- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------<ins>FORM 10-Q FOR NOVASTAR FINANCIAL</ins>
 
   

   UNITED STATES

   SECURITIES AND EXCHANGE COMMISSION

   Washington, DC 20549
 
                               ----------------
 
 

   FORM 10-Q
 
[X]
 
x
     QUARTERLY REPORT PURSUANT TO SECTION 13 OR
   15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 

   For the quarterly period ended March 31,June 30, 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
 
    (Address of principal executive
               offices)
                                (913) 362-1090
             (Registrant's telephone number, including area code)
 
                               ----------------
 
   (Former name, former address and former fiscal year, if changed since last
report)
 
   Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X]  No [_]
 
   The number of shares of the registrant's common stock outstanding as of May
10, 1999 was 8,130,069.
 
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------

 
 
Maryland
(State or other jurisdiction of
   

   incorporation or organization)
 
1901 W. 47th Place,
Suite 105, Westwood, KS
(Address of principal executive offices)
 
74-2830661
(I.R.S. Employer Identification No.)
 
66205
(Zip Code)
 
 
(913) 362-1090
(Registrant’s telephone number, including area code)
 
 

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

     Indicate by check mark whether the registrant (1) has filed all
     reports required to be filed by Section 13 or 15(d) of the
     Securities Exchange act of 1934 during the preceding 12 months (or
     for such shorter period that the registrant was required to file
     such reports), and (2) has been subject to such filing
     requirements for the past 90 days. Yes  x
       No  ¨
     
 
The
     number of shares of the registrant’s common stock outstanding
     as of August 13, 1999 was 8,130,069.
 
 
NOVASTAR FINANCIAL, INC.
 
FORM 10-Q
QUARTER ENDED MARCH 31,JUNE 30, 1999
INDEX
 

 

  
    Page
                                                                                                 ----

PART I FINANCIAL
     INFORMATION  
 
Item 1. Consolidated
     Financial Statements:
         Statements
   :  
  Balance Sheets.........................................................................    Sheets 1
  Statements of Operations...............................................................    Operations 2
  Statements of Cash Flows...............................................................    Flows 3
         Notes..................................................................................    
  Notes  4
Item 2.  Management's Management’s Discussion and Analysis of
     Financial Condition and Results of Operations..    Operations 6
Item 3. Quantitative and Qualitative Disclosures about Market
     Risk.............................   38
Risk 43
 
PART II OTHER INFORMATION
       
 
Item 1. Legal Proceedings...................................................................... Proceedings II-1
Item 2. Changes in Securities.................................................................. Securities II-1
Item 3. Defaults Upon Senior Securities........................................................ II-2
Securities II-1
Item 4. Submission of Matters to a Vote of Security Holders.................................... II-2
Holders
      II-1
Item 5. Other Information...................................................................... II-2
Information II-1
Item 6. Exhibits and Reports on Form 8-K....................................................... II-2
         Signatures............................................................................. 8-K II-1
  Signatures II-3

 

 
NOVASTAR FINANCIAL, INC.
 

 CONSOLIDATED BALANCE SHEETS
                  (dollars
(dollars in thousands, except share amounts)
 

 

  
                                               March
  June 30,
      1999
 December 
     31, 1999 December 31, 1998
                                               -------------- -----------------
                                                
  (unaudited)
Assets
   
            Cash and cash
     equivalents...................    equivalents  $168
       $ 2,403       $      --  
          —  
      
   
            Mortgage loans, net.........................     847,744          920,697net
      788,245
       945,798
      
   
            Accrued interest
     receivable.................       9,357            9,702receivable  15,589
       17,608
      
   
            Due from affiliates.........................      61,071           51,528affiliates
      26,724
       18,521
      
   
            Investment in NFI
     Holding Corporation.......       2,147               Corporation  9,787
       13
      
   
            Assets acquired through
     foreclosure.........      14,173           foreclosure  16,654
       10,583
      
   
            Amounts due from
     founders...................       5,561            founders  5,576
       5,354
      
   
            Other assets................................       1,867            assets  2,019
       4,359
                                                  --------       ----------
      
 
 
 
   
                
           Total assets..............................    $944,323       $1,002,236
                                                  ========       ==========
assets  $864,762
       $1,002,236
      
 
 
 
Liabilities and
     Stockholders'Stockholders’ Equity
Liabilities:
   
            Collateralized mortgage
     obligations.........    $819,899       obligations  $741,621
       $891,944
      
   
            Residual interest
     financing.................         --            financing  — 
       18,000
      
 
 
 
   
                
           Total borrowings  741,621
       909,944
      
   
            Dividends payable...........................       2,876            payable  525
       2,845
      
   
            Accounts payable and
     accrued expenses.......       1,836            expenses  1,379
       2,157
                                                  --------       ----------
      
 
 
 
   
                
           Total liabilities.........................     824,611          liabilities  743,525
       914,946
Stockholders'
      
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,June 30,
   

              
         1999 with a redemption and liquidation
     value of $7 per share..........          share 		 43              --
       —  
     
      
   
            Common stock, 8,130,069
     shares issued and outstanding................................          outstanding  81
       81
      
   
            Additional paid-in
     capital..................     151,247          capital  151,208
       122,180
      
   
            Accumulated deficit.........................     (31,108)         (32,804)deficit
      (29,788) (32,804)
   
            Accumulated other
     comprehensive income......       1,616              --income  1,860
       —  
     
      
   
            Forgivable notes
     receivable from founders...     founders  ( 2,167)          (2,167)
                                                  --------       ----------2,167) (2,167)
 
 
 
   
                
           Total stockholders' equity................     119,712           stockholders’
     equity  121,237
       87,290
                                                  --------       ----------
      
 
 
 
   
                
           Total liabilities and
     stockholders'
     equity...................................    $944,323       $1,002,236
                                                  ========       ==========stockholders’ equity  $864,762
       $1,002,236
      
 
 
 

 

 
 
See notes to consolidated financial statements.
 
                                       1


   NOVASTAR FINANCIAL, INC.
 

 CONSOLIDATED STATEMENTS OF OPERATIONS

   (unaudited; in thousands, except per share amounts)
 

 

  
  For the Six
   

   Months Ended
   

   June 30,
 For the Three
   
Months Ended
   March 31,
                                                               ----------------
                                                                

   June 30,
  1999
 1998
                                                               -------  -------

 1999
 1998
Interest income:        
        
       Mortgage loans.............................................. $19,550  $14,550loans  $36,641  $33,962  $17,091  $19,412
        
       Mortgage securities.........................................     --     9,364
                                                               -------  -------
securities  —   16,396  —   7,032
 
 
 
 
Total interest income.........................................  19,550   23,914
income  36,641  50,358  17,091  26,444
Interest expense..............................................  13,209   18,442
                                                               -------  -------
expense  24,853  38,860  11,644  20,418
 
 
 
 
Net interest income...........................................   6,341    5,472
income  11,788  11,498  5,447  6,026
Provision for credit losses...................................   2,299    1,076
                                                               -------  -------
losses  5,865  2,221  3,566  1,145
 
 
 
 
Net interest income after provision for credit
     losses.........   4,042    4,396
losses  5,923  9,277  1,881  4,881
Other income..................................................     935      364
income  2,000  1,093  1,065  729
Equity in earnings (loss) of NFI Holding
     Corporation..........     551     (271)
Corporation  942  (9) 391  262
General and administrative expenses:        
        
       Loan servicing fees paid to NovaStar Mortgage, Inc..........   1,115      630Inc.
      2,120  1,488  1,005  858
        
       Compensation and benefits.  937  896  352  460
        
       Other loan servicing expenses  946  128  476  84
        
       Professional and outside services  365  353  33  297
        
       Fees for other services provided by (to) NovaStar
     Mortgage,
   Inc........................................................   1,050    1,500
  Compensation and benefits...................................     585      436
  Professional and outside services...........................     332       56
  Other loan servicing expenses...............................     470       44

              
         Inc. 		 456  3,183  (594) 1,683
        
       Forgiveness of notes receivable from founders...............     --       founders  —   542  —   271
        
       Office administration.......................................     208      181
  Other.......................................................      42       92
                                                               -------  -------administration  408  405  200  224
        
       Other  62  193  20  101
 
 
 
 
        
                
      Total general and administrative expenses.................   3,802    3,210
                                                               -------  -------
expenses  5,294  7,188  1,492  3,978
 
 
 
 
Net income.................................................... income  $ 1,726  3,571  $ 1,279
                                                               =======  =======
3,173  $1,845  $1,894
 
 
 
 
Preferred stock dividends.....................................     (31)     --
                                                               -------  -------
dividends  (556) —   (525) 
 
 
 
 
Income available to common stockholders....................... stockholders  $ 1,695  3,015  $ 1,279
                                                               =======  =======
3,173  $1,320  $1,894
 
 
 
 
Basic earnings per common share............................... share  $  0.21  0.37  $0.40  $0.16
                                                               =======  =======
  $0.23
 
 
 
 
Diluted earnings per common share............................. share  $  0.20  0.34  $0.36  $0.15
                                                               =======  =======
  $0.21
 
 
 
 
Dividends declared per common share........................... share  $   --   —   $  0.30
                                                               =======  =======0.65  $—   $0.35
 
 
 
 

 

 
 
See
   notes to consolidated financial statements.
 
                                       2

NOVASTAR FINANCIAL, INC.
 

 CONSOLIDATED STATEMENTS OF CASH FLOWS
                           (unaudited;
(unaudited; in thousands)
 

 

  
  For the ThreeSix
     Months
   
Ended March 31,
                                                            ------------------
                                                             June 30,
  1999
 1998
                                                            -------  ---------

Net cash
     provided by operating activities $ 5,812  14,772
       $   2,913
5,069
      
Cash flow from
     investing activities:    
 
   
            Mortgage loans purchased
     from NovaStar Mortgage, Inc.....     --    (208,632)Inc.  — 
       (507,390)
   
            Mortgage loan repayments.................................  57,029     22,515repayments
      127,127
       66,659
      
   
            Mortgage loans sold to
     others............................   4,545        --others  4,900
       3,011
      
   
            Investment in NFI
     Holding Corp.  (7,000) — 
      
   
            Sales of assets acquired
     through foreclosure.............   3,757        --foreclosure  9,548
       485
      
   
            Purchases of
     available-for-sale securities...............     --    (293,992)securities  — 
        (375,051)
   
            Proceeds from sales of
     available-for-sale securities.....     --     315,573securities  — 
       315,743
      
   
            Proceeds from paydowns
     on and maturities of available-
   for-sale securities.....................................     --      63,892available-for-sale securities  — 
       111,093
      
   
            Net change in amounts
     due from affiliates................  (7,427)    (3,570)
                                                            -------  ---------affiliates  (6,087) (5,297)
 
 
 
   
            Net cash provided by
     (used in) investing activities......  57,904   (104,214)
activities  128,488
       (390,747)
 
Cash flow from
     financing activities:    
 
   
            Proceeds from issuing
     collateralized mortgage obligations.............................................     --      50,000obligations  — 
       350,000
      
   
            Payments on
     collateralized mortgage obligations.......... (72,395)   (29,324)obligations   (151,259
     ) (69,309)
   
            Debt issuance costs paid
     on collateralized mortgage obligations.............................................     --        (367)obligations  — 
       (1,461)
   
            Change in short-term
     borrowings.......................... (18,029)    85,646borrowings  (18,029) 109,771
      
   
            Proceeds from issuance
     of capital stock and exercise of equity instruments,
   

              
         net of offering costs of 1,240..........................  29,111          7$1,240 		 29,072
       (55)
   
            Dividends paid...........................................     --        (783)
                                                            -------  ---------paid  (2,876) (3,220)
 
 
 
   
            Net cash provided by
     (used in) financing activities...... (61,313)   105,179
                                                            -------  ---------activities  (143,092) 385,726
      
 
 
 
     
   
            Net increase in cash and
     cash equivalents................   2,403      3,878equivalents  168
       48
      
   
            Cash and cash
     equivalents, beginning of period...........     --         --period  — 
       — 
      
 
 
 
   
            Cash and cash
     equivalents, end of period................. period  $ 2,403  168
       $   3,878
                                                            =======  =========
48
      
 
 
 
Supplemental
     disclosure of cash flow information:    
 
   
            Note received in
     exchange for options exercised by founders................................................ founders  $   --   — 
     
       $   4,340
                                                            =======  =========4,350
      
 
 
 
   
            Cash paid for interest................................... $13,487  interest
      $  18,543
                                                            =======  =========25,317
       $38,102
      
 
 
 
   
            Dividends payable........................................ payable  $ 2,876  525
       $   2,436
                                                            =======  =========2,843
      
 
 
 
   
            Assets acquired through
     foreclosure...................... foreclosure  $ 7,270  15,542
       $   1,524
                                                            =======  =========4,415
      
 
 
 

 

 
 
See notes to consolidated financial statements.
 
                                       3


   NOVASTAR FINANCIAL, INC.
 

 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           March 31,

   June 30, 1999 (Unaudited)
 

   Note 1.    Financial Statement Presentation
 
 
            The
   consolidated financial statements as of and for the periods ended
   March
31,June 30, 1999 and 1998 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'sManagement’s Discussion and
   Analysis of Financial Condition and Results of Operations and the
   consolidated financial statements of NovaStar Financial and the
   notes thereto, included in NovaStar Financial'sFinancial’s annual report
   to shareholders and annual report on Form 10-K for the fiscal year
   ended December 31, 1998.
 
 
            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.
   NovaStar Financial formed these entities in connection with the
   issuance of collateralized mortgage obligations. The consolidated
   financial statements of NovaStar Financial include the accounts of
   these entities. Significant intercompany accounts and transactions
   have been eliminated in consolidation.
 
 
            NovaStar
   Financial owns 100 percent of the preferred stock of NFI Holding
   Corporation for which it receives 99 percent of any dividends paid
   by NFI Holding. The founders of NovaStar Financial own the voting
   common stock of NFI Holding. NovaStar Mortgage, Inc. and NovaStar
   Capital, Inc. are wholly owned subsidiaries of NFI Holding. NovaStar
   Mortgage Funding Corporation II and NovaStar REMIC Financing
   Corporation are subsidiaries of NovaStar Mortgage. NovaStar
   Financial accounts for its investment in Holding using the equity
   method.
 

   Note 2. Stockholders'   Stockholders’ 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 stated and liquidation value of $7 per share. Each
   holder of the preferred stock is entitled to quarterly dividends
   that accrue at 7% per annum on the stated value. Holders of the
   Class 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 or after March 31, 2002 at a
   price of $7.00 per share, payable in cash.
 
 
            Comprehensive
   income includes net income and revenues, expenses, gains and losses
   that are not included in net income. Currently, the only component
   of comprehensive income for NovaStar Financial is the net change in
   the unrealized gain (loss) on available-for-sale securities.
   Following is a summary of comprehensive income for the six and three
   monthsmonth periods ended March 31,June 30, 1999 and 1998.
 

 

  
  For the Six 
     Months
   

   Ended June 30,
 For the Three Months
   
Ended March, 31
                                                           --------------------
                                                             June 30,
  1999
 1998
                                                           --------------------
   
 1999
 1998
Net income............................................. income  $   1,726 3,571 $    1,279
   3,173  $1,845 $1,894 
Other comprehensive income--netincome—net change in
     unrealized

        gain (loss) on available-for-sale
     securities..........     1,616     (4,108)
                                                           --------- ----------
   securities 		 1,860 (4,302) 244 (194)
 
 
 
Comprehensive income (loss)............................  $   3,342 5,431 $   (2,829)
                                                           ========= ==========(1,129) $2,089 $1,700 
 
 
 

 

 4

 

   Note 3.    Earnings Per Share
 
 
            The
   computations of basic and diluted EPS computations for the six and three monthsmonth
   periods ended March 31,June 30, 1999 and 1998 are as follows (in
   thousands, except per share amounts):
 

 

  
  For the six
   

   months ended
   

   June 30,
 For the three
   
months ended
   March 31,
                                                         ----------------------
                                                            

   June 30,
  1999
 1998
                                                         ----------  ----------

 1999
 1998
Numerator:
Net Income.............................................. Income  $    1,726  3,571  $    1,279
3,173 $1,845  $1,894
Less: Preferred stock dividends.........................        (31)        --
                                                         ----------  ----------
dividends  (556) —  (525) —  
 
 
 
Income available to common
   stockholders--basic ................................... 

        stockholders—basic 		 $    1,695  3,015  $    1,279
                                                         ==========  ==========
3,173 $1,320  $1,894
 
 
 
 
Plus: Preferred stock dividends.........................         31         --
                                                         ----------  ----------
dividends  556  —  525  —  
 
 
 
Income available to common
   stockholders--diluted.................................. 

        stockholders—diluted 		 $    1,726  3,571  $    1,279
                                                         ==========  ==========
3,173 $1,845  $1,894
 
 
 
 
Denominator:        
Weighted average common
   

        shares outstanding--basic..............................      outstanding—basic 		 8,130       7,855
                                                         ==========  ==========
Warrants................................................        232         708
  7,987 8,130  8,121
 
 
 
Warrants  225  773 217  835
Stock options...........................................         options  22          97
  81 22  59
Convertible preferred stock.............................        254         --
                                                         ----------  ----------
stock  2,226  —  4,286  —  
 
 
 
Weighted average common
   

        shares outstanding--dilutive ..........................      8,638       8,660
                                                         ==========  ==========
outstanding—diluted 		 10,603  8,841 12,655  9,015
 
 
 
Basic earnings per share................................ share  $     0.21  0.37  $0.40 $0.16
                                                         ==========  ==========
  $0.23
 
 
 
Diluted earnings per share.............................. share  $     0.20  0.34  $0.36 $0.15
                                                         ==========  ==========  $0.21
 
 
 
 

 
 
            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'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
  For the six
   

   months ended
   March 31,
                                                             --------------------
                                                                

   June 30,
 For the three
   

   months ended
   

   June 30,
  1999
 1998
                                                             ---------- ---------

 1999
 1998
Number of stock options and warrants........................      4,417     --
warrants  4,351 5,000 4,522 5,000
Weighted average exercise price.............................     $11.61     --price  $11.55 $20.81 $11.46 $20.81

 

 5

 

   Note 4.    Reclassifications
 
 
            During the
   second quarter of 1999, NovaStar Financial reclassified the
   principal and interest collections received on the securitized
   mortgage loan portfolio to more closely match the timing of the
   principal and interest payments made to bondholders of the
   collateralized mortgage obligations (CMOs). Under the terms of
   NovaStar Financial’s CMOs, the principal and interest collected
   by NovaStar Mortgage, NovaStar Financial’s servicer, during any
   given month are held in trust and remitted to bondholders of the
   CMOs the following month. Prior to the reclassification change in
   1999, NovaStar Financial reduced the securitized mortgage loan
 
 

 Item 2. Management's   Management’s Discussion and
   Analysis of Financial Condition and Results of Operations
 
 
            The
   following discussion should be read in conjunction with the
   preceding consolidated financial statements of NovaStar Financial
   and the accompanying notes as well as NovaStar Financial'sFinancial’s
   annual report to shareholders and annual report on form 10-K for the
   fiscal year ended December 31, 1998.
 

   Safe Harbor Statement
 
   "Safe Harbor"
 
 
            “Safe
   Harbor” statement under the Private Securities Litigation
   Reform Act of 1995: Statements in this discussion regarding NovaStar
   Financial, Inc. and its business, which are not historical facts,
   are "forward-looking statements"“forward-looking statements” that involve risks and
   uncertainties. Risks and uncertainties, which could cause results to
   differ from those discussed in the forward-looking statements
   herein, are listed in "Risk Management"“Risk Management” section of this
   annual report. In addition, there are many important factors that
   could cause 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 in
   the asset securitization industry or the REIT provisions of the
   Internal Revenue Code, demand for services and products offered by
   NovaStar, the impact of covenants in loan agreements, the degree to
   which NovaStar Financial is leveraged, the needs for and
   availability of financing, access to capital and other risks
   identified in NovaStar Financial'sFinancial’s Securities and Exchange
   Commission filings. In addition, it should be noted that past
   financial and operational performance of NovaStar 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'sFinancial’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
 
 
            NovaStar
   Financial owns 100% of the common stock of NovaStar Assets
   Corporation, NovaStar Certificates Financing Corporation and
   NovaStar Mortgage Funding Corporation. These entities were
   established as special purpose entities used in issuance of
   collateralized mortgage obligations. The consolidated financial
   statements of NovaStar Financial include the financial condition and
   results of operations of these entities.
 
 
            NovaStar
   Financial also owns 100% of the non-voting preferred stock of NFI
   Holding Corporation for which it receives 99% of any dividends paid
   by NFI Holding. 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 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. Key officers of
   NovaStar 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 purchasetest the possibility of sourcing residential
   mortgage loans from banks, thrifts and sell mortgage loans.credit unions. NovaStar
   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).commonly known as REMICs.
   NovaStar Financial accounts for its investment in NFI Holding using
   the equity method.
 
 
            A separate
   section of this MD&A&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
     invest in mortgage assets;
 
  .  NovaStar Financial's assets have primarily come from the wholesale
     origination of 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 mortgage loan portfolio
     and indirectly by gains associated with the sale of loans to outside
     parties or through securitization transactions of NovaStar Mortgage.
 
 Business of NovaStar Mortgage:
 
  .  NovaStar Mortgage's customer is the retail mortgage broker who deals
     with the borrower. NovaStar Mortgage's account executives work with over
     3,000 brokers to solicit loans.
 
  .  NovaStar Mortgage's borrowers generally are individuals or families who
     do not qualify for agency/conventional lending programs because of a
     lack of available documentation or previous credit difficulties. Often,
     these borrowers have built up high-rate consumer debt and are attempting
     to use equity in their home to consolidate debt and lower their total
     monthly payments.
 
  .  NovaStar Mortgage's
 
Business of NovaStar Financial:
     
 

     Ÿ
NovaStar Financial
     was founded in 1996 as a specialty finance lender to invest in
     mortgage assets;
 

     Ÿ
NovaStar Financial
     ’s assets have primarily come from the wholesale origination
     of single-family nonconforming loans by its affiliate, NovaStar
     Mortgage;
 

     Ÿ
NovaStar Financial
     operates as a long-term portfolio investor;
 

     Ÿ
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;
 

     Ÿ
Earnings are
     generated from spread income on the mortgage loan portfolio and
     indirectly by gains associated with the sale of loans to outside
     parties or through securitization transactions of NovaStar
     Mortgage.
 
Business of NovaStar Mortgage:
     
 

     Ÿ
NovaStar Mortgage
     ’s customer is the retail mortgage broker who deals with the
     borrower. NovaStar Mortgage’s account executives work with
     over 2,000 brokers to solicit loans.
 

     Ÿ
NovaStar Mortgage
     ’s borrowers generally are individuals or families who do not
     qualify for agency/conventional lending programs because of a lack
     of available documentation or previous credit difficulties. Often,
     these borrowers have built up high-rate consumer debt and are
     attempting to use equity in their home to consolidate debt and
     lower their total monthly payments.
 

     Ÿ
NovaStar Mortgage
     ’s loans are financed on a short-term basis through warehouse
     facilities. Long-term financing is provided through securitization
     where asset-backed bonds are issued in transactions that are
     structured as a sale.
 

   Forgivable Notes Receivable from Founders
 
 
            The founders
   of NovaStar Financial purchased 216,666 units in the 1996 private
   placement in exchange for forgivable promissory notes. A unit
   consisted of one share of convertible preferred stock and one common
   stock warrant. Principal on these notes is divided into three equal
   parts, called "tranches"“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 stock price, the value of
   the warrants, and dividends paid. One tranche will be forgiven for
   each fiscal year NovaStar Financial generates a return of 15% to
   investors in the private placement. All three tranches will be
   forgiven if a return of 100% is generated within five years.
 
 
            During the
   period from the closing of the private placement through December
   31, 1997, NovaStar Financial'sFinancial’s stock price averaged $17.08 per
   share, dividends of $0.28 were declared and the value of each
   warrant was $2.08. The combination of these produced a return to
   investors in the private placement exceeding
 15%. As a result, the first tranche of these notes was forgiven
   resulting in a non-
cashnon-cash charge of $1,083,000 during the fourth
   quarter of 1997. NovaStar recorded a non-cash charge of $271,000$542,000 to
   earnings during the threesix months ended March
31,June 30, 1998 in anticipation
   of the forgiveness of the second tranche. However, as a result of
   NovaStar Financial'sFinancial’s significant loss in the fourth quarter of
   1998 and the market price of its stock during the same period, the
   second tranche of the notes receivable from founders was not
   forgiven in 1998. NovaStar Financial has not recognized any
   forgiveness of the second tranche in 1999 because management is
   uncertain of whether the incentive performance targets will be met.
   7

 

   Financial Condition of NovaStar Financial, Inc. as of March 31,June 30, 1999
   and December 31, 1998
 
 
            NovaStar
   Financial'sFinancial’s balance sheets at March 31,June 30, 1999 and December 31,
   1998 primarily consist of mortgage loans purchased from NovaStar
   Mortgage, which serve as collateral on its collateralized mortgage
   obligations. The carrying value of mortgage loans at March 31,June 30, 1999
   was $848$788 million versus $921$946 million at December 31, 1998. The
   carrying value of collateralized mortgage obligations at March 31,June 30,
   1999 was $820$742 million at 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 first six months of
   1999.
 
 
            During the
   second quarter of 1999.1999, NovaStar Financial reclassified the
   principal and interest collections received on the securitized
   mortgage loan portfolio to more closely match the timing of the
   principal and interest payments made to bondholders of the
   collateralized mortgage obligations commonly called CMOs. Under the
   terms of NovaStar Financial’s CMOs, the principal and interest
   collected by NovaStar Mortgage, NovaStar Financial’s servicer,
   during any given month are held in trust and remitted to bondholders
   of the CMOs the following month. Prior to the reclassification
   change in 1999, NovaStar Financial reduced the securitized mortgage
   loan and accrued interest balances when mortgage loan payments were
   received by NovaStar Mortgage. Thus at any given month-end, NovaStar
   Financial’s mortgage loan balance would reflect the principal
   and interest collected during the month. However, the CMO balances
   would not reflect these principal and interest payments until the
   following month. In order to better match the collateral principal
   and interest payments with the CMO principal and interest payments,
   a reclass was made on NovaStar Financial’s books to gross up
   mortgage loans and accrued interest and reduce the Due from
   Affiliates balance. NovaStar Mortgage’s Due to Affiliates and
   restricted cash were also reduced. Similar adjustments were made to
   the December 31, 1998 balance sheets of NovaStar Financial and
   NovaStar Mortgage to reflect the current year presentation.
 
 
              Table 1 is a
   presentation of loans as of March 31,June 30, 1999 and December 31, 1998 and
   their credit grades. Table 2 is a summary of all mortgage loans
   owned by NovaStar Financial as of March 31,June 30, 1999 and December 31,
   1998 by state.
 

   Table 1

   Mortgage Loans by Credit Grade

   (dollars in thousands)
 

 

  
                                                             March 31,
      June 30, 1999
 December 31, 1998
                                                       --------------------------- ---------------------------
                                                                          Weighted                    Weighted
                             
Credit
   

   Grade
 Allowed
   Weighted Average            Weighted Average

   Mortgage
   

   Lates (A)
 Maximum Loan-
   

   to-value
 Current
   
Principal
 Weighted
   
Average
   

   Coupon
 Weighted
   

   Average
   
Loan-to-
   

   value
 Current
   
Principal
 Weighted
   
Average
   

   Coupon
 Weighted
   

   Average
   
Loan-to-
   Credit Grade          Lates (A)      to-value    Principal  Coupon

   value   Principal  Coupon   value
      ------------       --------------- ------------- --------- -------- -------- --------- -------- --------

AA...................... 
AA  0 x 30                95(B)    95(B) $ 109,172   9.53%    83.5%  $117,172    9.51%    83.4%
A....................... 103,092 9.52% 83.3% $120,427 9.51% 83.4%
A  1 x 30 90        330,437   9.86       305,846 9.87  79.8  366,913 9.84  79.7    356,994    9.84     79.7
A.......................  
A  2 x 30 90        198,285    187,403 10.31     81.5    214,627     81.6  220,591 10.31  81.3
B.......................  
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....................... 		 85  115,284 10.71  78.2  142,346 10.62  77.9 
C  1 x 90 75         58,280  11.18     72.4     62,784     53,579 11.21  72.5  64,529 11.13  72.3
D.......................  
D  6 x 30, 3 x 60,
   65         11,853  12.09     62.0     13,328   12.14     62.2

   2 x 90
                                                       ---------                   --------
Total...................                               		 65  9,956 12.02  61.5  13,697 12.14  62.2 
    
 
 
 
 
Total      $ 832,277  10.17%    79.6%  $903,402   10.15%    79.5%
                                                       =========  =====     ====   ========   =====     ====775,160 10.18% 79.7% $928,503 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  
(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
 June 30, 1999
 December 31, 1998
- -------------------                                           ------------------

California...................................................         18%
Florida......................................................         
California  17% 18%
Florida  13  12
Washington...................................................           
Washington  8
Oregon.......................................................            8 
Oregon  5  5 
All other states.............................................         states  57
                                                                     ---
  Total......................................................        100%
                                                                     ===  57 
 
 
 
        
       Total  100% 100%
 
 
 

 

 8

 
 
              Table 3
   provides a summary of NovaStar Financial'sFinancial’s mortgage loans by
   type and carrying value as of March 31,June 30, 1999 and December 31, 1998.
   
 
Table 3

   Carrying Value of Loans by Product/Type
              March 31,

   June 30, 1999 and December 31, 1998
 
(in thousands)
 

 

  
                                                         March 31,  
Product/Type
 June 30, 1999
 December 31, Product/Type                                            1999         1998
   ------------                                          ---------  ------------
   
   Two-
Two and three-year fixed............................ $471,002     $511,824
   fixed  $434,442  $526,044 
Six-month LIBOR and one-year CMT.....................   75,201       88,958
   CMT  67,134  91,430 
30/15-year fixed and balloon.........................  286,074      302,620
                                                         --------     --------balloon  273,584  311,029 
 
 
 
        
       Outstanding principal..............................  832,277      903,402
   Premium..............................................   18,959       principal  775,160  928,503 
Premium  16,658  20,868 
Allowance for credit losses..........................   (3,492)      (3,573)
                                                         --------     --------losses  (3,573) (3,573)
 
 
 
        
       Carrying Value..................................... $847,744     $920,697
                                                         ========     ========
   Value  $788,245  $945,798 
 
 
 
Carrying value as a percent of principal.............   101.86%      101.91%
                                                         ========     ========principal  101.68% 101.86%
 
 
 

 
 
 
            During the
   first half of 1998, NovaStar Financial purchased securities as a
   temporary use of capital from its initial public offering. As
   NovaStar Financial'sFinancial’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 Financial
   has not purchased any additional securities.
 
 
            Table 4 is a
   summary of the securities acquired during 1999 and 1998 by quarter.
   
 
Table 4

   Mortgage Security Acquisitions

   Three Months Ended March 31,June 30, 1999 and 1998
 
(dollars in thousands)
 

 

  
  Principal
 Premium
 Discount
 Net
   Weighted

   Price
   Average
                                    Principal Premium Discount

   to Par
 Weighted
   

   Average
   

   Coupon
                                    --------- ------- -------- ------- --------

1999:
        
       Second quarter  $—   $—   $—    —   —  %
        
       First quarter.................... quarter  $ --         
      —   $ --          
      —   $ --       --      --       
      —    —   —  %
 
1998:
        
       Fourth quarter................... quarter  $ --         
      —   $ --          
      —   $ --       --      --       
      —    —   —  %
        
       Third quarter ...................      --      --      --       --      -- —   —   —    —   —   
        
       Second quarter--Federal National
     Mortgage Association..........   80,237     823     --     101.0    6.40
  First quarter:
    quarter—Federal National Mortgage
   Association...................   

              
              Association
     		  80,237 823 —    101.0 6.40 
        
       First quarter:
        
                
      Federal National Mortgage Association  40,929 444     --      —    101.1 6.12 
        
                
      Government National Mortgage
   Association...................

              
                
        Association 		  229,130  3,726    (364)     (364) 101.5 6.39 

 
 
 
            
   Short-term Financing Arrangements.Arrangements.    
   NovaStar Financial is a co-borrower with NovaStar Mortgage under
   warehouse lending and master repurchase agreements with First Union
   National Bank which are scheduled to mature in February 2000. As of
   March 31,June 30, 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. As of June 30, 1999 and December 31, 1998,
   NovaStar Financial had no borrowings outstanding, as of
March 31, 1999 and December 31, 1998, and NovaStar
   Mortgage had borrowings of $65,155,000$79,960,000 and $203,341,000 outstanding,
   respectively under these arrangements. Borrowings under these
   arrangements are secured by mortgage loans. The interest rate on
   borrowings under the warehouse lending arrangement is indexed to the
   federal funds rate. Under the master repurchase agreement,
   borrowings are indexed to one-month LIBOR.
 
 
            On February
   12, 1999, two additional one-year agreements were executed with
   First 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 bear interest at one-month LIBOR
   plus five percent. As of March 31,June 30, 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'sFinancial’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 short-term financing
   arrangement with GMAC/Residential Funding Corporation (GMAC/RFC)
   secured by residual interests in NovaStar Financial'sFinancial’s CMOs. In
   1998, NovaStar Financial borrowed $15 million from GMAC/RFC, which
   included a $3 million financing fee. In connection with the
   agreement, NovaStar Financial issued 812,731 warrants to GMAC/RFC
   for the purchase of NovaStar Financial'sFinancial’s stock at $4.63 per
   share and 364,982 tag along warrants to purchase common stock on the
   terms of the December 9, 1996 warrants which were issued at $15.00
   per share. NovaStar Financial had no other short-term borrowings
   outstanding as of December 31, 1998. In February of 1999, NovaStar
   Financial used financing sources at First Union to pay this debt in
   full.
 
 
            
   Collateralized mortgage obligations.obligations.    
   On a long-term basis, NovaStar Financial finances its mortgage loans
   using collateralized mortgage obligations commonly called CMOs.
   Investors in CMOs are repaid based on the performance of the
   mortgage loans collateralizing the CMOs. 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.
   Under 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 CMOs as of March 31,June 30, 1999 and December 31,
   1998 (dollars in thousands):
 

   Table 5

   Collateralized Mortgage Obligations
          March 31,

   June 30, 1999 and December 31, 1998
 
(dollars in thousands)
 

 

  
  Collateralized Mortgage
     Obligation
 Mortgage Loans
                          -------------------------------------- ------------------
                                              
  Remaining
   

   Principal
 Interest
   

   Rate
 Estimated Weighted
   Weighted
                          Remaining  Interest

   Average Months
   Remaining Average
                          Principal    Rate

   to Call
 Remaining
   

   Principal
 Weighted
   

   Average
   

   Coupon
                          ---------  -------- ------------------ --------- --------

As of March 31,June 30, 1999:
NovaStar Home Equity Series:
        
       Issue 1997-1..........  $141,994     5.19%          27         $146,350   10.64%1997-1  $113,319  5.34% 4 $125,287 10.76%
        
       Issue 1997-2..........   147,394     5.19           29          153,355   10.361997-2  135,471  5.34  27 144,887 10.33 
        
       Issue 1998-1..........   248,060     5.01           33          253,709   10.161998-1  226,911  5.16  40 240,459 10.03 
        
       Issue 1998-2..........   286,384     5.05           37          291,419   10.081998-2  269,266  5.20  43 280,250 9.97 
        
       Unamortized debt issuance
   

              
         costs, net..    (3,933)
                          --------
                          $819,899
                          ========
net of amortization 		 (3,346)        
 
       
  $741,621         
 
       
As of December 31, 1998:
NovaStar Home Equity Series:
        
       Issue 1997-1..........  $163,419     5.88%          1997-1  $163,419  5.88% 29         $166,821   10.56% $174,516 10.56%
        
       Issue 1997-2..........   1997-2  164,496  5.88  31          166,544    173,858 10.37 
        
       Issue 1998-1..........   1998-1  268,152  5.69  35          272,742    277,776 10.01 
        
       Issue 1998-2..........   1998-2  300,161  5.74  38          301,749     306,807 9.95 
        
       Unamortized debt issuance
   

              
         costs, net..    (4,284)
                          --------
                          $891,944
                          ========net of amortization 		 (4,284)        
 
       
  $891,944         
 
       

 
 
 
            NovaStar
   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,
   NovaStar Financial generally strives to acquire mortgage loans that
   have some form of prepayment penalty. During the threesix months ended
   March 31,June 30, 1999, NovaStar Financial collected $656,000$1.6 million in
   prepayment penalties from borrowers compared with the $200,000$678,000 during
   the 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,

   June 30, 1999 and December 31, 1998 (dollars in thousands)
 

 

  
        Weighted Average
                                                        -----------------------------------
                                                                             
  Current
   

   Principal
 Premium
 Percent with
   

   Prepayment
   

   Penalty
 Coupon
 Loan-to-
   

   value
 Remaining

   Prepayment Penalty
   Percent with

   Period (in years) Current           Prepayment          Loan-to-    -

   Loans with Principal Premium   Penalty    Coupon   value        Penalty
                         --------- ------- ------------ ------  -------- ------------------

As of March 31,June 30, 1999  
Loans collateralizing NovaStar

        Home Equity Series (CMO):
  1997-1................ $142,019  		            
        
       1997-1  $ 6,972      63%     10.64%    75.1%         0.80
  1997-2................  149,392    3,118      123,145 $5,680 32% 10.76% 75.3% 0.64
        
       1997-2  140,068 2,809 69  10.33  78.6  0.76
        
       1998-1  233,925 3,913 69  10.03  81.1  1.20
        
       1998-2  277,271 4,219 73      10.36     78.6          0.94
  1998-1................  249,901    4,295      69      10.05       9.97  81.1          1.34
  1998-2................  289,815    4,524      72       9.95     81.1          1.93
  1.77
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
                         ========  =======

loans 
 751 37 19  11.48  77.6  0.71
 
       
Total  $775,160 $16,658 64% 10.18% 79.7% 1.24
 
 
 
 
        Weighted Average
                                                        -----------------------------------
                                                                             
  Current
   

   Principal
 Premium
 Percent with
   

   Prepayment
   

   Penalty
 Coupon
 Loan-to-
   

   value
 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  
        
       1997-1  $170,118 $  7,975      65%     10.57%    75.1%          65% 10.57% 75.1% 0.89
  1997-2................  163,049    
        
       1997-2  170,363 3,403 72  10.37  78.5  1.10
  1998-1................  270,640    
        
       1998-1  275,673 4,651 69  10.01  81.1  1.51
  1998-2................  301,527    
        
       1998-2  306,586 4,703 71  9.95  81.1  2.09
All other loans.........    loans  5,763 136 65  9.91  80.0  1.59
                         --------  -------
Total................... $903,402  $20,868      70%     10.15%    79.5%         
 
       
Total  $928,503 $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 better interest 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.
 
 
            Prepayment
   rates in the table below represent the percent of loan principal
   that pre-pays in the most recent one, three and twelve month periods
   and over the life of the pool 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
 

 

  
  Issue Date
 Current
   

   Principal
   

   Balance
 Weighted
   

   Average Age
   

   of Loans at
   

   Inception
   

   (in months)
 Constant Prepayment Rate
   Average Age

   (Annual Percent)
                                            Current  of Loans at -------------------------
                                           Principal  Inception  
     One-
   

   month
 Three-
   

   month
 Twelve-
   Issue Date      Balance  (in months)

   month month   month  
 Life
                         ----------------- --------- ----------- ----- ------ ------- ----

As of March 31,June 30, 1999  
NovaStar Home Equity
   

        Series:
  1997-1................  		  
        
       1997-1  October 1, 1997  $142,019         $123,145 7       45    40       52 58 43 37    33
  1997-2................ 
        
       1997-2  December 11, 1997  149,392         140,068 3       25    27      26    22
  1998-1................   36 30 29 24
        
       1998-1  April 30, 1998    249,901         233,925 3       26    24     --     15
  1998-2................   33 28 21 18
        
       1998-2  August 18, 1998   289,815         277,271 3       15    12     --     10
 26 21 —  14
As of December 31, 1998  
NovaStar Home Equity
   

        Series:
  1997-1................  		  
        
       1997-1  October 1, 1997  $162,423         $170,118 7 44 36 33 31
  1997-2................ 
        
       1997-2  December 11, 1997  163,049         170,363 3 42 32 22 21
  1998-1................  
        
       1998-1  April 30, 1998    270,640         275,673 3 20 17     --      —   12
  1998-2................  
        
       1998-2  August 18, 1998   301,527         306,586 3 18 10     --       —   9

 

 To mitigate exposure to prepayment risk, NovaStar attempts to retain those
borrowers whose credit is considered desirable. NovaStar Financial encourages
borrowers who have satisfactorily met their obligations to refinance or rate
modify their loans with NovaStar Financial. Of the loans that prepaid during
the first quarter 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, $13.1 million, or 8% of the loans were successfully
refinanced and $2.0 million, or 1% of the loans were rate-modified. Although
these loans are considered prepayments for the purposes of the information in
Table 7, they remain in NovaStar Financial's loan portfolio.
 
                                       13

 
 
              Table 8
   summarizes mortgage asset activity during 1999 and 1998 and Table 9
   details the amount of premium as a percent of principal at quarter
   end for 1999 and 1998.
 

   Table 8

   Mortgage Assets Activity
                                  (thousands)

   (in thousands)
 

 

  
                                                  Mortgage
                           
  Mortgage Loans
 Mortgage Securities
 Total
                          ------------------  ------------------  --------------------
                          
  Principal Premium Principal Premium Principal  Premium
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...........   (27,224)   (1,160)   (63,892)    (731)    (91,116)  (1,891)
Dispositions............       --        --    (310,113)  (5,294)   (310,113)  (5,294)
                          --------   -------  ---------  -------  ----------  -------


        amortization 		 (27,224) (1,160) (63,892) (731) (91,116) (1,891)
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...........   (43,849)   (1,506)   (47,201)    (451)    (91,050)  (1,957)
Dispositions............    (2,843)      (53)       --       --       (2,843)     (53)
                          --------   -------  ---------  -------  ----------  -------


        amortization 		 (43,849) (1,506) (47,201) (451) (91,050) (1,957)
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...........   (54,745)   (1,442)   (38,925)    (493)    (93,670)  (1,935)
Dispositions............    (4,666)      (56)    (7,781)    (107)    (12,447)    (163)
                          --------   -------  ---------  -------  ----------  -------


        amortization 		 (54,745) (1,442) (38,925) (493) (93,670) (1,935)
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............     
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)
                          --------   -------  ---------  -------  ----------  -------


        amortization 		 (62,953) (2,135) (15,215) (173) (78,168) (2,308)
Adjustment(A)  25,101  —   —   —   25,101  —  
Dispositions  (378) (5) (372,016) (5,585) (372,394) (5,590)
 
 
 
 
 
 
 
Balance, December 31, 1998...................  $903,402   $20,868  1998 $928,503  $20,868  $ --        —
         $ --        —
         $  903,402  $20,868
                          ========   =======  =========  =======  ==========  =======
Acquisitions............       --        --         --       --          --       --
928,503  $20,868 
 
 
 
 
 
 
 
Acquisitions  —    —    —    —    —    —   
Principal repayments and
   amortization...........   (66,679)   (1,830)       --       --      (66,679)  (1,830)
Dispositions............    (4,446)      (79)       --       --       (4,446)     (79)
                          --------   -------  ---------  -------  ----------  -------


        amortization 		 (70,883) (1,830) —    —    (70,883) (1,830)
Dispositions  (4,446) (79) —    —    (4,446) (79)
 
 
 
 
 
 
 
Balance, March 31, 1999...................  $832,277   $18,959  1999 853,174  18,959  $ --   —    $ --   —    853,174  18,959 
Acquisitions  —   —   —   —   —   —  
Principal repayments and
   

        amortization 		 (77,650) (2,289) —   —   (77,650) (2,289)
Dispositions  (364) (12) —   —   (364) (12)
 
 
 
 
 
 
 
Balance, June 30, 1999  $  832,277  $18,959
                          ========   =======  =========  =======  ==========  =======775,160  $16,658  $—   $—   $775,160  $16,658 
 
 
 
 
 
 
 

 
(A)
Adjustment due to
     balance sheet reclassifications that were made in 1999 and 1998.
     See the “Financial Condition of NovaStar Financial as of June
     30, 1999 and December 31, 1998” section of this document for
     a description of the reclassifications that were made to better
     match the timing of principal and interest payments of NovaStar
     Financial’s securitized mortgage loan portfolio with the
     principal and interest payments of collateralized mortgage
     obligations.
 

   Table 9

   Premium as a Percent of Principal
 

 

  
  Mortgage
   

   Loans
 Mortgage
   

   Securities
 Total
   
Mortgage
   Mortgage  Mortgage
                                                     Loans   Securities

   Assets
                                                    -------- ---------- --------

As of:  
        
       June 30, 1999  2.15% —% 2.15%
        
       March 31, 1999...................................   2.28%       --%     2.28%1999  2.22  — 2.22 
        
       December 31, 1998................................   2.31        --      2.311998  2.25  —  2.25 
        
       September 30, 1998...............................   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 

 

 14

 
   Stockholders' equity.
 
 
            
   Stockholders’ equity.    
   During the first quartersix months of 1999, NovaStar Financial increased
   its equity from $87 million at December 31, 1998 to $120$121 million at
   March 31,June 30, 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"“Net Income
   ” below.
 
 
            Also, included
   in the accumulated other comprehensive income component of
   stockholders'stockholders’ equity as of March 31,June 30, 1999 is NovaStar Financial'sFinancial
   ’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“Financial
   Statement Condition as of March 31,June 30, 1999 and December 31, 1998--NovaStar1998—
   NovaStar Mortgage, Inc."
 
Results of Operations of NovaStar Financial, Inc.--Three Months Ended March 31,
1999 Compared to the Three Months Ended March 31,”
 
Results of Operations of
     NovaStar Financial, Inc.—Six Months Ended June 30, 1999
     Compared to the Six Months Ended June 30, 1998
 

   Net Income
 
 
            During the threesix
   months ended March 31,June 30, 1999, NovaStar Financial recorded net income
   of $1.7$3.0 million, $0.20$0.34 per diluted share, compared with net income
   of $1.3$3.2 million, $0.15$0.36 per diluted share, for the threesix months ended
   March 31,June 30, 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 quarterhalf of 1999, NovaStar Financial'sFinancial’s pro forma
   diluted earnings per share for the threesix months ended March 31,June 30, 1999,
   would have been $0.14$0.28 per share.
 
 
            NovaStar
   Financial'sFinancial’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
 
         
    Table 10 presents a summary of the average interest-earning
   assets, average interest-bearing liabilities and the related yields
   and rates thereon for the threesix months ended March 31,June 30, 1999 and 1998.
   
 
Table 10
Interest Analysis
                   Three
Six Months Ended March 31,June 30, 1999 and 1998
                             (dollars
(dollars in thousands)
 

 

  
  Mortgage Loans
     
 Mortgage
     Securities
 Total
                         ------------------------  ------------------------ --------------------------
                                  
  
June 30, 1999
     
 Average
   

   Balance
 Interest
   

   Income/
   

   Expense
 Annual
   

   Yield/
   

   Rate
 Average
   

   Balance
 Interest
   

   Income/
   

   Expense
 Annual
   

   Yield/
   

   Rate
 Average
   

   Balance
 Interest
   

   Income/
   

   Expense
 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%  assets  $793,973 $36,641 9.23% $—
      $ --    
       — —% $   --     --793,973
      $36,641 9.23% $  830,558 $19,550   9.42%
                         ========                  ========                 ==========

 
 
 
 
Interest-bearing
     liabilities                  
   
          Repurchase agreements............ agreements  $ -- —
      $ --     --—
      —% $ --  —
      $ --     --—
      —% $ -- —
      $ --     --—
      —%
   
          Collateralized mortgage obligations...........  862,559  12,139   5.63         --      --     --     862,559  12,139   5.63obligations
      825,540 23,156 5.61
       — — —
       825,540 23,156 5.61
      
   
          Other borrowings.......   17,051     490  11.47         --      --     --      17,051     490  11.47borrowings  8,482 541 12.76
       — — —
       8,482 541 12.76
      
 
     
 
 
   
          Cost of derivative financial                  
   
          Instruments hedging liabilities...........              580                                                  580
                                  -------                                              -------liabilities
        1,156           1,156  
  
 
  
 
   
                
       Total borrowings..... $879,610 $13,209   6.01   borrowings  $834,022 $24,853 5.96% $ --                 —
          $  879,610 $13,209   6.01
                         ======== -------  -----   ========                 ========== =======  -----834,022 $24,853 5.96%
 
 
   
 
   
          Net interest income....          income    $11,788     $ 6,341                    —
          $   --                    $ 6,341
                                  =======                                              =======11,788  
  
       
  
   
          Net interest spread....                    3.41%                       --spread      3.27%                      3.41%
                                           =====                      ====                      =====     —%     3.27%
 
 
 
 
   
          Net yield..............                    3.05%                      -- yield      2.97%                      3.05%
                                           =====                      ====                      =====

     —%     2.97%
 
 
 
 
   
          Provisions for credit losses   $5,865 1.48
       $— — —%   $5,865 1.48
      
  
      
 
   
          Net interest income after provision
     for credit
   

              
      losses 		  $5,923   $— —     $5,923  
  
       
  
   
          Net interest spread after provision
     for credit losses     1.79%     —%    1.79%
 
 
 
 
 
   
          Net yield after provision for credit
     losses     1.49%     —%     1.49%
 
 
 
 
  Mortgage Loans
     
 Mortgage
     Securities
 Total
                         ------------------------  ------------------------ --------------------------
                                  
June 30, 1998
     
 Average
   

   Balance
 Interest
   

   Income/
   
Expense
 Annual
   

   Yield/
   
Rate
 Average
   

   Balance
 Interest
   

   Income/
   

   Expense
 Annual
   

   Yield/
   

   Rate
 Average
   

   Balance
 Interest
   

   Income/
   

   Expense
 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%
                         ========                  ========                 ==========
assets  $719,081 $33,962 9.45% $511,385
      $16,396 6.41% $1,230,466
      $50,358 8.19%
 
 
 
 
Interest-bearing
     liabilities
   
          Repurchase agreements............ $136,145 agreements  $ 1,836   5.39%  $589,267   8,421   5.72% 163,471 $  725,412 $10,257   5.66%5,342 6.54% $521,824 14,662 5.62% $685,295 $20,004 5.84%
   
          Collateralized mortgage obligations...........  435,940   7,214   6.62         --      --     --     435,940   7,214   6.62obligations
      528,014 16,925 6.41
       — — —
       528,014 16,925 6.41
      
   
          Other borrowings.......   27,173     324   4.77         --      --     --      27,173     324   4.77
                         --------                  --------                 ----------borrowings  24,535 537 4.38
       — — —
       24,535 537 4.38
      
 
 
 
 
   
          Cost of derivative financial                  
   
          Instruments hedging liabilities...........              467                       180                        647
                                  -------                    ------                    -------liabilities
        999     395     1,394  
 
 
 
 
   
                
       Total borrowings..... $599,258 borrowings  $ 9,841   6.57   $589,267   8,601   5.84  $1,188,525 $18,422   6.21
                         ======== -------  -----   ========  ------         ========== =======  -----716,020 $23,803 6.37% $521,824 15,057 
       $1,237,844 $38,860 6.28%
 
 
 
 
   
          Net interest income....          income    $ 4,709                    10,159 
         $  763                    1,339 5.77%   $ 5,472
                                  =======                    ======                    =======11,498 
      
 
 
 
  
   
          Net interest spread....                    2.82%                     0.59%                      1.75%
                                           =====                      ====                      =====spread      3.08%     0.79%     1.91%
 
 
 
 
   
          Net yield..............                    3.04%                     0.52%                      1.82%
                                           =====                      ====                      =====yield      2.83%     0.52%     1.87%
 
 
 
 
   
          Provision for credit losses  $2,221 0.62
       $— 
      —      $ 2,221 0.36
      
  
 
 
  
 
   
          Net interest income after provision
     for credit
   

              
      losses 		  $7,938   $— 
            $9,277  
  
  
 
  
  
   
          Net interest spread after provision
     for credit
   

              
      losses 		     2.46%     — %     1.55%
 
 
 
 
 
   
          Net yield after provision for credit
     losses      2.21%     — %     1.51%
 
 
 
 
 

 

 16

 
 
              
   Interest income. income.    Average interest-earning
   assets were $830.6$794.0 million during the threesix months ended March 31,June 30,
   1999, all of which were mortgage loans, compared with average
   interest-earning assets of $1.2 billion for the same period of 1998,
   which included $582.3$511.4 million of mortgage securities. As mentioned earlier,discussed
   in “Financial Condition of NovaStar Financial, Inc. as of June
   30, 1999 and December 31, 1998”, 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 threesix months
   ended March 31,June 30, 1999. Mortgage securities earned $9.4$16.4 million for
   the six months ended March 31,June 30, 1998, or a yield of 6.4%. During the
   threesix months ended March 31,June 30, 1999, mortgage loans earned $19.6$36.6 million,
   or a yield of 9.4%9.2%, compared with $14.6$34.0 million, or a yield of 9.4%9.5%
   for the same period of 1998. In total, assets earned $19.6$36.6 million,
   or an 9.4%a 9.2% yield for threethe six months ended March 31,June 30, 1999. During the
   same period of 1998, assets earned $23.9$50.4 million or a 8.0%an 8.2% yield.
 
 
            A substantial
   portion of mortgage assets 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. Rates on
   the assets are expected to increase to their full potential as the
   assets season.
 
 
            As noted in
   Table 10, interest income is a function of volume and rates.
   Increasing the volume of assets will cause future increases in
   interest income, while declining balances will reduce interest
   income. Market interest rates will also affect future interest
   income.
 
 
            Interest
   expense. expense.
       The cost of borrowed funds was $13.2$24.9
   million during the threesix months ended March 31,June 30, 1999, or 6.0% of
   average borrowings, compared with $18.4$38.9 million for the same period
   of 1998, or 6.2%6.3% of average borrowings. The make upcomposition of interest
   expense is significantly different for the threesix months ended March 31,June 30,
   1999 compared with the same period of 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
 

     Ÿ
The majority of
     mortgage loans serve as collateral on collateralized mortgage
     obligations at June 30, 1999. At June 30, 1998, 72% 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 six months ended June 30, 1998
     are included under repurchase agreements and other borrowings in
     Table 10.
 

     Ÿ
NovaStar sold all of
     its mortgage securities in October 1998 and paid off all related
     financing on these assets. No mortgage securities have been
     purchased since that time.
 

     Ÿ
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 facility carried a substantially higher
     interest cost than other borrowing arrangements. 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 six months ended June 30, 1999 is included as
     a component of other borrowings in Table 10.
 
 
            Advances under
   the warehouse line of credit bear interest based on the federal
   funds rate plus a spread. NovaStar Financial and NovaStar Mortgage
   receive credits to warehouse line interest based on cash balances
   maintained with First Union. Advances under the master repurchase
   agreement bear interest at rates based on LIBOR, plus a spread.
   During the threesix months ended March 31,June 30, 1999, the one-month LIBOR averaged
   4.954.96 percent compared with 5.655.66 percent for the threesix months ended
   March 31,June 30, 1998. Because the Federal Reserve increased the targeted
   Federal Funds interest rate in June 1999, management expects
   effective borrowing costs to be higher
 for the second half of 1999. As with interest income, the cost of
   funds in the future will largely depend on market conditions, most
   notably levels of short-term interest rates. Rates on other
   borrowings generally fluctuate with short-term market interest
   rates, such as LIBOR or the federal funds rate.
 
                                       17

 
 
            Net
   interest income and spread.spread.    
   Net interest income during the threesix months ended March 31,June 30, 1999 was
   $6.3$11.8 million or 3.0% of average interest-earning assets, compared
   with $5.5$11.5 million, or 1.8%1.9% of average interest-earning assets
   during the same period of 1998. Net interest spread was 3.4%3.3% during
   the threesix months ended March 31,June 30, 1999 compared with 1.8%1.9% during the threesix
   months ended March 31,June 30, 1998. The significant increase in net margin
   and spread for the threesix months ended March 31,June 30, 1999 compared with the
   threesix months ended March 31,June 30, 1998 is due to the change in NovaStar
   Financial'sFinancial’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 asset yields relative to its costs
   of funds. The volume of assets and liabilities and how well the
   spread between earnings on assets and the cost of funds is managed
   will dictate future net interest income.
 
 
            Impact
   of interest rate agreements.agreements.    
   NovaStar Financial has entered into interest rate agreements
   designed to mitigate exposure to interest rate risk. Interest rate
   cap agreements require NovaStar 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. 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 threesix
   months ended March 31,June 30, 1999 and 1998, net interest expense was incurred
   on hedging agreements of $580,000was $1.2 million and $647,000,$1.4 million,
   respectively, which is included as a component of interest expense.
   The following table provides details of the interest rate agreements
   as of March 31,June 30, 1999 and December 31, 1998.
 

   Table 11

   Interest Rate Agreements
                      March 31,

   June 30, 1999 and December 31, 1998

   (dollars in thousands)
 

 

  
    Unrealized
                                                     ------------
                                                                  
    
  Notional
   

   Value
 Gains
 Losses
 Weighted
   Notional

   Days to
   
Maturity
 Cap
   Value   Gains Losses Maturity

   Rate
                                            -------- ----- ------ -------- ----

As of March 31,June 30, 1999:
Interest rate cap agreements............... $625,000 $--   $1,914   644    6.27%
                                            ======== ====  ======
agreements  $625,000 $—   $667 553 6.27%
 
 
As of December 31, 1998:
 
Interest rate cap agreements............... $625,000 $--   $2,483   agreements  $625,000 $—   $2,483 734    6.27%
                                            ======== ====  ====== 6.27%
 
 

 

 
 
Other Income
 
 
            Other income
   during the threesix months ended March 31,June 30, 1999 primarily consists of
   prepayment penalties of $656,000,$1.6 million, net gainslosses recognized on the
   sale of real estate owned properties of $77,000,$17,000, interest earned on
   securitization funds held in trust of $57,000,$111,000, and interest earned
   on notes receivable from founders of $120,000.$242,000. Other income for the
   same period of 1998 primarily consisted of prepayment penalties of $200,000, net gains on mortgage security sales of
$92,000 and$678,000,
   interest earned on notes receivable from founders of $57,000.$168,000, gains
   on mortgage loan sales of $115,000, net gains on mortgage security
   sales of $108,000 and interest earned on securitization funds held
   in trust of $24,000.

   Provisions for Credit Losses
 
 
            NovaStar
   Financial provides regular allowances for credit losses on its
   mortgage loans. Management continuously evaluates the potential for credit
losses for mortgage loans held in portfolio. Provisions have been made based on
NovaStar Financial's historical experience, general industry trends and
management's judgement. Loan defaults occur throughout the life of a 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 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

 
 
            Management
   ’s evaluation of the adequacy of reserves for credit losses is
   based primarily on NovaStar’s historical experience, but also
   incorporates general industry trends and management’s
   judgement. Recent loss experience for NovaStar includes numerous
   losses incurred on third-party sales of collateral where the
   borrower is delinquent, but where NovaStar has not foreclosed on the
   property. In this situation, NovaStar accelerates the timing for
   eliminating the defaulting borrower. In other situations, NovaStar
   chooses to fully charge-off loan balances, when it is economically
   beneficial to do so rather than incur significant costs of pursuing
   full foreclosure. In many cases, these sales and charge-offs result
   in lower losses than if NovaStar were forced to foreclose and
   liquidate the property on its own.
 
 
            Losses on
   recent third-party sales, as described above, have significantly
   increased total charge-offs. However, this activity eliminates
   credit risk that would have been charged off in future periods. All
   historical experience of NovaStar is used in management’s
   analysis of reserve adequacy. The analysis projects more consistent
   and lower levels of charge-offs over future periods of time than has
   been experienced recently. In the opinion of management, the
   reserves for credit losses are adequate as of June 30, 1999. If
   losses do not develop as historical analysis would project,
   provisions for loan losses will be increased accordingly.
 
 
            During the threesix
   months ended March 31,June 30, 1999, NovaStar Financial provided $2.3$5.9 million
   to the allowance for credit losses, compared with $1.0$2.2 million
   during the same 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 threesix months
   ended March 31,June 30, 1999 were $2.4$5.9 million compared with $518,000$1.2 million
   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, NovaStar Financial and NovaStar Mortgage
   executed an agreement with Commonwealth Mortgage Acceptance
   Corporation (CMAC) whereby CMAC will provide insurance coverage on
   mortgage loans. As of March 31,June 30, 1999 and December 31, 1998,
   approximately 27% and 26% of the loans owned by NovaStar Financial
   and substantially all of the loans owned by NovaStar Mortgage are
   covered under this agreement. During the threesix months ended March
31,June 30,
   1999, total premiums paid to CMAC totaled $457,000$912,000 and are included
   as a component of loan servicing expense in the financial
   statements. Management believes that its exposure to credit loss on
   loans insured by CMAC is minimal. Management expects that a
   substantial portion of loans originated in future periods will be
   covered under similar insurance arrangements.
 
 
            As of March 31,June 30,
   1999, NovaStar Financial had 149176 loans in real estate owned with a
   carrying value of $14.2$16.7 million compared with 126 loans with a
   carrying value of $10.6 million as of December 31, 1998.
 
 
            Table 12 is a
   rollforward of the allowance for credit losses during 1999 and 1998.
   
 
Table 12

   Rollforward of Allowance for Credit Losses

   1999 and 1998
 

 

  
  1999
 1998
                            -------- -----------------------------------------
                                                               
  June 30
 March 31
 December 31
 September 30
 June 30
 March 31
                            -------- ----------- ------------ ------  --------

Beginning balance..........  $3,573    $2,757       $3,341    $2,871   $2,313
balance  $3,492  $3,573  $2,757  $3,341  $2,871  $2,313 
Provision for credit
   losses....................   

        losses 		 3,566  2,299  4,030  1,179  1,145  1,076 
Amounts charged off, net
   

        of recoveries.............  (2,380)   (3,214)      (1,763)     (675)    (518)
                             ------    ------       ------    ------   ------
recoveries 		 (3,485) (2,380) (3,214) (1,763) (675) (518)
 
 
 
 
 
 
 
Ending Balance.............  $3,492    $3,573       $2,757    $3,341   $2,871
                             ======    ======       ======    ======   ======Balance  $3,573  $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 2123 and 22,24, in "Financial“
   Financial Condition of NovaStar Mortgage as of March 31,June 30, 1999 and
   December 31, 1998"1998”.
 
                                       19

General and Administrative Expenses
 
         
    General and administrative expenses for the threesix months ended
   March 31,June 30, 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
(dollars in thousands)
 

 

  
                                        Three
  Six Months
     Ended Three Months Ended
                                          March 31, June 30,
  1999      March 31, 
 1998
                                        ------------------- -------------------
                                                
    Percent of
   

   Net Interest
   

   Income
   Percent of
   
Net Interest
   Net Interest

   Income              Income
                                               ------------        ------------

Compensation and
     benefits.............  benefits  $  585      9.2%    937 7.9% $  436      8.0%
896 7.8%
Loan servicing
      946 8.0
       353 3.1
      
Professional and
     outside services.....     332      5.2         56      1.0
services  365 3.1
       128 1.1
      
Office
     administration  408 3.5
       405 3.5
      
Other loan servicing..................     470      7.4         44      0.8
Office administration.................     208      3.3        181      3.3
Other.................................      42      0.7         92       62 0.5
       193 1.7
                                        ------     ----     ------     ----

      
 
 
 
Total
     portfolio-related expenses......   1,637     25.8%       809     14.8%
                                                   ====                ====
expenses  2,718 23.0% 1,975 17.2%
  
  
 
Forgiveness of
     notes receivable from founders.............................     --                  271
founders  —  
        542  
Fees for services
     provided by NovaStar Mortgage, Inc........................   2,165               2,130
                                        ------              ------
 Total................................  $3,802              $3,210
                                        ======              ======Inc.  2,576   4,671  
 
  
  
   
       Total general and administrative expenses  $5,294 
       $7,188 
      
 
  
  
Efficiency
     Ratio(A)    38.4%   57.1%
  
  
 

 

 
 
A
The
     efficiency ratio is calculated by dividing general and
     administrative expenses by the sum of net interest income and
     other income.
 
Table 14
Portfolio Related Expenses as a
Percent of Net Interest Income
1999 and 1998
 

 

  
  Percent of
      Net

   Interest Income
                                                                 ---------------
      
      1998:
      
 Efficiency
   

   Ratio
1999:    
Second quarter
      19.8% 22.9%
First quarter.............................................      25.8%
      quarter
      25.8
       52.3
      
1998:
      1998......................................................      25.6%
          
1998  25.6
       5,747.0
      
Fourth quarter............................................      quarter
      89.7
       (14.1)
Third quarter.............................................      quarter
      22.3
       21.1
      
Second quarter............................................      20.1
      quarter
      19.3
       58.9
      
First quarter.............................................      quarter
      14.8
       55.0
      

 
 
         
    Compensation and benefits includes employee base salaries,
   benefit costs and incentive compensation awards. The increase in
   compensation and benefits for the threesix months ended March 31,June 30, 1999
   compared with the same period of 1998 is primarily due to salary
   increases and bonus accruals.
 
   Other loanadded personnel.
 
         
    Loan servicing for the threesix months ended March 31,June 30, 1999 consists
   principally of the fees paid to CMAC as discussed under the "Provisions“
   Provisions for Credit Losses." For the same period of 1998, these fees included” This line-item also includes 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. NovaStar
   loans were not covered by insurance during the first half of 1998,
   which caused the increase in loan servicing costs from 1998 to 1999.
   
 
 
              Professional
   and outside services include fees for legal, accounting services and
   accounting
services.annual and quarterly reports. 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 quarterhalf of 1999 is a result of legal fees incurred on the
   20
structuring of various financing arrangements, the filing of shelfpreparing securities
   registration statements and offering memorandums 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 (received from)
   NovaStar Mortgage for the threesix months ended March 31,June 30, 1999 and 1998:
   
 

  
                                                                 Three
  Six Months
   
Ended March 31,
                                                                ---------------
                                                                 June 30,
  1999
 1998
                                                                ------- -------
      
Amounts paid to NovaStar Mortgage:
     Loan servicing
     fees..................................... fees  $2,120  $1,488 
     Administrative
     fees  1,148  3,600 
 
 
 
Amounts received from NovaStar Mortgage:    
     Purchase
     commitment fee  —   (417)
     Interest income
      (692) —  
 
 
 
  $ 1,115 2,576  $ 630
       Administrative fees.....................................   1,050   1,500
                                                                ------- -------
                                                                $ 2,165 $ 2,130
                                                                ======= =======4,671 
 
 
 

 

 
 
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.
 

     Ÿ
Administrative fees
     for services, including the development of loan products,
     underwriting, funding, and quality control.
 

     Ÿ
Servicing fees to
     NovaStar Mortgage. NovaStar Mortgage receives 50 basis points on
     the collected principal balance of NovaStar Financial loans
     serving as collateral on CMOs.
 

     Ÿ
Purchase commitment
     fee. A fee NovaStar Mortgage pays to NovaStar Financial, if it
     chooses to retain the mortgage loans it originates or sells them
     to third parties.
 

     Ÿ
Interest income.
     Interest payments NovaStar Mortgage pays to NovaStar Financial for
     financing loan fundings and various operating costs of NovaStar
     Mortgage.
 
 
            The increase
   in loan servicing fees paid to NovaStar Mortgage for the threesix months
   ended March 31,June 30, 1999 compared with the threesix months ended March 31,June 30, 1998
   is due to the increase in NovaStar Financial'sFinancial’s securitized
   mortgage loan portfolio serviced by NovaStar Mortgage.
 
 
            The decline in
   the administrative fees paid to NovaStar Mortgage during these same
   periods is partly a result of the reduction in NovaStar Mortgage'sMortgage
   ’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. This agreement was cancelled
   on April 1, 1999, since NovaStar Financial is no longer purchasing
   loans from NovaStar Mortgage. Accordingly, NovaStar Financial is no
   longer utilizing the services as outlined in the agreement.
 
 
            The decrease
   in purchase commitment fees for the six months ended June 30, 1999
   compared with the same period of 1998 is due to the discontinuance
   of this intercompany agreement beginning January 1, 1999.
 
 
            The increase
   in interest income for the six months ended June 30, 1999 compared
   with the same period of 1998 is due to this intercompany agreement
   that went into effect April 1, 1999.
Equity in Earnings (Loss) of NFI Holding
   Corporation
 
         
    For the threesix months ended March 31,June 30, 1999, NFI Holding recorded
   net income of $557,000$951,000 compared with a net loss of $274,000$9,000 for the
   same period of 1998. NovaStar Financial records its portion of the
   income (loss)loss as equity in net earnings (loss)loss of NFI Holding in its income statement.
   NFI Holding'sHolding’s net income (loss)loss includes the net earnings of NovaStar
   Mortgage and NovaStar Capital, Inc., subsidiaries of NFI Holding as
   discussed under "Basis“Basis of Presentation"Presentation”. NFI Holding'sHolding’
   s financial position and results of operation for the six month
   period ended June 30, 1999 and 1998 are discussed further under the
   heading “NFI Holding Corporation”.
 
Results of Operations of NovaStar Financials, Inc.
   —Three Months Ended June 30, 1999 Compared to the Three Months
   Ended June 30, 1998.
 
Net Income
 
         
    During the three months ended June 30, 1999, NovaStar
   Financial recorded net income of $1.8 million, $0.15 per diluted
   share, compared with net income of $1.9 million, $0.21 per diluted
   share, for the three months ended June 30, 1998.
 
Net Interest Income
 
         
    Table 15 presents a summary of the average interest-earnings
   assets, average interest-bearing liabilities and the related yields
   and rates thereon for the three months ended June 30, 1999 and 1998.
   
 
Table 15
Interest Analysis
 
Three Months Ended June 30, 1999 and 1998
(dollars in thousands)
 
  Mortgage Loans
     
 Mortgage
     Securities
 Total
June 30, 1999
     
 Average
   

   Balance
 Interest
   

   Income/
   

   Expense
 Annual
   

   Yield/
   

   Rate
 Average
   

   Balance
 Interest
   

   Income/
   

   Expense
 Annual
   

   Yield/
   

   Rate
 Average
   

   Balance
 Interest
   

   Income/
   

   Expense
 Annual
   

   Yield/
   

   Rate
Interest-earning
     mortgage assets  $753,488 $17,091 9.07% $—  
      $—  
         
          % $753,488 $17,091 9.07%
   
  
   
 
Interest-bearing
     liabilities   
         
         
      
Repurchase
     agreements  $ — 
      $—  
      — % $— 
      $ — % $— 
      $— 
      — %
Collateralized
     mortgage obligations  788,894 11,068 5.61
       —  
      —  
      — 
       788,894 11,068 5.61
Other borrowings
      —  —  — 
       —  
      —  
      — 
       —  —  — 
      
 
       
   
Cost of derivative
     financial Instruments
   

       hedging liabilities 		  576 
         — 
        $576 
      
  
   
  
 
   
                
       Total borrowings  $788,894 $11,644 5.90% $— 
      $— 
      — % $788,894 $11,644 5.90%
   
 
   
 
Net interest
     income   $5,447 
         $— 
     
         
      
       
     
Net interest
     spread    3.17%   — %   3.17%
   
   
   
 
Net yield     
             2.89%   — %    2.89%
   
   
   
 
Provision for
     credit losses   $3,566 1.89
        $— 
      
        $3,566 1.89
  
  
   
 
Net interest
     income after provisions for
   

       credit losses 		  $1,881 
        $— 
      
        $1,881 
      
  
   
   
  
Net interest
     spread after provision for
   

       credit losses 		   1.28%   — %   1.28%
   
   
   
 
Net yield after
     provision for credit
   

       losses 		   1.00%   — %    1.00%
   
   
   
 
         
    
 
  Mortgage Loans
 Mortgage Securities
 Total
June 30, 1998
 Average
   

   Balance
 Interest
   

   Income/
   

   Expense
 Annual
   

   Yield/
   

   Rate
 Average
   

   Balance
 Interest
   

   Income/
   

   Expense
 Annual
   

   Yield/
   

   Rate
 Average
   

   Balance
 Interest
   

   Income/
   

   Expense
 Annual
   

   Yield/Rate
Interest-earning mortgage assets  $819,951 $19,412 9.47% $440,476 $7,032 6.39% $1,260,427 $26,444 8.39%
 
 
 
 
Interest-bearing liabilities                  
        
     Repurchase agreements  $190,497 $3,122 6.56% $455,151 $6,526 5.74% $645,618 $9,648 5.98%
        
     Collateralized mortgage obligations  620,626 9,707 6.26  — — —  620,626 9,707 6.26 
        
     Other borrowings  32,120 263 3.28  — — —  32,120 263 3.28 
 
   
 
 
   
        
     Cost of derivative financial Instruments
   

              
      hedging liabilities 		   518     282     800  
  
  
   
 
        
             Total borrowings
      $843,243 $13,610 6.21% $455,121 $6,808 5.98% $1,298,364 $20,418 6.29%
 
 
 
 
        
     Net interest income    $5,802     $224     $6,026  
  
   
   
  
        
     Net interest spread      3.26%     0.41%     2.10%
   
   
   
 
        
     Net yield      2.83%     0.20%     1.91%
   
   
   
 
        
     Provision for credit losses    $1,145 0.56    $—     $1,145 0.36 
  
  
   
 
        
     Net interest income after provision for
   

              
      credit losses 		   $4,657     $—     $4,881  
  
   
   
  
        
     Net interest spread after provision for
   

              
      credit losses 		     2.70%     —%     1.74%
   
   
   
 
        
     Net yield after provision for credit
   

              
      losses 		    2.27%    —%     1.55%
   
   
   
 
 
 
            Average
   interest-earnings assets were $753.4 million during the three months
   ended June 30, 1999, all of which were mortgage loans, compared with
   average interest-earning assets of $1.3 billion for the same period
   of 1998, which included $440.5 million of mortgage securities.
   Mortgage securities earned $7.0 million for the three months ended
   June 30, 1998, or a yield of 6.4%. During the three months ended
   June 30, 1999, mortgage loans earned $17.1 million, or a yield of
   9.1%, compared with $19.4 million, or a yield of 9.5% for the same
   period of 1998. In total, assets earned $17.1 million—a 9.1%
   yield for three months ended June 30, 1999 compared $26.4 million,
   or an 8.4% yield for the same period ended June 30, 1998.
 
 
            During the
   three months ended June 30, 1999, borrowed funds for NovaStar
   Financial averaged $788.9 billion on which interest was incurred of
   $11.6 million, or 5.9%. In comparison, for the three months ended
   June 30, 1998, borrowed funds for NovaStar Financial averaged $1.3
   billion on which interest was incurred of $20.4 million, or 6.3%.
   
 
 
            Net interest
   income during the three months ended June 30, 1999 was $5.4 million
   or 2.9% of average interest-earnings assets, compared with $6.0
   million, or 1.9% of average interest-earning assets during the same
   period of 1998. Net interest spread was 3.2% during the three months
   ended June 30, 1999 compared with 2.1% during the three months ended
   June 30, 1998. The significant increase in net margin and spread for
   the three months ended 
June
   30, 1999 compared with the three months ended June 30, 1998 is due
   to the change in NovaStar Financial’s asset and liability
   composition as discussed under “Results of Operations—Six
   Months Ended June 30, 1999 Compared to Six Months Ended June 30, 1998
   ”.
 
 
            During the
   three months ended June 30, 1999 and 1998, net interest expense was
   incurred on hedging agreements of $576,000 and $800,000,
   respectively, which is included as a component of interest expense.
   
 

   Other Income
 
 
            Other income
   during the three months ended June 30, 1999 primarily consists of
   prepayment penalties of $960,000, net losses recognized on the sale
   of real estate owned properties of $94,000, interest earned on
   securitization funds held in trust of $53,000, and interest earned
   on notes receivable from founders of $122,000.
 
 
Provisions for Credit Losses
 
         
    During the three months ended June 30, 1999, NovaStar
   Financial provided $3.6 million to the allowance for credit losses,
   compared with $1.1 million during the same period of 1998.
   Charge-offs during the three months ended June 30, 1999 were $3.5
   million compared with $675,000 during the same period of 1998. See
   discussion of “Provisions for Credit Losses” under “
   Results of Operations of NovaStar Financial, Inc.—Six Months
   Ended June 30, 1999 Compared to the Six Months Ended June 30, 1998.
   ”
 
General and Administrative Expenses
 
         
    General and administrative expenses for the three months ended
   June 30, 1999 and 1998 are provided in Table 16.
 
Table 16
General and Administrative Expenses
(dollars in thousands)
 
  Three Months
     Ended June 30,
  1999
 1998
    Percent
   

   of Net
   

   Interest
   

   Income
   Percent
   

   of Net
   

   Interest
   

   Income
Compensation and
     benefits  $352 6.5% $460 7.6%
Professional and
     outside services  33 0.6
       297 4.9
      
Other loan
     servicing  476 8.7
       84 1.4
      
Office
     administration  200 3.7
       224 3.7
      
Other  20 0.4
       101 1.7
      
 
 
 
Total
     portfolio-related expenses  1,081 19.9% 1,166 19.3%
  
  
 
Forgiveness of
     notes receivable from founders      271  
Fees for services
     provided by NovaStar Mortgage, Inc.  411   2,541  
 
  
  
   
            Total general and
     administrative expenses  $1,492   $3,978  
 
  
  
Efficiency Ratio
     (A)    22.9%   58.9%
  
  
 
A
The
     efficiency ratio is calculated by dividing general and
     administrative expenses by the sum of net interest income and
     other income.
 
         
    Compensation and benefits remained relatively stable, totaling
   $352,000 for the three months ended June 30, 1999 compared with
   $460,000 for the same period of 1998.
 
         
    Professional and outside services for the three months ended
   June 30, 1999 was $33,000 compared with $297,000 for the three
   months ended June 30, 1998. Professional and outside services
   include fees for legal and accounting services, costs of contract
   laborers, costs to publish annual and quarterly reports, etc. The
   amount of and variance in these costs is dependent on the timing of
   services performed.
 
         
    Other loan servicing for the three months ended June 30, 1999
   was $476,000 compared with $84,000 for the three months ended June
   30, 1998. Other loan servicing in 1999 consists principally of the
   fees paid to CMAC as discussed under the “Provisions for Credit
   Losses.” This line-item also includes 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. NovaStar loans were not
   covered by insurance during the first half of 1998, which caused the
   increase in loan servicing costs from 1998 to 1999.
 
 
              The
   following is a summary of the fees, in thousands, paid to NovaStar
   Mortgage for the three months ended June 30, 1999 and 1998:
 
  Three Months
   

   Ended June 30,
  1999
 1998
Amounts paid to NovaStar Mortgage:    
        
       Loan servicing fees  $1,005  $858 
        
       Administrative fees  98  2,100 
 
 
 
Amounts paid to NovaStar Mortgage:    
        
       Purchase commitment fee  —   (417)
        
       Interest income  (692) —  
 
 
 
  $411  $2,541 
 
 
 
 
 
            The increase
   in loan servicing fees paid to NovaStar Mortgage for the three
   months ended June 30, 1999 compared with the three months ended June
   30, 1998 is due to the increase in NovaStar Financial’s
   mortgage loan portfolio collateralizing CMOs.
 
 
            The decline in
   the administrative fees paid to NovaStar Mortgage during these same
   periods is a result of NovaStar Financial discontinued paying these
   fees to NovaStar Mortgage in April 1999.
 
 
            The decrease
   in purchase commitment fees for the six months ended June 30, 1999
   compared with the same period of 1998 is due to the discontinuance
   of this intercompany agreement beginning January 1, 1999.
 
 
            The increase
   in interest income for the six months ended June 30, 1999 compared
   with the same period of 1998 is due to this intercompany agreement
   went into effect April 1, 1999.
 

   Equity in Earnings of NFI Holding Corporation
 
 
            For the three
   months ended June 30, 1999, NFI Holding recorded net income of
   $394,000 compared with net income of $265,000 for the same period of
   1998. NFI Holding’s financial position and results of operation
   for the three month periodperiods ended March 31,June 30, 1999 and 1998 are
   discussed further under the heading "NFI“NFI Holding Corporation".
 
                                       21
Corporation.
   ”
 

   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 1517 is a summary of the differences between net income
   or loss reported for GAAP and taxable income for 1999 and 1998.
   
 
Table 1517

   Taxable Income (Loss)

   1999 and 1998 (in thousands)
 

 

  
  1999
 1998
                                   -------  -----------------------------------
                                    
  Second
   

   Quarter
 First
   

   Quarter
 Fourth
   

   Quarter
 Third
   

   Quarter
 Second
   

   Quarter
 First
   
Quarter  Quarter   Quarter  Quarter  Quarter
                                   -------  --------  -------  -------  -------

Net income (loss)................  $1,726   $(27,388) $2,394   $1,894   $1,279
 $1,845  $1,726  $(27,388) $2,394  $1,894  $1,279 
Use of net operating loss carryforward  (1,153) (1,475) —   —   —   —  
Results of NFI Holding and subsidiaries....................    (551)       subsidiaries  674  (551) 320  2,447      --         —    271 
Provision for credit losses......   losses  3,566  2,299  4,030  1,179  1,145  1,076 
Loans charged-off................  (2,380)    (3,214) (1,763)    (675)    (518)
charged-off   (3,484)  (2,380) (3,214)  (1,763) (675) (518)
Capital losses...................     --      losses  —   —    14,963     --       --       --
  —    —    —   
Other, net.......................     net  397  381       (370)       (370) 96  208       (2)
                                   ------   --------  ------   ------   ------
  (2)
 
 
 
 
 
 
 
Estimated taxable income (loss)..  $1,475   $(11,659) $4,353   $2,572   $2,106
                                   ======   ========  ======   ======   ====== $1,845  $—   $(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'sFinancial’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'sMortgage
   ’s loan sales.
 
                                       22

 
         
    The following table presents NFI Holding'sHolding’s consolidated
   financial statements as of March 31,June 30, 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
                            18
NFI Holding Corporation
Condensed Consolidated Balance Sheets
 
(in thousands)
 

 

  
                                                         March 31,  
  June 30, 1999
     
 December 31,
     1999         1998
                                                        ----------- ------------
                                                        
  (unaudited)
Assets    
   
            Cash and cash
     equivalents............................  equivalents.  $1,323 $ 249     $ 5,759
     Restricted cash......................................    28,300       33,007
   
            Mortgage loans.......................................    87,456      loans.  109,949 216,839
   
            Mortgage securities
     (available-for-sale).............     9,860          -- 9,635 —  
     
   
            Other assets.........................................     6,860        assets  8,991 4,492
                                                         --------     --------
 
   
                
           Total assets.....................................  $132,725     $260,097
                                                         ========     ========
assets  $129,898 $227,090
 
Liabilities and
     Stockholders'Stockholders’ Equity
  Liabilities:
    Borrowings.........................................    65,155          
   
            Borrowings  $79,960 $203,341
   
            Due to NovaStar
     Financial, Inc.....................    61,071       51,528Inc.  26,724 18,521
   
            Accounts payable and
     other liabilities.............     4,352        liabilities  13,426 5,215
    Stockholders' equity...............................     2,147           
   
            Stockholders’
     equity  9,788 13
                                                         --------     --------
 
   
                
           Total liabilities and
     stockholders' equity.......  $132,725     $260,097
                                                         ========     ========stockholders’ equity  $129,898 $227,090
 

 
 

   NFI Holding Corporation

   Condensed Consolidated Statements of Operations
             Three months ended March 31

   (unaudited; in thousands)
 

 

  
  For the Six
   

   Months Ended
   

   June 30,
 For the Three
   

   Months Ended
   

   June 30,
  1999
 1998
                                                                  ------ -----

 1999
 1998
Interest income.................................................. $2,745 income  $ 990
4,824  $2,395  $2,079 $1,405
Interest expense.................................................  1,561   874
                                                                  ------ -----expense.  2,220  2,019  659 1,145
 
 
 
        
                
      Net interest income..........................................  1,184   116
Income:
  Fees from third parties........................................    342   680income  2,604  376  1,420 260
Other income:        
        
       Administrative servicing fees received from NovaStar
     Financial.....................................................  2,165 2,130Financial  2,576  4,671  411 2,541
        
       Fees from third parties  554  1,617  212 937
        
       Net gain on sales of mortgage loans............................  2,847   --
                                                                  ------ -----loans  6,088  412  3,241 412
 
 
 
        
                
      Total Income.................................................  5,354 2,810
other income  9,218  6,700  3,864 3,890
General and administrative expenses..............................  5,747 3,200
                                                                  ------ -----
expenses   10,637   7,085  4,890 3,885
 
 
 
Income (loss) before taxes.......................................    791  (274)
taxes  1,185  (9) 394 265
Income tax expense...............................................    expense  (234   --
                                                                  ------ -----
) —   —  —  
 
 
 
Net income or (loss).............................................  $  557 $(274)
                                                                  ====== =====951  $(9) $394 $265
 
 
 

 

 23

 

   Financial Condition of NovaStar Mortgage, Inc. as of March 31,June 30, 1999
   and December 31, 1998
 
 
            Mortgage
   Loan Originations.    NovaStar Mortgage
   originated more than 800nearly 2,000 subprime residential mortgage loans during
   the threesix months ended March 31,June 30, 1999 with an aggregate principal
   amount of $82$194 million. Virtually all of NovaStar Mortgage'sMortgage’s
   mortgage assets at March 31,June 30, 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 1719 is a
   summary of wholesale loan originations for 1999 and 1998. Table 1820
   presents a summary of mortgage loan sales of NovaStar Mortgage
   during 1999 and 1998. Table 1921 is a summary of loan costs for
   NovaStar Mortgage relative to its wholesale loan originations.
 

   Table 1719

   1999 and 1998 Quarterly Wholesale Loan Originations--NovaStarOriginations—NovaStar
   Mortgage, Inc.
 

 and NovaStar Capital, Inc.
(dollars in thousands)
 

 

  
                                                                      Weighted 
  Number
   

   of Loans
 Principal
 Average
   Average               -------------------------  Percent with
                          Number

   Loan
   

   Balance
 Price Paid to
   

   Broker
 Weighted Average
 Percent with
   

   Prepayment
   

   Penalty
      Loan to
   

   Value
 Credit
   Prepayment
                         of Loans Principal Balance    Broker      Value

   Rating (A)
 Coupon    Penalty
                         -------- --------- ------- ------------- ------- ---------  ------  ------------

1999:                
        
       Second quarter  1,161 $114,631 $99 100.9 82% 5.14 9.82% 89%
        
       First quarter.........    quarter  865 82,495 95 100.5 81  4.95 9.88  89 
 
 
 
 
1999 total  2,026 $ 82,495   197,126 $ 95       100.5        81%    4.95      9.88%       89%
97 100.7 81% 5.06 9.85% 89%
 
 
 
 
 
1998:                
        
       Fourth
   quarter........  

              
         quarter 		 1,501   $133,739    $133,739 $89 100.8        81%     81% 4.75      9.78%       88% 9.78% 88%
        
       Third quarter.........  quarter  2,655 240,498 90 101.4 81  4.37 10.11  79 
        
       Second quarter........  quarter  3,133 294,303 94 101.3 81  4.43 9.93  71 
        
       First quarter.........  quarter  2,033 207,976  102 101.4 81  4.45 9.93  65
                          -----   --------   ----       -----       ---     ----     -----       ---
 
 
 
 
 
1998 total..............  total  9,322   $876,516    $876,516 $94 101.3        81%     81% 4.47      9.96%       74%
                          =====   ========   ====       =====       ===     ====     =====       === 9.96% 74%
 
 
 
 

 

 - --------
(A) AAA=7, AA=6, A=5, A-=4, B=3, C=2, D=1
 
                                       24

(A)
AAA=7, AA=6, A=5,
     A-=4, B=3, C=2, D=1
 

   Table 1820

   Mortgage Loan Sales to Third Parties--NovaStarParties—NovaStar Mortgage, Inc.
       Three

   Six Months Ended March 31,June 30, 1999 and Year Ended December 31, 1998

   (dollars in thousands)
 

 

  
  Principal
   

   Amount
 Gain
   

   Recognized
 Weighted
   
Average
   Percent
                                         Principal    Gain

   Price To
   

   Par
 Percent
   
Gain of
   Amount   Recognized   Par

   Principal
                                         --------- ---------- -------- ---------

1999:        
        
       Second quarter  $97,281 $2,875 104.4 2.96%
        
       First quarter......................... quarter  73,743 1,576 103.6 2.14 
 
 
        
       1999 total  $171,024 $4,451 104.0 2.60%
 
 
1998:        
        
       Fourth quarter  $108,800 $ 73,743    $1,576     1,985 103.6     2.14%
1998:
  Fourth quarter........................ $108,800    $1,985    103.6     1.82% 1.82%
        
       Third quarter.........................   quarter  18,133 826 106.0 4.56 
        
       Second quarter........................    quarter  6,742 173 106.0 2.57 
        
       First quarter.........................      --        --       --       --
                                         --------    ------    -----     ----quarter  —   —   —   —   
 
 
        
       1998 total............................ $133,675    $2,984    total  $133,675 $  2,984 104.0     2.23%
                                         ========    ======    =====     ==== 2.23%
 
 

 

 
 
Table 1921

   Costs of Loan Production NovaStar--Mortgage,—NovaStar Mortgage, Inc.
       Three

   Six Months Ended March 31,June 30, 1999 and Year Ended December 31, 1998

   (dollars in thousands)
 

 

  
  1999
 1998
                              -------  --------------------------------------
                               
  Second
   

   Quarter
 First
   

   Quarter
 Fourth
   

   Quarter
 Third
   

   Quarter
 Second
   

   Quarter
 First
   
Quarter  Quarter   Quarter   Quarter   Quarter
                              -------  --------  --------  --------  --------

Total costs of loan production (A)..............  $4,113  $4,778  $ 4,778   6,723  $ 6,723   4,975  $ 4,975   3,837  $ 3,837  $ 3,079 
Wholesale loan origination--
 principal...................  origination—principal
      111,952  82,495  133,739  240,498  294,303  207,974 
Premium paid to broker.......     broker  948  441  1,043  3,439  3,679  2,935
                              -------  --------  --------  --------  --------
 
 
 
 
 
 
 
 
Total acquisition cost (B)... $87,714  $141,505  $248,912  $301,819  $213,988
                              =======  ========  ========  ========  ========
 $117,013  $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%
                                  ===       ===       ===       ===       ===production  3.7% 5.8% 5.0% 2.1% 1.3% 1.5%
  
  
  
  
  
  
 
        
       Premium paid to broker.....     0.5%      0.8%      1.4%      1.3%      1.4%
                                  ===       ===       ===       ===       ===broker  0.8% 0.5% 0.8% 1.4% 1.3% 1.4%
  
  
  
  
  
  
 
        
       Total acquisition cost.....     6.3%      5.8%      3.5%      2.6%      2.9%
                                  ===       ===       ===       ===       ===cost (C)  4.5% 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) 
(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.
 
(C)
During the second
     quarter of 1999, NovaStar Mortgage gave brokers the option on all
     original full package submissions to 1) have the underwriting fee
     NovaStar Mortgage charged waived or 2) pay the underwriting fee
     and receive an extra 50 basis points in premium from NovaStar
     Mortgage. Prior to this point in time, the underwriting fee
     charged by NovaStar Mortgage was waived on all original full
     package submissions.
 
 
            Table 2022 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,June 30, 1999, NovaStar Mortgage had 6252
   account executives covering nearly 40 states.
 
                                       25

 

   Table 2022

   Mortgage Loan Originations by State--NovaStarState—NovaStar Mortgage, Inc.

   1999 and 1998
 

 

  
  Percent of Total Originations during Quarter

   (based on original principal balance)
                       ------------------------------------------------------
                         
  1999
 1998
                       --------   -------------------------------------------

Collateral Location
 Second
 First
 Fourth
 Third
 Second
 First
- -------------------    --------   ---------   --------   ---------   --------

Florida...............        15%        24%         17%        16%         12%
Michigan..............        
Florida  12% 15% 24% 17% 16% 12%
Michigan  10  12  6  5  5  5
Tennessee.............          
Ohio  10  8  9  4  5  2 
California  8  6  2  6  9  15 
Arizona  7  4  2  3  3  3 
Tennessee  6  9  6  4  4
Ohio..................         8          9             4 
Washington  5  3  3  5  6  7 
Pennsylvania  4  4  5  4  3  2
California............         6          2           6          9          15
Pennsylvania..........         4          5           4          3           2
 
North Carolina........         Carolina  1  2  4  5  3  2
Washington............          
Texas  1  2  3  5  3           5          6           7
Texas.................         2            3           5          3           3
 
All other states......        39         38          states  36  35  36  42  43  45         46          48 

 

 - --------
(A) 
(A)
Loans originated by
     NovaStar Mortgage, Inc.
 
 
            NovaStar
   Mortgage Inc.
 
   NovaStar Mortgage's’s loan originations are funded through warehouse and
   repurchase facilities at First Union and are discussed further in
   "Financial“Financial Condition of NovaStar Financial as of March 31,June 30, 1999
   and December 31, 1998"1998” and "Results“Results of Operations of
   NovaStar Financial, Inc.--ThreeInc.—Six Months Ended March
31,June 30, 1999
   Compared to the ThreeSix Months Ended March 31, 1998"June 30, 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 fromSPE, which represents the mortgageright to receive, over the life of the
   securitization, the excess of the weighted average coupon on the
   loans lesssecuritized over the sum of the interest loanrate on the bonds, a
   normal servicing fee, a trustee fee, an insurance fee (where
   applicable) and the credit losses and other costs relatedrelating to bond administration.the loans securitized.
   NovaStar Mortgage also retained loan servicing rights for the loans
   sold to the SPE. The value of the retained interests--theinterests—the
   residual certificate and the mortgage servicing rights--haverights—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%sold
      103.0%
        
       Assumptions used in determining future cash flow:
       
        
                
      Estimated prepayment speeds................................... speeds  30 to 35 CPR 
        
                
      Estimated rate of default.....................................       default  70 CDR 
        
       Discount rate...................................................         16.5%rate  16.5%
        
       Value of residual certificate................................... certificate  $   9,700,000 
        
       Value of mortgage servicing rights.............................. rights  $       
     646,000 
        
       Aggregate gain.................................................. gain  $   1,605,000 

 

 26

 
 
              Of the
   aggregate gain recognized in the securitization, $355,000 will bewas
   recorded upon the April closing.
 
 
            The value of
   the residual interest has been classified as an available-for-
saleavailable-for-sale
   mortgage security on NovaStar Mortgage'sMortgage’s balance sheet and had
   a carrying value of $9.9$9.6 million as of March 31,June 30, 1999. The value of
   the residual interest represents the present value of the residual
   cashflows (as described under the “Mortgage Loan Sales”
   section of this document) that NovaStar Mortgage expects to receive
   over the life of the securitization, taking into consideration
   estimated prepayment speeds and credit losses, and is discounted at
   a rate which management believes is an appropriate risk-adjusted
   market rate of return for the residual asset. The residual cashflows
   are realized over the life of the securitization as cash
   distributions are received from the trust. NovaStar Mortgage
   believes its residual asset is fairly valued at June 30, 1999 but
   can provide no assurance that future prepayment and loss experience
   or changes in the required market discount rate will not require
   write-downs of the residual asset. Such write-downs would reduce the
   income of future periods and could cause NovaStar Mortgage to report
   net losses for such periods.
 
 
            NovaStar
   Mortgage also sold more than $73$171 million of its whole loan portfolio to
   unrelated third parties for cash.
 
   cash at a net gain of $4.5 million at an
   average price of 104 during the six months ended June 30, 1999.
   Table 19 of “Financial Condition of NovaStar Mortgage, Inc. as
   of June 30, 1999 and December 31, 1998” provides a quarterly
   analysis of NovaStar Mortgage’s mortgage loan sales to third
   parties.
 
 
            Mortgage
   loan servicing.    Loan servicing is also a
   critical part of NovaStar Mortgage'sMortgage’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 2123 is a
   summary of delinquent loans in NovaStar Mortgage'sMortgage’s servicing
   portfolio as of March 31,June 30, 1999 and 1998 by quarter. Table 2224 provides
   summaries of delinquencies, defaults, and loss statistics as of March 31,June
   30, 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'sFinancial’s mortgage loans is provided in Table 1.
   
 
Table 2123

   Loan Delinquencies (90 days and greater) (A)
                            March 31,

   1999 and 1998
 

 

  
  1999
 1998
                             -------- -----------------------------------------
                             
  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% 5.13% 4.37% 5.45% 5.97% 5.86% 4.39%
        
       1997-2 (Issued December 11, 1997)................    4.03  5.38  5.62  4.97  4.72  2.23 
        
       1998-1 (Issued April 30, 1998)....................    4.13  4.64  4.44  2.06       --       --  —    —   
        
       1998-2 (Issued August 18, 1998)....................    3.94  3.72  2.35  0.40       --       --  —    —   
        
       1999-1 (Issued January 29, 1999) (B)................    3.39  2.35       --           --        --       --
  —    —    —    —   
All loans in servicing portfolio..................   portfolio  5.15  5.00  3.35  2.45  2.53  2.28 

 

 - --------
A) Includes loans in foreclosure or bankruptcy.
B) 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 22
                       
A)
Includes loans in
     foreclosure or bankruptcy.
B)
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.
Delinquencies, Defaults and Losses
                      March 31,
June 30, 1999 and December 31, 1998
                             (dollars
(dollars in thousands)
 

 

  
  NovaStar Home
     Equity Series (A)
                                          --------------------------------------
             March 31,
  
June 30, 1999
     
 1997-1
 1997-2
 1998-1
 1998-2
 1999-1
 Other (C)
     
 All
   
Loans
             --------------               --------  --------  --------  --------  ---------- ----------  ----------

Loan servicing
     portfolio (B)...........  $147,609  $167,685  $254,837  $291,747   $136,279   $   74,237  $1,072,393
                                          ========  ========  ========  ========   ========  ==========  ==========
118,522
       $140,758
       $234,279
       $273,976
       $156,649
       $107,881
       $1,032,065
      
 
 
 
 
 
 
 
 
Allowance for
     Credit Losses:              
   
           Balance, December 31, 1998............  January 1, 1999
      $   
          816
       $   
      1,049
       $   
      1,163
       $   
          346
       $ --     
            —  
       $   
          353
       $   
      3,727
      
   
           Provision for credit losses...........       450       458       768       617        --          176       2,469losses
      2,310
       909
       1,524
       1,112
       —  
     
       (106) 5,749
      
   
           Amounts charged off, net of
   recoveries...........................      (597)     (707)     (696)     (302)       --           21      (2,281)
                                          --------  --------  --------  --------   --------  ----------  ----------

              
       recoveries 		 (1,056) (1,570) (1,962) (1,167) —  
     
       (48) (5,803)
 
 
 
 
 
 
 
 
   
           Balance, March 31, 1999...............  June 30, 1999  $2,070
       $388
       $725
       $291
       $ 669    
            —  
       $    800  199
       $  1,235  $    661   $    --   $      550  $    3,915
                                          ========  ========  ========  ========   ========  ==========  ==========
3,673
      
 
 
 
 
 
 
 
 
Defaults as a
     percent of loan servicing              
   
           Delinquent loans......................      6.74%     5.07%     3.42%     3.51%      3.97%       1.91%       4.12%
                                              ====      ====      ====      ====       ====        ====        ====loans (D)  9.21% 6.03% 5.41% 5.17% 4.79% 2.82% 5.21%
  
  
  
  
  
  
  
 
   
           Loans in foreclosure..................      3.29      3.84      4.08      foreclosure  4.10
       3.59
       3.33
       3.28
       2.26        2.66        3.39
                                              ====      ====      ====      ====       ====        ====        ====
       5.63
       3.36
      
  
  
  
  
  
  
  
 
   
           Real estate owned.....................      3.54      3.07      2.00      0.52        --         1.13        1.66
                                              ====      ====      ====      ====        ===        ====        ====

owned 
 2.58
       4.41
       3.62
       1.28
       0.63
       0.43
       2.20
      
  
  
  
  
  
  
  
 
  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
                                          ========  ========  ========  ========   ========  ==========
 $168,255
       $167,685
       $273,583
       $301,857
       $268,587
       $1,179,967
        
 
 
 
 
 
 
   
Allowance for
     Credit Losses:              
   
           Balance, January 1, 1998..............  1998
      $   
      1,063
       $   
          967
       $ --     
            —  
       $ --      
            —  
       $   
         283
       $   
      2,313
        
   
           Provision for credit losses...........     losses
      1,895
       2,257
       1,878
       222
       1,388
       7,640
        
   
           Amounts charged off, net of
   recoveries...........................    (2,142)   (2,175)     (715)      

              
       recoveries 		 (2,142) (2,175) (715) 124     (1,318)     (6,226)
                                          --------  --------  --------  --------   --------  ----------
       (1,318) (6,226)  
 
 
 
 
 
 
   
   
           Balance, December 31, 1998............  1998
      $   
      816
       $1,049
       $1,163
       $ 1,049    
      346
       $ 1,163    
      353
       $    346   $    353  $    3,727
                                          ========  ========  ========  ========   ========  ==========

        
 
 
 
 
 
 
   
Defaults as a
     percent of loan servicing              
   
           Delinquent loans......................      6.45%     5.95%     4.89%     4.06%      2.01%       4.40%
                                              ====      ====      ====      ====       ====        ====loans (D)  6.45% 5.95% 4.89% 4.06% 2.01% 4.40%  
  
  
  
  
  
  
    
   
           Loans in foreclosure..................      foreclosure  2.63
       2.96
       3.60
       2.06
       0.40
       2.25
                                              ====      ====      ====      ====       ====        ====
        
  
  
  
  
  
  
    
   
           Real estate owned.....................      owned  3.54
       2.76
       1.01
       0.09
       0.23
       1.21
                                              ====      ====      ====      ====       ====        ====
        
  
  
  
  
  
  
    
 
  1999
 1998
  June 30
 March 31
 December 31
 September 30
 June 30
 March 31
Total defaults:
                 
   
           Delinquent loans  5.21% 4.12% 4.40% 2.95% 1.95% 1.92%
  
  
  
  
  
  
 
   
           Loans in foreclosure  3.36 3.39
       2.25
       2.02
       2.28
       2.29
      
  
  
  
  
  
  
 
   
           Real estate owned  2.20 1.66
       1.21
       0.81
       0.52
       0.24
      
  
  
  
  
  
  
 
(A)
Loans
     owned by NovaStar Financial

 

 

  
                                1999                     1998
                              -------- -----------------------------------------
                              March 31 December 31 September
(B)

     Includes assets acquired through foreclosure
(C)

     Includes loans owned by NovaStar Financial, NovaStar Mortgage and
     NovaStar Capital
(D)

     Includes loans delinquent 30 June 30 March 31
                              -------- ----------- ------------ ------- --------

Total defaults:
  Delinquent loans...........   4.12%     4.40%        2.95%     1.95%    1.92%
                                ====      ====         ====      ====     ====
  Loans in foreclosure.......   3.39      2.25         2.02      2.28     2.29
                                ====      ====         ====      ====     ====
  Real estate owned..........   1.66      1.21         0.81      0.52     0.24
                                ====      ====         ====      ====     ====days or greater

 

 - --------
(A) Loans 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
                25
Mortgage Loan Activity--NovaStarActivity—NovaStar Mortgage, Inc.
   (dollars
(dollars in thousands)
 

 

  
  1999
 1998
                          ------------------  ------------------
                          
  Principal
 Premium
 Principal
 Premium
                          ---------  -------  ---------  -------

Balance,
     January 1......  1 $206,495
     
       $3,114
       $ 206,495    
            —  
       $ 3,114  $     --   $   --
Originations............       
       —  
      
Originations
      82,495
       997
       207,976
       3,758
      
Sales to NovaStar
     Financial, Inc.........        --       --    (207,976)  (3,758)
Inc.  —  
     
       —  
     
       (207,976) (3,758)
Sales to third
     parties..   (204,280)  (2,759)       --       --
parties   (71,829
     )  (649) —  
     
       —  
     
      
Sales in
     securitization transactions  (132,451) (2,109) — 
       — 
      
Principal
     repayments and amortization...........     (1,963)     (45)       --       --
                          ---------  -------  ---------  -------
amortization  (1,963) (45) —  
     
       —  
     
      
 
 
 
 
 
Balance, March
     31.......  31 $82,747
       $1,308
       $ 82,747    
       —  
       $ 1,307  $     --   $   --
Originations............                          
       —  
      
Originations
      111,952
       1,641
       294,303
       5,207
      
Sales to NovaStar
     Financial, Inc.........                       (290,350)  (5,148)
Inc.  — 
       — 
       (290,350) (5,148)
Sales to third
     parties..                         (3,953)     (59)
parties  (64,225) (1,368) (3,953) (59)
Sales in
     securitization transactions  (25,436) (259) — 
       — 
      
Principal
     repayments and amortization...........                            --       --
                                              ---------  -------
amortization  (1,703) (46) —  
     
       —  
     
      
 
 
 
 
 
Balance, June 30........                      30
      $103,335
       $1,276
       $ --     
       —  
       $ --
Originations............                          
       —  
      
  
  
     
Originations
          240,498
       4,035
      
Sales to NovaStar
     Financial, Inc.........                            --       --
Inc.      —  
     
       —  
     
      
Sales to third
     parties..                        (12,836)    (517)
parties      (12,836) (517)
Principal
     repayments and amortization...........                         (1,567)      (7)
                                              ---------  -------
amortization      (1,567) (7)
      
  
 
Balance,
     September 30...                      30     $226,095
       $ 226,095  $ 3,511
     Originations............                        
      
Originations
          133,739
       1,821
      
Sales to NovaStar
     Financial, Inc.........                            --       --
Inc.      —  
     
       —  
     
      
Sales to third
     parties..                       (116,886)  (2,156)
parties      (116,886) (2,156)
Principal
     repayments and amortization...........                        (36,453)     (62)
                                              ---------  -------
amortization      (36,453) (62)
      
  
 
Balance,
     December 31....                      31     $ 206,495
       $ 3,114
                                              =========  =======
      
      
  
 

 

 29

 

   Results of Operations of NovaStar Mortgage, Inc.--ThreeInc.—Six Months
   Ended March 31,June 30, 1999 Compared to the Six Months Ended June 30, 1998
   
 
 
            The following
   table presents a summarized income statement of NovaStar Mortgage,
   Inc. for the six months ended June 30, 1999 and 1998:
 

   Table 26

   NovaStar Mortgage, Inc.—Statements of Operations

   Six Months Ended June 30 (dollars in thousands)
 
  1999
 1998
Net interest income  $2,605 $376 
Services provided to NovaStar Financial, Inc.
      2,576  4,671 
Fees from third parties  592 1,617 
Gains on sale of mortgage assets  6,044 412 
Expenses:
        
       Production  4,668 3,684 
        
       Servicing  2,337 1,363 
        
       Other  3,044 2,038 
 
 
Income (loss) before taxes  1,768 (9)
Income tax expense  234 —   
 
 
Net income (loss)  $1,534 $(9)
 
 
 
 
            The following
   summarizes changes in net earnings of NovaStar Mortgage for the six
   months ended June 30, 1999 compared with the same period of 1998:
   
 

     Ÿ
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 recognized $2.6 million
     in net interest income on these loans for the six months ended
     June 30, 1999. The net interest income NovaStar Mortgage
     recognized in 1998 was primarily net interest earned on mortgage
     securities. NovaStar Mortgage sold all of its mortgage securities
     during the latter part of 1998.
 

     Ÿ
The administrative
     fee agreement between NovaStar Financial and NovaStar Mortgage was
     cancelled on April 1, 1999. These fees are included in services
     provided to NovaStar Financial, Inc. The other components of this
     financial statement line-item are discussed further in the “
     Results of Operations of NovaStar Financial, Inc.—Six Months
     Ended June 30, 1999 compared to the Six Months Ended June 30, 1998.
     ”
 

     Ÿ
During the six months
     ended June 30, 1999, NovaStar Mortgage recognized net gains of
     $6.0 million on mortgage loan sales. $1.6 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 recognized $236,000 and $175,000 on sales of
     mortgage securities and mortgage loans, respectively, during the
     same period of 1998.
 

     Ÿ
NovaStar Mortgage
     ’s wholesale origination operation was not operating at full
     capacity during the six months ended June 30, 1999 compared with
     the six months ended June 30, 1998. NovaStar Mortgage’s costs
     of loan production as a percent of principal averaged 5.3% for the
     first half of 1999 versus 1.4% during the first half 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.
 

     Ÿ
NovaStar Mortgage
     ’s servicing staff doubled from June 30, 1998 to June 30,
     1999. This increase is due to growth in the loan servicing
     portfolio, which averaged $791 million for the six months ended
     June 30, 1998 compared with $1.1 billion for the six months ended
     June 30, 1999.
 

     Ÿ
NovaStar Mortgage
     recognized $140,000 in provisions for credit losses for the six
     months ended 
June 30, 1999, which are included
     as a component of other expenses compared with $24,000 during the
     same period of 1998.
 

     Ÿ
NovaStar Mortgage
     remitted $186,000 in premium payments to CMAC during the six
     months ended June 30, 1999, which are included as a component of
     other expenses. The agreement with CMAC was executed during the
     third quarter of 1998.
 

     Ÿ
Other departments of
     NovaStar Mortgage, including systems, quality control, and
     administration added staff from June 30, 1998 to June 30, 1999 to
     compensate for general company growth.
 

     Ÿ
Other expense for the
     six months ended June 30, 1999 also includes the development and
     design costs incurred for NovaStar Mortgage’s portion of the
     automated underwriting and origination system, Internet
     Underwriter, which was introduced during the second quarter of
     1999.
 

   Results of Operations of NovaStar Mortgage, Inc.—Three Months
   Ended June 30, 1999 Compared to the Three Months Ended March 31, 1998June 30, 1998.
   
 
 
            The following
   table presents a summarized income statement of NovaStar Mortgage,
   Inc. for the three months ended March 31,June 30, 1999 and 1998:
 

   Table 2427

   NovaStar Mortgage, Inc.--StatementsInc.—Statements of Operations

   Three Months Ended March 31June 30 (dollars in thousands)
 

 

  
  1999
 1998
                                                                 ------ ------
      
Net interest income....................................... $1,172 income  $  116
      1,433 $260
Services provided to NovaStar Financial, Inc..............  2,165  2,130
      Inc.
      411 2,541
Fees from third parties...................................    342    680
      parties  250 937
Gains on sale of mortgage assets..........................  2,826    --
      assets  3,218 412
Expenses:
        Production..............................................      
     Production  2,334  1,744
        Servicing...............................................  1,215    596
        Other...................................................  1,944    860
                                                                 ------ ------
        1,940
     Servicing  1,122 767
     Other  1,099 1,178
 
Income (loss) before taxes................................  1,012   (274)
      taxes  757 265
Income tax expense........................................    234    --
                                                                 ------ ------
      expense  —  — 
 
Net income (loss).........................................  $  778 757 $ (274)
                                                                 ====== ======265
 

 
 
 
            The following
   summarizes the explanation for the increase in net earnings of
   NovaStar Mortgage for the three months ended March 31,June 30, 1999 compared
   with the same period of 1998:
 
  .  Beginning July 1,
 

     Ÿ
Net interest income
     for the months ended June 30, 1999 was generated from NovaStar
     Mortgage’s mortgage loan portfolio. For the same period of
     1998, net interest income was generated from mortgage security
     investments. The change in portfolio composition between the two
     periods is discussed under “Results of Operations of NovaStar
     Mortgage, Inc.—Six Months Ended June 30, 1999 Compared to the
     Six Months Ended June 30, 1998.”
 

     Ÿ
The administrative
     fee agreement between NovaStar Financial and NovaStar Mortgage was
     cancelled on April 1, 1999. These fees are included in services
     provided to NovaStar Financial, Inc. The other components of this
     financial statement line-item are discussed further in the “
     Results of Operations of NovaStar Financial, Inc.—Six Months
     Ended June 30, 1999 compared to the Six Months Ended June 30, 1998.
     ”
 

     Ÿ
During the three
     months ended June 30, 1999, NovaStar Mortgage recognized net gains
     of 
$3.2 million on mortgage loan
     sales. $343,000 of the gains recognized was a result of the second
   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
     recognized net gains of $175,000 on mortgage loan sales during the
     three months ended June 30, 1998, all of which were sold to
     external parties. Also, included in this line-item for the three
     months ended June 30, 1998 are mortgage securities gains of
     $236,000.
 

     Ÿ
NovaStar Mortgage
     ’s wholesale origination operation was not operating at full
     capacity during the three months ended June 30, 1999 compared with
     the three months ended June 30, 1998. NovaStar Mortgage’s
     costs of loan production as a percent of principal averaged 4.5%
     for the second 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.
 

     Ÿ
NovaStar Mortgage
     ’s average servicing staff increased from June 30, 1998 to
     June 30, 1999 due primarily to an increase in the average mortgage
     loan portfolio volume serviced. The average mortgage loan
     servicing portfolio during the three months ended June 30, 1999
     was $1.1 billion compared with $911,000 during the same period of
     1998.
 

     Ÿ
Other departments,
     including systems, quality control, and administration expanded
     staff from June 30, 1998 to June 30, 1999 to compensate for
     general company growth.
 

     Ÿ
Other expenses for
     the six months ended June 30, 1999 also includes the development
     and design costs incurred for NovaStar Mortgage’s portion of
     the automated underwriting and origination system, Internet
     Underwriter, which was introduced during the second quarter of
     1999.
 

   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 recognized approximately $1
     million in net interest income on these loans for the three 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
     production as a percent of principal averaged 5.8% for the first 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 March
     31, 1998 compared with $1.1 billion for the three months ended March 31,
     1999.
 
                                       30

 
  .  NovaStar Mortgage recognized $159,000 in provisions for credit losses
     for the three months ended March 31, 1999, which are included as a
     component of other expenses. No provisions were recognized during the
     same period of 1998 as NovaStar Mortgage did not begin holding loans in
     portfolio until July 1, 1998.
 
  .  NovaStar Mortgage remitted $150,000 in premium payments to CMAC during
     the three months ended March 31, 1999, which are included as a component
     of other expenses. The agreement with CMAC was executed during the third
     quarter of 1998.
 
  .  Other departments of NovaStar Mortgage, including systems, quality
     control, and administration added staff from March 31,1998 to March 31,
     1999 to compensate for general company growth.
 
Recent Developments of NFI Holding,Capital, Inc.
 
 
            NovaStar
   Capital, Inc. was formed to focus on acquiring nonconforming
   residential mortgage loans from banks, thrifts and credit unions.
   Management plans to buildis building a sales force of account executives to
   develop a nationwide network of financial institutions to complement
   the wholesale origination operation of NovaStar Mortgage. Management
   believes this is another effective means of acquiring mortgage loans
   at a lower cost than achieved inlow-cost versus secondary market purchases. The short-term
   intent is to treat these loans similar to NovaStar Mortgage'sMortgage’s
   wholesale loan originations--tooriginations—to hold in portfolio to be sold
   either to independent third parties or in securitizations.
 
 
            During the six
   months ended June 30, 1999 and the three months ended June 30, 1999,
   NovaStar Capital incurred net losses of $583,000 and $363,000,
   respectively. NovaStar Capital’s operations for these periods
   primarily consist of compensation costs.
 

   Recent Developments
 
 
            During the
   second quarter of 1999, NovaStar Mortgage and NovaStar Capital
   announced “Internet Underwriter” or “IU”, an
   automated underwriting and origination system. IU represents full
   web-based underwriting and will provide NovaStar Mortgage and
   NovaStar Capital customers with the ability to receive an
   underwriting decision and approval within minutes. IU is currently
   being used by a select group of customers and will continue to be
   rolled out during the third quarter of 1999. In addition to being
   very easy to use, IU will provide certain unique features, such as
   the ability to adjust borrowers’ debt prospectively and to
   correct erroneous credit report information.
 
 
            IU will be
   available for use across the United States through a proprietary
   online network/website. IU will be accessible 24 hours a day, seven
   days a week with an approved customer ID and password. In addition
   to receiving underwriting approval, customers will also be able to
   lock the interest rate on the loan as well as order and receive loan
   closing documents.
 
 
              In
   connection with the introduction of IU, NovaStar Financial
   officially launched its website on July 1, 1999
   (www.e-Novastar.com). In addition to serving as the access point for
   IU, the website allows for the viewing and downloading of various
   company information, including press releases, annual reports and
   all filings with the Securities and Exchange Commission.
 
 
            Also, during
   the second quarter of 1999, NovaStar Mortgage received notification
   that it has been approved as a Fannie Mae seller/servicer.
 

   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 NovaStar Financial'sFinancial
   ’s stockholders. This added value is demonstrated in the
   estimated fair value of NovaStar Financial'sFinancial’s loan portfolio.
   The values presented in Tables 25 and 26 are management'smanagement’s
   estimates based on market conditions as of March 31,June 30, 1999.
 
 
            Management
   estimates the weighted-average value of its mortgage loan portfolio
   as of March 31,June 30, 1999 to be between 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 it is originating should warrant a value of 105. However, recent events have resulted
in whole loan prices being severely reduced. Accordingly, anyAny value
   assigned to March 31,June 30, 1999 loans should take into consideration at
   what value the loans could be sold in the open market. During the
   1999 first quarter,half of 1999, NovaStar Financial sold a number of whole loan
   packages at prices that averaged between
103 anda weighted average price of 104. Tables 2528 and 2629
   provide management'smanagement’s estimates of the value of the mortgage
   loans in its portfolio and 1999 firstsecond quarter production and the
   assumptions used for estimating fair value. Because any estimated
   value can vary dramatically based upon the assumptions used, a range
   of assumptions is used to determine the estimated value.
 
 
            During 1999,
   NovaStar Mortgage originated mortgage loans at an all-in cost of
   105.8%105.3% of principal, including direct costs of acquisition, such as
   broker premiums, and general overhead expenses. Table 1921 displays
   costs of production for each quarter. The cost of production during
   the first quarterhalf of 1999 and 1998 third and fourth quarters is higher
   than previous quarters as a result of lower production levels.
   NovaStar Mortgage operated at less than full 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. In 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 March 31,June 30,
   1999 represented 2.3%2.2% of principal. Using the estimated fair values
   from above, this implies an estimated unrealized gain, or additional
   value in the mortgage loan portfolio at March 31,June 30, 1999 of between 1.0%1%
   and 3.0%3%. Applying this percent to the balance of mortgage loans
   outstanding of $848$790 million results in an estimated unrealized gain
   of between $9$8 and $26$24 million. This additional value results in an
   estimated mark-to-market equity at March 31,June 30, 1999 of $129-$12.9-$14614.5
   million, or $10.39-11.76$10.39-11.68 per outstanding share, compared with a book
   value per outstanding share of $9.64.$9.87. On a diluted basis, book value
   per share at March
31,June 30, 1999 is $9.23,$9.43, while a mark-to-market book
   value is $9.40-10.64.$9.41-10.57.
 

   Table 2528

   Estimated Market Price on Entire Loan Portfolio

   As of March 31,June 30, 1999
 

 

  
  Estimated Market Price
                                         -------------------------
                                          
      
   

   Two- and Three-year
   

   Fixed Loan Products
Bond Equivalent Yield  8.40% 8.65% 8.90%
Spread to Index  2.75% 3.00% 3.25%
Assumed Prepayment
   

        Speed (CPR)
35  105.1% 104.6% 104.2%
40  104.4% 104.0% 103.5%
45  103.8% 103.4% 103.0%
  Estimated Market Price
  30/15-year Fixed and
   
Balloon Loan Products
   
(Three-year Treasury)
                                         -------------------------
                        
Bond Equivalent Yield..........   8.03%    8.28%    8.53%
                        Yield  8.09% 8.34% 8.59%
Spread to Index..........   3.50%    3.75%    4.00%
                        Index  2.50% 2.75% 3.00%
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%
25  105.1% 104.5% 103.9%
30  104.4% 103.9% 103.3%
35  103.8% 103.4% 102.9%

 

 

  
                       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)
35.................. 104.9% 104.4% 103.9%
40.................. 104.2% 103.8% 103.4%
45.................. 103.7% 103.3% 102.9%

  One-year CMT Loan
   
Products
                     --------------------

Bond Equivalent Yield..............  7.27%  7.52%  7.77%
Yield  7.80% 8.05% 8.30%
Spread to Index.....  Index  2.75% 3.00% 3.25%
Assumed Prepayment
   

        Speed (CPR)
35.................. 104.7% 104.2% 
35  104.9% 104.4% 104.0%
40  104.3% 103.8% 103.4%
45  103.7%
40.................. 104.1% 103.7%  103.3%
45.................. 103.6% 103.2% 102.9% 103.0%

 

 

  
  Six-month LIBOR Loan
   
Products
                         -------------------------

Bond Equivalent Yield..    8.06%    8.31%    8.56%
Yield  8.65% 8.90% 9.15%
Spread to Index..          Index  3.00% 3.25% 3.50%
Assumed Prepayment
   

        Speed (CPR)
40...............         
40  105.0% 104.6% 104.2%
45...............         
45  104.4% 104.0% 103.7%
50...............         
50  103.8%   103.5%   103.2% 103.4% 103.1%

 

 
 
Table 2629

   Estimated Market Price of Loans Originated in FirstSecond Quarter of 1999
   
 

  
  Estimated Market Price
                     --------------------
                     
  Two- and Three-year
   
Fixed Loan Products
                     --------------------

Bond Equivalent Yield..............  7.81%  8.06%  8.31%
Yield  8.15% 8.40% 8.65%
Spread to Index.....  Index  2.50% 2.75% 3.00%  3.25%

Assumed Prepayment
   

        Speed (CPR)
30.................. 105.1% 104.5% 
30  106.0% 105.4% 104.8%
35  104.9% 104.4% 103.9%
35.................. 104.3% 103.8% 103.4%
40.................. 103.8% 103.3% 102.9%
40  104.1% 103.6% 103.2%

 

 

  
  Estimated Market Price
                                                 -------------------------
                                                  
  30/15-year Fixed and
   
Balloon Loan Products
                                                 -------------------------
                        
Bond Equivalent Yield..    8.03%    8.28%    8.53%
                        Yield  8.09% 8.34% 8.59%
Spread to Index..........           3.50%    3.75%    4.00%
                        Index  2.50% 2.75% 3.00%
Assumed Prepayment
   

        Speed (CPR)
                        25..............          105.4%   104.7%   104.1%
                        30..............          104.6%   104.1%   103.5%
                        35..............          104.0%   103.5%   103.1%
20  105.9% 105.2% 104.4%
25  105.0% 104.4% 103.8%
30  104.3% 103.8% 103.3%

 

 32

 

   Liquidity and Capital Resources
 

   Liquidity means the need for, access to and uses of cash. The
   primary needs for cash include the acquisition of mortgage loans,
   principal repayment and interest on borrowings, operating expenses
   and dividend payments. Substantial cash is required to support the
   operating activities of the business, especially the mortgage
   origination operation. 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 quartersix months of
   1999, NovaStar Financial also improved its equity and liquidity
   positions significantly by:
 
  .
 
Ÿ
 Increasing borrowing capacity with First Union National Bank to nearly
   $400 million in February 1999.
 
  .
 
Ÿ
 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 management 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 March 31,June 30, 1999, NovaStar
   Mortgage owned $84$104.1 million of subprime 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 changing
   market valuation and margin calls. Management expects to continue
   selling loans originated by NovaStar Mortgage or securitizing those
   loans at a profit to meet the significant cash needs of the
   wholesale loan operation. However, management intends to raise sufficient capital during 1999 to begin
acquiring a majority of NovaStar Mortgage's production during the second half
of the year. Management believes NovaStar Financial can
   operate indefinitely in this manner, provided that the level of loan
   originations are at or near the capacity of its production
   infrastructure.
 
                                       33

 
         
    Table 2730 is a summary of financing arrangements and available
   borrowing capacity under those arrangements as of March 31,June 30, 1999:
   
 
Table 27
                              30
Liquidity Resources
                     March 31,
June 30, 1999

 (dollars in thousands)
 

 

  
  Maximum
   
Borrowing
   

   Limit
 Value of
   Limit

   Collateral
 Borrowings
 Availability
                                   --------- ---------- ---------- ------------

Resource
Cash..............................                                       
Cash        $ 2,403
168
      
First Union
     National Bank (A):  
   
            Committed warehouse line
     of credit......................... credit  $75,000   $42,403    $22,660      19,743 $60,906
       $36,597 24,309
      
   
            Committed secured whole
     loan repurchase
   agreement...........  

              
         agreement 		 300,000    42,495     42,495         -- 43,363
       43,363 —  
     
      
   
            Committed residual
     financing available under
   CMOs...........   

              
         CMOs 		 20,000        (B)       --        (B) —  
      20,000
                                                         -------     -------
    Total.........................                       $65,155     $42,146
                                                         =======     =======

      
      
 
 
   
                
           Total.      $79,960 $44,477
      
    
 
Total availability
     as a percent of:
   
            Total assets....................                                      4.46%
                                                                     =======assets        5%
     
 
   
            Total stockholders' equity......                                      3.52%
                                                                     =======stockholders’
     equity        37%
     
 

 

 - --------
(A) Value of collateral and borrowings include amounts for both NovaStar
    Financial and NovaStar Mortgage as they are co-borrowers under the
    arrangements with First Union National Bank.
(B) Management estimates the value of the residuals range from $50 to $70
(A)
Value
     of collateral and borrowings include amounts for both NovaStar
     Financial and NovaStar Mortgage as they are co-borrowers under the
     arrangements with First Union National Bank.
(B)

     Management estimates the value of the residuals range from $60 to
     $80 million and does not include the value of mortgage servicing
     rights.
 
         
    Cash activity during the threesix months ended March 31,June 30, 1999 and
   1998 are presented in the consolidated statement of cash flows.
   
 
 
              Capital allocation guidelines. Management's    
   Management’s goal is to balance between the under-utilization
   of leverage, which reduces returns to stockholders, and the
   over-utilization of leverage, which could reduce the ability of
   NovaStar to meet its obligations during adverse market conditions.
   Capital allocation guidelines have been approved by the Board of
   Directors. The guidelines are intended to keep NovaStar properly
   leveraged by:
 
  .Matching the amount of leverage allowed to the riskiness on return and
     liquidity of an asset; and
 
  .Monitoring the credit and prepayment performance of each investment to
     adjust the required capital.
 
                                       34

 

     Ÿ
Matching the amount
     of leverage allowed to the riskiness on return and liquidity of an
     asset; and
 

     Ÿ
Monitoring the credit
     and prepayment performance of each investment to adjust the
     required capital.
 
 
            This analysis
   takes into account hedging instruments and other risk programs
   discussed below. Balance sheet leverage is controlled by monitoring
   capital allocation. Following presents a summary of the capital
   allocation guidelines for the following levels of capital for
   various types of assets it owns.
 

   Capital Allocation Guidelines
                                 March 31,

   June 30, 1999

 

  
Asset Category
 (A)
   

   Minimum
   

   Lender
   

   Haircut
 (B)
   

   Estimated
   

   Price
   

   Duration
 (C)
   

   Duration
   

   Spread
   

   Cushion
 (D)
   

   Liquidity
   

   Spread
   

   Cushion
 (E)
   

   (c + d)
   

   Total
   

   Spread
   

   Cushion
 (F)
   (E)

   (b x e)
   

   Equity
   

   Cushion
   

   (% of
   

   MV)
 (F)
   (A)       (B)      (C)       (D)    (c + d) Equity

   (a + f)
   Minimum  Estimated Duration Liquidity  Total  Cushion

   CAG
   Lender     Price    Spread   Spread   Spread   (% of

   Equity
   Asset Category           Haircut  Duration  Cushion   Cushion  Cushion   MV)

   Required
- --------------           -------  --------- -------- --------- ------- ------- --------

Agency-issued:
        
      Conventional ARMs.....   3.00%    3.50%      ARMs  3.00% 3.50% 50        --        — 50    1.75%     4.75% 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 
Mortgage loans:  
        
      Collateral for warehouse
   financing..   

              
       financing 		 2.00  3.00  100 50 150 4.50  7.50 
        
      Collateral for CMO....   CMO  5.00      --       --         --      --      --         —    —   — —   —    5.00
  Delinquent............  
        
      Delinquent  100.00      --       --         --      --      --       —    —   — —   —    100.00
Hedging.................    --       --       --         --      --      --       5.80
Other...................  
Hedging  —    —    —   — —   —    5.23 
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 are
    substantially less liquid, and have more price volatility than agency
    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 treasury 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
    NovaStar 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
(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 are
     substantially less liquid, and have more price volatility than
     agency 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 treasury 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
     NovaStar 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--markguidelines—mark to
   market.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
   capital 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 management
   to predict or hedge the risk of the asset.
 
 
                                       35

 
 
            Table 2831 is a
   summary of the capital allocation for NovaStar Financial as they
   apply to mortgage assets and hedging instruments during 1999 and
   1998.
 

   Table 2831

   Required Equity
 

 

  
  1999
 1998
                          --------  -------------------------------------------
                          
  June 30
 March 31
 December 31
 September 30
 June 30
 March 31
                          --------  ----------- ------------ --------  --------

Category  
Mortgage loans:  
        
       Current unsecuritized
   loans................  

              
         loans 		 $4,397  $  3,823    $12,648       $12,648  $14,567  $21,566  $23,628 
        
       Delinquent unsecuritized
   loans..     

              
         loans 		 868  1,197  1,685  452  601  1,200 
        
       Securitized loans.....    loans  47,000  49,894  64,548  55,822  37,766  23,478 
Mortgage securities.....       --         --        securities  —   —    —    19,514  24,904  27,426 
Other assets............    assets  13,501  13,861  12,536  20,682  13,782  10,733 
Hedging instruments.....      (100)      (179)        (688)      (232)     (203)
                          --------    -------     --------   --------  --------
instruments  (35) (100) (179) (688) (232) (203)
  
  
  
  
  
  
 
Required equity.........    equity  65,731  68,675  91,238   110,349  98,387  86,262
Stockholders' equity.... 
Stockholders’ equity   121,237   119,712  87,204  109,848   114,875  115,798 
Market value in excess of the
   

             carrying
     value of assets
   

             and
     hedges...............     hedges 		   1,482  5,961  2,331  31,999  20,685
                          --------    -------     --------   --------  --------
 
  8,536 
 
 
 
 
 
  
  
  
  
  
  
 
Excess equity...........  equity  $64,042  $52,519  $1,927  $1,830  $48,487  $ 50,221
                          ========    =======     ========   ========  ======== 
 
 
 
 
 
 
 

 

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

   Impact of Recently Issued Accounting Pronouncements
 
 
            Note 1 to the
   consolidated financial statements of the annual report to
   shareholders and annual report on Form 10-K for the year ended
   December 31, 1998 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.
 

   The Year 2000
 
 
            NovaStar
   Financial and NovaStar Mortgage are highly dependent on purchased
   and leased computer software to conduct business. In addition,
   NovaStar Financial and NovaStar Mortgage are highly dependent on
   computer software used by market counterparties and vendors,
   including banks, in conducting business. Management recognizes that
   some computer software may not have the ability to correctly
   identify dates beyond December 31, 1999. Successful modification of
   computer software, or the vendors'vendors’ successful modification of
   their programs, to be year 2000 compliant is critical to the
   viability of NovaStar Financial 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 operations are as follows:
 
     .The internally developed loan origination and database system
 
     .The externally provided loan servicing system
 
     .The
 
     
          Ÿ
   The internally developed loan origination and database system
 
     
          Ÿ
   The externally provided loan servicing system
 
     
          Ÿ
   The purchased accounting system
 
 
            In addition,
   NovaStar Financial and NovaStar Mortgage integrate with a number of
   outside entities in normal business transactions. Interfaces with
   other businesses and third party solution providers are used to
   conduct some business processes. Other processes are supported by
   systems created internally.
 
 
            NovaStar
   Financial and NovaStar Mortgage are using the Federal Financial
   Institutions Examination Council'sCouncil’s (FFIEC) "Year“Year 2000
   Project Management Awareness"Awareness” document to guide year 2000
   readiness efforts. Each program/system interface used by NovaStar
   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'sFinancial’s and NovaStar Mortgage'sMortgage’s
   projected timeline is as follows:
 
            
 
 
            In the
   assessment phase, management has determined which business
   processes/interfaces rely on dates and date arithmetic. Most
   business processes/interfaces rely on dates and date arithmetic. All
   internally developed business processes/interfaces have been tested
   for compliance. Based 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-complaintnon-compliant Year 2000 software should bewere made in the
   correction phase. Corrections on NovaStar Financial and NovaStar
   Mortgage developed software will bewere made internally and are expected to bewere
   insignificant. NovaStar Financial and NovaStar Mortgage are
   requiring all market counterparties and vendors to document they
   have made all corrections.
         
      NovaStar Financial and NovaStar Mortgage staff will conduct "mock"conducted
   “mock” business as if it iswas in the year 2000 during the
   validation phase, scheduled for the
second quarter of 1999.1999—the validation phase of NovaStar
   Financial’s and NovaStar Mortgage’s year 2000 readiness
   efforts. During this phase, NovaStar Financial and NovaStar Mortgage
   will testtested all internally developed software as well as vendor
software.
 
         
    NovaStar Financial and NovaStar Mortgage have contacted all
   significant outside market counterparties and vendors to obtain
   documentation regarding their process and status for assuring year
   2000 compliance. Management has asked that each party adhere to the
   same FFIEC guidelines and to provide 37
documents of progress during
   each phase. NovaStar Financial and NovaStar Mortgage have received
   written confirmation from Alltel Residential Lending Solutions,
   vendor of NovaStar Mortgage'sMortgage’s servicing system and Baan/CODA,
   vendor of NovaStar Financial'sFinancial’s and NovaStar Mortgage'sMortgage’s
   accounting system stating that the versions currently used are fully
   year 2000 compliant. The Baan/CODA accounting system was
   successfully tested internally for Year 2000 compliance.
 
         
    All internally developed software was designed to be year 2000
   complaint.compliant. In addition, management has contacted its significant
   financial counterparty, First Union National Bank, who is completing
   their internal review of year 2000 compliance.
 
         
    Management believes the greatest risk in regard to year 2000
   compliance is the software and systems used to service its subprime
   mortgage loans. NovaStar Mortgage services the 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"“unserviced” for an extended
   period of
 time--several
weeks--the

 time—several weeks—the result could have a material adverse
   impact to 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 NovaStar Financial and NovaStar Mortgage are relying for
   financing and cash management fail. In a worst case scenario,
   NovaStar 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 NovaStar 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 NovaStar Financial and NovaStar Mortgage for these systems'systems
   ’ 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 NovaStar
   Financial and NovaStar Mortgage. Based on the information provided,
   management believes these vendors will meet their obligation for
   resolution of year 2000 issues.
 
         
    Management 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 management
   determines that any market counterparty will not be year 2000
   compliant.
 

 Item 3.    Quantitative and Qualitative
   Disclosures About Market Risk
 
Interest Rate/Market Risk
 
         
    Loan Price volatility.volatility.    
   Under its current mode of operation, NovaStar Financial depends
   heavily on the market for wholesale subprime mortgage loans. WithoutTo
   conserve capital, to support the purchase and retention of mortgage loans, NovaStar willmay sell loans originated by
 NovaStar Mortgage. The financial 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 mitigatesExposure to loan price volatility. Price
   volatility will be eliminated whenreduced as NovaStar Financial can raise capital and resumeresumes 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'sFinancial’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,June 30, 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,June 30, 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"“ 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 effectedaffected as the asset rate resets would "lag"“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. The risks are analyzed on both
   an income and market value basis.
 
 
            Table 2932 is a
   summary of the analysis as of March 31,June 30, 1999 and December 31, 1998.
   
 
Table 2932

   Interest Rate Sensitivity
                      March 31,Sensitivity-Income

   June 30, 1999 and December 31, 1998
 

 

  
  Basis Point Increase (Decrease)
     in Interest
                              -------------------------------------------
                                                 Rate(B)
                                              ----------------
   
    Rate(A)
  
As of March 31, 1998(A)        June 30, 1999
 (100)          Base(C)           
 Base(B)
 100
   -----------------------    --------------  ------------------------------
   
Income from:
     Assets..................        $84,496         $86,728         $88,879
     Liabilities.............         50,519          58,330          66,412  
        
       Assets  $77,262  $79,792  $82,096 
        
       Liabilities  47,328  54,261  61,437 
        
       Interest rate agreements.............         (1,781)         (1,781)            570
                              --------------  --------------  --------------
   agreements  (1,582) (1,582) 394 
 
 
 
 
Net spread income.........        $32,196         $26,617         $23,037
                              ==============  ==============  ==============
   income  $28,352  $23,949  $21,053 
 
 
 
 
Cumulative change in income from base (C)..... (B)
      $        5,579             --   4,403  —    $       (3,580)
   (2,896)
Percent change from base spread income (D)........           21.0%            --            (13.4)(C)
      18.4%
                              ==============  ==============  ==============
    —    (12.1)%
 
 
 
 
Percent change of capital(E)...............           4.66%            --            (2.99)capital(D)  3.6%
                              ==============  ==============  ============== —    (2.4)%
 
 
 
 

 

 - --------
(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


 

  
(A)
Income of asset,
     liability or interest rate agreement in a parallel shift in the
     yield curve, up and down 1%.
(B)
Total change in
     estimated spread income, in dollars, from “base.” “
     Base” is the estimated spread income
   

   at June 30, 1999.
(C)
Total change in
     estimated spread income, as a percent, from base.
(D)
Total change in
     estimated spread income as a percent of total stockholders’
     equity at June 30, 1999.
 
  Basis Point Increase (Decrease)
     in Interest
                                 -------------------------------------------
                                                    Rate(G)
                                                 ----------------
   
    Rate(F)
  
As of December 31, 1998(F)        1998
 (100)          Base(H)           
 Base(G)
 100
   --------------------------    --------------  ------------------------------
   
Income from:
     Assets....................         $80,507         $82,310         $83,966
     Liabilities...............            
        
       Assets  $80,507  $82,310  $83,966 
        
       Liabilities  47,546  55,259  63,233 
        
       Interest rate agreements..          (2,244)         (2,244)            agreements  (2,244) (2,244) 107
                                 --------------  --------------  --------------
    
 
 
 
 
Net spread income...........         $30,717         $24,807         $20,840
                                 ==============  ==============  ==============
   income  $30,717  $24,807  $20,840 
 
 
 
 
Cumulative change in income from base (H)..............  (G)
      $5,910             --     —    $3,967 
Percent change from base spread income (I)..........            23.8%            --            (16.0)(H)
      23.8%
                                 ==============  ==============  ==============
    —    (16.0)%
 
 
 
 
Percent change of capital(J).................            6.77%            --            (4.54)capital(I)  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"
(F)
Income of asset,
     liability or interest rate agreement in a parallel shift in the
     yield curve, up and down 1%.
(G)
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.
     
(H)
Total change in
     estimated spread income, as a percent, from base.
(I)
Total change in
     estimated spread income as a percent of total stockholders’
     equity at December 31, 1998.
 

   Table 33

   Interest Rate Sensitivity—Market Value

   June 30, 1999 and December 31, 1998
 
  Basis Point Increase (Decrease)
     in Interest
    Rate(A)
  
As of June 30, 1999
 (100)
 Base(B)
 100
Income from:  
        
       Assets  $932,612  $921,681 $908,502 
        
       Liabilities  858,700  856,590 854,122 
        
       Interest rate agreements  460  1,951 5,699 
 
 
 
Net market value  $74,372  $67,042 $60,079 
 
 
 
Cumulative change in market value from base (B)
      $7,330  —   $(6,963)
Percent change of market value portfolio equity
     (C)  5.6% —   (5.3)%
 
 
 
(A)
Market value of
     assets, liabilities or interest rate agreements in a parallel
     shift in the yield curve, up and down 1%.
(B)
Total change in
     estimated market value, in dollars, from “base.” “
     Base” is the estimated market value at June 30, 1999.
(C)
Total change in
     estimated market value as a percent of market value portfolio
     equity at June 30, 1999.
 
  Basis Point Increase (Decrease)
     in Interest
    Rate(D)
  
As of December 31, 1998
 (100)
 Base(E)
 100
Income from:  
        
       Assets  $933,171  $919,955 $905,059 
        
       Liabilities  883,706  882,992 882,279 
        
       Interest rate agreements  271  1,194 3,969 
 
 
 
Net market value  $49,736  $38,157 $26,749 
 
 
 
Cumulative change in market value from base (E)
      $11,579  —   $(11,408)
Percent change of market value portfolio equity
     (F)  12.4% —   (12.2)%
 
 
 
(D)
Market value of
     assets, liabilities or interest rate agreements in a parallel
     shift in the yield curve, up and down 1%.
(E)
Total change in
     estimated market value, in dollars, from “base.” “
     Base” is the estimated market value at December 31, 1998.
     
(F)
Total change in
     estimated market value as a percent of market value portfolio
     equity at December 31, 1998.
 
 
            Interest
   rate sensitivity analysis.    The values
   under the heading "Base"“Base” are management'smanagement’s estimates
   of spread income and market value for assets, liabilities and
   interest rate agreements on December 31, 1998. The values under the
   headings "100"“100” and "(100)"“(100)” are management'smanagement’s
   estimates of the income and market value of those same assets,
   liabilities and interest rate agreements assuming that interest
   rates were 100 basis points, or 1 percent higher and lower. The
   cumulative change in income or market value represents the change in
   income or market value of assets from base, net of the change in
   income or market value 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 1025 percent or more cumulative decrease in
   income from base, or a 10% cumulative decrease in market value from
   base, policy requires management to adjust the portfolio by adding
   or removing interest rate cap or swap agreements. The Board of
   Directors reviews and approves NovaStar Financial'sFinancial’s interest
   sensitivity and hedged position quarterly.
 
 
            
   Assumptions used in interest rate sensitivity analysis.  
     Management uses estimates in determining the
   income and market value of assets, liabilities and interest rate
   agreements. The estimation process is dependent upon a variety of
   assumptions, especially in determining the income and market value
   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,June
   30, 1999 and December 31, 1998.
 
   Management's
 
 
            Management
   ’s analysis for assessing interest rate sensitivity on its
   subprime mortgage loans relies significantly on estimates for
   prepayment speeds. A prepayment model has been internally developed
   based upon four main factors:
 
  . Refinancing incentives (the interest rate of the mortgage compared with
    the current mortgage rates available to the borrower)
 
  . Borrower credit grades
 
  . Loan-to-value ratios
 
  . 
 

     Ÿ
Refinancing
     incentives (the interest rate of the mortgage compared with the
     current mortgage rates available to the borrower)
 

     Ÿ
Borrower credit grades
     
 

     Ÿ
Loan-to-value ratios
     
 

     Ÿ
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"“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'smanagement’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 model and the projected results as shown
   in the above table.
 
 
            NovaStar
   Financial'sFinancial’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'sFinancial’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 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 interestratesinterest rates would
   require action to adjust the portfolio to adapt to changing rates.
   The investment policy for NovaStar Financial allows for no more than
   a ten25 percent decrease in the spread income of the portfolio and for
   no more than a 10% decrease in the market value of the portfolio
   when interest rates rise or fall by one percent.
 
 
            
   Sensitivity as of March 31,June 30, 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%3.63% and 6.77% of capital as of March 31,June 30, 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%2.39% and 4.54% of capital as of March
31,June 30, 1999 and December 31, 1998,
   respectively. If interest rates were to decrease one percent, the
   market value of portfolio equity would increase by an estimated 5.6%
   and 12.4% as of June 30, 1999 and December 31, 1998, respectively.
   If interest rates rise by one percent, the market value of portfolio
   equity would decrease by an estimated 5.3% and 12.2% as of June 30,
   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
   adjustable-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'smanagements’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 "counter-party"“counter-party”. The counter-party
   agrees to make payments to NovaStar Financial in the future should
   the one- or three-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.
 
Ÿ
   enters into ISDA Master Agreements with each counterparty,
 
Ÿ
   deals with counterparties with BBB/Baa ratings or higher from S&
     P and Moody’s, respectively 
 
Ÿ
   measures the risk on at least a monthly basis,
 
Ÿ
   obtains bilateral cross collateralization agreements on each
     agreement, and
 
Ÿ
   obtains the right for margin calls when hedges are in gain positions
     for NovaStar Financial.
 
 
            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-
monththree-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 hedging transaction over the life 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 offset 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“Federal Income Tax Consequences"Consequences
   ” of NovaStar Financial'sFinancial’s 1998 Annual Report on Form 10K.
   
 
 
            Table 11 of
   "Management's“Management’s Discussion and Analysis of Financial
   Condition and Results of Operations"Operations” provides a summary of
   hedging instruments owned by NovaStar Financial as of March 31,June 30, 1999
   and December 31, 1998.
 
                                       42

 
                           PART II. OTHER INFORMATION
 

 Item 1.    Legal Proceedings
 
         
    As of March 31,June 30, 1999, there were no material legal proceedings
   pending to which NovaStar Financial was a party or of which any of
   its property was subject.
 

 Item 2.    Changes in Securities
 
   On February 12,
 
         
    Not applicable.
 

 Item 3.    Defaults upon Senior Securities
 
         
    Not applicable
 

 Item 4.    Submission of Matters of Vote of
   Security Holders
 
         
    (a) The 1999 annual meeting of shareholders of NovaStar
   Financial, issued to First Union National Bank
350,000 warrants to purchaseInc. was held on June 9, 1999.
 
         
    (b) The following matters were voted on at the annual meeting:
   
 
  Vote
  For
 Against
 Abstain
 Broker Non-Votes
     
1. Election of
     Directors        
   
       Scott F. Hartman 6,287,690 0 36,534 1,805,845
   
       Bart O. Johnson 6,287,690 0 36,534 1,805,845
 
   
            The following Directors
     ’ terms of office continue after the meeting:
 
   
            W. Lance Anderson
   
            Gregory T. Barmore
   
            Edward W. Mehrer
 
  Vote
  For
 Against
 Abstain
 Broker Non-Votes
     
2. Ratification of
     KPMG LLP as NovaStar Financial,
   

   Inc.’s independent public accountants for 1999		 6,284,580 10,290 29,354 1,805,845
 
  Vote
  For
 Against
 Abstain
 Broker Non-Votes
     
3. Approval of
     amendments to NovaStar Financial,
   

   Inc.’s Executive and Non-Employee Director
   

   Stock Option Plan		 6,058,111 221,435 41,389 1,809,134
 

 Item 5.    Other Information
 
         
    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’s 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 proceedsand the issuance of approximately $30 million, which includes approximately $25 million acquired by
Wallace R. Weitz & Company. Stifel, Nicolaus & Company, Incorporated acted as
placement agent350,000 warrants at $6.94 per
   share and 812,731 warrants at $4.56 per share 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 arrangementarrangements entered into with First Union and
   GMAC/Residential Funding Corporation, respectively, resulted in a
   reduction of the $15.00effective exercise price for holders of the
   December 9, 1996 warrants issued in NovaStar Financial's private placement
in December 1996. The GMAC/Residential Funding Corporation's "tag-along"
warrants are similarly affected.to acquire common stock at $15.00 per
   share. 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.
 
                                      II-1


 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:
 
  11.1 Schedule regarding computation of per share earnings
  
 
11.1 Schedule regarding
     computation of per share earnings
21.1 Subsidiaries of the Registrant
     
27.1 Financial data schedule
 
 
            (b) NovaStar
   Financial has filed the following Form 8-K's:
 
  .  Regarding the announcement of the financing arrangement with First Union
     National Bank and related material financing documents and warrant
     agreement, filed on February 23, 1999.
 
  .  Regarding the March 1999 Class B 7% cumulative convertible preferred
     stock, the GMAC/RFC warrant agreement and the reduction in the 1996
     warrant effective exercise price, filed on April 6, 1999.
 
                                      II-2

 
                            NOVASTAR FINANCIAL, INC.8-K’s:
 

     Ÿ
Regarding the March
     1999 Class B 7% cumulative convertible preferred stock, the
     GMAC/RFC warrant agreement and the reduction in the 1996 warrant
     effective exercise price, filed on April 6, 1999.
 

 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.
 

 
NOVASTAR
     FINANCIAL, INC.
 
DATE: May 12,August 13, 1999                        /s/ Scott F. Hartman
                                          _____________________________________
                                          Scott F. Hartman
                                          Chairman of the Board, Secretary and
                                          Chief Executive Officer
                                          (Principal Executive Officer)
 

/S
   /    SCOTT 
   F. HARTMAN
Scott F. Hartman
     
Chairman of the
     Board, Secretary and
Chief Executive
     Officer
(Principal
     Executive Officer)
 
DATE: May 12,August 13, 1999                        /s/ Rodney E. Schwatken
                                          _____________________________________
                                          Rodney E. Schwatken
                                          Vice President, Controller and
                                          Assistant Treasurer
                                          (Principal Accounting Officer)
 
                                      II-3
/S
   /    RODNEY 
   E. SCHWATKEN
Rodney E. Schwatken
     
Vice President,
     Controller and
Assistant
     Treasurer
(Principal
     Accounting Officer)