are provided in Table 13. Table 14 displays the relationship of
portfolio expenses to net interest income during 1999 and 1998 by quarter.
Table 13
General and Administrative Expenses
(dollars in thousands)
Three Months Ended September 30,Three Months Ended
March 31, 1999 March 31, 1998
------------------- -------------------
Percent of Percent of
Net Interest Net Interest
Income Income
------------ ------------
Compensation and Yearbenefits............. $ 585 9.2% $ 436 8.0%
Professional and outside services..... 332 5.2 56 1.0
Other loan servicing.................. 470 7.4 44 0.8
Office administration................. 208 3.3 181 3.3
Other................................. 42 0.7 92 1.7
------ ---- ------ ----
Total portfolio-related expenses...... 1,637 25.8% 809 14.8%
==== ====
Forgiveness of notes receivable from
founders............................. -- 271
Fees for services provided by NovaStar
Mortgage, Inc........................ 2,165 2,130
------ ------
Total................................ $3,802 $3,210
====== ======
Table 14
Portfolio Related Expenses as a
Percent of Net Interest Income
1999 and 1998
Percent of Net
Interest Income
---------------
1998:
First quarter............................................. 25.8%
1998:
1998...................................................... 25.6%
Fourth quarter............................................ 89.7
Third quarter............................................. 22.3
Second quarter............................................ 20.1
First quarter............................................. 14.8
Compensation and benefits includes employee base salaries, benefit costs and
incentive compensation awards. The increase in compensation and benefits for
the three months ended March 31, 1999 compared with the same period of 1998 is
primarily due to salary increases and bonus accruals.
Other loan servicing for the three months ended March 31, 1999 consists
principally of the fees paid to CMAC as discussed under the "Provisions for
Credit Losses." For the same period of 1998, these fees included the direct
costs associated with the mortgage loan servicing operation that are paid
directly to independent third parties for such things as property appraisals
and borrower location services.
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
significant increase in the first quarter of 1999 is a result of legal fees
incurred on the
20
structuring of various financing arrangements, the filing of shelf registration
statements and general company growth. 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 NovaStar
Mortgage for the three months ended March 31, 1999 and 1998:
Three Months
Ended March 31,
---------------
1999 1998
------- -------
Amounts paid to NovaStar Mortgage:
Loan servicing fees..................................... $ 1,115 $ 630
Administrative fees..................................... 1,050 1,500
------- -------
$ 2,165 $ 2,130
======= =======
The fees for services provided by NovaStar Mortgage represent the following:
. Administrative fees for services, including the development of loan
products, underwriting, funding, and quality control.
. Servicing fees to NovaStar Mortgage. NovaStar Mortgage receives 50 basis
points on the collected principal balance of loans serviced for NovaStar
Financial.
The increase in loan servicing fees paid to NovaStar Mortgage for the three
months ended March 31, 1999 compared with the three months ended March 31, 1998
is due to the increase in NovaStar Financial's mortgage loan portfolio serviced
by NovaStar Mortgage.
The decline in the administrative fees paid to NovaStar Mortgage during
these same periods is a result of the reduction in NovaStar Mortgage's
production volumes as indicated in Table 17. The decline in first quarter 1999
originations reflect decisions made by management as a result of constrained
liquidity circumstances the subprime mortgage industry faced during the latter
part of 1998. Accordingly, the administrative fees NovaStar Financial paid to
NovaStar Mortgage during this same period were reduced.
Equity in Earnings (Loss) of NFI Holding Corporation
For the three months ended March 31, 1999, NFI Holding recorded net income
of $557,000 compared with a net loss of $274,000 for the same period of 1998.
NovaStar Financial records its portion of the income (loss) as equity in net
earnings (loss) of NFI Holding in its income statement. NFI Holding's net
income (loss) includes the net earnings of NovaStar Mortgage and NovaStar
Capital, Inc., subsidiaries of NFI Holding as discussed under "Basis of
Presentation". NFI Holding's financial position and results of operation for
the three month period ended March 31, 1999 and 1998 are discussed further
under the heading "NFI Holding Corporation".
21
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 15 is a summary of the differences
between net income or loss reported for GAAP and taxable income for 1999 and
1998.
Table 15
Taxable Income (Loss)
1999 and 1998 (in thousands)
1999 1998
------- -----------------------------------
First Fourth Third Second First
Quarter Quarter Quarter Quarter Quarter
------- -------- ------- ------- -------
Net income (loss)................ $1,726 $(27,388) $2,394 $1,894 $1,279
Results of NFI Holding and
subsidiaries.................... (551) 320 2,447 -- 271
Provision for credit losses...... 2,299 4,030 1,179 1,145 1,076
Loans charged-off................ (2,380) (3,214) (1,763) (675) (518)
Capital losses................... -- 14,963 -- -- --
Other, net....................... 381 (370) 96 208 (2)
------ -------- ------ ------ ------
Estimated taxable income (loss).. $1,475 $(11,659) $4,353 $2,572 $2,106
====== ======== ====== ====== ======
The net loss realized during the 1998 fourth quarter resulted in NovaStar
Financial incurring a net loss for both financial reporting and income tax
purposes for the 1998 fiscal year. NovaStar Financial has a net operating loss
carryforward of approximately $2.6 million available to offset taxable income
in 1999, and thereby reduce the amount of required distributions under REIT
guidelines. In addition, the $0.35 per common share, $2.8 million dividend paid
on April 15, 1999 represents a distribution of 1999 taxable income.
NFI Holding Corporation
Since NovaStar Financial discontinued its original strategy of 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.
22
The following table presents NFI Holding's consolidated financial statements
as of March 31, 1999 and 1998, which primarily consist of the assets,
liabilities, and operational results of NovaStar Mortgage. Accordingly, the
discussion that follows focuses on NovaStar Mortgage.
Table 16
NFI Holding Corporation
Condensed Consolidated Balance Sheets (in thousands)
March 31, December 31,
19971999 1998
----------- ------------
(unaudited)
Assets
Cash and cash equivalents............................ $ 249 $ 5,759
Restricted cash...................................... 28,300 33,007
Mortgage loans....................................... 87,456 216,839
Mortgage securities (available-for-sale)............. 9,860 --
Other assets......................................... 6,860 4,492
-------- --------
Total assets..................................... $132,725 $260,097
======== ========
Liabilities and Stockholders' Equity
Liabilities:
Borrowings......................................... 65,155 203,341
Due to NovaStar Financial, Inc..................... 61,071 51,528
Accounts payable and other liabilities............. 4,352 5,215
Stockholders' equity............................... 2,147 13
-------- --------
Total liabilities and stockholders' equity....... $132,725 $260,097
======== ========
NFI Holding Corporation
Condensed Consolidated Statements of Operations
Three months ended March 31 (unaudited; in thousands)
1999 1998
------ -----
Interest income.................................................. $2,745 $ 990
Interest expense................................................. 1,561 874
------ -----
Net interest income.......................................... 1,184 116
Income:
Fees from third parties........................................ 342 680
Administrative servicing fees received from NovaStar
Financial..................................................... 2,165 2,130
Net gain on sales of mortgage loans............................ 2,847 --
------ -----
Total Income................................................. 5,354 2,810
General and administrative expenses.............................. 5,747 3,200
------ -----
Income (loss) before taxes....................................... 791 (274)
Income tax expense............................................... 234 --
------ -----
Net income or (loss)............................................. $ 557 $(274)
====== =====
23
Financial Condition of NovaStar Mortgage, Inc. as of March 31, 1999 and
December 31, 1998
Mortgage Loan Originations. NovaStar Mortgage originated more than 800
subprime residential mortgage loans during the three months ended March 31,
1999 with an aggregate principal amount of $82 million. Virtually all of
NovaStar Mortgage's mortgage assets at March 31, 1999 and December 31, 1998
consist of subprime 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 17 is a summary of wholesale loan originations for 1999 and 1998.
Table 18 presents a summary of mortgage loan sales of NovaStar Mortgage during
1999 and 1998. Table 19 is a summary of loan costs for NovaStar Mortgage
relative to its wholesale loan originations.
Table 17
1999 and 1998 Quarterly Wholesale Loan Originations--NovaStar Mortgage, Inc.
(dollars in thousands)
Weighted Average
Average ------------------------- Percent with
Number Loan Price Paid to Loan to Credit Prepayment
of Loans Principal Balance Broker Value Rating (A) Coupon Penalty
-------- --------- ------- ------------- ------- --------- ------ ------------
1999:
First quarter......... 865 $ 82,495 $ 95 100.5 81% 4.95 9.88% 89%
1998:
Fourth quarter........ 1,501 $133,739 $ 89 100.8 81% 4.75 9.78% 88%
Third quarter......... 2,655 240,498 90 101.4 81 4.37 10.11 79
Second quarter........ 3,133 294,303 94 101.3 81 4.43 9.93 71
First quarter......... 2,033 207,976 102 101.4 81 4.45 9.93 65
----- -------- ---- ----- --- ---- ----- ---
1998 total.............. 9,322 $876,516 $ 94 101.3 81% 4.47 9.96% 74%
===== ======== ==== ===== === ==== ===== ===
- --------
(A) AAA=7, AA=6, A=5, A-=4, B=3, C=2, D=1
24
Table 18
Mortgage Loan Sales to Third Parties--NovaStar Mortgage, Inc.
Three Months Ended March 31, 1999 and Year Ended December 31, 1998
(dollars in thousands)
Weighted
Average Percent
Principal Gain Price To Gain of
Amount Recognized Par Principal
--------- ---------- -------- ---------
1999:
First quarter......................... $ 73,743 $1,576 103.6 2.14%
1998:
Fourth quarter........................ $108,800 $1,985 103.6 1.82%
Third quarter......................... 18,133 826 106.0 4.56
Second quarter........................ 6,742 173 106.0 2.57
First quarter......................... -- -- -- --
-------- ------ ----- ----
1998 total............................ $133,675 $2,984 104.0 2.23%
======== ====== ===== ====
Table 19
Costs of Loan Production NovaStar--Mortgage, Inc.
Three Months Ended March 31, 1999 and Year Ended December 31, 1998
(dollars in thousands)
1999 1998
------- --------------------------------------
First Fourth Third Second First
Quarter Quarter Quarter Quarter Quarter
------- -------- -------- -------- --------
Total costs of loan
production (A).............. $ 4,778 $ 6,723 $ 4,975 $ 3,837 $ 3,079
Wholesale loan origination--
principal................... 82,495 133,739 240,498 294,303 207,974
Premium paid to broker....... 441 1,043 3,439 3,679 2,935
------- -------- -------- -------- --------
Total acquisition cost (B)... $87,714 $141,505 $248,912 $301,819 $213,988
======= ======== ======== ======== ========
Costs as a percent of
principal:
Loan production............ 5.8% 5.0% 2.1% 1.3% 1.5%
=== === === === ===
Premium paid to broker..... 0.5% 0.8% 1.4% 1.3% 1.4%
=== === === === ===
Total acquisition cost..... 6.3% 5.8% 3.5% 2.6% 2.9%
=== === === === ===
- --------
(A) Loan production general and administrative expenses as reported for GAAP,
plus net deferred loan costs.
(B) Principal, premium and general and administrative expenses associated with
loan production.
Table 20 is a summary of loans originated by NovaStar Mortgage by state for
1999 and 1998 by quarter. NovaStar Mortgage has continued to add more account
executives throughout the United States. As of March 31, 1999, NovaStar
Mortgage had 62 account executives covering nearly 40 states.
25
Table 20
Mortgage Loan Originations by State--NovaStar Mortgage, Inc.
1999 and 1998
Percent of Total Originations during Quarter
(based on original principal balance)
------------------------------------------------------
1999 1998
-------- -------------------------------------------
Collateral Location First Fourth Third Second First
- ------------------------------------------------------------------------------------------------------------------------------------------ -------- --------- -------- --------- --------
Florida............... 15% 24% 17% 16% 12%
Michigan.............. 12 6 5 5 5
Tennessee............. 9 6 4 4 4
Ohio.................. 8 9 4 5 2
California............ 6 2 6 9 15
Pennsylvania.......... 4 5 4 3 2
North Carolina........ 2 4 5 3 2
Washington............ 3 3 5 6 7
Texas................. 2 3 5 3 3
All other states...... 39 38 45 46 48
- --------
(A) Loans originated by NovaStar Mortgage, Inc.
NovaStar Mortgage's loan originations are funded through warehouse and
repurchase facilities at First Union and are discussed further in "Financial
Condition of NovaStar Financial as of March 31, 1999 and December 31, 1998" and
"Results of Operations of NovaStar Financial, Inc.--Three Months Ended March
31, 1999 Compared to the Three Months Ended March 31, 1998".
Mortgage Loan Sales. In a securitization executed by NovaStar Mortgage
during the first quarter of 1999, $165 million in loans were sold to a Special
Purpose Entity (SPE), of which $26 million settled in April 1999. Proceeds of
bonds issued by the SPE, $160 million, were used to pay for the mortgage loans
acquired from NovaStar Mortgage. The loans were sold without recourse by
NovaStar Mortgage. NovaStar Mortgage retained a residual certificate issued by
the SPE. As the owner of the residual certificate, NovaStar Mortgage will
receive the net cash flow of the SPE--the cash received from the mortgage loans
less interest, loan losses and other costs related to bond administration.
NovaStar Mortgage also retained loan servicing rights for the loans sold to the
SPE. The value of the retained interests--the residual certificate and the
mortgage servicing rights--have been recorded as assets and the loans sold have
been removed from the balance sheet of NovaStar Mortgage.
NovaStar Mortgage allocates 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. An active market
exists for this type of mortgage loan sale and, therefore, their value was
estimated based on prevailing market prices. Management is not aware of an
active market for the purchase of residual certificates and mortgage servicing
rights. The values of these assets were determined by discounting estimated
future cash flows using the cash out method. Following are the significant
values and assumptions used in determining the values of the assets sold and
values of the resulting retained assets.
Estimated average value of mortgage loans sold.................... 103.0%
Assumptions used in determining future cash flow:
Estimated prepayment speeds................................... 30 to 35 CPR
Estimated rate of default..................................... 70 CDR
Discount rate................................................... 16.5%
Value of residual certificate................................... $ 9,700,000
Value of mortgage servicing rights.............................. $ 646,000
Aggregate gain.................................................. $ 1,605,000
26
Of the aggregate gain recognized in the securitization, $355,000 will be
recorded upon the April closing.
The value of the residual interest has been classified as an available-for-
sale mortgage security on NovaStar Mortgage's balance sheet and had a carrying
value of $9.9 million as of March 31, 1999.
NovaStar Mortgage also sold more than $73 million of its whole loan
portfolio to unrelated third parties for cash.
Mortgage loan servicing. Loan servicing is also a critical part of NovaStar
Mortgage's 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. Subprime borrowers are prone to late payments and are more likely
to default on their obligations than conventional borrowers. NovaStar Mortgage
strives to identify issues and trends with borrowers early and take quick
action to address such matters.
Table 21 is a summary of delinquent loans in NovaStar Mortgage's servicing
portfolio as of March 31, 1999 and 1998 by quarter. Table 22 provides
summaries of delinquencies, defaults, and loss statistics as of March 31, 1999
and 1998 by quarter. The information presented in both tables include 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.
Table 21
Loan Delinquencies (90 days and greater) (A)
March 31, 1999 and 1998
1997
--------------------------------- -----------------------------------------------
September 30 June 30
1999 1998
-------- -----------------------------------------
March 31 December 31 September 30 June 30 March 31
Beginning balance................ $ 3,341 $2,871 $2,313 $1,444 $ 718 $170 $ --
Provision for credit losses.... 1,179 1,145 1,076 1,009 726 548 170
Amounts charged off, net of
recoveries.................... (1,763) (675) (518) (140) -- -- ---------- ----------- ------------ ------- ------ ------ ------ ------ ---- ----
Ending Balance................... $ 2,757 $3,341 $2,871 $2,313 $1,444 $718 $170
======= ====== ====== ====== ====== ==== ====
Table XX is a summary of delinquent loans as of September 30, 1998 and 1997
by quarter. Table XXI provides summaries of the Company's delinquencies,
defaults, and loss statistics as of September 30, 1998 and 1997 by quarter.
Other information regarding the credit quality of the Company's mortgage loans
are provided in Tables V, VI and VII.
Table XX
Loan Delinquencies (90 days and greater)
Nine Months Ended September 30, 1998 and Year Ended December 31, 1997 (A)
- --------------------------------------------------------------------------------------------------------------------------
1998 1997
--------------------------------- -----------------------------------------------
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)....................... 4.37% 5.45% 5.97% 5.86% 4.39% 2.71% -- -- --
1997-2 (Issued December
11, 1997)................. 5.38 5.62 4.97 4.72 2.23 -- -- -- --
1998-1 (Issued April 30,
1998)........................ 4.64 4.44 2.06 -- -- -- -- -- --
1998-2 (Issued April 30,August 18,
1998)........................ 3.72 2.35 0.40 -- --
1999-1 (Issued January 29,
1999) (B)................ 2.35 -- -- -- --
All mortgage loans..................loans in servicing
portfolio.................. 5.00 3.35 2.45 2.53 2.28 1.80 1.47% -- --
- --------------------
(A)--------
A) Includes loans in foreclosure or bankruptcy.
18B) This securitization was treated as a sale under SFAS 125 and accordingly
the mortgage loans and related liability are not included on NovaStar's
balance sheet.
27
Table XXI
Delinquencies, Defaults and Losses
September 30,Table 22
Delinquencies, Defaults and Losses
March 31, 1999 and December 31, 1998
(dollars in thousands)
- --------------------------------------------------------------------------------------------------------------------
NovaStar Home Equity Series ------------------------------------------(A)
--------------------------------------
March 31, 1999 1997-1 1997-2 1998-1 1998-2 1999-1 Other (A)(C) All Loans
-------------- -------- -------- -------- -------- ---------- ---------- ----------
Loan servicing portfolio................... $187,838 $185,093 $286,891 $267,744 $251,295 $1,178,861portfolio (B)........... $147,609 $167,685 $254,837 $291,747 $136,279 $ 74,237 $1,072,393
======== ======== ======== ======== ======== ========== Reserve==========
Allowance for Credit Losses:
Balance, July 1, 1998....................December 31, 1998............ $ 1,446816 $ 1,1181,049 $ 5851,163 $ 346 $ -- $ 192353 $ 3,3413,727
Provision for credit losses.............. 179 204 460 270 65 1,179losses........... 450 458 768 617 -- 176 2,469
Amounts charged off, net of
recoveries... (575) (957) (233)recoveries........................... (597) (707) (696) (302) -- 3 (1,763)21 (2,281)
-------- -------- -------- -------- -------- ---------- ----------
Balance, March 31, 1999............... $ 669 $ 800 $ 1,235 $ 661 $ -- $ 550 $ 3,915
======== ======== ======== ======== ======== ========== ==========
Defaults as a percent of loan servicing
Delinquent loans...................... 6.74% 5.07% 3.42% 3.51% 3.97% 1.91% 4.12%
==== ==== ==== ==== ==== ==== ====
Loans in foreclosure.................. 3.29 3.84 4.08 3.28 2.26 2.66 3.39
==== ==== ==== ==== ==== ==== ====
Real estate owned..................... 3.54 3.07 2.00 0.52 -- 1.13 1.66
==== ==== ==== ==== === ==== ====
NovaStar Home Equity Series (A)
--------------------------------------
December 31, 1998 1997-1 1997-2 1998-1 1998-2 Other (C) All Loans
----------------- -------- -------- -------- -------- ---------- ----------
Loan servicing portfolio (B)............ $168,255 $167,685 $273,583 $301,857 $268,587 $1,179,967
======== ======== ======== ======== ======== ==========
Allowance for Credit Losses:
Balance, January 1, 1998.............. $ 1,063 $ 967 $ -- $ -- $ 283 $ 2,313
Provision for credit losses........... 1,895 2,257 1,878 222 1,388 7,640
Amounts charged off, net of
recoveries........................... (2,142) (2,175) (715) 124 (1,318) (6,226)
-------- -------- -------- -------- -------- ----------
Balance, September 30,December 31, 1998............ $ 1,050816 $ 3651,049 $ 8121,163 $ 270346 $ 260353 $ 2,7573,727
======== ======== ======== ======== ======== ==========
Defaults as a percent of loan servicing
Portfolio, September 30, 1998:
Delinquent loans......................... 3.99% 5.19% 3.05% 2.84% 0.55% 2.95%
======== ======== ======== ======== ======== ==========loans...................... 6.45% 5.95% 4.89% 4.06% 2.01% 4.40%
==== ==== ==== ==== ==== ====
Loans in foreclosure..................... 4.87 3.57 1.94 0.82 0.14 2.02
======== ======== ======== ======== ======== ==========foreclosure.................. 2.63 2.96 3.60 2.06 0.40 2.25
==== ==== ==== ==== ==== ====
Real estate owned........................ 2.24 1.99 0.15 -- 0.50 0.81
======== ======== ======== ======== ======== ==========owned..................... 3.54 2.76 1.01 0.09 0.23 1.21
==== ==== ==== ==== ==== ====
- -----------------------------------------------------------------------------------------------------------------------1999 1998
1997
--------------------------------- -----------------------------------------------
September 30 June 30-------- -----------------------------------------
March 31 December 31 September 30 June 30 March 31
-------- ----------- ------------ ------- --------
Total defaults:
Delinquent loans...............loans........... 4.12% 4.40% 2.95% 1.95% 1.92 1.76% 4.44% 3.09% --1.92%
==== ==== ==== ==== ====
==== ===
Loans in foreclosure...........foreclosure....... 3.39 2.25 2.02 2.28 2.29 2.05 0.47 0.01 --
==== ==== ==== ==== ====
==== ===
Real estate owned (%)..........owned.......... 1.66 1.21 0.81 0.52 0.24 0.05 -- -- --
==== ====
==== ==== ==== ==== =======
- -----------------------
(A) PrimarilyLoans owned by NovaStar Financial
(B) Includes assets acquired through foreclosure
(C) Includes loans owned by NovaStar Financial and NovaStar Mortgage
28
The following table presents a summary of the mortgage loan activity of
NovaStar Mortgage for 1999 and 1998.
Table 23
Mortgage Loan Activity--NovaStar Mortgage, Inc.
General and Administrative Expenses
General and administrative expenses for the nine months ended September 30,
1998 and September 30, 1997 are provided in table XXII. Table XXIII displays the
relationship of portfolio expenses to net interest income during the nine months
ended September 30, 1998 and 1997 by quarter.
19
Table XXII
General and Administrative Expenses
Nine Months Ended September 30, 1998 and September 30, 1997
(dollars in thousands)
- --------------------------------------------------------------------------------
Nine Months Ended Nine Months Ended
September 30,1999 1998
September 30, 1997
------------------------ -----------------------
Percent of Percent of
Net Interest Net Interest
Income Income------------------ ------------------
Principal Premium Principal Premium
--------- ------- --------- -------
Loan servicing........................................... $3,163 27.5%Balance, January 1...... $ 701 13.2%
Compensation206,495 $ 3,114 $ -- $ --
Originations............ 82,495 997 207,976 3,758
Sales to NovaStar
Financial, Inc......... -- -- (207,976) (3,758)
Sales to third parties.. (204,280) (2,759) -- --
Principal repayments and
benefits................................ 1,374 11.9 694 13.0
Professionalamortization........... (1,963) (45) -- --
--------- ------- --------- -------
Balance, March 31....... $ 82,747 $ 1,307 $ -- $ --
Originations............ 294,303 5,207
Sales to NovaStar
Financial, Inc......... (290,350) (5,148)
Sales to third parties.. (3,953) (59)
Principal repayments and
outside services........................ 649 5.6 430 8.1
Office administration.................................... 681 5.9 201 3.8
Other.................................................... 184 1.6 288 5.4amortization........... -- --
--------- -------
---- ------ ----
Total portfolio-related expenses......................... 6,051 52.6% 2,314 43.5%
==== ====
Forgiveness of notes receivable from founders............ 812
Administrative services provided byBalance, June 30........ $ -- $ --
Originations............ 240,498 4,035
Sales to NovaStar
Mortgage.... 5,700 2,450Financial, Inc......... -- --
Sales to third parties.. (12,836) (517)
Principal repayments and
amortization........... (1,567) (7)
--------- -------
------
Total................................................... $12,563 $4,764Balance, September 30... $ 226,095 $ 3,511
Originations............ 133,739 1,821
Sales to NovaStar
Financial, Inc......... -- --
Sales to third parties.. (116,886) (2,156)
Principal repayments and
amortization........... (36,453) (62)
--------- -------
Balance, December 31.... $ 206,495 $ 3,114
========= ======= ======
Table XXIII
Portfolio Related Expenses as a
Percent29
Results of Net Interest Income
NineOperations of NovaStar Mortgage, Inc.--Three Months Ended September 30,March 31,
1999 Compared to the Three Months Ended March 31, 1998
The following table presents a summarized income statement of NovaStar
Mortgage, Inc. for the three months ended March 31, 1999 and 1998:
Table 24
NovaStar Mortgage, Inc.--Statements of Operations
Three Months Ended March 31 (dollars in thousands)
- --------------------------------------------------------------------------------
Percent of Net
Interest Income
1998:1999 1998
------ ------
Third quarter................................ 38.6%
Second quarter............................... 33.6
First quarter................................ 26.3
1997:
Fourth quarter............................... 65.9
Third quarter................................ 36.3
Second quarter............................... 62.1
First quarter................................ 42.0
Net interest income....................................... $1,172 $ 116
Services provided to NovaStar Financial, Inc.............. 2,165 2,130
Fees from third parties................................... 342 680
Gains on sale of mortgage assets.......................... 2,826 --
Expenses:
Production.............................................. 2,334 1,744
Servicing............................................... 1,215 596
Other................................................... 1,944 860
------ ------
Income (loss) before taxes................................ 1,012 (274)
Income tax expense........................................ 234 --
------ ------
Net income (loss)......................................... $ 778 $ (274)
====== ======
The monthly administrative service fee paid byfollowing summarizes the Companyexplanation for the increase in net earnings of
NovaStar Mortgage for the three months ended March 31, 1999 compared with the
same period of 1998:
. Beginning July 1, 1998, NovaStar Mortgage retained its mortgage loan
production to sell to third parties or securitize versus selling them
directly to NovaStar Financial. Prior to this point in time, NovaStar
Financial acquired 100% of NovaStar Mortgage's wholesale loan
production. Accordingly, NovaStar Mortgage represents compensationrecognized approximately $1
million in net interest income on these loans for certain services, including the developmentthree months ended
March 31, 1999. The net interest income NovaStar Mortgage recognized in
1998 was a result of interest earned on mortgage securities. NovaStar
Mortgage sold all of its mortgage securities during the latter part of
1998.
. During the three months ended March 31, 1999, NovaStar Mortgage
recognized net gains of $2.8 million on mortgage loan sales. $1.3
million of the gains recognized was a result of the closing of NovaStar
Mortgage's first securitization transaction. The remainder of the gain
is due to various mortgage loan sales to independent third parties.
NovaStar Mortgage did not sell any of its mortgage assets during the
same period of 1998.
. NovaStar Mortgage's wholesale origination operation was not operating at
full capacity during the three months ended March 31, 1999 compared with
the three months ended March 31, 1998. NovaStar Mortgage's costs of loan
products, underwriting, funding, and quality control. The increase in
this feeproduction as a percent of principal averaged 5.8% for the ninefirst quarter
of 1999 versus 1.5% during the first quarter of 1998 as detailed in
Table 19. Accordingly, in 1999 NovaStar Mortgage capitalized a lower
percentage of its origination costs--which under GAAP are amortized as
an adjustment of the yield over the life of the loan versus expensed in
the period incurred.
. NovaStar Mortgage's servicing staff doubled from March 31, 1998 to March
31, 1999. This increase is due to growth in the loan servicing
portfolio, which averaged $671 million for the three months ended September 30,March
31, 1998 compared with September
30, 1997 is primarily a result of an increase in the extent of services
required.
Compensation and benefits include employee base salaries, benefit costs and
incentive bonus awards. The increase in compensation and benefits$1.1 billion for the ninethree months ended SeptemberMarch 31,
1999.
30
1998 compared with
. NovaStar Mortgage recognized $159,000 in provisions for credit losses
for the ninethree months ended September
30, 1997 is due to adding portfolio, accounting and finance management staff
throughout 1997 and 1998. In addition, during the first nine monthsMarch 31, 1999, which are included as a
component of 1998 the
Company recognized $812,000 of expense for the anticipated forgiveness of a
second tranche of founders' debt, as mentioned earlier in the Forgivable Notes
Receivable from Founders section of this document.other expenses. No debt forgiveness wasprovisions were recognized during the
same period of 1997.
Loan servicing consists of direct costs associated with the mortgage loan
servicing operation. The fee the Company pays for servicing its mortgage loan
portfolio is based on volume1998 as well as number of delinquencies and
foreclosures. During the first six months of 1997, the Company contracted the
servicing of its mortgage portfolio with an independent third party. Beginning
July 15, 1997, NovaStar Mortgage began servicing the Company's mortgage loan
portfolio. The increasedid not begin holding loans in
loan servicingportfolio until July 1, 1998.
. NovaStar Mortgage remitted $150,000 in premium payments to CMAC during
the ninethree months ended September
30, 1998 compared with September 30, 1997 is primarily due to the significant
growth in the Company's mortgage loan portfolio during the period ended
September 30, 1998 compared with September 30, 1997.
20
Professional and outside services include fees for legal and accounting
services. In the normal course of business, the Company incurs fees for
professional services related to general corporate matters and specific
transactions. Office administration includes items such as rent, depreciation,
telephone, office supplies, postage, delivery, maintenance and repairs. The
increases in both these financial statement captions can be attributable to
additional personnel and the general growth of the Company.
Equity in Earnings (Loss) of NFI Holding Corporation
For the nine months ended September 30, 1998, NFI Holding Corporation
(Holding) recorded a net loss of $2.48 million compared with a net loss of
$143,000 for the nine months ended September 30, 1997. The Company records its
portion of these losses as equity in net loss of Holding in its income
statement,March 31, 1999, which includes the net loss of its affiliates--NovaStar Mortgage and
NovaStar Capital, Inc. Net income generated by Holding is primarily a function
of the fees earned by NovaStar Mortgage relating to the origination and
servicing of loans for the Company and the costs of these activities. As the
Company did not purchase any of NovaStar Mortgage's production during the third
quarter of 1998, NovaStar Mortgage incurred significant losses during this
period. These losses were offset to a degree by net gains on sales of $1.0
million on $25 million of mortgage loan production. General and administrative
expenses consist largely of compensation and benefits for the marketing,
underwriting, funding and servicing staffs. NovaStar Mortgage incurs significant
general and administrative expenses in generating loan production and servicing
loans and will vary,are included as a general rule,component
of other expenses. The agreement with loan production. Net losses
incurred by NovaStar Capital, Inc. were $162,000 during the nine months ended
September 30, 1998 as this company started operationsCMAC was executed during the third
quarter of 1998.
Tables XXIV. Other departments of NovaStar Mortgage, including systems, quality
control, and XXV are summary financial statementsadministration added staff from March 31,1998 to March 31,
1999 to compensate for general company growth.
Recent Developments of NFI Holding, Corporation asInc.
NovaStar Capital, Inc. was formed to focus on acquiring nonconforming
residential mortgage loans from banks, thrifts and credit unions. Management
plans to build a sales force of and foraccount executives to develop a nationwide
network of financial institutions to complement the nine months ended September 30, 1998. Table XXVIwholesale origination
operation of NovaStar Mortgage. Management believes this is another effective
means of acquiring mortgage loans at a summary of loan costs forlower cost than achieved in secondary
market purchases. The short-term intent is to treat these loans similar to
NovaStar Mortgage relative to itsMortgage's wholesale loan originations.
Table XXIV
NFI Holding Corporation--Balance Sheet
September 30, 1998 (dollarsoriginations--to hold in thousands)
- --------------------------------------------------------------------------------
Assets
Restricted cash............................... $ 18,997
Mortgage loans................................ 238,207
Mortgage securities........................... 8,686
Other assets.................................. 5,186
--------
Total assets................................ $271,076
========
Liabilities and stockholders' equity
Securities under repurchase agreements........ $ 8,559
Due to NovaStar Financial, Inc................ 259,312
Other liabilities............................. 3,614
--------
Total liabilities............................. 271,485
Stockholders' equity.......................... (409)
Total liabilities and stockholders' equity.. $271,076
========
21
Table XXV
NFI Holding Corporation -- Statement of Operations
Nine Months Ended September 30, 1998 (dollarsportfolio to be
sold either to independent third parties or in thousands)
- -----------------------------------------------------------
Net interest income............................. $ 1,730
Services provided to NovaStar Financial, Inc.... 6,031
Fees from third parties......................... 879
Gains on sale of mortgage assets................ 1,209
Expenses:
Production.................................... 6,189
Servicing..................................... 2,170
Other......................................... 3,970
-------
Net loss........................................ $(2,480)
=======
Table XXVI
Cost of Loan Production -- NovaStar Mortgage, Inc.
Nine Months Ended September 30, 1998 and Year Ended December 31, 1997 (dollars
in thousands)
- ------------------------------------------------------------------------------
1998 1997
----------------------------------------------------------------------------------------
Third Second First Fourth Third Second First
Quarter Quarter Quarter Quarter Quarter Quarter Quarter
Total costs of loan production (A)..... $ 4,975 $ 3,837 $ 3,079 $ 2,096 $ 1,938 $ 1,401 $ 410
Wholesale loan origination -- principal 232,333 294,303 207,974 183,012 136,582 77,692 12,688
Premium paid to broker................. 3,322 3,679 2,935 2,896 2,119 1,618 295
-------- -------- -------- -------- -------- ------- -------
Total acquisition cost (B)............. $240,630 $301,819 $213,988 $188,004 $140,639 $80,711 $13,393
======== ======== ======== ======== ======== ======= =======
Costs as a percent of principal:
Loan production...................... 2.1% 1.3% 1.5% 1.1% 1.4% 1.8% 3.2%
=== === === === === === ===
Premium paid to broker............... 1.4% 1.3% 1.4% 1.6% 1.6% 2.1% 2.3%
=== === === === === === ===
Total acquisition cost............... 3.6% 2.6% 2.9% 2.7% 3.0% 3.9% 5.6%
=== === === === === === ===
- ----------------
(A) Loan production general and administrative as reported for GAAP, plus net
deferred loan costs.
(B) Principal, premium and general administrative expenses associated with loan
production.securitizations.
Value of Mortgages Added through Wholesale Operations
By establishing a wholesale lending operation to originate subprime
residential mortgage loans, NovaStar Financial has developed a process to add
mortgage assets to its balance sheet at amounts management believes are below
what it would generally cost, in most market environments, to acquire the same
assets in bulk through open market purchases. In effect, the value created by
generating assets at this lower cost is creating future economic benefit, or
value, for ourNovaStar Financial's stockholders. This added value is demonstrated
in the estimated fair value of ourNovaStar Financial's loan portfolio. The values
presented in tables XXVIITables 25 and XXVIII26 are management's estimates based on market
conditions as of September 30, 1998. As
discussed in "Events Subsequent to September 30, 1998," market conditions
changed during October 1998. The change in market conditions has, among other
things, caused supplyMarch 31, 1999.
Management estimates the weighted-average value of its mortgage loan
portfolio as of March 31, 1999 to be greater than demand for subprimebetween 103 and 105 in terms of price to
par, based upon certain return assumptions and secondary market prices.
Management believes the inherent returns in the mortgage loans.
Asloans it is
originating should warrant a result,value of 105. However, recent events have resulted
in whole loan prices being severely reduced. Accordingly, any value assigned to
March 31, 1999 loans should take into consideration at what value the loans
could be sold in the open market. During the 1999 first quarter, NovaStar
Financial sold a number of whole loan packages at prices reflected below may not be indicative of market prices
subsequent to September 30, 1998.
Table XXVII providesthat averaged between
103 and 104. Tables 25 and 26 provide management's estimates of the value of
the mortgage loans in its portfolio givenand 1999 first quarter production and the
assumptions presented.used for estimating fair value. Because any estimated value assigned can
vary dramatically based upon the assumptions used, the
Company has presented a range of assumptions is
used to allow readers to apply their own
judgment in determining andetermine the estimated value.
The Company estimates the weighted-
average value of its mortgage loan portfolio as of September 30, 1998 to be
between 103 and 104 (in terms of price to par).
As presented in Table XXVI, during 1998,During 1999, NovaStar Mortgage originated mortgage loans at an all-in cost
of 103.6 percent105.8% of principal, including direct costs of acquisition, such as broker
premiums, and general overhead expenses. ThisTable 19 displays costs of production
for each quarter. The cost of production during the first quarter of 1999 and
1998 third and fourth quarters is higher than in recent quarters. However,previous quarters as a result of
lower production levels. NovaStar MortgagesMortgage operated during
the third quarter at less than full capacity.capacity
during the second half of 1998, partly by design. If NovaStar Mortgage had
operated at or near full capacity, the all-in cost would be similar to prior
quarters. Direct costs of acquisition are capitalized as premium and amortized
as an adjustment of yield over the life of the loan. 22In addition, NovaStar
Mortgage took measures at the end of the fourth quarter of 1998 to reduce
operating costs to be in line with expected short-term production volume.
31
The weighted-average premium on mortgage loans outstanding at September 30,
1998March 31, 1999
represented 2.44 percent2.3% of principal. Using the estimated marketfair values from above, this
implies an estimated unrealized gain, (oror additional value)value in the Company's mortgage loan
portfolio at September 30, 1998March 31, 1999 of between 1.01.0% and 2.0 percent.3.0%. Applying this percent to
the balance of mortgage loans outstanding of $1.2 billion$848 million results in an
estimated unrealized gain of between $12$9 and $24$26 million. This additional value
results in an estimated mark-to-market equity at March 31, 1999 of between $122 and $134$129-$146
million, or $15$10.39-11.76 per outstanding share.
Table XXVII
Estimated Market Price on Entire Loan Portfolio
As of September 30, 1998
- ---------------------------------------------------------------------------------------------------------------------------share, compared with a book value per
outstanding share of $9.64. On a diluted basis, book value per share at March
31, 1999 is $9.23, while a mark-to-market book value is $9.40-10.64.
Table 25
Estimated Market Price on Entire Loan Portfolio
As of March 31, 1999
Estimated Market Price
-------------------------
------------------------
Two-30/15-year Fixed and
Three-year Six-month LIBOR Loan
FixedBalloon Loan Products
Products(Three-year Treasury)
-------------------------
------------------------
Bond Equivalent
Yield............ 8.25% 8.50% 8.75% Bond Equivalent Yield............ 9.00% 9.25% 9.50%Yield.......... 8.03% 8.28% 8.53%
Spread to
Index.................. 3.00% 3.25% 3.50% Spread to Index.................. 3.75% 4.00% 4.25%
Assumed Prepayment Speed (CPR)... Assumed Prepayment Speed (CPR)...
30............................... 105.6% 105.0% 104.4% 35............................... 104.6% 104.1% 103.6%
35............................... 104.7% 104.2% 103.7% 40............................... 104.4% 103.5% 103.1%
40............................... 104.0% 103.6% 103.2% 45............................... 103.4% 102.9% 102.5%
30/15-year Fixed and
One-year CMT Loan Balloon Loan Products
Products (Three-year Treasury)
------------------------- ------------------------
Bond Equivalent Yield............ 7.64% 7.89% 8.14% Bond Equivalent Yield............ 7.75% 8.00% 8.25%
Spread to Index.................. 3.25% 3.50% 3.75% Spread to Index..................Index.......... 3.50% 3.75% 4.00%
Assumed
Prepayment
Speed (CPR)...
25.............. 105.4% 104.7% 104.1%
30.............. 104.6% 104.1% 103.5%
35.............. 104.0% 103.5% 103.0%
Estimated Market
Price
--------------------
Two- and Three-year
Fixed Loan Products
--------------------
Bond Equivalent
Yield.............. 7.81% 8.06% 8.31%
Spread to Index..... 2.75% 3.00% 3.25%
Assumed Prepayment
Speed (CPR)...
30...............................
35.................. 104.9% 104.3%104.4% 103.9%
40.................. 104.2% 103.8% 103.4%
45.................. 103.7% 25............................... 106.3% 105.6% 104.9%
35............................... 104.1% 103.6% 103.2% 30............................... 105.4% 104.9% 104.3%
40............................... 103.6% 103.2% 102.7% 35...............................103.3% 102.9%
One-year CMT Loan
Products
--------------------
Bond Equivalent
Yield.............. 7.27% 7.52% 7.77%
Spread to Index..... 2.75% 3.00% 3.25%
Assumed Prepayment
Speed (CPR)
35.................. 104.7% 104.2% 103.7%
40.................. 104.1% 103.7% 103.3%
45.................. 103.6% 103.2% 102.9%
Table XXVIIISix-month LIBOR Loan
Products
-------------------------
Bond Equivalent Yield.. 8.06% 8.31% 8.56%
Spread to Index.. 3.00% 3.25% 3.50%
Assumed
Prepayment
Speed (CPR)
40............... 105.0% 104.6% 104.2%
45............... 104.4% 104.0% 103.7%
50............... 103.8% 103.5% 103.2%
Table 26
Estimated Market Price of Loans Originated in First Quarter of 1999
Estimated Market
Price
of Loans Originated in Third Quarter of 1998
Third Quarter 1998
- ---------------------------------------------------------------------------------------------------------------------------
Estimated Market Price--------------------
Two- and Three-year
Fixed Loan Products
--------------------
Bond Equivalent
Yield.............. 7.81% 8.06% 8.31%
Spread to Index..... 2.75% 3.00% 3.25%
Assumed Prepayment
Speed (CPR)
30.................. 105.1% 104.5% 103.9%
35.................. 104.3% 103.8% 103.4%
40.................. 103.8% 103.3% 102.9%
Estimated Market Price
-------------------------
------------------------
Two- and Three-year Six-month LIBOR Loan
Fixed Loan Products Products
------------------------- ------------------------
Bond Equivalent Yield............ 8.25% 8.50% 8.75% Bond Equivalent Yield............ 7.50% 7.75% 8.00%
Spread to Index.................. 3.00% 3.25% 3.50% Spread to Index.................. 2.25% 2.50% 2.75%
Assumed Prepayment Speed (CPR)... Assumed Prepayment Speed (CPR)...
30............................... 105.4% 104.9% 104.3% 30............................... 104.2% 103.6% 103.0%
35............................... 104.6% 104.1% 103.6% 35............................... 103.6% 103.1% 102.6%
40............................... 103.9% 103.5% 103.1% 40............................... 103.1% 102.7% 102.3%
One-year CMT Loan 30/15-year Fixed and
Products
Balloon Loan Products
-------------------------
------------------------
Bond Equivalent Yield............ 7.64% 7.89% 8.14% Bond Equivalent Yield............ 7.75% 8.00% 8.25%Yield.. 8.03% 8.28% 8.53%
Spread to
Index.................. 3.25% 3.50% 3.75% Spread to Index..................Index.......... 3.50% 3.75% 4.00%
Assumed
Prepayment
Speed (CPR)... Assumed Prepayment Speed (CPR)...
30............................... 104.3% 103.7%
25.............. 105.4% 104.7% 104.1%
30.............. 104.6% 104.1% 103.5%
35.............. 104.0% 103.5% 103.1% 25............................... 106.4% 105.7% 105.1%
35............................... 103.7% 103.2% 102.7% 30............................... 105.5% 105.0% 104.4%
40............................... 103.2% 102.8% 102.3% 35............................... 104.8% 104.3% 103.8%
2332
Table XXIX
Carrying ValueLiquidity and Capital Resources
Liquidity means the need for, access to and uses of Loanscash. 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. Principal, interest and fees
received on mortgage assets and residual interests on CMOs will serve to
support cash needs. Drawing upon various borrowing arrangements typically
satisfies major cash requirements. During the first quarter of 1999, NovaStar
Financial also improved its equity and liquidity positions significantly by:
. Increasing borrowing capacity with First Union National Bank to nearly
$400 million in February 1999.
. Raising additional capital through the issuance of 4 million shares of
Class B 7% cumulative convertible preferred stock in March 1999; gross
proceeds aggregating $30 million.
Historically, NovaStar Financial demonstrated the ability to access public
capital markets as a source of long-term cash resources. The events in early
October 1998 changed the liquidity position of NovaStar Financial and many
other subprime companies and REITs. The number of options available to NovaStar
Financial with regard to financing and capital resources have been restricted.
The actions taken by Product/Typemanagement in the fourth quarter of 1998 to restore
liquidity and mitigate additional margin call risk have significantly reduced
cash requirements. The mortgage loans owned by NovaStar Financial have minimal
liquidity risk as they are financed with non-recourse CMOs. Management expects
that interest income on the loans will generate sufficient cash to meet
financing and operating costs.
NovaStar Mortgage requires substantial cash to fund loan originations and
operating costs. As of September 30, 1998 (in thousands)
- -----------------------------------------------------------------
Product/Type Amount
Two- and three-year fixed.................... $521,535
Six-month LIBOR.............................. 61,342
One-year CMT................................. 40,471
30/15-year fixed and balloon................. 301,087
--------
Outstanding principal.................... 924,435
Premium...................................... 22,550
Reserve for credit losses.................... (2,757)
--------
Carrying Value........................... $944,228
========
Carrying value as a percent of principal..... 102.4%
========
ResultsMarch 31, 1999, NovaStar Mortgage owned $84 million of
Operations -- Three Months Ended September 30, 1998 Comparedsubprime mortgage loans. NovaStar Mortgage provides financing for these loans
through warehouse and repurchase credit facilities at First Union. Loans
financed with warehouse and repurchase credit facilities are subject to
Three
Months Ended September 30, 1997
Net Income
During the three months ended September 30, 1998, the Company realized net
income of $2.4 million compared with net income of $177,000 for the same period
of 1997. The components of net income are discussed in the following
paragraphs.
Net Interest Income
Table XXX presents a summary of the average interest-earning assets,
average interest-bearing liabilitieschanging market valuation and the related yields and rates thereon
for the three months ended September 30, 1998.
Table XXX
Interest Analysis
Three Months Ended September 30, 1998 (dollars in thousands)
- --------------------------------------------------------------------------------
Mortgage Loans Mortgage Securities Total
---------------------------- --------------------------- ------------------------------
Interest Annual Interest Annual Interest Annual
Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/
Balance Expense Rate Balance Expense Rate Balance Expense Rate
Mortgage Assets......................... $927,132 $22,312 9.63% $412,335 $6,485 6.29% $1,339,467 $28,797 8.60%
======== ======== ==========
Liabilities.............................
Repurchase agreements................. $144,041 2,303 6.40% $419,901 6,121 5.83% $ 563,942 8,424 5.98%
Collateralized mortgage obligations... 821,739 12,734 6.20 821,739 12,734 6.20
Other borrowings...................... 10,446 111 4.25 10,446 111 4.25
-------- ---------
Cost of derivative financial
Instruments hedging liabilities....... 638 181 819
------- ------ -------
Total borrowings.................... $976,226 15,786 6.47 $419,901 6,302 6.00 $1,396,127 $22,088 6.33
======== ------- ======== ------ ========== =======
Net interest income................... $ 6,526 $ 183 $ 6,709
======= ====== =======
Net interest spread................... 3.16% 0.29% 2.27%
==== ==== ====
Net yield............................. 2.82% 0.18% 2.00%
==== ==== ====
The Company had average interest-earning assets of $1.34 billion during the
three months ended September 30, 1998, compared with $629.0 million for the
three months ended September 30, 1997. During the three month period ended
September 30, 1998, mortgage securities earned $6.5 million, or a yield of 6.3
percent, while mortgage loans earned $22.3 million, or a yield of 9.6 percent.
For the same period of 1997, mortgage securities earned $4.6 million, or a
yield of 6.6 percent, while mortgage loans earned $7.7 million, or a yield of
8.7 percent. In total, assets earned $28.8 million -- a yield of 8.6 percent
for the period ending September 30, 1998 compared with $12.2 million, or a yield
of 7.8 percent for the period ending September 30, 1997.
During the three months ended September 30, 1998, borrowed funds for the
Company averaged $1.4 billion on which interest was incurred of $22.1 million,
or 6.3 percent. In comparison, for the three months ended September 30, 1997,
borrowed
24
funds for the Company averaged $593.2 million on which interest was incurred of
$9.8 million, or 6.6 percent. Rates on other borrowings generally fluctuate with
short-term market interest rates, such as LIBOR or the Federal Funds rate.
Net interest income during the three months ended September 30, 1998 was
$6.7 million, or 2.00 percent of average interest-earning assets compared with
$2.4 million, or 1.53 percent of average interest-earning assets for the three
month period ending September 30, 1997. Net interest spread for the Company was
2.27 percent versus 1.18 percent during the three months ended September 30,
1998 and September 30, 1997, respectively.
Provisions for Credit Losses
During the three months ended September 30, 1998, the Company provided $1.2
million for credit losses compared with $726,000 for the three months ended
September 30, 1997. Credit losses recognized during the three-month period
ended September 30, 1998 were $1.8 million. The Company recognized no losses on
its mortgage loan portfolio during the three-month period ended September 30,
1997. As mentioned earlier, reserves are maintained for losses managementmargin calls. Management expects to incur oncontinue
selling loans in the portfolio.
Fees providedoriginated by NovaStar Mortgage Inc. and Other Income
Fees paid by NovaStar Mortgageor securitizing those loans at a
profit to meet the Company in accordance withsignificant cash needs of the Mortgage Loan Sale and Purchase Agreement aggregated $3.3 millionwholesale loan operation.
However, management intends to raise sufficient capital during the
third quarter 1998.
During the three months ended, September 30, 1998, the Company recognized1999 to begin
acquiring a $200,000 gain on sale of mortgage loans, pooling $4.7 million of mortgage loans
in the transaction. Also, included in other income during the third quarter of
1998, are prepayment penalties of $625,000 and interest on founders' notes
receivable of $129,000.
General and Administrative Expenses
General and administrative expenses during the three months ended September
30, 1998 and September 30, 1997, respectively, were $5.0 million and $2.1
million. Consistent with prior periods, the single largest component of general
and administrative expenses is the administrative outsourcing fee paid to
NovaStar Mortgage, which was $2.1 million for the three month period ending
September 30, 1998 compared with $1.2 million for the three month period ended
September 30, 1997. Compensation and benefits totaled $478,000 during the third
quarter of 1998 compared with $332,000 for the third quarter of 1997.
Professional and outside services include legal fees and contract labor for
the development of information systems. These expenses were $296,000 and
$181,000 for the third quarter of 1998 and 1997, respectively.
Loan servicing costs were $1.5 million compared with $123,000 for the three
month period ending September 30, 1998 and 1997, respectively. Loan servicing
costs include direct costs of managing the loan portfolio which are not
reimbursable by the borrower. In addition, loan servicing costs include fees
associated with the service provider who services the Company's loans. These
fees were paid to NovaStar Mortgage in 1998 and to an outside party during the
same period of 1997 as the Company outsourced this service until July 15, 1997.
Equity in Earnings (Loss) of NFI Holding Corporation
For the three months ended September 30, 1998, Holding recognized a net
loss of $2.5 million of which the Company recorded its portion. For the same
period of 1997, Holding realized a net income of 293,000. As mentioned earlier,
the increase in the net loss is largely due to the fee from NovaStar Mortgage to
the Company as NFI did not acquire anymajority of NovaStar Mortgage's production during the third quartersecond half
of 1998. This loss was partly offset by realized gainsthe year. Management believes NovaStar Financial can operate indefinitely in
this manner, provided that the level of $798,000 onloan originations are at or near the
salecapacity of mortgage securities and loans.
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.its production infrastructure.
33
Table XXXI27 is a summary of the
differences between the Company's net income or loss reported for GAAP the three
month period ended September 30, 1998financing arrangements and 1997 by quarter and its taxable
income.
25
available borrowing
capacity under those arrangements as of March 31, 1999:
Table 27
Liquidity Resources
March 31, 1999 (dollars in thousands)
Table XXXI
Taxable Income (Loss)
Nine months Ended September 30, 1998 (in thousands)
- ---------------------------------------------------------------------------------------------------------
1998 1997
--------------------------------------------------------------------
Third Second First Fourth Third Second First
Quarter Quarter Quarter Quarter Quarter Quarter QuarterMaximum
Borrowing Value of
Limit Collateral Borrowings Availability
--------- ---------- ---------- ------------
Net income (loss)..................Resource
Cash.............................. $ 2,394 $1,894 $1,2792,403
First Union National Bank (A):
Committed warehouse line of
credit......................... $ (433) $ 177 $(1,073) $194
Results of Holding and subsidiary.. 2,44775,000 $42,403 $22,660 19,743
Committed secured whole loan
repurchase agreement........... 300,000 42,495 42,495 --
273 (169) (393) 126 408
Provision for credit losses........ 1,179 1,145 1,076 1,009 726 547 171
Loans charged-off.................. (1,762) (675) (518) (140)
Other, net......................... 95 208 (4) 296 (4) (8)Committed residual financing
available under CMOs........... 20,000 (B) -- 20,000
------- ------ ------ ------ ----- -------
----
Taxable income (loss).............. $ 4,353 $2,572 $2,106 $ 563 $ 506 $ (408) $773Total......................... $65,155 $42,146
======= ====== ====== ====== ===== =======
====
As discussed under "Events Subsequent to September 30, 1998," the Company
executed several transactions during October 1998 that included the sale of
assets and termination of hedging arrangements. Management anticipates the
significant losses resulting from these transactions will eliminate taxable
income for 1998.
Interest rate sensitivity. In its assessment of the interest sensitivity
and as an indication of the Company's 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. These amounts contain estimates and assumptions regarding
prepayments and future interest rates. Actual economic conditions may produce
results significantly different from the results depicted below. However,
management believes the interest sensitivity model used is a valuable tool to
manage the Company's exposure to interest rate risk. Table XXXII details the
Company's Interest Rate Sensitivity as of September 30, 1998.
Table XXXII
Interest Rate Sensitivity (A) (B)
September 30, 1998
- ------------------------------------------------------------------------------------------------
Basis Point Increase (Decrease) in Interest Rate (C)
----------------------------------------------------
(100) Base (D) 100
---------- ---------- ----------
Market valueTotal availability as a percent
of:
Assets............................. $1,715,188 $1,703,308 $1,687,861
Liabilities........................ 1,594,020 1,593,078 1,592,136
Interest rate agreements........... 69 571 2,977
---------- ---------- ----------
Net market value..................... $ 121,237 $ 110,801 $ 98,702
========== ========== ==========
Cumulative change in value(D)........ $ 10,436 -- $ (12,099)
========== ========== ==========
Percent change from base assets(E)... 0.83% -- (0.95)%
========== ========== ==========
Percent change of capital(F)......... 9.50% -- (11.01)%
========== ========== ==========Total assets.................... 4.46%
=======
Total stockholders' equity...... 3.52%
=======
- -----------------------
(A) Management analyzes the interest sensitivityValue of the Companycollateral and borrowings include amounts for both NovaStar
Financial and NovaStar Mortgage on a combined basis. The assets and liabilities of NovaStar
Mortgage consist primarily of mortgage loans with a carrying value of
$238,207 and securities with a current face of $8.5 million and their
related repurchase agreement financing.
(B) Reflects the sale of all securities and all swap terminations made in
October 1998.
(C) Value of asset, liability or interest rate agreement in a parallel shift in
the yield curve, up and down 1%.
(D) Total change in estimated market value, in dollars, from "base." "Base" is
the estimated market value at October 15, 1998.
(E) Total change in estimated market value, as a percent, from base.
(F) Total change in estimated market value as a percent of total stockholders'
equity at September 30, 1998.
Interest Rate Sensitivity Analysis. The valuesthey are co-borrowers under the
heading "Base" are
management'sarrangements with First Union National Bank.
(B) Management estimates of market values of the Company's assets, liabilities and
interest rate agreements on September 30, 1998. The values under the headings
"100" and "(100)" are management's estimates of the market value of those same
assets, liabilities and interest rate agreements assuming that interest rates
were 100 basis points (1%) higher and lower. The cumulative change in value
represents the change in value of assets from base, net of the change in value
of liabilities and interest rate agreements from base.
The interest sensitivity analysis is prepared regularly (at least monthly).
If the analysis demonstrates that a 100 basis point shift (up or down) in
interest rates would result in 10% or more cumulative change in value from base,
management will modify the Company's portfolio by adding or removing interest
rate cap or swap agreements.
26
Sensitivity as of September 30, 1998. As shown in the table above, if
interest rates were to decrease one percent (-100 basis points), the value of the Company's capital would increase by an estimated 9.50 percent. If interest
rates rise by one percent (+100 basis points),residuals range from $50 to $70
million and does not include the value of mortgage servicing rights.
Cash activity during the Company's
capital would decrease by an estimated 11.01 percent.three months ended March 31, 1999 and 1998 are
presented in the consolidated statement of cash flows.
Capital Allocation Guidelines (CAG). The Company'sallocation guidelines. Management's goal is to strike a balance between the
under-utilization of leverage, which reduces returns to stockholders, and the
over-utilization of leverage, which could reduce the Company's ability of NovaStar to
meet its obligations during adverse market conditions. The Company's CAGCapital allocation
guidelines have been approved by the Board of Directors. The CAGguidelines are
intended to keep the CompanyNovaStar properly leveraged by (i) matchingby:
.Matching the amount of leverage allowed to the riskiness (returnon return and
liquidity)liquidity of an assetasset; and
(ii)
monitoring.Monitoring the credit and prepayment performance of each investment to
adjust the required capital.
34
This analysis takes into account the Company's various
hedgeshedging instruments and other risk programs
discussed below. In this way, the use of balanceBalance sheet leverage will be controlled.is controlled by monitoring capital
allocation. Following presents a summary of the Company's CAGcapital allocation guidelines
for the following levels of capital for thevarious types of assets it owns.
Table XXXIII
Capital Allocation Guidelines
September 30, 1998March 31, 1999
- ---------------------------------------------------------------------------------------------------------------------------------(F)
(E) (b x e) (F)
(A) (B) (C) (D) (E) (F) (F)
Minimum Duration Liquidity (c+(c + d) (bxe)Equity (a + f)
Minimum Estimated Duration Liquidity Total Cushion CAG
Lender Estimated Price Spread Spread Total Spread Equity Cushion CAG(% of Equity
Asset Category Haircut Duration Cushion Cushion Cushion (% of MV) Required
- -------------- ------- --------- -------- --------- ------- ------- --------
Agency-issued:
Conventional ARMs.......ARMs..... 3.00% 3.50% 50 -- 50 1.75% 4.75%
GNMA ARMs...............ARMs............. 3.00 4.50 50 -- 50 2.25 5.25
GNMA Fixed Rates........Rates...... 3.00 5.00 50 -- 50 2.50 5.50
Corporate Bonds......... 10.00 3.50 225 25 250 8.75 18.75
Mortgage loans:
Collateral for
warehouse financing....financing.. 2.00 3.00 100 50 150 4.50 7.50
Collateral for CMO...... 5.80CMO.... 5.00 -- -- -- -- -- 5.80
Delinquent..............5.00
Delinquent............ 100.00 -- -- -- -- -- 100.00
Hedging..................Hedging................. -- -- -- -- -- -- 5.80
Other....................Other................... 100.00 -- -- -- -- -- 100.00
- --------------------------------------------------------------
(A) Indicates the minimum amount of equity a typical lender would require with
an asset from the applicable asset category. There is some variation in
haircut levels among lenders. From the lender perspective, this is a
"cushion" to protect capital in case the borrower is unable to meet a
margin call. The size of the haircut depends on the liquidity and price
volatility of the asset. Agency securities are very liquid, with price
volatility in line with the fixed income markets, which means a lender
requires a smaller haircut. On the other extreme, "B" rated securities and
securities not registered with the Securities and Exchange Commission (the "Commission")
are
substantially less liquid, and have more price volatility than Agencyagency
securities, which results in a lender requiring a larger haircut.
Particular securities that are performing below expectations would also
typically require a larger haircut.
(B) Duration is the price-weighted average term to maturity of financial
instruments' cash flows.
(C) Estimated cushion need to protect against investors requiring a higher
return compared to Treasurytreasury securities, assuming constant interest rates.
(D) Estimated cushion required due to a potential imbalance of supply and
demand resulting in a wider bid/ask spread.
(E) Sum of duration (C) and liquidity (D) spread cushions.
(F) Product of estimated price duration (B) and total spread cushion. The
additional equity, as determined by management, to reasonably protect the
CompanyNovaStar Financial from lender margin calls. The size of each cushion is
based on management's experience with the price volatility and liquidity in
the various asset categories. Individual assets that have exposure to
substantial credit risk will be measured individually and the leverage
adjusted as actual delinquencies, defaults and losses differ with
management's expectations.
Implementation of the capital allocation guidelines--mark to market. Each
month, assets are marked to market. Market values of the mortgage loan
portfolio are calculated internally using assumptions for losses, prepayments
and discount rates. Mortgage securities are valued using independent market
quotes. The face amount of all financing used for securities and mortgage loans
is subtracted from the current market value of the assets and hedges. This is
the current market value of equity. This number is compared to the required
capital as determined by the capital allocation guidelines. If the actual
equity falls below the capital required by the capital allocation guidelines,
NovaStar Financial must prepare a plan to bring the actual capital above the
level required by the capital allocation guidelines.
Each quarter, management presents to the Board of Directors the results of
the CAGcapital allocation guidelines compared to actual equity. Management may
propose changing the capital required for a class of investments or for an
individual investment based on its prepayment and credit performance relative
to the market and the ability of the Companymanagement to predict or hedge the risk of
the asset.
35
Table XXXIV28 is a summary of the capital allocation for NovaStar Financial as
they apply to the Company's mortgage assets and hedging instruments during 19981999 and 1997.
27
1998.
Table 28
Required Equity
Table XXXIV
Required Equity
- ----------------------------------------------------------------------------------------------------------------------1999 1998
1997
---------------------------------- -----------------------------------------------
Category September 30 June 30-------- -------------------------------------------
March 31 December 31 September 30 June 30 March 31
-------- ----------- ------------ -------- --------
Category
Mortgage loans:
Current........................Current unsecuritized
loans................ $ 3,823 $12,648 $ 14,567 $ 21,566 $ 23,628
$ 6,675 $ 33,832 $22,780 $15,958
Delinquent.....................Delinquent
unsecuritized loans.. 1,197 1,685 452 601 1,200
1,600 2,376 -- --
Securitized loans..............loans..... 49,894 64,548 55,822 37,766 23,478
22,500Mortgage securities..... -- -- --
Mortgage securities.............. 19,514 24,904 27,426
36,170 12,763 13,549 1,646
Other assets.....................assets............ 13,861 12,536 20,682 13,782 10,733
-- -- -- --
Hedging instruments..............instruments..... (100) (179) (688) (232) (203)
5,500 427 1,787 2,804-------- ------- -------- -------- --------
-------- --------- ------- -------
Required equity..................equity......... 68,675 91,238 110,349 98,387 86,262
72,445 49,398 38,116 20,408
Stockholders' equity.............equity.... 119,712 87,204 109,848 114,875 115,798 116,489 47,036 46,337 46,202
Market value in excess
of the carrying value
of assets and
hedges (A)......................hedges............... 1,482 5,961 2,331 31,999 20,685
-- -- -- ---------- ------- -------- -------- --------
-------- --------- ------- -------
Excess equity....................equity........... $ 52,519 $ 1,927 $ 1,830 $ 48,487 $ 50,221
$ 44,044 ($ 2,362) $ 8,221 $25,794
======== =============== ======== ======== ========= ======= ===============
- -----------------
(A) The Company revised its CAG model during the first quarter of 1998 to
include the market value in excess of the carrying value of assets and
hedges as the Company has the ability to borrow against this residual.
Inflation
Virtually all of the Company's assets and liabilities of NovaStar Financial are financial in
nature. As a result, interest rates and other factors drive the Company'scompany performance
far more than does inflation. Changes in interest rates do not necessarily
correlate with inflation rates or changes in inflation rates. The Company's financial
statements of NovaStar Financial are prepared in accordance with generally
accepted accounting principles and the Company's dividends are based upon the
Company'son taxable income.
In each case, the Company'sfinancial activities and balance sheet are measured with
reference to historical cost or fair market value without considering
inflation.
Impact of Recently Issued Accounting Pronouncements
Note 1 to the consolidated financial statements of the Annual Reportannual report to
Shareholdersshareholders and Annual Reportannual report on Form 10-K for the year ended December 31,
19971998 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.
During June 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 133, Accounting for Derivative
Instruments and Hedging Activities (SFAS No. 133). SFAS No. 133 requires that
entities recognize all derivatives as either assets or liabilities in the
statement of financial position and measure those instruments at fair value.
Derivatives meeting certain conditions may be designated as hedging instruments,
for which SFAS No. 133 prescribes accounting treatment, depending on the type of
hedge. For those derivatives not designated as a hedging instrument, the gain or
loss is recognized in earnings in the period of change. For the Company, SFAS
No. 133 must be applied not later than for the fiscal year beginning January 1,
2000. Management is currently evaluating the impact of SFAS No. 133 to the
company's financial statements.
Statement of Financial Accounting Standards No. 134, Accounting for
Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans
Held for Sale by a Mortgage Banking Enterprise was issued by the FASB during
October 1998. SFAS No. 134 amends SFAS No. 65 and 115, and requires entities to
classify retained mortgage-backed securities after the securitization of
mortgage loans held for sale in accordance with SFAS No. 115. However, a
mortgage banking enterprise must classify as trading retained mortgage-backed
securities that it commits to sell before or during the securitization process.
This statement is effective for the first fiscal quarter beginning after
December 15, 1998. Management does not expect the adoption of this standard to
have a material impact on the Company's financial position and results of
operations.
28
The Year 2000
The Company isNovaStar Financial and NovaStar Mortgage are highly dependent on purchased
and leased computer software to conduct business. In addition, the Company isNovaStar
Financial and NovaStar Mortgage are highly dependent on computer software used
by market counterparties and vendors, including banks, in conducting business.
The CompanyManagement recognizes that some computer software may not have the ability to
correctly identify dates beyond December 31, 1999. The
Company's successfulSuccessful modification of
computer software, or the vendors' successful modification of their programs,
to be year 2000 compliant is critical to the Company's viability.viability of NovaStar usesFinancial
and NovaStar Mortgage.
36
NovaStar Financial and NovaStar Mortgage use three major, and a number of
smaller, internal automation solutions to conduct its business operations. The
three computer systems considered the most significant to the Company's operations are as
follows:
. The.The internally developed loan origination and database system
. The.The externally provided loan servicing system
. The.The purchased accounting system
In addition, the Company integratesNovaStar Financial and NovaStar Mortgage integrate with a
number of outside entities in
our normal business transactions. Interfaces with
other businesses and third party solution providers are used to conduct some
of our business processes. Certain otherOther processes are supported by systems created
internally.
NovaStar isFinancial and NovaStar Mortgage are using the Federal Financial
Institutions Examination Council's (FFIEC) "Year 2000 Project Management
Awareness" document to guide our year 2000 readiness effort.efforts. Each program/system
interface used by the Company isNovaStar Financial and NovaStar Mortgage are being reviewed
and tested for year 2000 compliance. The FFIEC guide calls for a three-phase
approach to assess year 2000 compliance. Based on this three-phase approach
NovaStar Financial's and NovaStar Mortgage's projected timeline is as follows:
In the Assessment Phase, the Companyassessment phase, management has determined which business
processes/interfaces rely on dates and date arithmetic. Most of the Company's
business
processes/interfaces rely on dates and date arithmetic. TheseAll internally
developed business processes/interfaces are beinghave been tested internally for compliance. The Company
has asked itsBased
on these tests, all software and automation solutions created by NovaStar
Financial and NovaStar Mortgage are year 2000 compliant. As of April 15, 1999
NovaStar Financial and NovaStar Mortgage have updated all internal operating
systems and software with year 2000 compliant versions. NovaStar Financial and
NovaStar Mortgage are still working with market counterparties and vendors to
document that they have assessed software for year 2000 compliance.
Solution updates to non-compliantnon-complaint Year 2000 software should be made in the
Correction Phase.correction phase. Corrections on CompanyNovaStar Financial and NovaStar Mortgage
developed software will be made internally and are expected to be
insignificant. The Company isNovaStar Financial and NovaStar Mortgage are requiring all
market counterparties and vendors to document they have made all corrections.
The CompanyNovaStar Financial and NovaStar Mortgage staff will conduct "mock" business
as if it is in the year 2000 during the Validation Phase.validation phase, scheduled for the
second quarter of 1999. During this phase, the CompanyNovaStar Financial and NovaStar
Mortgage will test all internally developed software as well as vendor
software.
NovaStar hasFinancial and NovaStar Mortgage have contacted all of its significant
outside market counterparties and vendors to obtain documentation regarding
their process and status for assuring year 2000 compliance. The CompanyManagement has
asked that each party adhere to the same FFIEC guidelines and to provide
37
documents of progress during each phase. Recent status reportsNovaStar Financial and NovaStar
Mortgage have been received written confirmation from Alltel Residential Lending
Solutions, (vendor of the Company's servicing system) and Baan/CODA (vendor of
the Company's accounting system) and are as follows:
. Alltel, vendor of theNovaStar Mortgage's servicing platform expects to complete testing by
December 31, 1998system and maintains they will be fully year 2000 compliant
by the first quarter of 1999.
. Baan/CODA, vendor
of theNovaStar Financial's and NovaStar Mortgage's accounting system has provided the Company
written confirmationstating that
the version the Companyversions currently uses isused are fully year 2000 compliant.
All internally developed software was designed to be year 2000 compliant.complaint. In
addition, the Companymanagement has contacted its significant financial counterparty,
First Union National Bank, who is completing their internal review of year 2000
compliance.
The CompanyManagement believes that itsthe greatest risk in regardsregard to year 2000 compliance is
the software and systems used to service its subprime mortgage loans. NovaStar
Mortgage Inc., an affiliate of the Company, services the Company's loans.loans owned by NovaStar Financial. NovaStar Mortgage uses
systems developed by Alltel for loan servicing. If these systems fail, NovaStar
Mortgage will not be able to continue on a manual basis. In this worst case
scenario, loans would not be serviced until the failed system could be
remedied. If the loans go "unserviced" for an extended period of time -- several weeks -- thetime--several
weeks--the result could have a material adverse impact on the Company.
The Company isto NovaStar Financial
and NovaStar Mortgage.
NovaStar Financial and NovaStar Mortgage are also at significant risk in the
event the systems of financial institutions, on which the Company isNovaStar Financial and
NovaStar Mortgage are relying for financing and cash management fail. In a
worst case scenario, the CompanyNovaStar Financial and NovaStar Mortgage may not be able
to meet financial obligations during the period of failure --- an unknown
timeframe. The result could have a material adverse impact on the
Company.
The Company isNovaStar
Financial and NovaStar Mortgage.
NovaStar Financial and NovaStar Mortgage are exposed to smaller risks in the
event other systems, including those developed internally, fail to perform
beyond December 31, 1999. However, management believes functions, other than
servicing, can be maintained on a manual basis should systems fail. Although
processing and performance would be slow, risk of material adverse impact to
the CompanyNovaStar Financial and NovaStar Mortgage for these systems
failuressystems' failure is expected
to be minimal.
Management expects, through the completion of its year 2000 plan, the
likelihood of a material business disruption is not significant. The major
risks presented above involve year 2000 remediation efforts of third party
vendors used by the Company.
29
NovaStar Financial and NovaStar Mortgage. Based on the
information provided, the Companymanagement believes these vendors will meet their
obligation for resolution of year 2000 issues.
The CompanyManagement estimates it has incurred less than $75,000 in costs to date in
carrying out its year 2000 compliance plan and estimates it will spend less
than $100,000 in completing the plan. However, the costs could increase
dramatically if the Companymanagement determines that any market counterparty will not be
year 2000 compliant.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Interest Rate/Market Risk
Price volatility. Under its current mode of operation, NovaStar Financial
depends heavily on the market for wholesale subprime mortgage loans. Without
capital to support the purchase and retention of mortgage loans, NovaStar will
sell loans originated by NovaStar Mortgage. The Companyfinancial results of NovaStar
Financial will depend, in part, on the ability to find purchasers for the loans
at prices that cover origination expenses. NovaStar Mortgage originates loans
at a low all-in cost and therefore mitigates price volatility. Price volatility
will be eliminated when NovaStar Financial can raise capital and resume
acquisition and retention of its subprime 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 our
liabilities or when the assets are fixed rates and the liabilities are
adjusting,
38
future earnings potential is affected. Management primarily uses financing
sources where the interest rate resets frequently. As of March 31, 1999,
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 March 31, 1999, adjust on a monthly basis and none adjust
daily. 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" 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 could be significantly effected as the
asset rate resets would "lag" 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.
Table 29 is a summary of the analysis as of March 31, 1999 and December 31,
1998.
Table 29
Interest Rate Sensitivity
March 31, 1999 and December 31, 1998
Basis Point Increase (Decrease) in Interest
-------------------------------------------
Rate(B)
----------------
As of March 31, 1998(A) (100) Base(C) 100
----------------------- -------------- ------------------------------
Income from:
Assets.................. $84,496 $86,728 $88,879
Liabilities............. 50,519 58,330 66,412
Interest rate
agreements............. (1,781) (1,781) 570
-------------- -------------- --------------
Net spread income......... $32,196 $26,617 $23,037
============== ============== ==============
Cumulative change in
income from base (C)..... $ 5,579 -- $ (3,580)
Percent change from base
spread income (D)........ 21.0% -- (13.4)%
============== ============== ==============
Percent change of
capital(E)............... 4.66% -- (2.99)%
============== ============== ==============
- --------
(A) The securitized mortgage assets of NovaStar Financial are managed on a
spread income basis.
(B) Income of asset, liability or interest rate agreement in a parallel shift
in the yield curve, up and down 1%.
(C) Total change in estimated spread income, in dollars, from "base." "Base" is
the estimated spread income at March 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'
equity at March 31, 1999.
39
Basis Point Increase (Decrease) in Interest
-------------------------------------------
Rate(G)
----------------
As of December 31, 1998(F) (100) Base(H) 100
-------------------------- -------------- ------------------------------
Income from:
Assets.................... $80,507 $82,310 $83,966
Liabilities............... 47,546 55,259 63,233
Interest rate agreements.. (2,244) (2,244) 107
-------------- -------------- --------------
Net spread income........... $30,717 $24,807 $20,840
============== ============== ==============
Cumulative change in income
from base (H).............. $ 5,910 -- $ 3,967
Percent change from base
spread income (I).......... 23.8% -- (16.0)%
============== ============== ==============
Percent change of
capital(J)................. 6.77% -- (4.54)%
============== ============== ==============
- --------
(F) The securitized mortgage assets of NovaStar Financial are managed on a
spread income basis.
(G) Income of asset, liability or interest rate agreement in a parallel shift
in the yield curve, up and down 1%.
(H) Total change in estimated spread income, in dollars, from "base." "Base" is
the estimated spread income at December 31, 1998.
(I) Total change in estimated spread income, as a percent, from base.
(J) Total change in estimated spread income as a percent of total stockholders'
equity at December 31, 1998.
Interest rate sensitivity analysis. The values under the heading "Base" are
management's estimates of spread income for assets, liabilities and interest
rate agreements on December 31, 1998. The values under the headings "100" and
"(100)" are management's estimates of the income 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
represents the change in income of assets from base, net of the change in
income of liabilities and interest rate agreements from base.
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 10 percent or more cumulative decrease in income 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's interest sensitivity and hedged position quarterly.
Assumptions used in interest rate sensitivity analysis. Management uses
estimates in determining the income of assets, liabilities and interest rate
agreements. The estimation process is dependent upon a variety of assumptions,
especially in determining the income of its subprime mortgage loan holdings.
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 March
31, 1999 and December 31, 1998.
Management's analysis for assessing interest rate sensitivity on its
subprime mortgage loans relies significantly on estimates for prepayment
speeds. A prepayment model has notbeen internally developed formal contingency plansbased upon four main
factors:
. Refinancing incentives (the interest rate of the mortgage compared with
the current mortgage rates available to bethe borrower)
. Borrower credit grades
. Loan-to-value ratios
. Prepayment penalties, if any
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
40
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"
refinance. Each of these factors presumably 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, under the
assumption that the penalty is a deterrent to refinancing.
These factors are weighted based on management's experience and an
evaluation of the important trends observed in the subprime mortgage
origination industry. Actual results may differ from the estimates and
assumptions used in the eventmodel and the projected results as shown in the above
table.
NovaStar Financial's projected prepayment rates 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 curve is also
multiplied by a factor of 60% on average for periods when a prepayment penalty
is in effect on the loan. These assumptions change with levels of interest
rates. The actual historical speeds experienced on NovaStar Financial's loans
shown in Table 7 are weighted average speeds of all loans in each deal.
As shown in Table 7, 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. However, 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.
The 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 assets.
Although management evaluates the portfolio using interest rate increases
and decreases greater than one percent, management focuses on the one percent
increase as any further increase in interestrates would require action to
adjust the portfolio to adapt to changing rates. The investment policy for
NovaStar Financial allows for no more than a ten percent decrease in the spread
income of the portfolio when interest rates rise or fall by one percent.
Sensitivity as of March 31, 1999 and December 31, 1998. As shown in the
above table, if interest rates were to decrease one percent (-100 basis
points), the spread income of capital would increase by an estimated 4.66% and
6.77% of capital as of March 31, 1999 and December 31, 1998, respectively. If
interest rates rise by one percent (+100 basis points), the spread income of
capital would decrease by an estimated 2.99% and 4.54% of capital as of March
31, 1999 and December 31, 1998, respectively.
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 hardware, softwareadjustable-rate mortgage loans and
related borrowings.
NovaStar Financial uses interest rate cap and swap agreements and financial
futures 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 to build a balance sheet and undertake an interest
rate risk management program that is likely, in managements's view, to enable
NovaStar Financial to maintain an equity liquidation value
41
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 Financial
and a third party firm or other computerized systems,"counter-party". The counter-party agrees to make
payments to NovaStar Financial in the future should the one- or thosethree-month
LIBOR interest rate rise above the strike rate specified in the contract.
NovaStar Financial either makes quarterly premium payments or has 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. Should the reference LIBOR interest rate rise above the
contractual strike rate, NovaStar Financial will 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 swap agreements stipulate that NovaStar Financial pay a fixed
rate of interest to the counterparty. In return, the counterparty pays NovaStar
Financial a variable rate of interest based on the notional amount. The
agreements have fixed notional amounts, on which the interest is computed, and
set terms to maturity. As mentioned earlier, NovaStar Financial terminated all
swap agreements and paid off the liabilities pertaining to these hedging
instruments in October 1998.
NovaStar Financial is subject to credit risk under its interest rate
agreements because the counterparty may fail on its obligation to NovaStar
Financial. To limit counterparty credit risk, NovaStar Financial:
.enters into ISDA Master Agreements with each counterparty,
.deals with counterparties with BBB/Baa ratings or higher from S&P and
Moody's, respectively
.measures the risk on at least a monthly basis,
.obtains bilateral cross collateralization agreements on each agreement,
and
.obtains the right for margin calls when hedges are in gain positions for
NovaStar Financial.
The net market value of all agreements with each counterparty is in a loss
position as of March 31, 1999, exposing NovaStar Financial to no credit risk at
that date.
All interest rate agreements are tied to either one- or three-month LIBOR.
All financing agreements reset based on one-month LIBOR or short-term
repurchase agreement rates. Therefore, the extent of the basis risk of NovaStar
Financial lies in the differences in movements between one and three-month
LIBOR and short-term repurchase agreements rates versus one-month and three-
month LIBOR. Historically, the basis movements between these rates have been
minimal.
ISDA Master Agreements set the legal framework for transactions with
counterparties in over-the-counter derivative markets. NovaStar Financial
considers its exposure to legal enforcement risk to be minimal. Corporate
counsel reviews legal documents at the discretion of management.
When analyzed in isolation, the cost of a vendor, are not ready forhedging transaction over the year 2000. A full contingency planlife
of the agreement may exceed the benefit of the transaction if market interest
rates move against the hedge. However, if analyzed in the context of the entire
portfolio, losses on hedging transactions in downward interest rate movements
will be developed prioroffset by gains on the asset side of the balance sheet.
In order to retain REIT status, NovaStar Financial must meet requirements
established by the Internal Revenue Code. Income from hedges that reduce the
interest rate risk of REIT liabilities is treated as qualifying income under
the Internal Revenue Code. All hedging instruments owned by NovaStar Financial
are REIT-qualifying. Further details regarding qualification as a REIT and
income restrictions is provided under the heading "Federal Income Tax
Consequences" of NovaStar Financial's 1998 Annual Report on Form 10K.
Table 11 of "Management's Discussion and Analysis of Financial Condition and
Results of Operations" provides a summary of hedging instruments owned by
NovaStar Financial as of March 31, 1999.
301999 and December 31, 1998.
42
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
As of September 30, 1998,March 31, 1999, there were no material legal proceedings pending to
which the CompanyNovaStar Financial was a party or of which any of its property was
subject.
Item 2. Changes in Securities
Not applicableOn February 12, 1999, NovaStar Financial issued to First Union National Bank
350,000 warrants to purchase NovaStar Financial common stock at a price of
$6.9375 per share, the closing price of the common stock on February 11, 1999.
These warrants were issued in exchange for 186,667 existing warrants with an
exercise price of $15.00 per share, all of which will be retired. The new
warrants are exercisable until February 12, 2002.
On March 10, 1999, NovaStar Financial issued to GMAC/Residential Funding
Corporation 812,731 warrants to purchase NovaStar Financial common stock at a
price of $4.5625 per share, the closing price of NovaStar Financial's common
stock on October 12, 1998. These warrants will expire on October 13, 2003. In
connection with this same warrant agreement, NovaStar Financial issued to
GMAC/Residential Funding Corporation 364,982 "tag-along" warrants to purchase
NovaStar Financial common stock at a price of $15.00 per share, which are
exercisable until February 3, 2001.
On March 29, 1999, NovaStar Financial completed the private placement and
issuance of 4,285,714 shares of Class B 7% cumulative convertible preferred
stock at a price of $7.00 per share, resulting in total proceeds of
approximately $30 million, which includes approximately $25 million acquired by
Wallace R. Weitz & Company. Stifel, Nicolaus & Company, Incorporated acted as
placement agent in connection with the issuance and received commissions and
reimbursement of expenses totaling approximately $1,240,000. Each share of the
preferred stock is convertible, at the option of the holder, into one share of
common stock and is redeemable at par by NovaStar Financial at any time after
March 31, 2002.
The issuance of the preferred stock and the earlier issuance of warrants in
connection with the financing arrangement entered into with First Union and
GMAC/Residential Funding Corporation resulted in a reduction of the $15.00
exercise price of the warrants issued in NovaStar Financial's private placement
in December 1996. The GMAC/Residential Funding Corporation's "tag-along"
warrants are similarly affected. Pursuant to anti-dilution provisions contained
in the 1996 warrants, each warrant exercised at $15.00 will purchase 1.29
shares of common stock, which represents an effective exercise price of $11.62
per share.
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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) Exhibits filed with this report are as follows:
10.1 Master repurchase agreement with First Union National Bank
10.2 Primary mortgage insurance agreement with Commonwealth Mortgage
Assurance Company
11.1 Schedule regarding computation of per share earnings
21.1 Subsidiaries of the Registrant
27.1 Financial data schedule
99.1 Press release dated October 29, 1998
(b) The CompanyNovaStar Financial has filed the following Form 8-K's:
. Regarding certain amendments made to its charterthe announcement of the financing arrangement with First Union
National Bank and related material financing documents and warrant
agreement, filed on July 6,
1998.February 23, 1999.
. Regarding announcement of current market conditionsthe March 1999 Class B 7% cumulative convertible preferred
stock, the GMAC/RFC warrant agreement and postponement
of the third quarter dividendreduction in the 1996
warrant effective exercise price, filed on October 12, 1998.
. Regarding announcement of $15 million 90-day committed secured
financing agreement to address immediate liquidity needs filed on
October 13, 1998.
. Regarding announcement of steps taken to address immediate liquidity
needs filed on October 15, 1998.
31April 6, 1999.
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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: NovemberMay 12, 19981999 /s/ Scott F. Hartman
--------------------_____________________________________
Scott F. Hartman
Chairman of the Board, Secretary and
Chief Executive Officer
(Principal Executive Officer)
DATE: NovemberMay 12, 19981999 /s/ Rodney E. Schwatken
-----------------------_____________________________________
Rodney E. Schwatken
Vice President, Controller and
Assistant Treasurer
(Principal Accounting Officer)
32
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